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May 19, 2009

Economist's View - 6 new articles

Notes

This is just for my records:

The Paul Mann Show, Arcata, CA KHSU May 19, 7:30-8:30 p.m. The Mark and Dave Show, Portland, OR KEX May 12, 3:30-3:40 p.m. The Mark Martinez Show, Bakersfield, CA KGEO May 9, 3:30-4:00 p.m.

I also, on occasion, do the Mark Thoma show in Springfield, Illinois.

I've been wondering why most of the hosts who call me are named Mark, or even share my name completely, and if that's the main reason they call (it's definitely the reason I was called in one case). So I was glad when Paul Mann called me to do his show again.


"Paul Romer's Many Hong Kongs"

Michael Perelman discusses Paul Romer's new initiative:

Paul Romer's Many Hong Kongs, by Michael Perelman: I just got this from Stewart Brand, who organizes lectures at San Francisco's Fort Mason. Romer is suggesting that less developed countries contract with capitalist nations to set up Hong Kong's for them. What about the alternative, having capitalist nations let us set up little socialist republics to demonstrate an alternative system.

This talk was the first public launch of an idea that Romer has been working on for two years.

His economic theory of history explains phenomena such as the constant improvement of the human standard of living by looking primarily at just two forms of innovative ideas: technology and rules.

Technologies rearrange materials with ingenious recipes and formulas. More people create more technologies, which in turn generates more people. In recent decades technology has enabled the "demographic transition" which lowers birthrates and raises income per person even higher as population levels off.

Rules structure the interactions between people. As population density increased, the idea of ownership became an important rule. A supporting rule for managing violations replaced the old idea of deadly vengeance with awarding damages instead: simply shifting value replaced destroying value. For the idea of open science, recognition replaced ownership as the main event, which means that whoever publishes first is most rewarded, and that accelerates science.

Rules can amplify or stifle technological progress. China was the world leader in inventing new technologies until about a thousand years ago, when centralized dynastic rules slowed innovation almost to a stop.

Romer notes that business keeps evolving as new companies introduce new rule sets. The good ideas are copied, and workers migrate from failing companies to the new and old ones where the new rules are working well. The same goes for countries. Starting about 1970, China took some of the effective rules of Hong Kong (which was managed from afar by England) and set up four special economic zones along the coast operating as imitation Hong Kongs. They worked so well that China rolled out the scheme for the whole country, and its Gross Domestic Product took off. "Hong Kong was the most successful economic development program in history."

Romer suggests that we rethink sovereignty (respect borders, but maybe import administrative control); rethink citizenship (support residency, but maybe import voice in political affairs); and rethink scale (instead of focusing on nations, focus on cities—on city states like Hong Kong and Singapore.)

Paul Romer proposes that developing countries could invite instant Hong Kongs—new cities in new locations run by experienced governments such as Canada or Finland. They would enrich the country where they are built as special economic zones while also rewarding the distant government that makes the investment of building the new city state and installing a set of fair and productive rules. Over time, as with Hong Kong, the new city is turned over to the host country.

The idea is getting some traction in the developing world. This summer Romer is going public with a Bridge Cities Institute website for further exploration and eventual application of the idea.

One miracle of cities is that they sometimes renew themselves brilliantly. This could be a whole new form of that.


FRBSF Economic Outlook

Here's a graph from latest forecast from the San Francisco Fed. No surprise - they are not expecting a quick recovery relative to past recessions:

Slow-recovery

As for the timing, they believe we are past the bottom, and headed back up - slowly - into positive growth by the end of the year:

Gradual

That's for GDP. To me the forecast seems optimistic, but in any case, employment is unlikely to turn around until many months after output recovers. From the report:

In sum, we expect GDP growth to turn positive by the fourth quarter of this year. However, we envision a much slower recovery than those of the past four recessions. In fact, we only expect GDP growth to return to its trend level by the end of 2010. ...We expect this persistent slack in the economy will result in a peak unemployment rate of around 9.5 percent and a very slow decline in the rate during 2010 and 2011.

And again, to me that seems optimistic. Let's hope the forecast is correct, or even understates the speed of recovery, but policymakers must take seriously the possibility that this forecast - as has been generally true for all the forecasts from various sources that have come before it - will have to be revised downward later.


"Foolish Consistency"

Paul Krugman says:

Prodigal intellectuals: So I see Richard Posner has decided that modern conservatism is intellectually bankrupt. And Bruce Bartlett has a new book saying it's time to let go of Reagan.

At one level it's good to see decent people showing some intellectual flexibility (Bartlett, in particular, has always come across as someone with whom one can have honest disagreements.) And yet — why, exactly, should we listen to people who by their own admission completely missed the story? I mean, anyone who actually listened to what Newt Gingrich and Dick Armey were saying in 1994, let alone what passed for thought in the Bush administration, should have realized long ago that if there ever was an intellectual basis for modern conservatism, it was long gone.

And the truth is that the Reaganauts were a pretty grotesque bunch too. Look for the golden age of conservative intellectualism in America, and you keep going back, and back, and back — and eventually you run up against William Buckley in the 1950s declaring that blacks weren't advanced enough to vote, and that Franco was the savior of Spanish civilization.

So the idea that we should pay any attention to people who somehow failed to see all this until very late in the game — and, in the case of Posner (not Bartlett), waited to express their doubts until conservatism had lost power …

Bruce Bartlett emails:

Paul Krugman says nice things about me.

I posted a comment that has not yet appeared saying that Washington tends to enforce a foolish consistency. If you are someone of some prominence whose views are known publicly, then everything you have ever said in the past tends to be projected forward and everything you say today is projected backward. Any discrepancy potentially brings charges of flip-flopping or hypocrisy or selling-out or whatever. Certainly, these charges are valid in many cases, but the simple possibility that circumstances have changed or that experience or new evidence has caused one to change one's mind seems never to be seriously entertained. The result is to force people to stick with positions they know are wrong because they less fear being foolishly consistent than being attacked for flip-flopping.

Part of this is the clash of economic and social conservatism and the inherent conflict between the two groups within the GOP. Social conservatives are anything but anti-government no matter how much they might want you to think otherwise. Gary Becker highlights this:

Its support of competition and private markets, and hostility to sizable regulations, is a direct descendant of the classical liberal views, as espoused for example in Smith's Wealth of Nations. ... To such conservatives, the present US government's management of the American auto industry is an invitation to disaster... Classical conservatism would recognize that the intervention of the Fed and Treasury in the finance sector may be necessary, given the crisis in that sector, but classical conservatives would look for this involvement to end as soon as possible.

The other pillars of modern conservatism are aggressive foreign policy to promote democracy in other countries, and government actions to further various social goals, such as fewer abortions or outlawing gay "marriage". These views fit less comfortably in the conservative tradition that is hostile to big government and skeptical about the use of government power to override individual decisions. Classical conservatives would argue that governments are no more effective at interventions internationally or on social issues than they are on economic matters. So governments should usually not get involved in such issues...

The ... Republican Party under the leadership of Eisenhower and Reagan had a more consistent classical conservative philosophy... Neither Eisenhower nor Reagan was particularly religious, and they did not have strong views about gays or abortion rights. The shift in the attitudes of the Republican Party toward more interventionist views on social issues, and to some extent also on military involvement to create more democratic governments in other countries, has created this crisis in conservatism.

But is that all it is, the inevitable clash of a coalition within the GOP with very different views about the use of government to promote social issues and democracy, a clash currently being won by the Rush Limbaugh wing of the party?

I think it's more than that. It's also the view that the party has been captured by the rich and powerful, that the party's interests do not include the typical household. For a long time the GOP could claim that what was good for rich, white, powerful males who dominated the financial industry, or industry more generally, was good for everyone, working class and rich alike. Ideas like "trickle down" economics expressed this directly, but so does the view, for example, that if we raise taxes the rich will flee to another country leaving us helpless and unable to respond with creative innovations to a changing, dynamic world. If the rich leave the country, where will that leave the working class? Without anywhere to work, or so the story goes. Where would we be without our rich overlords to provide for us?

When everyone was doing well during the bubble - jobs were plentiful, housing and stock prices were going up, etc. - it appeared that everyone was sharing in the bounty. Sure, the rewards were unequal, and the reality was that although we were near full employment, wages were stagnating for the middle class, but that's not what we heard about during this time. Rather it was all about our dynamic, flexible, wonderful, laissez faire economy providing high rates of economic growth and opportunity. If you were stuck in a dead end job, did not own a house, did not have 401ks for retirement to capture your share of the wealth, and so on, why that was your own fault, your own lack of initiative. The opportunity was there, you just had to knock on the door. And if you didn't, then that is your problem, not a problem with the system (of course, in reality we are a less mobile society than much of Europe, but the popular belief was otherwise).

But it all came crashing down when the air came out of the housing bubble. The crash in housing prices, stock prices, job markets, etc. made it clear that wealth and opportunity hadn't been shared after all, it had been distributed upward, massively, and the bailout that was needed - a bailout that would fall on households - would only make that worse. The idea that free, unregulated markets where the rich and powerful were left alone to do their economic wonders for the world began to be revealed as a false promise. After the crash, the typical household was no better off than it had been decades before, many were worse off, and given the uncertainties before us it's not clear when that will change.

The political consequences of the realization of these false promises has been large. Arnold Kling explains why he thinks the GOP is in big political trouble going forward:

1. The larger Hispanic population poses a challenge for Republicans.

2. For the next few years, the Federal government will dominate the economy as never before. Corporate leaders will come to realize that it is a business necessity to support Democrats financially and to co-operate with them in terms of public relations (for example, the health care trade groups promising to help President Obama with health care costs).

3. As I recall, the Senate elections in 2010 will have more vulnerable Republican seats, so that the Republicans should be deeper in the hole for 2012 and 2014.

4. The census in 2010 is likely to show much bigger population increases in urban areas. Although the fastest-growing states are Red states, the shift within those Red states is probably toward more urban, Democratic populations. That will hurt Republican chances of gaining in the House. Also, note that the White House has taken control over the census.

5. The Republican Party leaders are not exactly impressive.

6. The divisions within the Republican Party seem difficult to overcome. Both economic libertarians and social conservatives fear being betrayed. Yet all sorts of people are telling the Republicans that in order to broaden their appeal they have to be either less socially conservative, less economically libertarian, or both.

7. Young voters are neither socially conservative nor economically libertarian. Look at how badly the Republicans did in 2008 with voters born after 1980. Over the next several elections, the proportion of the electorate born after 1980 is going to increase.

The Republican party will be back. It wasn't all that long ago that I was very unhappy with the voices representing the Democratic Party. In my view, they were way too far left, too shrill, too anti-market, and they were driving away voters in the middle of the political spectrum. I wanted new voices, new faces representing the party in the media - I thought our Limbaugh equivalents were hurting us - and the outlook I had for the party was as grim as it appears to be for Republicans right now. (I should note that my own views have shifted a bit and the voices I once heard as unreasonable - particularly on matters dealing with free market economics - now sound a whole lot wiser.)

What will the Republican party look like ten years from now? The pendulum always swings back, and Republicans will find their voice and their appeal once again. I'm not sure exactly sure what the party will look like, whether the social or economic conservatives will prevail, and to what extent international relations will play a role. Maybe it will be something else entirely. But I have no doubt the GOP will move to make itself more attractive to the typical household, particularly since most of those in control of the party who remember things like Vietnam and the threat of socialism as if it were still happening today, those from "the golden age of conservative intellectualism," are getting along in their years and will be replaced by younger leaders with new ideas. And when that happens, the political process will, once again, be as competitive as it can be in a market with only two dominant players. It's nice having a monoply on political power, and I hope that Democrats continue to win, but it's hard to deny that the process works better when there is effective (and sane) opposition.


FRBSF: U.S. Household Deleveraging and Future Consumption Growth

How will household deleveraging affect consumption? According to this Economic Letter by Reuven Glick and Kevin Lansing of the San Francisco Fed, it "could result in a substantial and prolonged slowdown in consumer spending."

The large increase in the leverage ratio for US households over the last ten years is shown in Figure 3. The question is how far the ratio will fall, and how long will it take for it to reach its new level. I believe the fall in this ratio will be slow, and this is one of the reasons I believe the recovery from the recession will be a long, drawn out process (another reason to expect a slow recovery is that unlike some recent recessions, this time the economy cannot go back to where it was prior to the recession, and the structural change that must occur to move resources out of housing and the financial sector and into other, productive uses will take time to bring about):

U.S. Household Deleveraging and Future Consumption Growth, by Reuven Glick and Kevin J. Lansing, FRBSF Economic Letter: U.S. household leverage, as measured by the ratio of debt to personal disposable income, increased modestly from 55% in 1960 to 65% by the mid-1980s. Then, over the next two decades, leverage proceeded to more than double, reaching an all-time high of 133% in 2007. That dramatic rise in debt was accompanied by a steady decline in the personal saving rate. The combination of higher debt and lower saving enabled personal consumption expenditures to grow faster than disposable income, providing a significant boost to U.S. economic growth over the period.

In the long-run, however, consumption cannot grow faster than income because there is an upper limit to how much debt households can service, based on their incomes. For many U.S. households, current debt levels appear too high, as evidenced by the sharp rise in delinquencies and foreclosures in recent years. To achieve a sustainable level of debt relative to income, households may need to undergo a prolonged period of deleveraging, whereby debt is reduced and saving is increased. This Economic Letter discusses how a deleveraging of the U.S. household sector might affect the growth rate of consumption going forward.

History provides examples of significant deleveraging episodes, both in the household and business sectors, which offer a basis for gauging how debt reduction may affect spending. From 1929 to 1933, in the midst of the Great Depression, nominal debt held by U.S. households declined by one-third (see James and Sylla 2006). In a contemporary account, Persons (1930, pp. 118-119) wrote, "[I]t is highly probable that a considerable volume of sales recently made were based on credit ratings only justifiable on the theory that flush times were to continue indefinitely....When the process of expanding credit ceases and we return to a normal basis of spending each year,...there must ensue a painful period of readjustment."

More recently, private nonfinancial firms in Japan reduced their debt relative to GDP by roughly 30 percentage points over 10 years following the bursting of twin bubbles in stocks and real estate in the early 1990s. Firms slashed their debt by significantly reducing the growth of investment spending.

U.S. household borrowing behavior

Figure 1: Real household debt, wealth, and incomeSince 1960, the growth rate of real (inflation-adjusted) household debt in the United States has far outpaced the growth rates of real disposable income and real household wealth tied to either residential housing or stocks (Figure 1). A portion of long-run debt growth is likely attributable to credit industry innovation and product development that expanded consumer access to borrowed money.

Beginning in 2000, however, the pace of debt accumulation accelerated dramatically. Much of the run-up in debt was mortgage-related. During the decade, a combination of factors including low interest rates, weak lending standards, the spread of exotic mortgages, and the growth of a global market for securitized loans promoted increased borrowing.

Rising debt levels were accompanied by rising wealth. An influx of new and often speculative homebuyers with access to easy credit helped bid up prices to unprecedented levels relative to fundamentals, as measured by rents or disposable income. Equity extracted from rapidly appreciating home values provided hundreds of billions of dollars per year in spendable cash for households that was used to pay for a variety of goods and services.

The housing bubble burst in 2006. Since then, wealth tied to residential housing has declined dramatically. Wealth tied to stocks began to drop in 2007 with the onset of a financial crisis that triggered a global recession. Together, these events have wiped out a significant fraction of the collateral that previously helped support elevated levels of household debt.

Going forward, downward pressure on debt is likely to come from both lenders and households. On the supply side, tighter lending standards will require more income, collateral, and documentation for any given loan. Demand for mortgage debt could also wane as expectations of future house price appreciation are adjusted downward to reflect market conditions. Concerns about future job security and the risk of foreclosure or bankruptcy may spur consumers to boost their precautionary saving. Moreover, the need to rebuild nest eggs held for college education or retirement may prompt consumers to shift toward a more saving-oriented lifestyle.

Figure 2: Consumption growth and debt growthFigure 2 shows that real consumption and real debt growth have been strongly correlated since 1960. Rapid debt growth allowed consumption to grow faster than income. Conversely, if households were to go through a sustained period of deleveraging (negative debt growth), then consumption growth would be expected to slow.

How much deleveraging?

Since the start of the U.S. recession in December 2007, household leverage has declined. It currently stands at about 130% of disposable income. How much further will the deleveraging process go? In addition to factors governing the supply and demand for debt, the answer will depend on the future growth trajectory of the U.S. economy. While it's true that Japanese firms and U.S. households may differ in important ways regarding decisions about paying down debt, the Japanese experience provides a recent example of a significant deleveraging episode that took place in the aftermath of a major real estate bubble and is useful as a benchmark.

The Japanese stock market bubble burst in late 1989, followed soon after by the bursting of the real estate bubble in early 1991. Nearly 20 years later, stock and commercial real estate prices remain more than 70% below their peaks, while residential land prices are more than 40% below their peak.

Figure 3: Leverage ratiosFigure 3 compares Japan's nonfinancial corporate sector with the U.S. household sector over 10-year periods before and after the leverage-ratio peaks. In both countries, leverage ratios rose rapidly in the years before the peak.

After Japan's bubbles burst, private nonfinancial firms undertook a massive deleveraging, reducing their collective debt-to-GDP ratio from 125% in 1991 to 95% in 2001. By reducing spending on investment, the firms changed from being net borrowers to net savers. If U.S. households were to undertake a similar deleveraging, their collective debt-to-income ratio would need to drop to around 100% by year-end 2018, returning to the level that prevailed in 2002.

Effect on saving and consumption

Figure 4: U.S. personal saving rateFigure 4 shows that the U.S. personal saving rate has recently started to increase following a decades-long decline that bottomed out near zero in 2005. As described in Lansing (2005), the secular decline in the saving rate appears to have been driven, at least in part, by long-lived bull markets in stocks and housing. The recent price declines in these markets might therefore initiate a sustained rebound in the saving rate over time.

A simple model of household debt dynamics can be used to project the path of the saving rate that is needed to push the debt-to-income ratio down to 100% over the next 10 years--a Japan-style deleveraging. Assuming an effective nominal interest rate on existing household debt of 7%, a future nominal growth rate of disposable income of 5%, and that 80% of future saving is used for debt repayment, the household saving rate would need to rise from around 4% currently to 10% by the end of 2018. A rise in the saving rate of this magnitude would subtract about three-fourths of a percentage point from annual consumption growth each year, relative to a baseline scenario in which the saving rate did not change. An even larger subtraction from consumption growth would occur relative to a baseline in which the saving rate were declining, as occurred prior to 2005. In either case, the subtraction from consumption growth would act as a near-term drag on overall economic activity, slowing the pace of recovery from recession.

Conclusion

More than 20 years ago, economist Hyman Minsky (1986) proposed a "financial instability hypothesis." He argued that prosperous times can often induce borrowers to accumulate debt beyond their ability to repay out of current income, thus leading to financial crises and severe economic contractions.

Until recently, U.S. households were accumulating debt at a rapid pace, allowing consumption to grow faster than income. An environment of easy credit facilitated this process, fueled further by rising prices of stocks and housing, which provided collateral for even more borrowing. The value of that collateral has since dropped dramatically, leaving many households in a precarious financial position, particularly in light of economic uncertainty that threatens their jobs.

Going forward, it seems probable that many U.S. households will reduce their debt. If accomplished through increased saving, the deleveraging process could result in a substantial and prolonged slowdown in consumer spending relative to pre-recession growth rates. Alternatively, if accomplished through some form of default on existing debt, such as real estate short sales, foreclosures, or bankruptcy, deleveraging could involve significant costs for consumers, including tax liabilities on forgiven debt, legal fees, and lower credit scores. Moreover, this form of deleveraging would simply shift the problem onto banks that hold these loans as assets on their balance sheets. Either way, the process of household deleveraging will not be painless.

References

James, John, and Richard Sylla. 2006. "Net Public and Private Debt, by Major Sector: 1916:1976." In Historical Statistics of the United States: Earliest Times to the Present, ed. S. Carter, et al. New York: Cambridge University Press.

Lansing, Kevin J. 2005. "Spendthrift Nation." FRBSF Economic Letter 2005-30 (November 10).

Minsky, Hyman P. 1986. Stabilizing an Unstable Economy. New Haven, CT: Yale University Press.

Persons, Charles E. 1930. "Credit Expansion, 1920 to 1929, and Its Lessons." Quarterly Journal of Economics 45, pp. 94-130.


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