Redirect


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

June 30, 2008

Economist's View - 7 new articles

Brad DeLong: The Democrats' Line in the Sand

Brad DeLong says it might be correct that the only way for Democrats "to tie the Republicans' hands and keep them from launching another wealth-polarizing offensive is to widen the deficit enough that even they are scared of it." If so, then there's a line that Democrats cannot cross:

The Democrats' line in the Sand, by J. Bradford DeLong, Project Syndicate: ...[I]f an economy as a whole is under-saving and under-investing, the government ought to help to correct this problem by running surpluses, not make it worse by running deficits that drain the pool of private savings available to fund investment. This is why most economists are deficit hawks.

Of course, governments need to run deficits in depressions in order to stimulate demand and stem rising unemployment. Moreover, a lot of emergency government spending on current items is really best seen as national savings and investment. ...

But the rule is that governments should run surpluses and not deficits, so various American presidents' economic advisers have been advocates of aiming for budget surpluses except in times of slack demand and threatening depression. This was certainly true of Eisenhower's, Nixon's, and Ford's economic advisors, and of George H.W. Bush's and Bill Clinton's economic advisers.

It was true of Reagan's economic advisers as well. Some of Reagan's advisers sincerely did not believe that the tax cuts of the early 1980's would generate the large deficits that they did (Beryl Sprinkel and Lawrence Kudlow come to mind). Others, like Martin Feldstein and Murray Weidenbaum, understood the consequences of the Reagan tax cuts and were bitter bureaucratic opponents, even if they did not speak out publicly.

In fact, since WWII, only George W. Bush's economic advisers have broken with this consensus. A few have done so because they are making careers as party-line Republicans, so their priority is to tell Republican politicians what they want to hear (Josh Bolton and Mitch Daniels come to mind here). As for the rest, their reasons for supporting the Bush administration's savings-draining policies remain mysterious. It is not as though they were angling for lifetime White House cafeteria privileges, or that having said "yes" to George W. Bush will open any doors for them in the future.

But their failings do pose a dilemma for Democratic deficit-hawk economists trying to determine ... economic policies ... should Barack Obama become president. Those of us who served in the Clinton administration and worked hard to ... turn deficits into surpluses are keenly aware that, after eight years of the George W. Bush administration, things look worse than when we started back in 1993. All of our work was undone by our successors in their quest to win the class war by making America's income distribution more unequal.

A chain is only as strong as its weakest link, and it seems pointless to work to strengthen the Democratic links of the chain of fiscal advice when the Republican links are not just weak but absent. Political advisers to future Democratic administrations may argue that the only way to tie the Republicans' hands and keep them from launching another wealth-polarizing offensive is to widen the deficit enough that even they are scared of it.

They might be right. The surplus-creating fiscal policies established by Robert Rubin and company in the Clinton administration would have been very good for America had the Clinton administration been followed by a normal successor. But what is the right fiscal policy for a future Democratic administration to follow when there is no guarantee that any Republican successors will ever be "normal" again? That's a hard question, and I don't know the answer.

There is, however, one fiscal principle that must be respected. Fiscal deficits so large that they put the debt-to-GDP ratio on an explosive upward trend do not merely act as a drag on long-term economic growth; they also create the possibility that at any moment the economy might face an immediate macroeconomic and financial disaster. A more hawkish fiscal stance may no longer be possible in future Democratic administrations, and might not be good policy if it were, given the likely complexion of successor administrations. Stabilizing the debt-to-GDP ratio is thus the line in the sand that must not be crossed.

"The Income-Inequality Denialists"

Speaking of the George W. Bush administration ... quest to win the class war by making America's income distribution more unequal," Justin Fox finds out what happens if you say the inequality in the U.S. has been increasing. I've been down this road:

The strange fantasy world of the income-inequality denialists, by Justin Fox: One of the more interesting developments in the U.S. economy over the past few decades has been the dramatic rise in incomes at the very top of the scale. There's all sorts of anecdotal evidence for this... But the most exhaustive empirical evidence for this income explosion at the top has come from the work of economists Thomas Piketty and Emanuel Saez...

Certain elements among the right-wing economic chattering classes ... have honed an interesting response to this rise in income inequality: They deny that it exists. My economic policy cover story of a while back, which cited Piketty and Saez, seems to be drawing these denialists out of the woodwork. Gary North is one, and now David Gitlitz joins in at National Review Online:

On income inequality, Fox accepts as fact the findings of economists Thomas Piketty and Emanuel Saez that "75% of all income gains from 2002 to '06 went to the top 1% — households making more than $382,600 a year." But as Piketty and Saez have acknowledged, these results are significantly skewed by the fact that their data only includes income reported on individual tax returns.

Following cuts in individual tax rates in 1986 (under Ronald Reagan) and 2003 (under George W. Bush), many of the businesses that had been reporting income under the corporate tax switched to the lower individual rate. In 1986, business income accounted for only 11 percent of the income reported by the top 1 percent of earners. By 2005 that share jumped to more than 29 percent. Clearly, much of the reported gain of the top 1 percent is accounted for in this bookkeeping shift.

Uh, no it's not. That purported problem, raised by Alan Reynolds, was swatted down pretty convincingly by Piketty and Saez:

Most of the scenarios described by Alan Reynolds, such as a shift from corporate income to individual income or from qualified stock-options to non-qualified stock options, would imply that high incomes used to receive capital gains instead of ordinary income. For example, a closely held C-corporation which does not distribute its profits increases in value and those accumulated profits would appear as realized capital gains on the owner individual tax return when the business is sold. Yet, our top 1% income share series including realized capital gains has also doubled from 10.0% in 1980 to 19.8% in 2004.

A fair description of the current state of knowledge on the income distribution is that members of the economics establishment (from right-wingers to left) more or less unanimously accept the Piketty and Saez data as a more or less accurate representation of reality. There are big debates about what it all means, and why it's happening, but the only major objections that I know of to the Piketty-Saez data itself have been those raised on the op-ed page of the Wall Street Journal by Reynolds, a senior fellow at the libertarian Cato Institute who doesn't appear to have an advanced degree in economics or in anything else.

It's a case where the scientific consensus says one thing, and this one guy says the opposite. I don't have an advanced degree in anything either, and I like to think that on occasion the scientific consensus will turn out to be wrong and the lone outsider right. But I'm pretty sure this isn't one of those cases.

Why not? First, there's all that anecdotal evidence of vast new fortunes being created.

Second, Piketty and Saez have pretty convincing answers to all of Reynolds' objections to their data.

Third, Piketty and Saez come across as data jockeys with no particular axe to grind, while Reynolds is an overt ideologue.

Finally, when Reynolds strays into an area that I actually know something about--the use of stock options in compensation--he is so clearly blowing smoke that it becomes difficult for me to trust anything else he says....

So here's where all that leaves me. I'm going to keep "accept[ing] as fact the findings of economists Thomas Piketty and Emanuel Saez." And anyone who says I shouldn't do so, without raising some major objections beyond the feeble array already trotted out by Reynolds, goes down in my book as something of a joker.

Paul Krugman: The Obama Agenda

If Obama wins, how much change will he bring about?:

The Obama Agenda, by Paul Krugman, Commentary, NY Times: It's feeling a lot like 1992 right now. It's also feeling a lot like 1980. But which parallel is closer? Is Barack Obama going to be a Ronald Reagan of the left, a president who fundamentally changes the country's direction? Or will he be just another Bill Clinton? ...

Reagan, for better or worse — I'd say for worse... — brought a lot of change. He ran as an unabashed conservative, with a clear ideological agenda. And he had enormous success in getting that agenda implemented. ... America at the end of the Reagan years was not the same country it was when he took office.

Bill Clinton also ran as a candidate of change, but it was much less clear what kind of change he was offering. He portrayed himself as someone who transcended the traditional liberal-conservative divide, proposing "a government that offers more empowerment and less entitlement." The economic plan he announced during the campaign was something of a hodgepodge: higher taxes on the rich, lower taxes for the middle class, public investment in things like high-speed rail, health care reform without specifics.

We all know what happened next. The Clinton administration achieved a number of significant successes... But the big picture is summed up by the title of a new book by the historian Sean Wilentz: "The Age of Reagan: A history, 1974-2008."

So whom does Mr. Obama resemble more? At this point, he's definitely looking Clintonesque.

Like Mr. Clinton, Mr. Obama portrays himself as transcending traditional divides. ... Mr. Obama's economic plan also looks remarkably like the Clinton 1992 plan...

Sometimes the Clinton-Obama echoes are almost scary. During his speech accepting the nomination, Mr. Clinton led the audience in a chant of "We can do it!" Remind you of anything?

Just to be clear, we could — and still might — do a lot worse than a rerun of the Clinton years. But Mr. Obama's most fervent supporters expect much more.

Progressive activists, in particular, overwhelmingly supported Mr. Obama during the Democratic primary even though his policy positions, particularly on health care, were often to the right of his rivals'. In effect, they convinced themselves that he was a transformational figure behind a centrist facade.

They may have had it backward.

Mr. Obama looks even more centrist now than he did before wrapping up the nomination. Most notably, he has outraged many progressives by supporting a wiretapping bill that, among other things, grants immunity to telecom companies for any illegal acts ... undertaken at the Bush administration's behest.

The candidate's defenders argue that he's just being pragmatic — that he needs to do whatever it takes to win, and win big, so that he has the power to effect major change. But critics argue that by engaging in the same "triangulation and poll-driven politics" he denounced during the primary, Mr. Obama actually hurts his election prospects, because voters prefer candidates who take firm stands.

In any case, what about after the election? The Reagan-Clinton comparison suggests that a candidate who runs on a clear agenda is more likely to achieve fundamental change than a candidate who runs on the promise of change but isn't too clear about what that change would involve.

Of course, there's always the possibility that Mr. Obama really is a centrist...

One thing is clear: for Democrats, winning this election should be the easy part. Everything is going their way: sky-high gas prices, a weak economy and a deeply unpopular president. The real question is whether they will take advantage of this once-in-a-generation chance to change the country's direction. And that's mainly up to Mr. Obama.

Social and Economic Ideologies

This diagram shows the "average economic and social ideology of adults within each state ... scaled so that negative numbers are liberal and positive are conservative...""

...In the graph below, each state is shown twice: the avg social and economic ideologies of Democrats in the state are shown in blue, the avgs for Republicans in red.

Socialeconomicideol1

...the big thing we see from the graph immediately above is that Democrats are much more liberal than Republicans on the economic dimension: Democrats in the most conservative states are still much more liberal than Republicans in even the most liberal states. On social issues there is more overlap (although in any given state, the average Republican is more conservative than the average Democrat). ...

The graph is from Andrew Gelman and David Park. More graphs here.

Does the Death Penalty Have a Deterrent Effect?

Justin Wolfers and Cass Sunstein say members of the Supreme Court "misread the evidence" on the deterrent effect of the death penalty:

A Death Penalty Puzzle The Murky Evidence for and Against Deterrence, by Cass R. Sunstein and Justin Wolfers, Commentary, Washington Post: ...Last month, capital punishment resumed after a seven-month moratorium. Rapid scheduling of executions followed the Supreme Court's ruling in Baze v. Rees, reaffirming the constitutionality of the death penalty in general and lethal injection in particular.

To support their competing conclusions on the legal issue, different members of the court invoked work by each of us on the deterrent effects of the death penalty. Unfortunately, they misread the evidence.

Justice John Paul Stevens cited recent research by Wolfers (with co-author John Donohue) to justify the claim that "there remains no reliable statistical evidence that capital punishment in fact deters potential offenders." Justice Antonin Scalia cited a suggestion by Sunstein (with co-author Adrian Vermeule) that "a significant body of recent evidence" shows "that capital punishment may well have a deterrent effect, possibly a quite powerful one."

What does the evidence actually say? ...

In short, the best reading of the accumulated data is that they do not establish a deterrent effect of the death penalty.

Why is the Supreme Court debating deterrence? A prominent line of reasoning, endorsed by several justices, holds that if capital punishment fails to deter crime, it serves no useful purpose and hence is cruel and unusual, violating the Eighth Amendment. This reasoning tracks public debate as well. While some favor the death penalty on retributive grounds, many others (including President Bush) argue that the only sound reason for capital punishment is to deter murder. ...

But what if the evidence is inconclusive? We are not sure how to answer that question. But as executions resume, the debates over the death penalty should not be distorted by a misunderstanding of what the evidence actually shows.

"McCain's Visit is Ill-Advised"

Don Pedro has a question:

Why is McCain Going to Colombia?, Economists for Obama: I just learned that McCain is going to Mexico and Colombia next week. Mexico, OK, but Colombia? Presumably, the idea is for him to highlight his support for the stalled U.S.-Colombia trade agreement. But do his advisers realize that Colombia is embroiled in a political crisis?

Colombia's president, Alvaro Uribe--the torch bearer for the trade agreement--was only able to run for the second term he's now serving because the Colombian legislature amended the constitution to permit re-election. The constitutional amendment passed by just one vote. Last week, the Colombian Supreme Court sentenced a former congresswoman for accepting favors in exchange for her vote. With that ruling, the Court questioned the legitimacy of Uribe's re-election, and asked the separate Constitutional Court to determine the validity of the amendment.

Uribe's response was to call for the 2006 election to be held again and to ask a congressional committee to investigate the Supreme Court. The idea of a new election might be reasonable if the 2006 election results were in question, but it's not. What's at issue is whether Uribe should have been a candidate at all in 2006. Uribe knows that he would easily win a new vote, because his popularity has skyrocketed due to his government's successes in the fight against the FARC guerrilla group.

Uribe's reaction is what you would expect from a populist dictator,--someone like Uribe's nemesis, Venezuelan president Hugo Chavez--and there have been calls for him to resign. In light of his popularity, Uribe will undoubtedly stay, but Colombia's political institutions will be increasingly frayed, and Uribe's image abroad will suffer. In particular, I think there's now little chance the U.S. Congress will approve the trade accord while Uribe is in office, regardless of whether McCain or Obama wins, since Uribe's authoritarian moves have given opponents of the agreement a whole new argument against it.

Which is all to say that McCain's visit is ill-advised. I'm sure he'll be asked repeatedly for his take on the crisis, and there's no right answer to that question. If he says he supports Uribe, he's backing an emerging dictator. And if he criticizes Uribe, he'll have to explain why he still supports signing the trade accord, despite Uribe's anti-democratic behavior. All of this makes me think the McCain people who scheduled this trip aren't the brightest crayons in the box. Recall that these are largely the people who weren't good enough to get jobs in the Bush administration.

Meanwhile, Obama's chief adviser for Latin America, Dan Restrepo (who is Colombian American) recently gave an interview (in Spanish) with Colombia's leading newsweekly. When asked if Obama would accept Uribe's invitation to visit Colombia during the campaign, he replied that Obama has said he's thought about visiting Latin America during the campaign, but that it's not easy. I think it is extremely unlikely that before the election Obama would follow McCain's lead and walk into the political minefield of a visit to Colombia.

links for 2008-06-30

June 29, 2008

Economist's View - 4 new articles

Sachs: "Simplistic Free-Market Optimism is Misplaced"

Jeff Sachs says this time it's different:

Saving Resources to Save Growth, by Jeffrey D. Sachs, Project Syndicate: Reconciling global economic growth, especially in developing countries, with the intensifying constraints on global supplies of energy, food, land, and water is the great question of our time. Commodity prices are soaring worldwide ... because increased demand is pushing up against limited global supplies. Worldwide economic growth is already slowing under the pressures...

A new global growth strategy is needed to maintain global economic progress. The basic issue is that the world economy is now so large that it is hitting against limits never before experienced. There are 6.7 billion people, and the population continues to rise by around 75 million per year, notably in the world's poorest countries. ...

Many free-market ideologues ridicule the idea that natural resource constraints will now cause a significant slowdown in global growth. They say that fears of "running out of resources," notably food and energy, have been with us for 200 years, and we never succumbed. Indeed, output has continued to rise much faster than population.

This view has some truth. Better technologies have allowed the world economy to continue to grow despite tough resource constraints in the past. But simplistic free-market optimism is misplaced for at least four reasons.

First, history has already shown how resource constraints can hinder global economic growth. After the upward jump in energy prices in 1973, annual global growth fell from roughly 5% between 1960 and 1973 to around 3% between 1973 and 1989.

Second, the world economy is vastly larger than in the past, so that demand for key commodities and energy inputs is also vastly larger.

Third, we have already used up many of the low-cost options that were once available. Low-cost oil is rapidly being depleted. The same is true for ground water. Land is also increasingly scarce.

Finally, our past technological triumphs did not actually conserve natural resources, but instead enabled humanity to mine and use these resources at a lower overall cost, thereby hastening their depletion.

Looking ahead, the world economy will need to introduce alternative technologies that conserve energy, water, and land, or that enable us to use new forms of renewable energy (such as solar and wind power) at much lower cost than today. ...

Yet investments in new resource-saving technologies are not being made at a sufficient scale, because market signals don't give the right incentives, and because governments are not yet cooperating adequately to develop and spread their use.

If we continue on our current course – leaving fate to the markets, and leaving governments to compete with each other over scarce oil and food – global growth will slow under the pressures of resource constraints. But if the world cooperates on the research, development, demonstration, and diffusion of resource-saving technologies and renewable energy sources, we will be able to continue to achieve rapid economic progress.

A good place to start would ... the climate-change negotiations... The rich world should commit to financing a massive program of technology development – renewable energy, fuel-efficient cars, and green buildings – and to a program of technology transfer to developing countries. Such a commitment would also give crucial confidence to poor countries that climate-change control will not become a barrier to long-term economic development.

An Increase in Worldwide Demand for Oil

Another round on the oil market model, this time to show what happens when there is an increase in the world demand for oil due to some factor such as increased demand from developing economies. The point is to show that, in this simple model, the increase in demand would increase in the long-run equilibrium price, but it would not change the level of inventories in the long-run. There are also other results to note, e.g. the possibility of overshooting the new long-run equilibrium and mimicking a bubble.

Case 1: An Increase in the Expected Future Price of Oil

First, the continuous time version of an increase in the expected price. I did a discrete time-version of this yesterday, but the continuous time version of this case Paul Krugman did yesterday is much simpler, so let's use that. Here's a quick review of that case:

Stockflow1

In this model, the initial equilibrium is at point a. Then, there is an increase in the expected future price or a drop in the interest rate that increases the stock demand, Nd, and the equilibrium moves to point b. At this point, the spot price is above the equilibrium value in the flow market shown on diagram on the right, and there is excess supply as indicated by the red line. This excess supply increases the stock so, as shown by the arrow, the stock supply curve begins shifting out. Eventually, the economy settles at the new equilibrium shown at point c.

Summarizing the results for an expected increase in the future price:

  1. The spot price, p, rises in the short-run, but is unchanged in the long-run.
  2. The stock of inventories, N, rises.
  3. The long-run flow equilibrium is unaltered.
  4. The change in inventories depends upon the horizontal shift in the stock demand curve. This can be related to the slope of the stock demand curve, but it is not necessarily the case that a steeper demand curve leads to a smaller horizontal shift.
  5. Steeper flow supply and demand curves affect the size of the change in the spot price during the transition (and the slopes can affect the transition path for inventories), but this does not change the ultimate size of the inventory change since this depends only upon the size of the shift in the stock demand curve.

Case 2: An Increase in Worldwide Demand for Oil

Moving to the next case, what happens if there is an increase in the world demand for oil due to worldwide economic growth. This shifts the flow demand curve outward:

Stockflow2

Starting at the equilibrium a, as the flow demand curve shifts out, this causes an excess demand for oil as shown by the red line on the diagram. This excess demand is met by reducing stocks, so the stock supply curve begins shifting left and the economy moves to point b. Thus, so far there is an increase in price, and a decline in inventories.

But this isn't the end of the story. Because the increase in flow demand is permanent, the increase in price is permanent, and this will increase the expected future price. The increase in the expected future price will shift the demand curve out as shown in the next diagram:

Stockflow3

As the demand curve shifts out to reflect the higher expected future price, the price moves up to point c. At point c, the flow market has excess supply as shown by the orange line segment, and this pushes the stock supply curve outward as the excess flow supply is absorbed as new stocks. Eventually, the economy reaches point d which, compared to point a, reflects a higher price but no change at all in inventories. Notice that the spot price overshoots its long-run value as it moves from b to c, then back down to b.

Why does the demand curve go through the same point for inventories as before? Recall from Krugman's post that Nd = N(i-(pe-p)/p), where i is the interest rate, p is the spot price, and pe is the expected future price. At the initial long-run equilibrium, it must be that pe=p, otherwise there would be a tendency for something to change (and hence it wouldn't be a long-run equilibrium [Update: I should add that there is no mechanism in this model to force pe=p, but adding this in is a simple fix, e.g. just add an equation that says dpe/dt = f(pe-p), f'<0,>e=p arises from making the model internally consistent with the definition of a LR equilibrium]). Thus, at the long-run equilibrium, the stock demand is just N(i). That means that the long-run equilibrium for stocks is independent of the spot price and its expected future value. Thus, the inventory level will be the same as its initial value after the offsetting changes in p and pe.

Summarizing the results for an increase in flow demand:

  1. The long-run spot price rises.
  2. In the short-run, the spot price can overshoot in the new long-run equilibrium. The model doesn't predict overshooting, the a-b-c-d progression shown in the diagram is just for exposition, the actual path can be different (e.g. there's no reason for the expected spot price to increase only after the economy reaches point b). But the model is consistent with overshooting, and therefore the change in the spot price can look like a bubble that is inflating, then deflating even though the change is driven purely by fundamentals, i.e. by a shift in world demand.
  3. The level of inventories can change in the short-run, but is unchanged in the long-run. (However, in a more general model, there might be a change in, say, the interest rate or convenience yield and this would cause an additional shift in the stock demand curve and change inventory levels. But it's still possible for the variation in inventories to be small.)

Finally, this is just a "vintage" Branson-style exchange rate model applied to commodities, so if you are familiar with those models and the bells and whistles that can be added to them, or with alternative models, for the most part the results and intuition ought to carry through to this case.

Update: From Paul Krugman in response to Tyler Cowen and others:

Stock-flow equilibrium (wonkish and trivial), by Paul Krugman: Oh, dear. I have the same feeling one gets when grading final exams: the students have missed the point so badly it must be my fault.

Tyler Cowen thinks I've made some institutional assumption that keeps markets from clearing.

It's stock-flow equilibrium: at any instant in time the price is determined by willingness of investors to hold the current stock, but over time this price leads to additions or subtractions to that stock.

I couldn't find an exchange rate example online, but here's an investment example where the price in question is Tobin's q, and the capital stock is what adjusts.

And it's not Hotelling. I know all about Hotelling; it's where I started my professional life (read the acknowledgments). Hotelling requires contango equal to the interest rate plus storage.

links for 2008-06-29

Do We Need Another Stimulus Package?

Robert Shiller says the stimulus checks don't provide enough insurance against the possibility of a recession, and much more is needed:

One Rebate Isn't Enough, by Robert Shiller, Economic View, NY Times: Tax rebates ... will eventually put more than $100 billion into the hands of consumers. The hope is that by spending the money, they will lessen the risk of economic disaster from the subprime crisis.

Have the rebates, now mostly distributed, achieved their objective?

It's not very likely. The rebates may be helping..., but the stimulus they are providing is certainly too small to make a real difference. More will be needed, perhaps much more, before the economy is truly on safe ground.

From the outset, government officials considered the tax rebates as a kind of insurance for the overall economy. ... Has the tax rebate substantially reduced the probability of a downward spiral?

It is too soon to tell, because the Treasury only started to send out rebate checks in late April. Retail sales did rise in May. But the dreaded serious recession still seems very much a possibility. The unemployment rate shot up to 5.5 percent in May, from 5 percent. The Reuters/University of Michigan consumer sentiment index has fallen below the lowest levels of the last two recessions.

The theory supporting tax rebates was originally devised by John Maynard Keynes... But people who have studied [Keynesian] models find that these repercussions aren't powerful enough unless the initial stimulus is really large. ... Why aren't they more powerful?

Part of the answer is in the slowness of people to spend extra money. Another is that some of the rebates will be spent on imports. That money will flow abroad..., with little of their rounds of expenditures finding their way back home. Third, the domestic expenditures will tend to result in higher interest rates,... which should reduce investment and lower asset prices. When asset values decline, people tend to cut spending through a negative "wealth effect."

It is also possible that ...[h]eightened anxiety about the economy might spur people to ... pay off debts and to save, rather than spend. ...

Fuzzy as this picture may seem, there is unfortunately even more uncertainty about the rebates' effects. ... [from] the peculiar lending dynamics in the subprime mortgage market,... the state of financial institutions' balance sheets and the confidence that the public has in these institutions..., the vagaries of speculative asset markets, mistakes by securities rating agencies and the problems of bond insurers.

The economy is too complex to capture all these things in any single model. In trying to steer the economy, we are necessarily trying to steer something we don't properly understand.

We simply do not have the means to quantify all the issues related to the rebates. But the models we do have suggest that the overall effects of the rebates are modest at best.

The reality of the subprime situation, augmented by the energy crisis, at least suggests that we'd better get ready for another round of rebates. There is little talk of it now, but we should be putting in place another stimulus package..., and stand ready for another after that, and another.

To me, the economy feels like a tug-of-war with good news on some fronts pulling one way, bad news on other fronts pulling in the other direction, and it's not yet clear which side will win the battle. If we can get more help on the good side of the rope, wouldn't that be best?

I'm sort of indifferent on a big push for a stimulus package right now, mostly because it seems like a non-starter on the political front - even if congress went along Bush would likely veto it - but it might also reflect a different probabilistic outlook for the economy. If we had included, say, infrastructure spending as part of the initial stimulus package, then the effects would kick in on a sustained basis over time rather than as a one-time hit as with the tax cuts. Thus, this type of spending could have provided the continuous stimulus Shiller is calling for. And if we are wrong and there is no recession, how big a problem is that? Well, what's so bad about building new infrastructure repairing what we already have, don't we need to do that anyway? With a stronger economy, wouldn't it be easier to pay for it? Insurance that also has investment value seems like a good bet to me. But we didn't include infrastructure spending, or any other type of sustained stimulus in the initial package, and while I'd like to see more infrastructure investment in any case, short of an obvious and sharp downturn in the outlook, there doesn't appear to be much chance of any new tax rebates, or spending on infrastructure or anything else anytime soon.

Update: Robert Reich says Unleash Fiscal Policy Now, or More Severe Recession Ahead.

June 28, 2008

Economist's View - 5 new articles

Do We Need Another Stimulus Package?

Robert Shiller says the stimulus checks don't provide enough insurance against the possibility of a recession, and much more is needed:

One Rebate Isn't Enough, by Robert Shiller, Economic View, NY Times: Tax rebates ... will eventually put more than $100 billion into the hands of consumers. The hope is that by spending the money, they will lessen the risk of economic disaster from the subprime crisis.

Have the rebates, now mostly distributed, achieved their objective?

It's not very likely. The rebates may be helping..., but the stimulus they are providing is certainly too small to make a real difference. More will be needed, perhaps much more, before the economy is truly on safe ground.

From the outset, government officials considered the tax rebates as a kind of insurance for the overall economy. ... Has the tax rebate substantially reduced the probability of a downward spiral?

It is too soon to tell, because the Treasury only started to send out rebate checks in late April. Retail sales did rise in May. But the dreaded serious recession still seems very much a possibility. The unemployment rate shot up to 5.5 percent in May, from 5 percent. The Reuters/University of Michigan consumer sentiment index has fallen below the lowest levels of the last two recessions.

The theory supporting tax rebates was originally devised by John Maynard Keynes... But people who have studied [Keynesian] models find that these repercussions aren't powerful enough unless the initial stimulus is really large. ... Why aren't they more powerful?

Part of the answer is in the slowness of people to spend extra money. Another is that some of the rebates will be spent on imports. That money will flow abroad..., with little of their rounds of expenditures finding their way back home. Third, the domestic expenditures will tend to result in higher interest rates,... which should reduce investment and lower asset prices. When asset values decline, people tend to cut spending through a negative "wealth effect."

It is also possible that ...[h]eightened anxiety about the economy might spur people to ... pay off debts and to save, rather than spend. ...

Fuzzy as this picture may seem, there is unfortunately even more uncertainty about the rebates' effects. ... [from] the peculiar lending dynamics in the subprime mortgage market,... the state of financial institutions' balance sheets and the confidence that the public has in these institutions..., the vagaries of speculative asset markets, mistakes by securities rating agencies and the problems of bond insurers.

The economy is too complex to capture all these things in any single model. In trying to steer the economy, we are necessarily trying to steer something we don't properly understand.

We simply do not have the means to quantify all the issues related to the rebates. But the models we do have suggest that the overall effects of the rebates are modest at best.

The reality of the subprime situation, augmented by the energy crisis, at least suggests that we'd better get ready for another round of rebates. There is little talk of it now, but we should be putting in place another stimulus package..., and stand ready for another after that, and another.

To me, the economy feels like a tug-of-war with good news on some fronts pulling one way, bad news on other fronts pulling in the other direction, and it's not yet clear which side will win the battle. If we can get more help on the good side of the rope, wouldn't that be best?

I'm sort of indifferent on a big push for a stimulus package right now, mostly because it seems like a non-starter on the political front - even if congress went along Bush would likely veto it - but it might also reflect a different probabilistic outlook for the economy. If we had included, say, infrastructure spending as part of the initial stimulus package, then the effects would kick in on a sustained basis over time rather than as a one-time hit as with the tax cuts. Thus, this type of spending could have provided the continuous stimulus Shiller is calling for. And if we are wrong and there is no recession, how big a problem is that? Well, what's so bad about building new infrastructure repairing what we already have, don't we need to do that anyway? With a stronger economy, wouldn't it be easier to pay for it? Insurance that also has investment value seems like a good bet to me. But we didn't include infrastructure spending, or any other type of sustained stimulus in the initial package, and while I'd like to see more infrastructure investment in any case, short of an obvious and sharp downturn in the outlook, there doesn't appear to be much chance of any new tax rebates, or spending on infrastructure or anything else anytime soon.

Another Iteration on the Speculation Model

Here's another iteration on the model of oil markets we've been developing. [Update: Paul Krugman comments on the model and provides a simple, continuous time version.]

(I doubt very many of you will have much interest in digging into the details, it's tedious, so the results are summarized at the end).

Here's where it stands. After posting the graphical version of the speculation model, and incorporating Steve Waldman's comments on convenience yields, Paul Krugman noted:

Steve Waldman is right. But we should add that the convenience yield isn't a fixed number. Actually — I should have realized this earlier — the demand for inventories is like the demand for money. People hold some money for convenience even though money normally yields less than bonds. The amount of money they hold, however, depends on the yield differential. Similarly, the demand for oil inventories should depend negatively on the interest rate minus the contango.

I'll reformulate my little model to reflect this when I get a chance. ...

And Tyler Cowen remarked:

Mark Thoma has an exhaustive post on convenience yield. The models used are too piecemeal and they allow "inventories," "convenience yield," and "speculation," to serve as free-floating, not necessarily attached concepts. The discussion here pays insufficient attention to Holbrook Working, who knew that convenience yield was front and center of the entire analysis, just as "the demand for money" is the centerpiece of the quantity theory. ...

I don't think I will deal sufficiently with Workings discussion for Tyler's taste on this iteration, maybe later, but let me try to incorporate some of the other comments and make convenience yield more "front and center".

The previous version mostly illustrated how the model worked, and used Krugman's model as a baseline for adding in Steve Waldman's suggestion that:

...the future price of a storable commodity is determined by the spot price plus the total cost of storage, defined as foregone interest, plus storage costs, minus ... the convenience yield...

Thus, all that was required was to subtract the convenience yield from the costs specified in Krugman's model, and show how that changed the results.

This model will be quite a bit different than the previous iteration, and, as you can guess from the introduction, I view this as a work in progress. Also, this is a general model of integrating stocks and flows, there may be particulars of oil markets that still need to be incorporated or that I've missed. But it hopefully captures the essence of what we are after.

The model assumes there is a flow demand and flow supply for oil each period. A period could be a day, a week, a month, something like that, I'll use a day just to fix ideas. For example, we might be at a flow equilibrium where we use 100 units of oil each day. Thus, at equilibrium there is a constant flow of oil - we bring in 100 units each day and burn it in our cars, use it to heat our homes, etc. The market is in equilibrium so both the flow demand and flow supplies are 100 at the current spot price.

There are also stock supply and stock demand curves in the model (stock meaning a quantity, not the financial asset sold on Wall Street). For example, suppose a speculator enters the market and wants to purchase 10 units of fuel to store and sell at a later date. The extra demand for fuel that day will increase the spot price. As the spot price goes up, the flow quantity demanded falls, the flow quantity supplied increases, say to 95 and 105 for an excess supply of 10. This 10 units can then be used to augment the speculators stock, as desired.

At this price, then, both markets clear. In the flow market, the price is above equilibrium and there is an excess supply of 10 units, but the extra 10 units are used to increase the existing stock of oil.

Here are the pieces of the model in more detail:

Stock Demand

The stock demand curve has two components, a speculative component, and a service or convenience yield component. The speculative demand, E, depends upon the expected net return from storing oil which, following the lead of others, is assumed to be

[(expected yield per unit) - (cost per unit)] = [((f-p)/p) - (i + c)],

where f is the expected future price, p is the spot price, i is the interest rate, and c is the storage cost. The first term, (f-p)/p, is the expected yield from holding oil and selling it at a future date. As the expected appreciation increases, demand increases. The term i is the opportunity cost of holding the oil, and as i goes up the demand goes down. When the storage costs, c, are higher, demand is lower. Therefore, speculative demand is

E = E[(f-p)/p - (i + c)],

and E is increasing in f, and decreasing in p, i, and c.

The other term is the convenience yield. Here, I'll take Krugman's suggestion above and model this as depending upon the difference between i and contango

C = C[i-(f-p)/p, c],

that is, it is assumed that the convenience yield depends negatively on the interest rate differential, and also negatively on the storage cost.

Note that all arguments have the same effect on demand as they did in the speculative demand case. That is, as p increases, the expected appreciation falls causing the interest rate differential to increase and this causes C, and hence overall demand for stock balances, to fall. As f increases, the appreciation term increases, the differential falls, and C goes up. Finally, as i and c increase, C falls.

The bottom line, then, is that total stock demand, the sum of speculative demand plus the convenience yield demand, is

D = E + C = D(p, f, i, c) ,

with signs -, +, -, -. [I need to think more about the specification of the arguments of the E and C functions above, but the bottom line assumption about the general form of D in terms of its arguments and their signs seems correct.]

Stock Supply

Stock supply at time t is assumed to be the stock supply at time t-1 plus any additions or subtractions from the stock due to imbalances in the flow market. That is,

St = St-1 + (s-d),

where s-d is the excess supply in the flow market. For example, if the flow supply is s=100, but the flow demand is only d=90, then the stock today, St, will rise above the stock yesterday, St-1, by (s-d) = 10.

The connection between the stock supply curve and excess supply or excess demand in the flow market shown in the equation will be important below, so here's how it fits together graphically:

Specul6

Start at the long-run flow equilibrium shown by Q0 and p*. At this price, the flow supply and flow demand curves are in balance.

Now let the price rise above p* to p1. At p1, there is excess flow supply as shown by the orange line, and this increases the stock above Q0 as shown by the corresponding orange line in the stock diagram. If the price increases again to p2, excess flow supply will go up as shown by the red line, and the stock supply rises to match, again as shown by the corresponding red line in the stock diagram.

For a decrease in the price to p3, there is excess demand in the flow market as shown by the green line, and the excess demand is met by reducing the stock as indicated by the green line in the stock diagram showing the stock falling below its initial value of Q0.

One further point on the mechanics of the model. Suppose the price rises to p1 as in the diagram increasing the stock supply by the amount indicated by the orange line. Since supply today is supply yesterday plus any additional stock added today from the flow market, i.e. since

S2 = S1 + (s-d),

the stock at the beginning of the second period will be higher than in the first period by the amount of the orange line.

This means that at the start of the next period the supply curve will shift out to reflect the higher initial stock:

Specul8

After the shift, the starting point at the beginning of the second period is p* and Q1, and the supply curve is S2. Any changes in the stock above or below Q1 must come from excess supply or demand in the flow market, as before. That is, the beginning second period looks just like the diagram above for the first period except that the initial stock is labeled Q1, not Q0, and the supply curve is S2 rather than S1.

Flow Demand

Nothing fancy here, will simply assume

d = d(p), d'<0

Flow Supply

Again, simply

s=s(p), s'>0

We can add more to these functions later as needed. For example, one key question to ask the model is what happens if d, the daily demand for fuel, increases permanently due to higher world demand, and this can be modeled by adding a variable to represent growth in world demand (e.g. world GDP).

We also want to ask the model about speculation, so let's do the graphs for that case next.

Here's a picture of the initial equilibrium:

Specul1

At the spot price of p*, both the stock market and flow markets are in equilibrium.

Now let f, the expected future price, go up for some reason. The increase in f will increase both the convenience yield and the expected appreciation, and this will shift the stock demand curve out:

Specul2

After the shift in demand due to the increase in f, and with price still at p*, there is excess stock demand. This excess demand begins to bid the spot price, p, up above p* and as it does excess supply begins appearing in the flow market. As the price gets higher, the excess flow supply, s-d, increases until at some point, p1 in the diagram, enough excess supply has been created to satisfy the increased stock demand.

Now lets move to the next period. As explained above, because the stock increased from Q0 to Q1, the stock supply curve shifts out to start the next period. The shift sets a new round in motion:

Specul3

The increase in the stock supply causes an excess of stock supply over stock demand at the temporary price of p1, that drives the spot price down to p2, and at p2, the new equilibrium, the excess flow supply just meets the amount needed to clear the stock market.

Again though, since the stock supply went up, there will be a new baseline stock for the next period. One more iteration to fix ideas:

Specul4

And finally, after enough time, we reach a new long-run equilibrium:

Specul5

At the new equilibrium, the spot price is the same as its initial value, the amount stored has gone up, and the flow equilibrium is unchanged.

Summarizing, an increase in the expected future price causes

1. a temporary increase in the spot price, but not a permanent increase. When the spot price goes up, some of the daily flow is diverted into storage, and this happens each day that the spot price is above p*. However, after enough time periods have passed, the stock of fuel in storage will be as high as desired, and there's no need or desire to divert any more of the flow into storage. At this point, the spot price returns to where it started, and the flow market will be in balance once again.

2. the amount stored to increase.

In addition,

3. the increase in the expected future price that shifts the stock demand curve isn't driven by a change in the fundamentals in the model, i.e. the change did not shift the S, D, s, or d curves. Thus, if the expected future price returns to its long-run value of p* over time, as it should since nothing fundamental changed, this would all reverse itself. The whole process described above would run backwards.

4. a signature of speculation of the type modeled here is changes in stocks. When the expected future price goes up storage increases, when it goes down, storage decreases.

5. an increase in the spot price over long periods of time is not likely to be a signature of speculation. Speculation can and does drive the price in the short-run, but not the long-run.

Interesting that an increase in speculative demand for oil causes a temporary price spike, but not a permanent one. I missed that before. I guess that's why you build models (and this is a work in progress - more iterations may be needed...).

There are lots of questions we can ask this model, and I probably haven't asked the model the questions Arnold Kling or Tyler Cowen might want to ask of it, but next up: Use the model to show what happens in the short-run and long-run when there is an increase in d, the flow demand, due to an increase in the world demand for oil. I think I can show this is consistent with very little change in inventories, i.e. with little change in stocks, but we shall see. If so, then an increase in flow demand, d, from growth in world demand would be consistent with rising prices and stagnant (or even falling) inventories, while an increase in speculation would show little change in the price and higher inventories. Thus, if we were to observe rising prices and stagnant inventories, that would be consistent with a world demand growth story, but inconsistent with a story that involves an increase in speculative activity to a higher level (though spot prices would rise in the short-run, and a continual infusion of new speculative activity could keep the spot price rising until the increase in speculative activity leveled off).

[In the link in the update at the beginning of the post, Paul Krugman recasts this model in continuous time rather than discrete time.

For example, as he notes, at a point in time with inv=inventories and p = the spot price, let the reduced form equations be p=f(inv, expected future p) and dinv/dt = S(p)-D(p). In this model, as in the model above, the equilibrium price is determined the stock equilibrium and the flows from the commodity market change the stocks over time. It's "basically Bill Branson's 1970-something portfolio balance exchange rate model adapted to commodities." The continuous time formulation is a much simpler framework, both mathematically and graphically.]

"The Blame for High Gas prices"

Richard Serlin:

The blame for high gas prices rests on simple-minded Republican ideology not speculators, by Richard Serlin: In Paul Krugman's June 27th column he writes:

Why are politicians so eager to pin the blame for oil prices on speculators? Because it lets them believe that we don't have to adapt to a world of expensive gas.

A perhaps even bigger reason why Republicans want to blame speculators for sky high gas costs is that they don't want the public to put the blame where it's really due – on them.

For decades Republicans have constantly blocked Democratic attempts to increase fuel mileage and many other efficiency and conservation measures. They've also constantly blocked or cut spending on alternative energy, all the while mindlessly chanting "Free market". The economics community had proven long ago that there are many situations and ways where a government role can add greatly to efficiency, wealth, and welfare, but this is a party that long ago refused to think beyond slogans. They acted as though not being simple-minded was a vice, liberal and un-American, when in fact, thinking, and believing in science, evidence, and logic is one of the things that made this country great, and the richest and strongest in the world.

Now we're paying a big price for Republican ideology in energy and so many other things. Had the Democrats not been outvoted, filibustered, and vetoed from enacting their "big government" mileage, conservation, research, and other energy measures over the last almost three decades, gasoline might be less than half its price today...

And, of course, it wouldn't hurt that this would have starved the terrorists, and some of the worst authoritarian regimes in the world, of money, and greatly decreased the momentous risks of global warming,... benefits that aren't taken into account by the magical free markets. ...

It's the Only Thing

On the political front, what do you think of this argument?:

For Obama, winning is everything, by Michael Tomasky: So we've now plunged into the turbid waters of the age-old expediency versus principle debate. Three times now in the space of a week, Barack Obama has departed from what would seem to be liberal principle: his refusal to accept public financing for the general election, his decision to vote for a bill that gives American telecoms retroactive immunity from prosecution for cooperating with the Bush administration's surveillance initiatives and his statement siding with the supreme court's conservative minority that on Wednesday voted to permit the death penalty for child rapists. Denunciations are ringing across the blogosphere.

We'll go through the issues individually. But the larger question here is about how far a candidate for president can go to inoculate himself against likely attacks – attacks that have a proven track record of working – before he's no longer the candidate you believed in a year ago. ...

Liberals don't have to be happy about these decisions, and those who want to attack Obama and hold his feet to the fire and so forth should do so to their heart's content. But it's worth remembering that a presidential campaign is one of the worst contexts in which to expect or demand ideological consistency.

Obama has, in fact, taken a number of strong stands that might hurt him. He did back the supreme court on habeas corpus rights for non-citizen detainees – not a popular position. He's against offshore oil drilling while polls are showing that majorities support it. His is a position that could harm him in the crucial state of Florida, but he's taken it. He'll presumably continue to stand his ground on opposing the federal gas-tax repeal, a position John McCain might choose to revive at some point. And he will have to defend ... his support for increasing the capital gains tax by up to 10%, as he will assuredly be attacked for that. He supports a large cap-and-trade scheme on carbon emissions that will surely be attacked as a tax on business. And so on.

I've always objected to setting up principle as a value that's oppositional to winning. To me, winning is a principle. It's the highest principle there is. If you win the election, you can do at least some of the good things that will improve people's lives in the country and around the world. If you lose it, you can't do any of them.

People will naturally disagree on which compromises are necessary and which ones aren't. What people shouldn't disagree on is that some are. ...

Are we sure these are positions of convenience rather than what he actually believes?

links for 2008-06-28

Economist's View - 4 new articles

FRBSF: Consumer Sentiment and Consumer Spending

Today, we learn that "The consumer sentiment index fell to ... the lowest since 1980 and the third-lowest reading in the 56-year history of the survey."

Will this impact consumer spending? Perhaps, as "Forecasts including the [Index of Consumer Sentiment] questions were more accurate when consumption growth was falling (as in the 2001 recession) or low (as in the sluggish recovery year of 2002) and when the economy was slowing (as in 2007). ... Thus, the forecasting contributions of consumer attitudes seem stronger when the economy is weaker, although, admittedly, the reasons for these results are not yet fully understood":

Consumer Sentiment and Consumer Spending, by , James A. Wilcox, FRBSF Economic Letter: In the U.S. economy, two-thirds of production and expenditures are devoted to consumer spending, or personal consumption expenditures (PCE), which include most of retail sales, as well as households' expenditures on such items as rent, utilities, and much of medical care. Because this is such a large sector of the economy, the forecast accuracy of PCE affects the forecast accuracy of some of the key variables that policymakers focus on, such as unemployment, incomes, inflation, and interest rates. A large body of research has documented that measures of income, wealth, and interest rates, which indicate consumers' ability to spend, do consistently help forecast future consumer spending. The research results are less consistent, however, for forecast models that also include measures of consumers' willingness to spend, such as the University of Michigan's Index of Consumer Sentiment (ICS). Nonetheless, at some times, measures of consumer attitudes do seem to provide additional information about households' future spending; one such example is the period near the 1990-1991 recession.

This Economic Letter describes how the ICS is constructed and reviews some past research on whether measures of consumer attitudes improve forecasts of consumer spending. It also reports on some new research, which found that using the answers to the individual component questions of the ICS, rather than the ICS itself, further improved forecasts of PCE and its components. Finally, it shows how much and when measures of consumer attitudes might have helped forecasts in recent years.

Component questions of the ICS

From the large number of questions that it asks households, the University of Michigan's Survey Research Center constructs the ICS by aggregating the answers to five questions. (The possible answers to the five questions that are used to construct the ICS are shown in brackets below.)

1. "We are interested in how people are getting along financially these days. Would you say that you (and your family living there) are better off or worse off financially than you were a year ago?" [better off, same, worse off, or don't know]

2. "Now looking ahead—do you think that a year from now you (and your family living there) will be better off financially, or worse off, or just about the same as now?" [better off, same, worse off, or don't know]

3. "Now turning to business conditions in the country as a whole—do you think that during the next 12 months we'll have good times financially, or bad times, or what?" [good times, uncertain, bad times, don't know]

4. "Looking ahead, which would you say is more likely—that in the country as a whole we'll have continuous good times during the next 5 years or so, or that we will have periods of widespread unemployment or depression, or what?" [good times, uncertain, bad times, don't know]

5. "About the big things people buy for their homes—such as furniture, a refrigerator, stove, television, and things like that. Generally speaking, do you think now is a good or a bad time for people to buy major household items?" [good time, uncertain, bad time]

Why consumer attitudes might improve forecasts

Measures of consumer attitudes, such as the ICS, might improve consumption forecasts for several reasons. First, while most other macroeconomic data report what already happened, the ICS data report on consumers' views about their own and the economy's recent, current, and expected economic conditions. Thus, these data may be more informative about future consumer spending.

Second, consumer attitudes may incorporate households' estimates of the impacts of rare or even unique shocks, whose effects cannot be directly estimated from past experience or data. Such events might include the first oil embargo and oil price shock in the mid-1970s, the Gulf wars, the effects of Hurricane Katrina, or even a dramatic surge in oil prices to well over $100 per barrel. Such shocks could include events or policies that importantly change how the economy operates. For example, if a new Fed Chair were widely anticipated to follow a distinctly different monetary policy from his predecessor's, consumer attitudes then might well incorporate how households, businesses, and the entire economy might react differently to various economic and financial events. The changed responses of consumer spending would not typically be forecastable from macroeconomic data.

Third, households' answers might reflect changed expectations and uncertainties about future conditions that have not yet occurred. For example, significant changes in political candidates' election prospects might lead households to have both higher expectations of and higher uncertainty about future taxes. As a result, the numbers of households who answer that this is a good time to buy major household goods might well decline, followed by actual declines in such purchases. These repercussions on households' expectations and on their spending often would not be captured by the macroeconomic variables that are typically used to forecast consumer spending.

Some results of previous research

Research has long noted a strong, positive correlation between consumer attitudes and consumer spending. The empirical evidence, however, is less consistent about whether, once other macroeconomic variables are allowed for, consumer attitudes forecast consumer spending. Juster and Wachtel (1972a, b), for example, reported that "anticipatory variables" (including the ICS) were of considerable importance in forecasting expenditures on autos. Kelly (1990) reported that consumer attitudes directly affected consumer spending, imports, business inventories, and industrial production. In addition, Carroll, Fuhrer, and Wilcox (1994) reported that consumer attitudes further improved consumption forecasts, even after other macroeconomic variables were allowed for.

In other studies, however, consumer attitudes did not significantly improve consumption forecasts when macroeconomic variables (such as income, interest rates, assets, or liabilities) were taken into account. Hymans (1970) pointed out that in the majority of econometric models, consumer attitudes played little if any part. Mishkin (1978) found that, once the effects of financial assets and liabilities were considered, the effects of consumer attitudes were typically insignificant. Further, the large, multi-equation forecasting models of the Federal Reserve, of the OECD, and of some consultancies historically omitted consumer attitudes from their equations for forecasting consumer spending.

Recent research

Wilcox (2007) compared models for forecasting consumer spending without measures of consumer attitudes to models with them. The study evaluated the forecasting improvements attributable to the ICS and to each of its component questions. The study used national aggregate data for 1960-2006 for (annualized growth rates of seasonally adjusted, real, per capita) consumer spending, personal disposable income, and household wealth. Consumer spending was measured by PCE. The study also evaluated forecasts of the components of PCE: durables (including expenditures on vehicles and on nonvehicle durables), nondurable goods, and services. To explore further the forecasting contributions of consumer attitudes, out-of-sample forecasts were calculated for each year from 2000 through 2005.

The baseline models used in the study were fairly similar to those used by Carroll, Fuhrer, and Wilcox (1994), Bram and Ludvigson (1998), and others: the models forecast the annualized, one-quarter-ahead and four-quarter-ahead growth rates of consumption (and each of its components), based on four quarterly lags of the forecasted variable, of income, of the home-equity and non-home-equity components of household net worth, and the levels of interest and inflation rates. Interest and inflation rates were represented by the one-year nominal interest Treasury bill yield and the year-over-year percent change in the seasonally adjusted, quarterly average, consumer price index.

Forecasting results

—Earlier studies typically focused on the ICS, which aggregates the answers to the five questions above. In contrast, this study found that the individual component questions were much more informative about future consumption than the aggregate ICS. For instance, answers to Question 5 more reliably improved year-on-year forecasts of total consumption growth and each of its components than did either the ICS or any of the other four questions.

—Earlier studies focused on the usefulness of the ICS for forecasting consumption for the next calendar quarter. This study found that the individual component questions (and the ICS) much more reliably improved forecasts for a longer, four-quarter horizon.

—Earlier studies found that consumer attitudes improved forecasts of expenditures on durables and, in particular, on the vehicles component of durables. The study found that the individual component questions of the ICS improved not only forecasts of expenditures on durables but also forecasts of expenditures on nondurables and on services.

—Earlier studies focused on whether consumer attitudes improved forecasts after considering the effects of income, wealth, and interest rates. The study found that the individual questions tended to improve forecasts of PCE and of its components as much as, or more than, macroeconomic variables did.

—The study also found that including the ICS or its components improved forecasts for recent years.

Figure 1: actual consumption growth and forecasts excluding and including consumer attitudesFigure 1 shows the actual growth rate of (real, per capita) PCE for each year during 2001-2007 and two sets of forecasts that, for each year, could have been made from the end of the prior year. The middle bar for each year shows forecasts based on models that excluded any questions about consumer attitudes ("excluding attitudes"). The rightmost bar shows forecasts based on models that included all five component questions of the ICS ("including attitudes"). Forecasts excluding the questions averaged about 1 percentage point above, while forecasts including them averaged about ½ percentage point below, actual consumption growth. By that measure, forecasts including the questions were more accurate.

Increases or decreases in accuracy seem to align with periods of weakness or strength in the economy. Forecasts including the ICS questions were more accurate when consumption growth was falling (as in the 2001 recession) or low (as in the sluggish recovery year of 2002) and when the economy was slowing (as in 2007). Forecasts excluding the ICS questions were more accurate when the economy and consumer spending were booming (as in 2005 and 2006). Thus, the forecasting contributions of consumer attitudes seem stronger when the economy is weaker, although, admittedly, the reasons for these results are not yet fully understood. Given the importance and difficulty of forecasting when the economy is weaker, that strength may appear just when it is most valuable to analysts and policymakers.

References

Bram, Jason, and Sydney C. Ludvigson. 1998. "Does Consumer Confidence Forecast Household Expenditure? A Sentiment Index Horse Race." FRB New York Economic Policy Review 4(2), pp. 59-78.

Carroll, Christopher D., Jeffrey C. Fuhrer, and David W. Wilcox. 1994. "Does Consumer Sentiment Affect Household Spending? If So, Why?" American Economic Review 84(5), pp. 1,397-1,408.

Hymans, Saul H. 1970. "Consumer Durable Spending: Explanation and Prediction." Brookings Papers on Economic Activity 2, pp. 173-199.

Juster, F. Thomas, and Paul Wachtel. 1972a. "Inflation and the Consumer." Brookings Papers on Economic Activity 1, pp. 71-114.

Juster, F. Thomas, and Paul Wachtel. 1972b. "Anticipatory and Objective Models of Durable Goods Demand." American Economic Review 62(4), pp. 564-579.

Kelly, David. 1990. "The Plunge in Confidence Will Hit Spending, But How Hard?" DRI/McGraw Hill U.S. Review.

Mishkin, Frederic S. 1978. "Consumer Sentiment and Spending on Durable Goods." Brookings Papers on Economic Activity 1, pp. 217-231.

Wilcox, James A. 2007. "Forecasting Components of Consumption with Components of Consumer Sentiment." Business Economics 42(4), pp. 36-46.

Paul Krugman: Fuels on the Hill

Blaming speculators for high oil prices is a way to avoid facing the reality that things will have to change:

Fuels on the Hill, by Paul Krugman, Commentary, NY Times: Congress has always had a soft spot for "experts" who tell members what they want to hear, whether it's supply-side economists declaring that tax cuts increase revenue or climate-change skeptics insisting that global warming is a myth.

Right now, the welcome mat is out for analysts who claim that out-of-control speculators are responsible for $4-a-gallon gas.

Back in May, Michael Masters, a hedge fund manager, made a big splash when he told a Senate committee that speculation is the main cause of rising prices for oil and other raw materials. ...

Many economists scoffed: Mr. Masters was making the bizarre claim that betting on a higher price of oil ... is equivalent to actually burning the stuff.

But members of Congress liked what they heard, and ... much of Capitol Hill has jumped on the blame-the-speculators bandwagon.

Somewhat surprisingly, Republicans have been at least as willing as Democrats to denounce evil speculators. But it turns out that conservative faith in free markets somehow evaporates when it comes to oil. For example, National Review has been publishing articles blaming speculators for high oil prices for years...

And it was John McCain, not Barack Obama, who recently said this: "While a few reckless speculators are counting their paper profits, most Americans are coming up on the short end..."

Why are politicians so eager to pin the blame for oil prices on speculators? Because it lets them believe that we don't have to adapt to a world of expensive gas.

Indeed, this past Monday Mr. Masters assured a House subcommittee that ..[i]f Congress passed legislation restricting speculation,... gasoline prices would fall almost 50 percent in a matter of weeks.

O.K., let's talk about the reality.

Is speculation playing a role in high oil prices? It's not out of the question... Whether that's happening now is a subject of highly technical dispute. (Readers who want to wonk themselves out can go to my blog and follow the links.) Suffice it to say that some economists, myself included, make much of the fact that the usual telltale signs of a speculative price boom are missing. But other economists argue, in effect, that absence of evidence isn't solid evidence of absence.

What about those who argue that speculative excess is the only way to explain the speed with which oil prices have risen? Well, I have two words for them: iron ore.

You see,... its price is set in direct deals between producers and consumers. So there's no easy way to speculate on ore prices. Yet the price of iron ore, like that of oil, has surged over the past year. In particular, the price Chinese steel makers pay to Australian mines has just jumped 96 percent. This suggests that growing demand from emerging economies, not speculation, is the real story...

In any case, one thing is clear: the hyperventilation over oil-market speculation is distracting us from the real issues.

Regulating futures markets more tightly isn't a bad idea, but it won't bring back the days of cheap oil. Nothing will. Oil prices will fluctuate in the coming years ... but the long-term trend is surely up.

Most of the adjustment to higher oil prices will take place through private initiative, but the government can help the private sector in a variety of ways, such as helping develop alternative-energy technologies and new methods of conservation and expanding the availability of public transit.

But we won't have even the beginnings of a rational energy policy if we listen to people who assure us that we can just wish high oil prices away.

"Why the Stock Market Had a Terrible Day"

I think the Fed made the right move at its last rate setting meeting when the target rate was held constant, but Robert Reich doesn't share that view. He wants action on both the monetary and fiscal policy fronts to prevent a downturn, rebuild infrastructure, and implement green technologies. I don't think we need the threat of a recession to justify spending more on infrastructure and the environment, so I'd support that in any case:

Why the Stock Market Had a Terrible Day, by Robert Reich: The big surprise is why anyone should be surprised the stock market dropped 3 percent today. The immediate trigger was the price of oil moving above $140 a barrel for the first time. A secondary trigger was yesterday's decision by the Fed not to reduce interest rates. (Some conservatives maintain it was the Fed's failure to RAISE them that caused today's ruckus on Wall Street... They're wrong. The recession is the biggest worry for everyone...) Another was the implosion of the US autos sector, and additional writedowns by major Wall Street banks.

But behind all of this is the one fundamental fact that economic analysts would rather not dwell on: American consumers are at the end of their ropes. High energy prices have contributed to it, as have high food prices. Consumer confidence is plunging. Housing prices are still dropping, which means the piggy banks of home equity and refinancing are closing.

But without consumers, there's no one to buy all the goods and services we create. Sure, big American companies are doing fine abroad, but foreign sales can't sustain them. Nor can exports. Hence, bond defaults by companies are up. Earnings are down.

What to do? Two things. We need an expansive fiscal policy that stimulates the economy with infrastructure spending -- especially mass transit, levees, and bridges, as well as investments in green technologies.

We also need a more progressive tax system that puts more money into the hands of the middle class and working class -- which will spend it. ...

links for 2008-06-27