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June 17, 2009

Economist's View - 7 new articles

"Unlearned Lessons"

Did the false belief that land suitable for building houses was becoming scarce help to drive the housing bubble?:

Unlearned lessons from the housing bubble, by Robert J Shiller, Project Syndicate: There is a lot of misunderstanding about home prices. Many people all over the world seem to have thought that since we are running out of land in a rapidly growing world economy, the prices of houses and apartments should increase at huge rates.

That misunderstanding encouraged people to buy homes for their investment value – and thus was a major cause of the real estate bubbles around the world whose collapse fuelled the current economic crisis. This misunderstanding may also contribute to an increase in home prices again, after the crisis ends. Indeed, some people are already starting to salivate at the speculative possibilities of buying homes in currently depressed markets.

But we do not really have a land shortage. Every major country of the world has abundant land in the form of farms and forests, much of which can be converted someday into urban land. ...

There are often regulatory barriers to converting farmland into urban land, but these barriers tend to be thwarted in the long run if economic incentives to ... become sufficiently powerful. It becomes increasingly difficult for governments to keep telling their citizens that they can't have an affordable home because of land restrictions. ...

Many people seem to think that the US experience is not generalisable, because the US has so much land relative to its population. ... But, to the extent that the products of land (food, timber, ethanol) are traded on world markets, the price of any particular kind of land should be roughly the same everywhere. ...

Shortages of construction materials do not seem to be a reason to expect high home prices, either. For example, in the US, the ... Building Cost Index ... has actually fallen relative to consumer prices over the past 30 years. To the extent that there is a world market for these factors of production, the situation should not be entirely different in other countries.

The ... expectations for real estate prices ... during the recent bubbles were often totally unrealistic. A few years ago Karl Case and I asked random home buyers in US cities undergoing bubbles how much they think the price of their home will rise ... on average over the next ten years. The median answer was sometimes 10% a year. ... Home prices cannot have shown such increases over long time periods, for then no one could afford a home.

The sobering truth is that the current world economic crisis was substantially caused by ... speculative bubbles ... were made possible by widespread misunderstandings of the factors influencing prices.

These misunderstandings have not been corrected, which means that the same kinds of speculative dislocations could recur.

In general, even though I don't always share Shiller's psychological approach to economic problems, it seems to be a bad idea to bet against his forecasts, in this case that people will once again misperceive that the real cost of housing is flat or slightly declining in the long-run, instead they will forecast long-run increases, and this will generate yet another housing bubble.

Update: Richard Green says "Shiller is largely right but for two things."

"An Interview with Paul Samuelson"

Conor Clarke interviews Paul Samuelson:

An Interview With Paul Samuelson, Part One, by Conor Clarke: ...Paul Samuelson ... has a long list of accomplishments -- A John Bates Clark Medal, a Nobel Prize -- that I won't try to recap here. But by most accounts he is responsible for popularizing Keynesian economics...

I've decided to break the transcript into two parts. I'll publish part two tomorrow morning. The first part ... is mostly economic history -- the rise and fall (and rise) of Keynes, the influence of Milton Friedman, and the era of Alan Greenspan. Part two covers current events -- the need for a more stimulus spending and how his nephew (one Larry Summers) is doing running the economy. ...

...Milton Friedman?

Milton Friedman. Friedman had a solid MV = PQ doctrine from which he deviated very little all his life. By the way, he's about as smart a guy as you'll meet. He's as persuasive as you hope not to meet. And to be candid, I should tell you that I stayed on good terms with Milton for more than 60 years. But I didn't do it by telling him exactly everything I thought about him. He was a libertarian to the point of nuttiness. People thought he was joking, but he was against licensing surgeons and so forth.

And when I went quarterly to the Federal Reserve meetings, and he was there... He wanted a machine. He wanted a machine that spit out M0 basic currency at a rate exactly equal to the real rate of growth of the system. And he thought that would stabilize things.

Well, it was about the worst form of prediction that various people who ran scores on this -- and I remember a very lengthy Boston Federal Reserve study -- thought possible. Walter Reston, at that time one of the most respected bankers in the country and in the world fired his whole monetarist, Friedmaniac staff overnight, because they were so off the target.

But Milton Friedman had a big influence on the profession -- much greater than, say, the influence of Friedrich Hayek or Von Mises. ... I don't know whether you read the newspapers, but there's almost an apology from Ben Bernanke that we didn't listen more to Milton Friedman.

But anyway. The craze that really succeeded the Keynesian policy craze was not the monetarist, Friedman view, but the [Robert] Lucas and [Thomas] Sargent new-classical view. And this particular group just said, in effect, that the system will self regulate because the market is all a big rational system.

Those guys were useless at Federal Reserve meetings. Each time stuff broke out, I would take an informal poll of them. If they had wisdom, they were silent. My profession was not well prepared to act.

And this brings us to Alan Greenspan, whom I've known for over 50 years and who I regarded as one of the best young business economists. ... But the trouble is that he had been an Ayn Rander. You can take the boy out of the cult but you can't take the cult out of the boy. He actually had instruction, probably pinned on the wall: 'Nothing from this office should go forth which discredits the capitalist system. Greed is good.'

However, unlike someone like Milton, Greenspan was quite streetwise. But he was overconfident that he could handle anything that arose. I can remember when some of us -- and I remember there were a lot of us in the late 90s -- said you should do something about the stock bubble. And he kind of said, 'look, reasonable men are putting their money into these things -- who are we to second guess them?' Well, reasonable men are not reasonable when you're in the bubbles which have characterized capitalism since the beginning of time.

But now Greenspan admits he was wrong.

Because we had, instead of three standard deviations storm, a six standard deviation storm. ... I think looking for scapegoats and blame can be left to the economic historian. But, at the bottom, with eight years of no regulation from the second Bush administration, from the day that the new SEC chairman -- Harvey Pitt -- said 'I'm going to run a kinder and gentler SEC,' every financial officer knew they weren't going to be penalized.

Self regulation never worked as far as macroeconomic events -- whether we're talking about post-Napoleonic War business cycles or the big south sea bubble back in Isaac Newton's time, up to today's time. ...

"Health Care Rationing Rhetoric"

The basic economic problem is how to allocate a finite amount of resources among practically unlimited wants. Suppose there are seven kids, but only five tickets to an amusement park, and all seven kids would all like to go to. How do you decide who gets to go and who stays home? You could use non-market schemes such as drawing who gets to go randomly, giving them to the youngest kids who might enjoy this particular park a little more, hold a contest of some sort, or you could use price mechanisms such as asking them to give up allowance and awarding the tickets to the highest bidder, or allowing them to barter against future trips where space is also limited. The prices can be implicit as well, e.g. you could find out who is willing to stand in place saying absolutely nothing the longest, and those who are willing to do so get the tickets.

For the most part, we use market mechanisms to solve these problems, but not always. Market outcomes are efficient, or as efficient as we know how to be, but they are not necessarily equitable in any grand sense and sometimes we believe that equity is the dominant principle. National parks, for example, are often under priced so that everyone can afford to go. In such cases, the government intervenes and allocates spaces randomly, on a first come first serve basis, by seeing who will wait in line for hours to get in, etc.

I believe that when it comes to health care, equity is the dominant principle. Everyone should have the chance to go to a beach, or the redwoods, or the Grand Canyon if they want to, these places shouldn't be locked up as private property and completely inaccessible to those without the means to buy their way in. Everyone should have access to education as well, and in the same way everyone should have the access to health care. Access to life-saving and life-improving technology and treatments should not depend upon having sufficient household income.

But if we don't use the price mechanism to allocate health care resources, what mechanism do we use? As I've said, I believe that there ought to be a broad set of treatments and care available to everyone, without exception, but where do we draw the line? If we don't use the price mechanism, how do we properly and fairly allocate resources both between health care and the production of other goods, and within the health care system itself? Within the system is easy, equal access ought to prevail, but how much of GDP to allocate to health care overall is a hard question, and it depends in part on something discussed below, the relative effectiveness of various medical procedures. It also depends upon our general level of wealth. As we get wealthier as a nation over time, as we will with economic growth, we will be able to afford to spend a greater share of output on medical care, and will likely be willing to do so, but how much more? In any case, one way or another, it's a question we'll have to find a way to answer:

Health Care Rationing Rhetoric Overlooks Reality, by David Leonhardt, NY Times: Rationing. More to the point: Rationing! ... The r-word has become a rejoinder to anyone who says that this country must reduce its runaway health spending, especially anyone who favors cutting back on treatments that don't have scientific evidence behind them. ...

Today, I want to try to explain why the case against rationing isn't really a substantive argument. It's a clever set of buzzwords that tries to hide the fact that societies must make choices.

In truth, rationing is an inescapable part of economic life. It is the process of allocating scarce resources. ... We ration lakefront homes. We ration the best cuts of steak and wild-caught salmon. Health care, I realize, seems as if it should be different. But it isn't. Already, we cannot afford every form of medical care that we might like. So we ration. ...

The choice isn't between rationing and not rationing. It's between rationing well and rationing badly. Given that the United States devotes far more of its economy to health care than other rich countries, and gets worse results by many measures, it's hard to argue that we are now rationing very rationally. ...

There are three main ways that the health care system already imposes rationing on us. The first is the most counterintuitive, because it doesn't involve denying medical care. It involves denying just about everything else.

The rapid rise in medical costs has put many employers in a tough spot. They have had to pay much higher insurance premiums, which have increased their labor costs. To make up for these increases, many have given meager pay raises. ... Our expensive, inefficient health care system is eating up money that could otherwise pay for a mortgage, a car, a vacation or college tuition.

The second kind of rationing involves the uninsured. The high cost of care means that some employers can't afford to offer health insurance and still pay a competitive wage. Those high costs mean that individuals can't buy insurance on their own. ...

The final form of rationing is ... the failure to provide certain types of care, even to people with health insurance. ... In Australia, 81 percent of primary care doctors have set up a way for their patients to get after-hours care... In the United States, only 40 percent have. ...

The comparative-effectiveness research ... has inspired opposition from some doctors, members of Congress and patient groups. Certainly, the critics are right to demand that the research be done carefully. ...

But flat-out opposition to comparative effectiveness is, in the end, opposition to making good choices. And all the noise about rationing is not really a courageous stand against less medical care. It's a utopian stand against better medical care.

Obama's Wall Street Joural Interview

Given recent debates around here on regulating the shadow banking sector, it was nice to see that the first thing Obama mentions in response to a question about why financial markets failed is an outdated "regulatory system that ... did not encompass the non-bank sector":

Transcript of Obama's Interview With the Journal, Washington Wire: A transcript of The Journal's interview with President Obama, which touches on financial-regulatory reform, the power of free markets, health care and Bernanke's future at the Fed. ...

Question: Thank you for doing this, very much. ... Obviously a lot of things went wrong in the markets in the last year. Where do you think they failed?

THE PRESIDENT: Well, I think that there are some immediate and obvious culprits. We had a regulatory system that was outdated that did not encompass the non-bank sector. We had a securitization market that had separated borrowers and lenders and investors in ways that allowed everybody to take risks, with nobody feeling accountable or feeling their money was at stake. We had I think banks who were incented to boost their profits with some of these same risky financial instruments, and you didn't have the kind of systemic oversight that would anticipate the enormous failures that could arise if any link in the chain broke. So that set of regulatory problems is what we are looking to solve in the proposals I'll put forward tomorrow.

You then have, though, just to finish up, I think you've got a broader structural problem in our economy in which our last two recoveries had been based on bubbles, and a massively overleveraged consumer, a massively overleveraged corporate sector, and a financial system that didn't have much restraint.

And so the question for us is how do we create the foundation for a more sustainable model of economic growth, one that doesn't impinge on the dynamism of the free market, the innovative products that are critical and the entrepreneurship that creates jobs, but also recognizes that the levels of debt and a model that's premised on an endless supply of foreign dollars is not one that is going to be sustainable over the long term. ...

Question: One of the things that you're going to do this week that hasn't gotten as much attention is try to directly regulate the consumer part of the financial system. ... What are you thinking there? Is there a danger of going too far? Why do consumers need that kind of help?

THE PRESIDENT: ... What we are saying is, number one, that we should have some common-sense protections around transparency, around full disclosure. Whether we're talking about the mortgage market, credit cards, annuities — on a whole host of these financial instruments, in fact, people didn't know what they were getting themselves into. And making sure that they are properly informed is I think the most market-friendly of regulatory approaches...

I think that the world has gotten more complicated. If suddenly you can, as a 20-year-old college student, sign for up for five different credit cards, if you find yourself able on a $30,000-a-year income to buy a $400,000 house with no money down, then you are much more vulnerable to the inducements that are out there than a generation ago.

Now, I know that some people would argue, well, people have to suffer the consequences when they make these bad decisions. The problem is, is that when you start seeing the entire housing market collapse because of foreclosures, or banks and other financial institutions requiring extraordinary support from taxpayers because they've greatly overextended themselves, this is not just a problem for one individual consumer; this is a problem for the economy as a whole.

Question: Does all that say to you that capitalism failed here somehow? The system needs to be changed, that there has to be some kind of a hybrid — capitalism and something else?

THE PRESIDENT: I am a firm believer in the power of the free market to allocate capital and produce goods and services, and ultimately wealth. I think the system is unsurpassed. But I think we've understood at least since the 1930s, ... that a sensible regulatory structure can ensure that the benefits of the free market are obtained without the risks of the system falling in on itself. And we just want to update that for a new environment in which you have things like credit default swaps. ...

I think the irony — and you wouldn't know this from reading your publication's editorial page — (laughter) — is that I actually would like to see a relatively light touch when it comes to the government. I think what I described in terms of financial regulation is typical, and that is set up so the rules of the road; ensure transparency and openness; guard against huge, systemic risks that will lead us potentially into — lead government potentially having to step in to avoid a depression; and then let entrepreneurs and individual businesses compete and do what they do.

And so it's puzzling to me sometimes to hear the standard conservative critique of what we're doing, when essentially every step we're taking really involves cleaning up the mess that we found when we arrived here at 1600 Pennsylvania Avenue. ...

Question: Two quick questions on this, and then I'll let you go. Ben Bernanke — you've obviously seen a lot of him. ... Inclined to reappoint him?

THE PRESIDENT: I think that Ben Bernanke has handled his position extraordinarily well under extraordinarily difficult circumstances, but I'm not going to make news on that right now.

Question: Okay. If you had your druthers, in the long run what would the top tax rate for the very richest Americans settle at?

THE PRESIDENT: Well, I think instinctively that the tax rates that existed for the top — for the very wealthiest Americans under Bill Clinton struck the right balance. ...

I do think that tackling tax reform, both on the individual side and on the corporate side at some point — akin to what was done in 1986, where you clear out some of the underbrush and you make sure that the base is broad, but everybody knows what it is that they're paying and there aren't a whole bunch of loopholes; there is serious enforcement and predictability — that kind of reform could end up generating the revenues that we need to run the basics of our government while actually in some cases lowering some rates. But that requires that everybody buy into a simpler, fairer system.

The one thing that I think is very important to understand is that there's no free lunch, and sometimes politicians have been pretty irresponsible in saying you can have a prescription drug plan, you can have two wars, we can do a whole bunch of things, but we're going to cut your taxes at the same time. And at some point something has to give.

He seems to get it, but what will the legislation look like in the end? I'm having a hard time imagining George Bush exhibiting the same depth of understanding of this issue, but he did seem to get the legislation he wanted. Somehow the Bushies would have sold financial reform as a patriotic duty to our troops. Or something like that.

"A Long Way to Inflation"

Andy Harless says we're not even close to experiencing an outbreak of inflation:

A Long Way to Inflation, by Andy Harless: Most of the media seem to have interpreted today's lower-than-expected increase in the producer price index as good news. ... Personally, I was more worried about deflation, and I still am. The inflation risk, if it exists at all, is in the distant future, and you could even argue that deflation in the short run increases the risk of high inflation in the long run. It's hard for me to see how falling prices today are good news at all. And prices – excluding food and energy – did fall in May according to the PPI.

You might worry about energy and commodity prices feeding through to the broader price level. I'm worried about that too, but not in the way you might think. Undoubtedly some of that feed-through is already happening, and it hasn't been enough to keep core producer price growth on the positive side of zero. I'm worried about what happens when commodity prices (1) stop rising (which they must do eventually) and/or (2) start falling again (which they may well do if the recent increases have been driven largely by unsustainable forces such as stockpiling by China). If core prices are already falling, and only energy prices are keeping the overall PPI inflation rate positive, what happens when energy prices stop rising?

What worries me particularly is that about 70% of the costs of production go to labor, and the forces of deflation work very slowly in the labor market. ... Wage growth is decelerating, and, based on all historical experience, the deceleration is likely to continue – in this case, to continue to the point where it becomes deflationary.

I'm not talking about what will happen in the next 6 months; I'm talking about what will happen over the next 5 years. "Green shoots" – however green they may be – do not presage an imminent end to deflationary wage pressure. And they certainly don't presage the beginning of inflationary wage pressure. Consider everything that has to happen before the wage pressure reverses and becomes inflationary:

  1. Output must stabilize.
  2. Output must start growing.
  3. Output must grow faster than trend productivity.
  4. Firms must slow layoffs to the normal rate.
  5. Firms must remobilize slack full-time employees (workers who are still on the full-time payroll but aren't being asked to produce much, because businesses have been trying to reduce inventories).
  6. Firms must bring part-time employees back to full time. (This recession in particular has been characterized by the tendency to reduce hours rather than laying off employees.)
  7. Hiring (which has been falling rapidly) must stabilize.
  8. Hiring must rise to the point where it equals the normal rate of layoffs, to get total employment to start rising.
  9. Hiring must become rapid enough that employment starts to grow faster than the population.
  10. Hiring must become rapid enough that employment growth is faster than the sum of the population growth & labor force re-entry. In other words, net hiring has to be fast enough to absorb all the workers who will start looking for jobs again once there are more jobs around to look for.
  11. The unemployment rate must start declining.
  12. The unemployment rate must decline by 4 or more percentage points, which, by historical experience, will take a matter of years.
  13. Firms must start competing for labor.
  14. Firms must start raising wages.
  15. Firms must raise wages faster than trend productivity growth.

Maybe – just maybe – we have already reached step 1. Step 2 may be just around the corner. There is no evidence thus far that we are approaching step 3. As for steps 4, 5, 6, 7, 8, 9, 10, 11, 12, 13, 14, and 15......that show may come to town eventually, but...I don't see much need to start reserving tickets in advance.

Economists are Seeking Remedies to the Crisis

Francesco Caselli of the London School of Economics rebuts a recent attack on the economics profession:

Economists are actively engaged in seeking remedies to the crisis, by Francesco Caselli, CIF: Larry Elliott's claim that "as a profession, economics not only has nothing to say about what caused the world to come to the brink of financial collapse last autumn, but also a supreme lack of interest", deserves a rebuttal.

The alleged lack of interest is belied by the outpouring of commentary and discussion that has swept the profession over the last couple of years and shows no sign of abating. I can think of few of the top academic stars in macroeconomics who have not been busy editorialising, blogging, and participating in discussions and policy events.

The evidence for the lack-of-interest charge is that "if, for example, you scroll down the list of papers scheduled for publication by the Review of Economic Studies, one of the prestigious UK journals, there is not the slightest sense that the world of general equilibrium and real business cycle models has been turned upside down in the past two years".

Never mind that it is dubious the crisis should lead us to eschew general equilibrium, which is simply the notion that to understand what happens in one part of the economy one needs to take into account what is going on in other parts as well - a principle the wisdom of which may arguably have been reinforced, rather than weakened, by the crisis. And let's pass over the fact that real business cycle theory has not been the dominant paradigm for the study of business cycles for years. The reason there are no crisis-related articles in the Review is that the publication lags of economic journals are extremely long, and none of those looked at by Elliott has been written after the crisis started.

Much more relevant is whether current academic research focuses on the crisis. And this is absolutely the case. To give just one example: every year one of the main events in the international macroeconomics calendar is the NBER Macro Annual - a conference where top macro researchers discuss work in progress. Half of the papers on this year's programme (as well as the keynote speaker) focused on aspects of the crisis.

A more serious issue is whether all this commentary and research is helpful in explaining the crisis and proposing appropriate remedies. Elliott says mainstream macroeconomists are not "interested in looking at the world as it is", but "in how it would be if it conformed to the dictates of their mathematical models". The real problem is that there are many sensible and down-to-earth explanations for the crisis, and we inevitably differ on which ones are most important - a disagreement that could not arise if we all lived in the make-believe mathematical world where the article places us.

Because we disagree on the causes, we naturally prefer different remedies. In the medical sciences, when multiple hypotheses for a severe illness are proposed by different researchers, the general reaction is to give them more resources and encourage them to keep going so more progress can be made. But when economists grapple with multiple plausible explanations for a certain event, the reaction is to pronounce them all useless!

Still, there may be something to this:

Soul searching continues among macroeconomists who failed to predict the economic crisis. One culprit behind the great macro-flub: the "Control Illusion," in which economists are blinkered by overconfidence in computer models just because they, as Levitt recently wrote, "solve a problem that is really, really hard mathematically."

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