Redirect


This site has moved to http://economistsview.typepad.com/
The posts below are backup copies from the new site.

February 29, 2008

Economist's View - 7 new articles

Paul Krugman: Trade and Wages, Reconsidered

Paul Krugman posted a link to a very preliminary draft of a paper he is writing on the relationship between trade and wages. Here is the introduction and concluding paragraph:

Trade and Wages, Reconsidered, by Paul Krugman, February 2008: This is a very preliminary draft for the spring meeting of the Brookings Panel on Economic Activity. Comments welcome.

There has been a great transformation in the nature of world trade over the past three decades. Prior to the late 70s developing countries overwhelmingly exported primary products rather than manufactured goods; one relic of that era is that we still sometimes refer to wealthy nations as "industrial countries," when the fact is that industry currently accounts for almost twice as high a share of GDP in China as it does in the United States. Since then, however, developing countries have increasingly become major exporters of manufactured goods, and latterly selected services as well.

From the beginning of this transformation it was apparent to international economists that the new pattern of trade might pose problems for low-wage workers in wealthy nations. Standard textbook analysis tells us that to the extent that trade is driven by international differences in factor abundance, the classic analysis of Stolper and Samuelson (1941) – which says that trade can have very strong effects on income distribution – should apply. In particular, if trade with labor-abundant countries leads to a reduction in the relative price of labor-intensive goods, this should, other things equal, reduce the real wages of less-educated workers, both relative to other workers and in absolute terms. And in the 1980s, as the United States began to experience a marked rise in inequality, including a large rise in skill differentials, it was natural to think that growing imports of labor-intensive goods from low-wage countries might be a major culprit.

But is the effect of trade on wages quantitatively important? A number of studies conducted during the 1990s concluded that the effects of North-South trade on inequality were modest. Table 1 summarizes several well-known estimates, together with one crucial aspect of each: the date of the latest data incorporated in the estimate.

Krugt1

For a variety of reasons, possibly including the reduction in concerns about wages during the economic boom of the later 1990s, the focus of discussion in international economics then shifted away from the distributional effects of trade in manufactured goods with developing countries. When concerns about trade began to make headlines again, they tended to focus on the new and novel – in particular, the phenomenon of services outsourcing, which Alan Blinder (2006), in a much-quoted popular article, went so far as to call a second Industrial Revolution. Until recently, however, surprisingly little attention was given to the increasingly out-of-date nature of the data behind the reassuring consensus that trade has only modest effects on income distribution. Yet the problem is obvious, and was in fact noted by Ben Bernanke (2007) last year: "Unfortunately, much of the available empirical research on the influence of trade on earnings inequality dates from the 1980s and 1990s and thus does not address later developments." And there have been a lot of later developments.

Krugf1

Figure 1 shows U.S. imports of manufactured goods as a percentage of GDP since 1989, divided between imports from developing countries and imports from advanced countries.[1] It turns out that developing-country imports have roughly doubled as a share of the economy since the studies that concluded that the effect of trade on income inequality was modest. This seems, at first glance, to suggest that we should scale up our estimates accordingly. Bivens (2007) has done just that with the simple model I offered in 1995, concluding that the distributional effects of trade are now much larger.

And there's another aspect to the change in trade: as we'll see, the developing countries that account for most of the expansion in trade since the early 1990s are substantially lower-wage, relative to advanced countries, than the developing countries that were the main focus of concern in the original literature. China, in particular, is estimated by the Bureau of Labor Statistics (2006) to have hourly compensation in manufacturing that is equal to only 3 percent of the U.S. level. Again, this shift to lower-wage sources of imports seems to suggest that the distributional effects of trade may well be considerably larger now than they were in the early 1990s.

But should we jump to the conclusion that the effects of trade on distribution weren't serious then, but that they are now? It turns out that there's a problem: although the "macro" picture suggests that the distributional effects of trade should have gotten substantially larger, detailed calculations of the factor content of trade – which played a key role in some earlier analyses – do not seem to support the conclusion that the effects of trade on income distribution have grown larger. This result, in turn, rests on what appears, in the data, to be a marked increase in the sophistication of the goods the United States imports from developing countries – in particular, a sharp increase in imports of computers and electronic products compared with traditional labor-intensive goods such as apparel.

Lawrence (2008), in a study that shares the same motivation as this paper, essentially concludes from the evidence on factor content and apparent rising sophistication that the rapid growth of imports from developing countries has not, in fact, been a source of rising inequality. But this conclusion is, in my view, too quick to dismiss what seems like an important paradox. On one side, the United States and other advanced countries have seen a surge in imports from countries that are substantially poorer and more labor-abundant than the third-world exporters that created so much anxiety a dozen years ago. On the other side, we seem to be importing goods that are more skill-intensive and less labor-intensive than before. As we'll see, the most important source of this paradox lies in the information technology sector: for the most part there is a clear tendency for developing countries to export labor-intensive products, but large third-world exports of computers and electronics stand out as a clear anomaly.

One possible resolution of this seeming paradox is that the data on which factor-content estimates are based suffer from severe aggregation problems – that developing countries are specializing in labor-intensive niches within otherwise skill-intensive sectors, especially in computers and electronics. I'll make that case later in the paper, while admitting that the evidence is fragmentary. If this is the correct interpretation, however, the effect of rapid trade growth on wage inequality may indeed have been significant.

The remainder of this paper is in four parts. The first part offers an overview of changing U.S. trade with developing countries, in a way that sets the stage for the later puzzle. The second part describes the theoretical basis for analyzing the distributional effects of trade, then shows how macro-level calculations and factor content analysis yield divergent conclusions. The third part turns to the case for aggregation problems and the implications of vertical specialization within industries. A final part considers the implications both for further research and for policy. ...

Implications of the analysis

The starting point of this paper was the observation that the consensus that trade has only modest effects on inequality rests on relatively old data – that there has been a dramatic increase in manufactured imports from developing countries since the early 1990s. And it is probably true that this increase has been a force for greater inequality in the United States and other advanced countries.

What really comes through from the analysis here, however, is the extent to which the changing nature of world trade has outpaced our ability to engage in secure quantitative analysis—even though this paper sets to one side the growth in service outsourcing, which has created so much anxiety in recent years. Plain old trade in physical goods has become remarkably exotic.

In particular, the surge in developing-country exports of manufactures involves a peculiar concentration on apparently sophisticated products, which seems at first to put worries about distributional effects to rest. Yet there is good reason to believe that the apparent sophistication of developing country exports is, in reality, largely a statistical illusion, created by the phenomenon of vertical specialization in a world of low trade costs.

How can we quantify the actual effect of rising trade on wages? The answer, given the current state of the data, is that we can't. As I've said, it's likely that the rapid growth of trade since the early 1990s has had significant distributional effects. To put numbers to these effects, however, we need a much better understanding of the increasingly fine-grained nature of international specialization and trade.

Hillary Clinton and NAFTA

Did Hillary Clinton oppose moving forward on NAFTA in 1993? Robert Reich tells what he remembers:

Hillary and Barack, Afta Nafta, by Robert Reich: Was Hillary Clinton really against NAFTA in 1993? I was in the administration then, and I remember her position quite precisely. And I'll get to that in a moment. But before I do, I want to say something: It's a shame the Democratic candidates for president feel they have to make trade – specifically NAFTA – the enemy of blue-collar workers and the putative cause of their difficulties. NAFTA is not to blame. ... What happened? The economy ... crashed in late 2000, and the manufacturing jobs lost in that last recession never came back. They didn't come back for two reasons: In some cases, employers automated the jobs out of existence... In other cases, employers shipped the jobs abroad, mostly to China – not to Mexico.

NAFTA has become a symbol for the mounting insecurities felt by blue-collar Americans. While the ... winners from trade ... far exceed the losers, there's a big problem: The costs fall disproportionately on the losers -- mostly blue-collar workers who get dumped because their jobs can be done more cheaply by someone abroad...

Even though the winners from free trade could theoretically compensate the losers and still come out ahead, they don't. America doesn't have a system for helping job losers find new jobs that pay about the same as the ones they've lost... There's no national retraining system. Unemployment insurance reaches fewer than 40 percent of people who lose their jobs... We have no national health care system to cover job losers and their families. There's no wage insurance. Nothing. And unless or until America finds a way to help the losers, the backlash against trade is only going to grow.

Get me? The Dems shouldn't be redebating NAFTA. They should be debating how to help Americans adapt to a new economy in which no job is safe. Okay, so back to my initial question. The answer is HRC didn't want the Administration to move forward with NAFTA, but not because she was opposed to NAFTA as a policy. She opposed NAFTA because of its timing. She wanted her health-care plan to be voted on first. She feared that the fight over NAFTA would use up so much of the White House's political capital that there wouldn't be enough left when it came to pushing for health care. In retrospect, she was probably right.

Mortgaging the Nest Egg

This is not a good sign. A lot of people are borrowing from their retirement accounts to pay off debt:

Borrowing from the Nest Egg, by Lane Kenworthy: This news is discouraging, but hardly unexpected. According to a "Marketplace" report, a survey by the Transamerica Center for Retirement Studies (pdf here) finds that the share of workers borrowing from their 401(k) retirement funds increased from 11% in 2006 to 18% in 2007. Nearly half of those taking out such loans in 2007 cited the need to pay off debt, compared to a quarter in 2006.

Stagnant wages and salaries, most spouses already employed, rising health care and college tuition costs, higher mortgage debt loads, and falling home values mean lots of American households — including many middle-income ones — are pinched financially. The late 1990s economic boom lessened the strain for a while. Then home equity loans helped. More recently, credit card usage has jumped. Borrowing against retirement savings is the logical next step.

See more discussion here, here, and here.

This is why I wonder about the long-term participation rate in "opt out" retirement accounts that are being promoted as a way to deal with the retirement security problem. How many people will opt out of these accounts when economic conditions for the household deteriorate temporarily for some reason? And once they opt out, will they opt back in? People who are motivated enough to borrow against their retirement accounts - almost one fifth in 2007 - would also be motivated enough to opt out of an automatic savings plan. Many of the studies, at least the ones I have seen, do not track people over long periods of time where this type of deterioration would be present, and they do not follow people through a recession when the pressure to opt out would be greatest. I'm not saying we shouldn't have these programs, they do help some people save, and even if some people opt out at least they have a source of funds to use when times get tough. The point, though, is that the people most likely to opt out are the very ones we would like to see participate in savings programs so that they have more than just Social Security available during their retirement years. Because of that, we should be careful not to place too much emphasis on opt-out types of mechanisms for solving the retirement security problem. These accounts may not provide as much of a boost as we hope to key segments of the population.

Update: Megan McArdle follows up with comments on forced saving as a solution to this problem.

Why Bubbles Occur

In 1998, Paul Krugman explained why housing and stock bubbles occur. The answer? "Me want mammoth meat!":

The Ice Age Commeth, by Paul Krugman: The more I look at the amazing rise of the U.S. stock market, the more I become convinced that we are looking at a mammoth psychological problem. I don't mean mammoth as in "huge" (though maybe that too), but as in "elephant". Let me explain.

If you follow trends in psychology, you know that Freud is out and Darwin is in. The basic idea of "evolutionary psych" is that our brains are exquisitely designed to help us cope with our environment - but unfortunately, the environment they are designed for is the one we evolved and lived in for the past two million years, not the alleged civilization we created just a couple of centuries ago. We are, all of us, hunter-gatherers lost in the big city. And therein, say the theorists, lie the roots of many of our bad habits. Our craving for sweets evolved in a world without ice-cream; our interest in gossip evolved in a world without tabloids; our emotional response to music evolved in a world without Celine Dion. And we have investment instincts designed for hunting mammoths, not capital gains.

Imagine the situation back in what ev-psych types call the Ancestral Adaptive Environment. Suppose that two tribes - the Clan of the Cave Bear and its neighbor, the Clan of the Cave Bull - live in close proximity, but traditionally follow different hunting strategies. The Cave Bears tend to hunt rabbits - a safe strategy, since you can pretty sure of finding a rabbit every day, but one with a limited upside, since a rabbit is only a rabbit. The Cave Bulls, on the other hand, go after mammoths - risky, since you never know when or if you'll find one, but potentially very rewarding, since mammoths are, well, mammoth.

Now suppose that it turns out that for the past year or two the Cave Bulls have been doing very well - making a killing practically every week. After this has gone on for a while, the natural instinct of the Cave Bears is to feel jealous, and to try to share in the good fortune by starting to act like Cave Bulls themselves. The reason this is a natural instinct, of course, is that in the ancestral environment it was entirely appropriate. The kinds of events that would produce a good run of mammoths - favorable weather producing a good crop of grass, migration patterns bringing large numbers of beasts into the district - tended to be persistent, so it was a good idea to emulate whatever strategy had worked in the recent past.

But now transplant our tribes into the world of modern finance, and - at least according to finance theory - those instincts aren't appropriate at all. Efficient markets theory tells us that all the available information about a company is supposed to be already built into its current price, so that any future movement is inherently unpredictable - a random walk. In particular, the fact that people have made big capital gains in the past gives you absolutely no reason to think they will in the future. Rational investors, according to the theory, should treat bygones as bygones: if last year your neighbor made a lot of money in stocks while you unfortunately stayed in cash, that's no reason to get into stocks now. But suppose that, for whatever reason, the market goes up month after month; your MBA-honed intellect may say "Gosh, those P/Es look pretty unreasonable", but your prehistoric programming is shrieking "Me want mammoth meat!" - and those instincts are hard to deny.

And those instincts can be self-reinforcing, at least for a while. After all, whereas an increase in the number of people acting like Cave Bulls tended to mean fewer mammoths per hunter, an increase in the number of modern bulls tends to produce even bigger capital gains - as long as the run lasts. Any broker can tell you that in the last few months the market has been rising, despite mediocre earnings news, because of fresh purchases by ever more people distraught about having missed out on previous gains and desperate to get in on the action. Sooner or later the supply of such people will run out; then what?

OK, OK, I know that this isn't supposed to happen. Sophisticated investors are supposed to take the long view, and arbitrage away these boom-bust cycles. And maybe, just maybe, the market is where it is because wise and far-seeing people have understood that the New Economy can produce growing profits forever, and that the rise of mutual funds has eliminated the need for old-fashioned risk premia. But my sense is that people who try to take a long view have been driven to the edge of extinction by the sheer scale of recent gains, and that the supposed explanations you now hear of why current prices make sense are rationalizations rather than serious theories.

The whole situation gives me the chills. It could be that I just don't get it, that I'm a Neanderthal too thick-skulled to understand the new era. But if you ask me, I'd say that there's an Ice Age just over the horizon.

Free to Choose: A Debate between Milton Friedman, Jamie Galbraith, and David Brooks

Jamie Galbraith debates Milton Friedman and David Brooks. Arnold Schwarzenegger also makes an appearance at the beginning. The debate begins about halfway through the video (from 1990):

Multilateralising Regionalism: The WTO's Next Challenge

Richard Baldwin says it's time for the WTO to "adjust to the new realities of regionalism" (more on regionalsim):

Multilateralising regionalism: The WTO's next challenge, by Richard Baldwin, Vox EU: The world's most important trade talks – the Doha Round – appear to be slipping into a coma while key nations play a waiting game. What are they waiting for? Some are waiting to see if Europe commits to unilaterally dismantling the EU's massively distortionary agricultural policies during its 2008/2009 review. Others are waiting to see if the next US president is more protectionist or more accommodating. And the major developing nations see their exports growing at double-digit rates despite the stalemate, so what's the rush?

But trade liberalisation is not standing still. Nations around the global are falling over themselves to liberalise trade regionally, bilaterally and unilaterally. The world trade system is labouring under a massive proliferation of regional trade agreements and the problem gets worse month by month. The resulting tangle of trade deals conspires to inject both inefficiency and discrimination against poor countries into the multilateral system.

Most amazingly, the WTO has had next to no involvement in this important development. The WTO – and this means the WTO membership since the institution only does what its members want – has adopted the role of "innocent bystander". Key figures in world trade – negotiators, ministers, the WTO secretariat, academics, civil society and the media – need to look beyond the Doha Round. Doha or not, countries will continue to strike bilateral and regional deals. Doha will do little or nothing to 'tame the tangle'. What is needed is a WTO Action Plan on Regionalism.

Regionalism is here to stay

The argument for action is simple. It is based on four facts:

Fact #1. The world trade system is marked by a motley assortment of discriminatory trade agreements known as the 'spaghetti bowl' for reasons that the diagram of trade relations in the Western Hemisphere makes clear.

Figure 1. 'Spaghetti bowl' RTAs in the Western Hemisphere

Fact #2. Regionalism is here to stay. Even if the Doha Round finishes tomorrow, free trade agreements will continue to proliferate and the motley assortment will continue to get 'motley-er'.

Fact #3. This tangle of trade deals is a bad way to organise world trade. The discrimination inherent in regionalism is already economically inefficient but its costs are rising rapidly as manufacturing becomes ever more internationalised. Stages of manufacturing that used to be performed in a single nation are now often geographically unbundled in an effort to boost efficiency. Supply chains spread across many borders. Unbundling, which accelerated since the 1990s, is the most important new element in the regionalism debate. It is the reason why business is pushing so many nations to 'tame the tangle.'

Fact #4. While the spaghetti bowl is a problem for firms in big nations, it is much more so for firms in poor nations. Rich nations have the resources and negotiating leverage to navigate the tangle's worse effects. The governments of small and poor nations do not. The spaghetti bowl falls much harder on the heads of the world's small and poor nations.

Implication. Since the spaghetti bowl's inefficiencies are increasingly magnified by unbundling and the rich/poor asymmetry, the world must find a solution. Since regionalism is here to stay, the solution must work with existing regionalism, not against it. The solution must multilateralise regionalism.

The WTO must choose innocence or engagement

The WTO faces a choice. What that means is that the WTO membership faces a choice. Should the WTO remain as an innocent bystander, or should it engage constructively and creatively in making regionalism as multilateral-friendly as possible? Innocence or engagement is the choice. The problem will not go away on its own.

The innocence option poses many difficulties and pitfalls. Regionalism is so pervasive that some political leaders view it as an alternative to multilateralism – Plan B for the world trading system. Starting from this situation, the continued and uncoordinated proliferation of regionalism might kill the proverbial gold-laying goose – the multilateral trade system that brought post-war prosperity to today's rich nations and helped lift billions out of subsistence agriculture.

Engagement is also difficult. WTO members have shown little appetite for cooperating on regionalism. Recent progress on the Transparency Mechanism shows that they recognise the problem, but negotiating a WTO Action Plan on Regionalism would be difficult.

In a new book published this week, a co-author and I argue that engagement is the right option. Developing a WTO Action Plan on Regionalism is both necessary and feasible. The book discusses more than a dozen ideas for the Action Plan. Some ideas require WTO sponsorship, negotiations and actions while others would mainly engage the parties to RTAs with the WTO playing more of a coordinating and fair broker role.

Most of the proposals turn on critical details and intricacies that can give headaches to even the most dedicated trade specialist – not the sort of thing that works well in an essay. The one proposal that is easy to understand concerns help for the developing nations. To make regionalism more development friendly and help poor nations with their free trade agreements, we should establish a WTO advisory services and/or a Centre on RTAs for poor nations – something along the lines of the Advisory Centre on WTO Law that helps them with WTO legal issues.

This advisory centre would provide subsidised economic, legal and negotiation services and training to developing nations. The proposed Centre's role and practical details could take inspiration from the Advisory Centre on WTO Law. To avoid waste, it should link up with the efforts of regional banks (Inter-American Development Bank, Asian Development Bank, etc.).

Action is needed

The ideas in the book – which stem from a three day conference of the world's leading trade experts held at the WTO in September 2007 – need more work. They may not be the right answer as to what the WTO should do, but "Do nothing" is surely the wrong answer. If the WTO does not adjust to the new realities of regionalism, it risks an erosion of its relevance.

The GATT/WTO survived and flourished during its half-century's existence by adapting to new realities. When the colonies became countries, the GATT expanded from a cosy club of two dozen members to a global organisation. When the distinct trade needs of developing nations were recognised, the GATT responded with the Enabling Clause. When non-tariff barriers began to replace tariff barriers, the GATT expanded its negotiating agenda. And when the need for greater institutional stability became clear, the GATT was embedded in the WTO.

Today's new reality is regionalism. If the WTO is to survive and flourish, it must adapt because regionalism is here to stay. Embarking on a WTO Action Plan on Regionalism would be a strong step towards adapting to the new reality.

References

Baldwin, Richard and Philip Thornton (2008). Multilateralising Regionalism.

links for 2008-02-29

February 28, 2008

Economist's View - 5 new articles

Recessions and Democratic Change in Sub-Saharan Africa

Do recessions cause democracies?:

Recessions open a window of opportunity for democratic change in sub-Saharan Africa, by Antonio Ciccone, Vox EU: Four out of five Sub-Saharan African countries were autocracies in 1980, but twenty-five years later there were more democracies than autocracies. One cannot help wondering why some countries became democracies while others didn't. What factors trigger democratic change?

According to the economic theory of political transitions as developed by Acemoglu and Robinson (2006), economic shocks are one important factor. They show that democratisation becomes more likely after transitory, negative shocks. These shocks give rise to a window of opportunity for citizens to contest power, as the cost of fighting ruling autocratic regimes is relatively low. When citizens reject policy changes that are easy to renege upon once the window of opportunity closes, autocratic regimes must make democratic concessions to avoid costly repression.

An interesting pattern emerges from the history of democratisation in Sub-Saharan Africa over the twenty-five year period from 1980 to 2004. Pick the five years with least and most rainfall for each Sub-Saharan African country. It turns out that the five years where rainfall was scarcest were followed by twice as many transitions to democracy as the five years with most rainfall. This is true whether one uses the democracy indicator of Persson and Tabellini (2003) or Przeworski et al. (2000). If there were no relationship between rainfall and democratisation, there would be a similar number of transitions to democracy following years of low and high rainfall. When the concept of democratic transition is widened to include democratic transitions according to Persson and Tabellini and to Przeworski et al., the five years where rainfall was scarcest were followed by almost three times as many transitions to democracy as the five years with most rainfall.

This historical pattern linking low rainfall and transitions to democracy suggests that democratic change is more likely during recessions as Sub-Saharan African economies are very dependent on rainfall. But does this conclusion hold up under the scrutiny of regression analysis?

It seems likely that – due to history and economic circumstances – some Sub-Saharan African countries are more likely to democratise than others, regardless of rainfall. A careful statistical analysis must account for this. It is also likely that there are democratisation trends affecting all of Sub-Saharan Africa. The disappearance of the Soviet Union, for example, triggered political changes all around the world. But the link between low rainfall and democratic change remains significant after accounting for these factors (Brückner and Ciccone 2008). To get an idea of the strength of this effect: during the "average drought" – rainfall levels 50% below average – the probability of a transition to democracy increases by around 6 percentage points.

How much more likely then is democratic change during an economic recession? In our sample, a 50% drop in rainfall reduces real income per capita by around 4% relative to trend. Putting the two pieces of the puzzle – the effect of low rainfall on income per capita and its effect on the probability of a transition from autocracy to democracy – together yields that a drought-driven recession that decreases income by 5% relative to trend raises the probability of democratisation by around 7 percentage points.

Thus, the recent history of Sub-Saharan Africa provides empirical support for the idea that economic recessions put autocratic regimes in a position where they have no choice but to make democratic concessions.

References

Acemoglu, D. and J. Robinson (2006). Economic Origins of Dictatorship and democracy. New York, Cambridge University Press.

Brückner, M. and A. Ciccone (2008). "Rain and the Democratic Window of Opportunity," February, CEPR Discussion Paper 6691.

Persson, T. and G. Tabellini (2003). The Economic Effects of Constitutions. MIT Press, Cambridge.

Przeworski, A., M. Alvarez, J. Cheibub, and F. Limongi (2000). Democracy and Development: Political Institutions and the Well-Being of the World, 1950-1990.

Thinking about the Great Depression and whether it fits into this framework, it seems that depressions bring about change. I'm wondering, though, does the change always go in one direction, i.e. does it always produce more democracy? Can anyone think of an example where an economic disaster caused the opposite type of change, i.e. moved away from a democracy toward something else? Russia comes to mind - as economic conditions have languished central authority has reemerged - but I'm not sure it was economic conditions that were the major impetus for change. There are lots of other cases of failed democracies, e.g. in South America, but without more digging I don't know if they were preceded by economic downturns. In any case, given that there are lots of failed democracies, it would be interesting to put these through the same methodology used above and see if there is evidence that recessions can cause countries to move away from a democratic system. My point is that I agree that economic recessions provide a strong motivation for change, I'm just not sure the change is necessarily toward democracy. But if it is true that bad economic conditions do bring about positive change, it's interesting to think through the policy implications. Should we hope for economic stagnation and misery of the masses, maybe even help to bring it about, so that democracy can emerge?

Why Bubbles Occur

In 1998, Paul Krugman explained why housing and stock bubbles occur. The answer? "Me want mammoth meat!":

The Ice Age Commeth, by Paul Krugman: The more I look at the amazing rise of the U.S. stock market, the more I become convinced that we are looking at a mammoth psychological problem. I don't mean mammoth as in "huge" (though maybe that too), but as in "elephant". Let me explain.

If you follow trends in psychology, you know that Freud is out and Darwin is in. The basic idea of "evolutionary psych" is that our brains are exquisitely designed to help us cope with our environment - but unfortunately, the environment they are designed for is the one we evolved and lived in for the past two million years, not the alleged civilization we created just a couple of centuries ago. We are, all of us, hunter-gatherers lost in the big city. And therein, say the theorists, lie the roots of many of our bad habits. Our craving for sweets evolved in a world without ice-cream; our interest in gossip evolved in a world without tabloids; our emotional response to music evolved in a world without Celine Dion. And we have investment instincts designed for hunting mammoths, not capital gains.

Imagine the situation back in what ev-psych types call the Ancestral Adaptive Environment. Suppose that two tribes - the Clan of the Cave Bear and its neighbor, the Clan of the Cave Bull - live in close proximity, but traditionally follow different hunting strategies. The Cave Bears tend to hunt rabbits - a safe strategy, since you can pretty sure of finding a rabbit every day, but one with a limited upside, since a rabbit is only a rabbit. The Cave Bulls, on the other hand, go after mammoths - risky, since you never know when or if you'll find one, but potentially very rewarding, since mammoths are, well, mammoth.

Now suppose that it turns out that for the past year or two the Cave Bulls have been doing very well - making a killing practically every week. After this has gone on for a while, the natural instinct of the Cave Bears is to feel jealous, and to try to share in the good fortune by starting to act like Cave Bulls themselves. The reason this is a natural instinct, of course, is that in the ancestral environment it was entirely appropriate. The kinds of events that would produce a good run of mammoths - favorable weather producing a good crop of grass, migration patterns bringing large numbers of beasts into the district - tended to be persistent, so it was a good idea to emulate whatever strategy had worked in the recent past.

But now transplant our tribes into the world of modern finance, and - at least according to finance theory - those instincts aren't appropriate at all. Efficient markets theory tells us that all the available information about a company is supposed to be already built into its current price, so that any future movement is inherently unpredictable - a random walk. In particular, the fact that people have made big capital gains in the past gives you absolutely no reason to think they will in the future. Rational investors, according to the theory, should treat bygones as bygones: if last year your neighbor made a lot of money in stocks while you unfortunately stayed in cash, that's no reason to get into stocks now. But suppose that, for whatever reason, the market goes up month after month; your MBA-honed intellect may say "Gosh, those P/Es look pretty unreasonable", but your prehistoric programming is shrieking "Me want mammoth meat!" - and those instincts are hard to deny.

And those instincts can be self-reinforcing, at least for a while. After all, whereas an increase in the number of people acting like Cave Bulls tended to mean fewer mammoths per hunter, an increase in the number of modern bulls tends to produce even bigger capital gains - as long as the run lasts. Any broker can tell you that in the last few months the market has been rising, despite mediocre earnings news, because of fresh purchases by ever more people distraught about having missed out on previous gains and desperate to get in on the action. Sooner or later the supply of such people will run out; then what?

OK, OK, I know that this isn't supposed to happen. Sophisticated investors are supposed to take the long view, and arbitrage away these boom-bust cycles. And maybe, just maybe, the market is where it is because wise and far-seeing people have understood that the New Economy can produce growing profits forever, and that the rise of mutual funds has eliminated the need for old-fashioned risk premia. But my sense is that people who try to take a long view have been driven to the edge of extinction by the sheer scale of recent gains, and that the supposed explanations you now hear of why current prices make sense are rationalizations rather than serious theories.

The whole situation gives me the chills. It could be that I just don't get it, that I'm a Neanderthal too thick-skulled to understand the new era. But if you ask me, I'd say that there's an Ice Age just over the horizon.

Fed Watch: This Train Doesn't Stop

How will the Fed respond to recent evidence of heightened inflationary pressures and slower economic growth?

This Train Doesn't Stop, by Tim Duy: Dual mandate, but one policy tool. A choice has to be made in the short run. Focus on inflation, and hold policy relatively tight? Or focus on growth, hoping that soft economic growth will tame inflationary pressures? The Fed continues to choose the latter path. In truth, at this point they have no other choice. It was unlikely that the Fed could bring a halt to this easing cycle as long as economic data point at recessionary conditions; this was always the danger of moving so quickly early in the cycle. And it became unthinkable to back away from the current set of policies after Congress followed up on Fed Chairman Ben Bernanke's push for fiscal stimulus. The die is cast. Look for another 50bp in March and then two more 25bp cuts at subsequent meetings to bring the Fed Funds rate to 2%.

Bernanke's Senate testimony left unchanged market expectations for additional easing. The overall tone was, as expected, in line with the dour assessment offered by Vice Chair Donald Kohn. The encouraging signs – low inventories, solid balance sheets in nonfinancial corporations, solid export growth – were few, while weakness was abundant. It read as an extended version of his February 14th testimony. That said, there are heightened inflation concerns. This sentence from February 14:

A critical task for the Federal Reserve over the course of this year will be to assess whether the stance of monetary policy is properly calibrated to foster our mandated objectives of maximum employment and price stability and, in particular, whether the policy actions taken thus far are having their intended effects.

Has evolved to:

A critical task for the Federal Reserve over the course of this year will be to assess whether the stance of monetary policy is properly calibrated to foster our mandated objectives of maximum employment and price stability in an environment of downside risks to growth, stressed financial conditions, and inflation pressures.

While not saying so outright, the new sentence implies stagflation. Not surprising, as incoming price data are difficult to ignore, and left the Fed revising upward their near term inflation expectations despite a downwardly revised growth outlook:

The central tendency of the projections for core PCE inflation in 2008, at 2.0 percent to 2.2 percent, was a bit higher than in our July report, largely because of some higher-than-expected recent readings on prices.

Still, the expectation is that inflation will moderate in the months ahead, allowing Bernanke to succinctly define the near term path of policy:

Therefore, our policy stance must be determined in light of the medium-term forecast for real activity and inflation as well as the risks to that forecast. Although the FOMC participants' economic projections envision an improving economic picture, it is important to recognize that downside risks to growth remain. The FOMC will be carefully evaluating incoming information bearing on the economic outlook and will act in a timely manner as needed to support growth and to provide adequate insurance against downside risks.

Insurance against downside risk + benign inflation outlook = more rate cuts. While interesting to dissect, the relevance of Bernanke's testimony for near-term policy was something of a forgone conclusion. Consider this:

However, the recently enacted fiscal stimulus package should provide some support for household spending during the second half of this year and into next year.

I don't think it should be forgotten that the stimulus package was arguably custom designed by Bernanke:

I agree that fiscal action could be helpful in principle, as fiscal and monetary stimulus together may provide broader support for the economy than monetary policy actions alone. But the design and implementation of the fiscal program are critically important…

To be useful, a fiscal stimulus package should be implemented quickly and structured so that its effects on aggregate spending are felt as much as possible within the next twelve months or so.

In other words, "DO IT NOW." Congress and the President obliged, spilling red ink to get the checks in the mail in time for the summer driving season. If Bernanke fails to deliver additional rate cuts as expected, it will be perceived as a negative policy shock. I have got to imagine that Fed action to offset the fiscal stimulus that Bernanke supported would not go over well on Capitol Hill. The Senate would be inclined to crack open the Federal Reserve Act and make an omelet.

Not surprisingly, Bernanke's inclination to continue pushing rates lower is resonating throughout financial markets. Inflationary pressures are building globally (note that China is completing the chain that leads to an inflationary spiral, setting the expectation that high inflation will be matched by higher wages), reflected in surging commodity prices and the freefall of the dollar. The former is weighing heavily on US consumers. Indeed, I am amazed that this story is only starting to capture the attention of the press. So much attention is placed on the housing market as the source of declining consumer confidence, but over the last three months, headline CPI has surged 6.8% annualized. Sure doesn't look like nominal wages gains are keeping up. No wonder confidence is collapsing.

And I sense it's going to get worse – the Fed's policy stance is giving additional impetus to commodity prices as investors pile into the asset class as an inflation hedge and a response to the weaker dollar. Moreover, low US risk free returns (a measly 2% on a 2 year Treasury) are forcing market participants to search out higher returns, and commodity prices look like a safe bet for the time being. The new asset bubble? Perhaps – but this one will have a primarily inflationary impact on the US economy. Moreover, it will weigh against the deflationary impact of the housing/credit market turmoil. Swamping it if the policy response is to continue propping up an unsustainable level of domestic demand. (I wonder when someone in Congress is going to realize that higher inflation is rapidly chipping away at the recent minimum wage hike?)

Not a pretty combination of events. And Bernanke knows it:

Upside risks to the inflation projection are also present, however, including the possibilities that energy and food prices do not flatten out or that the pass-through to core prices from higher commodity prices and from the weaker dollar may be greater than we anticipate. Indeed, the further increases in the prices of energy and other commodities in recent weeks, together with the latest data on consumer prices, suggest slightly greater upside risks to the projections of both overall and core inflation than we saw last month.

But the bottom line is that he can't stop the rate-cutting train now. He can only hope that inflation expectations remain reasonably well anchored while his attention is focused on the deteriorating growth outlook. To pull this off, Bernanke will have to hope for minimal nominal wage growth. I don't know if this will be a political feasible outcome after the period of real wage stagnation experienced during the Bush Administration.

Sidenote: CR found the silver lining to higher inflation – it will accelerate the housing correction in real terms.

NAFTA Isn't the Problem in Ohio

Brad DeLong provides a follow-up to the "Reactionary, Populist, Xenophobic and Just Plain Silly" Roundup:

Stagnant Wages and Ohio: NAFTA Isn't the Problem: An excellent column by David Leonhardt:

The Politics of Trade in Ohio: Now come Mr. Obama and Mrs. Clinton... tough talk about foreign trade... you'd have to conclude that they believe that Nafta and other trade agreements have caused Ohio's huge economic problems.

"She says speeches don't put food on the table," Mr. Obama said in Youngstown. "You know what? Nafta didn't put food on the table, either." Later, he went further, claiming that Ohio's workers have "watched job after job after job disappear because of bad trade deals like Nafta."

Mrs. Clinton's advisers, meanwhile, have been putting out the word that she tried to persuade her husband not to support Nafta -- which liberalized trade with Mexico and Canada -- when he was running for president....

[However, n]either candidate calls for a repeal of Nafta, or anything close to it. Both instead want to tinker with the bureaucratic innards of the agreement.... They call the country's trade policy a disaster, and yet their plan to fix it starts with, um, cracking down on Mexican pollution....

The first problem with what the candidates have been saying is that Ohio's troubles haven't really been caused by trade agreements. When Nafta took effect on Jan. 1, 1994, Ohio had 990,000 manufacturing jobs. Two years later, it had 1.03 million. The number remained above one million for the rest of the 1990s, before plummeting in this decade to just 775,000 today. It's hard to look at this history and conclude Nafta is the villain. In fact, Nafta did little to reduce tariffs on Mexican manufacturers, notes Matthew Slaughter, a Dartmouth economist. Those tariffs were already low before the agreement was signed.

A more important cause of Ohio's jobs exodus is the rise of China, India and the old Soviet bloc, which has brought hundreds of millions of workers into the global economy.... [Y]our credit card's customer service center isn't in Ireland because of a new trade deal. All this global competition has brought some big benefits, too. Consider that cars, furniture, clothing, computers and televisions -- which are all subject to global competition -- have become more affordable, relative to everything else. Medical care, movie tickets and college tuition -- all protected from such competition -- have become more expensive.

So what can be done for Ohio?

There is actually a fair amount of agreement among economists on this question. The solution should involve more government investment in infrastructure, the medical sciences, alternative energy and other areas that could produce good new jobs. A more strategic approach to investment, one less based on the whims of individual members of Congress, would also help....

Over the last week, the candidates' talk has, at times, been silly and even inaccurate. And Ohio's problems would certainly be easier to solve if, as Luis Proenza, president of the University of Akron put it, the candidates were "more true to reality and less prone to invective." But the larger problem is that Ohio's voters have good reason to be angry. For years, they have been promised that globalization was making the United States a richer country. They're still waiting for their share of the bounty.

This is from a previous post:

I want to highlight an important distinction [Olivier] Blanchard makes between protecting jobs and protecting workers:

...It is one thing to say that labor market institutions matter, and another to know exactly which ones and how. Humility is needed here... Nevertheless, even if one cannot pretend to have much confidence about the optimal overall architecture, much has been learned... We know much more about the incentive aspects of unemployment insurance on search intensity and unemployment duration... We know more about the effects of decreasing social contributions on low wages ... We know more about the effects of employment protection, ... From both the macro evidence and this body of micro–economic work, a large consensus—right or wrong—has emerged:

  • It holds that modern economies need to constantly reallocate resources, including labor, from old to new products, from bad to good firms.
  • At the same time, workers value security and insurance against major adverse professional events, job loss in particular. While there is a trade-off between efficiency and insurance, the experience of the successful European countries suggests it need not be very steep.
  • What is important in essence is to protect workers, not jobs.
  • This means providing unemployment insurance, generous in level, but conditional on the willingness of the unemployed to train for and accept jobs if available.
  • This means employment protection, but in the form of financial costs to firms to make them internalize the social costs of unemployment, including unemployment insurance, rather than through a complex administrative and judicial process.
  • This means dealing with the need to decrease the cost of low skilled labor through lower social contributions paid by firms at the low wage end, and the need to make work attractive to low skill workers through a negative income tax rather than a minimum wage.

This consensus underlies most recent reforms or reform proposals ... These measures are probably all desirable...

The point is, if you go along with the idea that we should use social insurance programs to protect workers but not jobs, then this gives a means of evaluating candidate's trade proposals that doesn't depend upon whether the changes are driven by technology, globalization, or some other shock. To what extent does a particular proposal protect jobs and hence inhibit needed flexibility of the labor market? To what extent do the proposals compensate for job flexibility and the insecurity that comes along with it by protecting workers who have been displaced? Do the proposals cause firms to fully internalize the costs of their employment decisions? What types of incentives are built into worker protection programs, i.e. do workers still retain the incentive to seek out and accept new employment?

Workers in Ohio and elsewhere are feeling the effects of something - I think the story above is basically correct but does not place enough emphasis on technological innovation as a cause of recent labor displacing change - but debate over the cause of their troubles shouldn't delay the implementation of policies that could help now.

links for 2008-02-28

February 27, 2008

Economist's View - 7 new articles

"Does Stabilizing Inflation Contribute to Stabilizing Economic Activity?"

I have been a proponent of inflation targeting procedures. However, many people take that to mean that inflation stability should take precedence over the stabilization of output and employment, or that we should suppress wages to prevent inflation. Here's a simulated interview with Frederic Mishkin generated from a recent speech that tries to clear this up (see also "Divine Coincidence is Unlikely" and "Mankiw on "Divine Coincidence" in Monetary Policy"). There are also comments about the use of core rather than headline inflation to guide monetary policy:

MT: Thanks for agreeing to do this in the simulation. Let's start by defining what the Fed is supposed to do. What are the Fed's goals?

FM: The ultimate purpose of a central bank should be to promote the public good through policies that foster economic prosperity.

MT: And how is that expressed practically?

FM: Research in monetary economics describes this purpose by specifying monetary policy objectives in terms of stabilizing both inflation and economic activity. Indeed, this specification of monetary policy objectives is exactly what is suggested by the dual mandate that the Congress has given to the Federal Reserve to promote both price stability and maximum employment.

MT: Let's get right to the big question. Does stabilizing inflation mean that the Fed is less focused on stable output and employment?

FM: We might worry that, under some circumstances, the objectives of stabilizing inflation and economic activity could conflict, particularly in the short run. However, economic research over the past three decades suggests that such conflicts may not, in fact, be that serious. Indeed, stabilizing inflation and stabilizing economic activity are mutually reinforcing not only in the long run, but in the short run as well.

MT: You mentioned both the short-run and the long-run. Let's start with the long-run becasue there is less controversy there. What do theory and evidence tell us about the long-run tradeoff between inflation and unemployment?

FM: Both economic theory and empirical evidence indicate that the stabilization of inflation promotes stronger economic activity in the long run. Two principles underlie that conclusion. The first principle is that low inflation is beneficial for economic welfare. Rates of inflation significantly above the low levels of recent years can have serious adverse effects on economic efficiency and hence on output in the long run. The distortions from a moderate to high level of long-run inflation are many. High inflation can cause confusion among households and firms, thereby distorting savings and investment decisions. The interaction of inflation and the tax code, which is often applied to nominal income, can have adverse effects, especially on the incentive of firms to invest in productive capital. Infrequent nominal price adjustment implies that high inflation results in distorted relative prices, thereby leading to an inefficient allocation of resources. And high inflation distorts the financial sector as firms and households demand greater protection from inflation's erosion of the value of cash holdings.

MT: So, high inflation leads to distortions which can impact growth. But what about the tradeoff?

FM: The second principle is the lack of a long-run tradeoff between unemployment and the inflation rate. Rather, the long-run Phillips curve is vertical, implying that the economy gravitates to some natural rate of unemployment in the long run no matter what the rate of inflation is.

MT: Then what determines the natural rate?

FM: The natural rate, in turn, is determined by the structure of labor and product markets, including elements such as the ease with which people who lose their jobs can find new employment and the pace at which technological progress creates new industries and occupations while shrinking or eliminating others. Importantly, those structural features of the economy are outside the control of monetary policy. As a result, any attempt by a central bank to keep unemployment below the natural rate would prove fruitless. Such a strategy would only lead to higher inflation that, as the first principle suggests, would lower economic activity and household welfare in the long run.

MT: What does the evidence say about all of this?

FM: Empirical evidence has starkly demonstrated the adverse effects of high inflation. In most industrialized countries, the late 1960s to early 1980s was a period during which inflation rose to high levels while economic activity stagnated. While many factors contributed to the improved economic performance of recent decades, policymakers' focus on low and stable inflation was likely an important factor.

MT: Now let's turn to the short-run. Is there a tradeoff there?

FM: Although there is no long-run tradeoff between unemployment and inflation, in the short run, expansionary monetary policy that raises inflation can lower unemployment and raise employment. That is, the short-run Phillips curve is not vertical. That fact would seem to suggest that achieving the dual goals of price stability and maximum sustainable employment might at times conflict. However, several lines of research provide support for the view that stabilization of inflation and economic activity can be complementary rather than in conflict.

MT: And it is that complementary nature of the tradeoff we want to highlight because that is where there is a lot of confusion over the conduct of monetary policy. How does this work, i.e. can you describe how the two goals of inflation and output stability might reinforce each other?

FM: Economists have long recognized that some sources of economic fluctuations imply that output stability and inflation stability are mutually reinforcing. Consider a negative shock to aggregate demand (such as a decline in consumer confidence) that causes households to cut spending. The drop in demand leads, in turn, to a decline in actual output relative to its potential. As a result of increased slack in the economy, future inflation will fall below levels consistent with price stability, and the central bank will pursue an expansionary policy to keep inflation from falling. The expansionary policy will then result in an increase in demand that boosts output toward its potential to return inflation to a level consistent with price stability. Stabilizing output thus stabilizes inflation and vice versa under these conditions.

MT: I see. What role do inflation expectations play in all of this?

FM: One critical precondition for effective central-bank easing in response to adverse demand shocks is anchored long-run inflation expectations. Otherwise, lowering short-term interest rates could raise inflation expectations, which might lead to higher, rather than lower, long-term interest rates, thereby depriving monetary policy of one of its key transmission channels for stimulating the economy.

MT: And how does this relate to the main question, the complementarity of inflation and output stability?

FM: The role of expectations illustrates two additional basic principles that help explain why stabilizing inflation helps stabilize economic activity: First, expectations of future policy actions and accompanying economic conditions play a crucial role in determining the effects of current policy actions on the economy. Second, monetary policy is most effective when the central bank is firmly committed, through its actions and statements, to a "nominal anchor"--such as to keeping inflation low and stable. A strong commitment to stabilizing inflation helps anchor inflation expectations so that a central bank will not have to worry that expansionary policy to counter a negative demand shock will lead to a sharp rise in expected inflation--a so-called inflation scare. Such a scare would not only blunt the effects of lower short-term interest rates on real activity but would also push up actual inflation in the future. Thus, a strong commitment to a nominal anchor enables a central bank to react more aggressively to negative demand shocks and, therefore, to prevent rapid declines in employment or output.

MT: You've mostly been talking about the response to demand shocks. Does any of this change, e.g. does the tradeoff return, if the shocks are from the supply-side of the economy?

FM: Unlike demand shocks, which drive inflation and economic activity in the same direction and thus present policymakers with a clear signal for how to adjust policy, supply shocks, such as the increases in the price of energy that we have been experiencing lately, drive inflation and output in opposite directions. In this case, because tightening monetary policy to reduce inflation can lead to lower output, the goal of stabilizing inflation might conflict with the goal of stabilizing economic activity.

MT: Given the recent oil and commodity price shocks we have seen, that isn't good news.

FM: Here again, a strong, previously established commitment to stabilizing inflation can help stabilize economic activity, because supply shocks, such as a rise in relative energy prices, are likely to have only a temporary effect on inflation in such circumstances. When inflation expectations are well anchored, the central bank does not necessarily need to raise interest rates aggressively to keep inflation under control following an aggregate supply shock. Hence, the commitment to price stability can help avoid imposing unnecessary hardship on workers and the economy more broadly.

MT: Good theory, but is there any evidence to support it?

FM: The experience of recent decades supports the view that a substantial conflict between stabilizing inflation and stabilizing output in response to supply shocks does not arise if inflation expectations are well anchored. The oil shocks in the 1970s caused large increases in inflation not only through their direct effects on household energy prices but also through their "second round" effects on the prices of other goods that reflected, in part, expectations of higher future inflation. Sharp economic downturns followed, driven partly by restrictive monetary policy actions taken in response to the inflation outbreaks. In contrast, the run-up in energy prices since 2003 has had only modest effects on inflation for other goods; as a result, monetary policy has been able to avoid responding precipitously to higher oil prices. Many factors were likely at work, but this experience suggests that inflation stabilization does not have to come at the cost of greater volatility of real activity; in fact, it suggests that, by anchoring inflation expectations, low and stable inflation is an important precondition for macroeconomic stability.

MT: Back to theory. How do modern models explain this evidence?

FM: Research over the past decade using so-called New Keynesian models has added further support to the proposition that inflation stabilization may contribute to stabilizing employment and output at their maximum sustainable levels. This research has also led to a deeper understanding of the benefits of price stability and the setting of monetary policy in response to changes in economic activity and inflation.

In particular, research has emphasized the interaction between stabilizing inflation and economic activity and has found that price stability can contribute to overall economic stability in a range of circumstances.

MT: What's the intuition behind this result?

FM: The intuition that leads to the conclusion that stabilizing inflation promotes maximum sustainable output and employment is simple, and it holds in a range of economic models whose policy prescriptions have been dubbed the New Neoclassical Synthesis. To begin, the prices of many goods and services adjust infrequently. Accordingly, under general price inflation, the prices of some goods and services are changing while other prices do not, thus distorting relative prices between different goods and services. As a consequence, the profitability of producing the various goods and services no longer reflects the relative social costs of producing them, which in turn yields an inefficient allocation of resources. A policy of price stability minimizes those inefficiencies.

MT: So, when some prices are sticky, monetary policy should attempt to keep relative prices at the values they would attain if prices were perfectly flexible hereby duplicating the flexible price outcome? How is this accomplished, by simply stabilizing all prices?

FM: There are several subtleties here. First, in some circumstance, relative prices should change. For example, the rapid technological advances in the production of information-technology goods mean that the prices of these goods relative to other goods and services should decline. Thus, the policy prescription refers to stability of the price level as a whole, not to the stability of each individual price.

MT: Then which prices should be stabilized?

FM: The New Neoclassical Synthesis suggests that only those prices that move sluggishly, referred to as sticky prices, should be stabilized. Indeed, these models indicate that monetary policy should try to get the economy to operate at the same level that would prevail if all prices were flexible--that is, at the so-called natural rate of output or employment. Stabilizing sticky prices helps the economy get close to the theoretical flexible-price equilibrium because it keeps sticky prices from moving away from their appropriate relative level while flexible prices are adjusting to their own appropriate relative level.

MT: So only the slowest moving prices are stabilized? Does that mean we should ignore prices that move around a lot - prices like food and energy - and focus on the "core" inflation rate?

FM: The New Neoclassical Synthesis does not suggest that headline inflation, in which the weight on flexible prices is larger, should be stabilized.

Monetary policy should focus on stabilizing a measure of "core" inflation, which is made up mostly of sticky prices. Simulations with FRB/US, the model of the U.S. economy created and maintained by the staff of the Federal Reserve Board, illustrate this point. To keep the simulations as simple as possible, I have assumed that the economy begins at full employment with both headline and core inflation at desired levels. The economy is then assumed to experience a shock that raises the world price of oil about $30 per barrel over two years; the shock is assumed to slowly dissipate thereafter. In each of two scenarios, a Taylor rule is assumed to govern the response of the federal funds rate; the only difference between the two scenarios is that in one, the federal funds rate responds to core personal consumption expenditures (PCE) inflation, whereas in the other, it responds to headline PCE inflation. Figure 1 illustrates the results of those two scenarios.

MT: Dude, you brought graphs to an interview? Cool! (oops, that didn't come out quite right, though I did think I saw the hint of a smile, but maybe not, anyway, he just ignores me and goes on)

FM (continuing): The federal funds rate jumps higher and faster when the central bank responds to headline inflation rather than to core inflation, as would be expected (top-left panel). Likewise, responding to headline inflation pushes the unemployment rate markedly higher than otherwise in the early going (top-right panel), and produces an inflation rate that is slightly lower than otherwise, whether measured by core or headline indexes (bottom panels). More important, even for a shock as persistent as this one, the policy response under headline inflation has to be unwound in the sense that the federal funds rate must drop substantially below baseline once the first-round effects of the shock drop out of the inflation data.

MT: Can you summarize what these graphs tell us?

FM: The basic point from these simulations is that monetary policy that responds to headline inflation rather than to core inflation in response to an oil price shock pushes unemployment markedly higher than monetary policy that responds to core inflation. In addition, because this policy has larger swings in the federal funds rate that must be reversed, it leads to more pronounced swings in unemployment. On the other hand, monetary policy that responds to core inflation does not lead to appreciably worse performance on stabilizing inflation. Stabilizing core inflation, therefore, leads to better economic outcomes than stabilizing headline inflation.

MT: Are the oals of inflation and output stability always perfectly aligned, i.e. do we have what some have referred to as a "divine coincidence"?

FM: Although the simplest sticky-price models imply that stabilizing sticky-price inflation and economic activity are two sides of the same coin, the presence of other frictions besides sticky prices can lead to instances in which completely stabilizing sticky-price inflation would not imply stabilizing employment (or output) around their natural rates. For example, in response to an increase in productivity, the real wage has to rise to reflect the higher marginal product of labor inputs, which requires either prices to fall or nominal wages to rise for employment to reach its natural rate. If both nominal wages and prices are sticky, a policy of completely stabilizing prices will force the necessary real wage adjustment to occur entirely through nominal wage adjustment, thereby impeding the adjustment of employment to its efficient level. Indeed, if wages are much stickier than prices, the best strategy is to stabilize nominal wage inflation rather than price inflation, thereby allowing price inflation to decline to achieve the required increase in real wages.

MT: Are there any other examples where the the output and price stabilization goals are in conflict?

FM: Fluctuations in inflation and economic activity induced by variation over time in sources of economic inefficiency, such as changes in the markups in goods and labor markets or inefficiencies in labor market search, could also drive a wedge between the goals of stabilizing inflation and economic activity.

MT: I can see the opponents of inflation targeting emphasizing the result that the two goals aren't always aligned in realistic models.

FM: These examples narrow the degree to which the recent findings of congruence between stabilizing inflation and economic activity apply in all cases, but they do not necessarily overturn the findings. The example of sticky wages would not invalidate the view that stabilizing inflation stabilizes economic activity if wages are sticky, for example, because they are held constant in order to operate as an "insurance" contract between employers and workers. And for many of the inefficient shocks that drive a wedge between the sustainable level of output and the level of output associated with price stability, monetary policy may be the wrong tool to offset their effects.

MT: So is it a no brainer, just stabilize inflation and go home?

FM: Central banks at times will still face difficult decisions regarding the short-run tradeoff between stabilizing inflation and output. For example, judging from the fit of New Keynesian Phillips curves, a substantial fraction of overall inflation variability seems related to supply-type shocks that create a tradeoff between inflation and output-gap stabilization. But the key insight from recent research--that the interaction between inflation fluctuations and relative price distortions should lead to a focus on the stability of nominal prices that adjust sluggishly--will likely prove to have important practical implications that can help contribute to inflation and employment stabilization.

MT: One last topic. How does the Fed stabilize the economy around the natural rate of output when it doesn't know for sure what that is? There have been mistakes in the past that have resulted in suboptimal policy.

FM: If a central bank errs in measuring the natural rates of output and employment, its attempts to stabilize economic activity at those mismeasured natural rates can lead to very poor outcomes. For example, most economists now agree that the natural unemployment rate shifted up for many years starting in the late 1960s and that the growth of potential output shifted down for a considerable time after 1970. However, perhaps because those shifts were not generally recognized until much later, monetary policy in the 1970s seems to have been aimed at achieving unsustainable levels of output and employment. Hence, policymakers may have unwittingly contributed to accelerating inflation that reached double digits by the end of the decade as well as undesirable swings in unemployment. And although subsequent monetary policy tightening was successful in regaining control of inflation, the toll was a severe recession in 1981-82, which pushed up the unemployment rate to around 10 percent.

MT: What does this mean for policy?

FM: Uncertainty about the natural rates of economic activity implies that less weight may need to be put on stabilizing output or employment around what is likely to be a mismeasured natural rate. Furthermore, research with New Keynesian models has found that overall economic performance may be most efficiently achieved by policies with a heavy focus on stabilizing inflation.

MT: Any final words?

FM: Because monetary policy has not one but two objectives, stabilizing inflation and stabilizing economic activity, it might seem obvious that those objectives would usually, if not always, conflict. As so often occurs with the "obvious," however, the impression turns out to be incorrect. The economic research that I have discussed today demonstrates, rather, that the objectives of price stability and stabilizing economic activity are often likely to be mutually reinforcing.

A key policy recommendation from the past three decades of research in monetary economics is that monetary policy makers must always keep their eye on inflation and emphasize the importance of price stability in their actions and communications. Doing so does not mean that monetary policy makers are less concerned about stabilizing economic activity. Rather, by appropriately focusing on stabilizing inflation along the lines I have outlined here, monetary policy is more likely to better stabilize economic activity.

MT: Thanks. I've been trying to make two points about monetary policy for a long time, that the Fed's use of core inflation is justified on both a theoretical and empirical basis, and that focusing on inflation stability does not come at the cost of output stability, and I apprecitaed the opportunity to have you help me make them one more time.

New Chart, for Descartes

This is from Lee Arnold who says:

I wonder if you would be kind enough to mention this one. It's unfinished and I am putting it up to fish for comments. It's the first two-thirds of a synthetic piece. It's a little different than all of the others. Essentially it's the "metaphysics of information," in the biological and social sciences. It creates the symmetrical grammar of ecolanguage. It observes a formal distinction between matter-energy and information (most recently Romer called that "atoms vs. bits" -- but the distinction goes back at least to Gregory Bateson, who wrote that he got it from Jung.)

I am hoping to drum up some comments in order to polish the rewrite of the last third -- which shows some examples, touches on institutional economics and the very different type of systems (i.e. flow-through webs) in climate and ecology, and ends with a simple summary.

Bernanke's Testimony before the House Financial Services Committee

Here's a video of Ben Bernanke's testimony this morning before the House Financial Services Committee and a link to a text version of his prepared testimony (video expires in 15 days):

Discussion: Bloomberg, NY Times, Financial Times, WSJ Blog. Each highlights Bernanke's indication that the Fed is prepared, if it is needed, to cut rates further.

"Reactionary, Populist, Xenophobic and Just Plain Silly" Roundup

This column, "The dangerous protectionism of Barack Obama," drew several responses. First, Greg Mankiw:

"reactionary, populist, xenophobic and just plain silly": That's how economists Willem Buiter and Anne Sibert describe the Patriot Employer Act.

Free Exchange:

Obama a dangerous protectionist?: Economists, the unaligned ones anyway, have had their hands full trying to parse the probable policy choices of the American presidential candidates. ...

With potential economic strategies unclear, observers are left to ascribe great importance to the smallest policy signs emanating from the campaigns. That, I have concluded, is what's behind a breathless and overstated attack on Barack Obama at VoxEU today. Forced to read so much into so little, authors Willem Buiter and Anne Sibert throw some of the nastiest adjectives available to economists (xenophobic, protectionist) at a piece of legislation introduced by the Illinois Senator.

Their piece opens on an objectionable note. The authors declare, "Senator Barack Obama's campaign has been long on slogans and mood music but short on concrete proposals and policies." This is patently false and beneath Mr Buiter and Ms Sibert, who should have stuck to an analysis of the proposed policy itself. Mr Obama's website is home to a number of (lengthy) documents outlining energy and health care policies, among other things. The merits of the proposals may be debatable, but they are substantive.

Mr Buiter and Ms Sibert go on to criticise Mr Obama's proposed legislation, the dreadfully titled Patriot Employer Act. There is much to dislike in the bill. Essentially, it offers employers a tax credit, worth one percent of taxable income, in exchange for adherence to a set of economic limitations. Among them are: a minimum wage, minimum standards on retirement and health plans, and protections for workers and headquarters based in America. Certainly, the bill has an element of distasteful economic nationalism to it, as well as a preference for reduced flexibility in compensation.

In short, Mr Obama deserves a slap on the wrist. He does not, in my opinion, deserve the rhetorical pounding he receives. Why not?

This bill is much less bad than it could be, primarily because the restrictions it contains are optional. ... In other words, optionality ensures that firms will only adopt these measures if it's relatively cheap (and minimally distortionary) to do so. ...

There is a case to be made that Mr Obama is the most economist-friendly candidate out there. One would hope that he'd use his growing popularity as an excuse to defend good but unpopular economic policies. He hasn't done that with this Patriot Employer Act, and he deserves a dose of criticism.

But the language used at VoxEU is odd. This bill is bad, but it's not dangerous. It's far less offensive than many of the anti-trade, anti-immigration proposals seen elsewhere in the campaign. Politicians are practically required to say silly and outrageous things. Economists shouldn't volunteer to do so.

Felix Salmon:

In Defense of the Patriot Employer Act: ...Obama's proposal, while hardly at the top of any sensible economist's wish-list, is not nearly as harmful as Buiter and Sibert make it out to be. ... I think the amount of harm the Obama bill would cause is really rather small, and it might actually do some good for working families. ...

Andrew Leonard:

"The dangerous protectionism of Barack Obama": Barack Obama's "Patriot Employer Act," say Willem Buiter and Anne Sibert, two prominent U.K.-based economists, is "idiotic legislation" -- "reactionary, populist, xenophobic, and just plain silly."

Tell us how you really feel!

The guts of the Patriot Employer Act, which Obama introduced in the Senate last August, would provide tax breaks for American corporations that keep their headquarters in the U.S., maintain a certain ratio of U.S.-based employees to foreign employees, pay a decent minimum wage and at least 60 percent of healthcare premiums, along with a few other worker-friendly goodies. For Buiter and Sibert, such heavy-handed government interference would be the worst kind of economic policy, a misguided, "unenforceable" attempt to pander to organized labor that would end up punishing workers all over the world. ...

But for Sherrod Brown, the Democratic senator of Ohio who won an upset election in 2006 by campaigning on a strong economic populist platform (and who has signed on as a co-sponsor of the legislation), the Patriot Employer Act makes sound political sense. It's how you win in Ohio.

As he told Katrina Vanden Heuvel in the Nation two weeks ago, while comparing his success in Ohio in 2006 to John Kerry's failure in 2004:

[The Patriot Employer Act] does two things.. it helps win Ohio and helps them govern in the right way. I think you can really take the country in a very different direction building a progressive message around that kind of economic issue... We won 32 or 33 more counties than John Kerry did mostly in small towns in rural Ohio where they were very responsive to a populist progressive message. One town in particular -- this is something that just happened -- there's a company called American Standard, they make toilets, plumbing fixtures... They're in Tiffin, Ohio, town of 20,000. They've just announced back around 3 months ago, the closing of the plant. It was bought by some investors, they're moving offshore, they're honoring the union contract as far as they have to, which is those who already have their 30 years. If you have less than 30 you're pretty screwed... And the company that came in and bought it was Bain Capital, Mitt Romney's firm.... These investors come in, take millions of dollars out of the company, and you know, it's pension and healthcare. And those are going on all over the country. And this is a town of 20,000. I carried that county, Kerry didn't. ...

(Thanks to Ben Muse's Custom House for the link.)

How the World Works is sympathetic to economists who argue in favor of bulking up the social safety net and making investments in infrastructure and education, rather than attempting to micromanage corporate behavior, as a way of addressing the inequities catalyzed by trade. But if Willem Buiter ran for political office in Ohio with a stump speech that included a lecture on how the winners from trade outnumber the losers and how "Bill Clinton's greatest achievement as President was his remarkable and unstinting support for a liberal international economic order" and therefore Ohioans need to stop moaning about NAFTA, he would lose. He would be pummeled. Economists pride themselves on understanding how the world is. But doesn't that imply that their calculus include political reality? The political reality is that voters in Ohio do not feel as if they have benefited from a liberal international economic order. And the political reality is that the voters of Ohio may well determine who the next president of the United States is.

It's tricky: There's a fine line between pandering and recognizing political reality. We have good reason to distrust politicians who say whatever it is they think will win them an election. When they are too obvious in their weather-vane spinning, we reject them, as Republican voters rejected Mitt Romney...

But right now, that isn't happening to Barack Obama, which is either a sign that voters believe he's sincere, or that he is just superlatively good at electioneering. ...

Barack Obama is playing to win. This may dismay some economists. Maybe they should try winning an election in the American Midwest in 2008.

How Principled Is It?

Dean Baker on the administration's (not so) principled objection to the Senate's Mortgage Relief Bill:

Changing Bankruptcy Rules and the Sanctity of Contracts, by Dean Baker: The banks are very upset over the possibility that Congress may change the law to allow bankruptcy judges to rewrite the terms of mortgage loans as they can other loans when a person declares bankruptcy. Naturally they are pulling out all the stops in making their case. The Washington Post quotes a Bush administration spokesperson saying that the proposed change "is interfering with contracts."

This is an interesting charge to come from the Bush administration... Those old enough to remember may recall the bankruptcy reform of 2005. This bill altered the enforcement of loans in the opposite direction, making it easier for lenders to collect from debtors. It was applied to loans that had already been contracted not just future debt yet to be incurred, in that sense, it interfered with contracts.

Clearly, neither the Bush administration nor the banks, both of whom eagerly supported the bankruptcy reform bill, have any principled objection to interfering with contracts. Their objection seems to be based more on whom the interference is favoring. ...

"Deterrence Effects of Prohibitions and Remedies in Mergers"

Does merger policy deter undesirable merger outcomes?:

Competition policy at work: Deterrence effects of prohibitions and remedies in mergers, by Pedro Pita Barros, Joseph A. Clougherty, and Jo Seldeslachts, Vox EU: Evaluations of merger policy usually ask whether the correct decision was made in actual merger cases. Yet by only considering the direct effects of merger policy, these studies may simply be detecting the 'tip of the iceberg' with regard to policy implications. Active merger enforcement can also deter firms from engaging in merger behaviour and/or from engaging in certain types of mergers – the 'what lies beneath' element of merger policy. Moreover, deterrence effects may be even more important than the direct effects of actual merger investigations.

Does merger policy deter? Competition-policy authorities generally acknowledge the existence of a deterrence effect for merger policy but have found it difficult to quantify its importance. For instance, the influential U.S. Federal Trade Commission (1999) divestiture study observed that the total effect of the Commission's merger enforcement is presumably much greater than that reflected by the actual number of mergers modified and blocked. Furthermore, the 2001 Congressional submission by the U.S. Department of Justice stated that 'we have not attempted to value the deterrence effects (...) of our successful enforcement efforts. While we believe that these effects in most matters are very large, we are unable to approach measuring them'. Competition-policy practitioners assume the relevance of deterrence for merger control but little literature quantifies the existence and size of merger policy deterrence effects.

In light of the dearth of empirical literature, a few competition authorities have recently commissioned practical studies to help assess the importance of merger policy deterrence effects. The Davies and Majumdar (2002) study for the U.K. Office of Fair Trading (OFT) attempted to quantify the overall benefit to consumers of competition policy and, in doing so, consider how merger policy deterrence effects might manifest. Moreover, two recent survey-based commissioned studies – one for the OFT and the other for the Dutch NMa – have yielded some evidence that merger policy yields a deterrence effect.

The Deloitte and Touch (2007) study for the OFT involved a survey of legal professionals, and found that for every merger blocked ('prohibition') or modified ('remedy') by U.K. competition authorities, some five mergers are later either abandoned or altered.[1] This five to one ratio should be considered a lower bound, as the survey only captured those mergers abandoned or modified following external legal advice: the decision to alter or abandon a merger in response to a change in the tenor of merger policy is, of course, often taken by firms without legal advice. Accordingly, the U.K. evidence suggests that the deterrence effect exceeds the direct effect of merger enforcement: i.e., every merger enforcement action ultimately affects five potential mergers.

The Twynstra Gudde (2005) study surveying competition lawyers – commissioned by the NMa in the Netherlands – estimates that the existence of Dutch merger policy leads to merger proposals being abandoned 7.5 times per year and altered 15 times per year; thus, 22.5 mergers per year are ultimately affected. As the Dutch competition authority averaged only three merger enforcement actions (prohibitions and remedies) per year over the 1998-2003 period, it appears that each Dutch merger enforcement action ultimately affected 7.5 potential mergers.

An empirical approach Motivated by the scarcity of empirical literature and a clear policy need for better evidence, we are currently engaged in a research project to quantify the importance of deterrence effects for merger policy. Our CEPR working paper (Seldeslachts, Clougherty & Barros, 2007) represents the first step in this larger research project. There we consider (using data on 28 competition jurisdictions over the 1992-2005 period) the impact of the use of merger policy tools on the proclivity of firms to engage in future merger activities. Unlike the practical studies surveyed above, we consider whether remedies and prohibitions have different effects.

We find that the use of prohibitions by competition authorities does indeed yield a significant deterrence effect in the sense that firms are induced to propose fewer mergers in the following year. In the typical jurisdiction, an additional prohibition would lead to thirty-four fewer merger notifications in the following year. However, we do not find remedies to involve a significant deterrence effect.

While this suggests a more substantial deterrence effect than that found in the two commissioned surveys, it should be noted that our study differs in some important respects. First, we only consider the impact of merger enforcements on the proclivity of firms to engage in future merger activity, while the survey studies consider the proclivity of firms to both abandon and alter future merger activity. This suggests that our results indicate a more robust deterrence effect than the surveys (in line with their claims to be estimating a lower bound). Second, we allow for different merger enforcement tools to have different deterrence effects, while the survey studies lump prohibitions and remedies together. Hence, our results indicate that the overall deterrence effect found in the survey-based studies may be masking some heterogeneity in the effectiveness of different merger policy instruments. This, on the other hand, suggests that our results tend more toward those of the commissioned studies.

While the empirical support for a prohibition-driven deterrence effect conforms to the priors of competition-policy practitioners, the lack of a deterrence effect for remedies comes as a bit of a surprise. Remedies – like prohibitions – should represent a cost to engaging in merger activity; though clearly, remedies likely involve less of a penalty than do prohibitions, thereby implying a relatively smaller deterrence effect. Accordingly, an increased probability of incurring remedies (where some merger related profits are eliminated) should result in fewer merger frequencies.

It may be that prospective merging firms do not perceive the possibility of incurring a remedy to be a sufficient burden to deterring them from proposing a merger. If so, then one must re-evaluate the usefulness of remedies, particularly in light of the recent proclivity by competition authorities to employ remedies instead of prohibitions to deal with anti-competitive problems.[2] Remedies may be a more precise tool in the sense that they specifically address anti-competitive elements, but, given the importance of deterrence as a benefit of merger policy, they may be a less powerful tool than currently perceived.

Strengthening the hand of competition authorities Accordingly, one of the early implications of our research is that competition-policy authorities may want to reconsider their increasing use of remedies as a substitute for prohibitions, since prohibitions appear to have a unique ability to deter future merger notifications. The soundness of this prescription depends, of course, on the assumption that anti-competitive – not pro-competitive – mergers are deterred by merger enforcements. The Deloitte and Touche (2007) study for the OFT provides some corroborating evidence, as their survey of both legal-professionals and managers indicates that the U.K. merger policy never – or rarely – deters pro-competitive mergers. Of course, further investigation of the types of mergers that are deterred, the next step in our research programme, is needed to judge the ultimate value of merger policy's deterrence effects.

References

Davies, S. and Majumdar, A. (2007) 'The development of targets for consumer savings arising from competition policy', OFT Report No. 386. Deloitte & Touche. (2007) 'The deterrent effect of competition enforcement by the OFT', OFT Report No. 962. Seldeslachts, J., Clougherty, J.A and Barros, P. P. (2007) 'Remedy for Now but Prohibit for Tomorrow: The Deterrence Effects of Merger Policy Tools,' CEPR Discussion Paper 6437. Twynstra Gudde (2005) 'Research into the anticipation of merger control', report submitted to NMa, October 27 2005. U.S. Federal Trade Commission. (1999) 'A Study of the Commission's Divestiture Process'.

Footnotes

1 Firms proposing a merger may be allowed to proceed if they take measures that alleviate the anti-competitive concerns raised by antitrust authorities. Such measures are referred to as remedies. A frequently occurring remedy is the obligatory sale of some subsidiaries. 2 For instance, the European Commission has largely relied on remedies by only blocking a couple of mergers since 2001.

links for 2008-02-27