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August 4, 2009

Economist's View - 4 new articles

"Mass. Bashers Take Note: Health Reform is Working"

An editorial from the Boston Globe defends health care reform in Massachusetts against critics who are trying to use it as an example of what might go wrong with the reform at the national level:

Mass. bashers take note: Health reform is working, Editorial, Boston Globe: Pundits and politicians who oppose universal healthcare for the nation have a new straw man to kick around - the Massachusetts reform plan that covers more than 97 percent of the state's residents. In the myth that these critics have manufactured, this state's plan is bleeding taxpayers dry, creating nothing less than a medical Big Dig.

The facts - according to the Massachusetts Taxpayers Foundation - are quite different. Its report this spring put the cost to the state taxpayer at about $88 million a year, less than four-tenths of 1 percent of the state budget of $27 billion. ... The main reason costs to the state have been well within expectations? More than half of all the previously uninsured got coverage by buying into their employers' plans, not by opting for one of the state-subsidized plans.

This should be exciting news for those fiscal conservatives, including both Republicans and "blue dog'' Democrats, who claim to support the goal of universal coverage while despairing over its budget impact. But that's not what you hear from the Massachusetts bashers. Trying to scare off the nation from helping the uninsured get coverage, Fox News host Bill O'Reilly said recently, "You don't have to look any further than the universal healthcare mess in Massachusetts to see disaster ahead.'' New York Times columnist Ross Douthat ... accused President Obama of "pushing a health plan that looks a lot like the system currently hemorrhaging money in Massachusetts.'' ...

Whether out of ignorance or convenience,... bashers have it wrong. Unlike the Big Dig, health reform came in on time and under budget. It will be proportionately more expensive nationally to provide coverage for the uninsured than it has been here simply because the state began the task with a much lower rate of uninsured, 7 percent, compared with the US rate of 17 percent. But a national plan that relies, as Massachusetts' does, on both government-subsidized insurance and a mandate on employers to offer insurance or pay a penalty ... should be able to cover nearly everyone without busting the budget. ...

Spending versus Tax Cuts

Paul Krugman says:

Spending versus tax cuts, by Paul Krugman: Jeff Frankel says what I wanted to say about what we know so far about the impact of the stimulus:

Martin Feldstein and others predicted that the tax-cut component of the 2009 fiscal stimulus package would have substantially less expansionary bang-for-the-buck than the spending component of the package, because much of the tax cut would be saved, as had been the case with the 2008 tax cut. ("Bang for the buck" in this case could be defined as demand stimulus divided by budget cost.) We knew this from Milton Friedman's permanent income hypothesis, or even from good old Keynesian multiplier theory.

And sure enough, that's what's happening.

It's worth emphasizing this point, because there's been a lot of nonsense written about the issue. Take this conspiracy theorizing from Clive Crook:

Politics more than economics guided the design of the first stimulus, after all. Democrats preferred public spending because they wanted to widen government's role and repudiate the Republicans' instinct to cut taxes regardless of the circumstances.

Um, no. Democrats preferred spending because they feared, based on quite standard economics, that tax cuts would be ineffective. And so they have proved.

There are two ways in which tax cuts can help. First, if the money is spent, it stimulates aggregate demand, output, and employment. This is what people generally have in mind. Second, tax cuts that are saved can shorten the length of recessions. When the income from tax cuts is saved rather than spent, that helps households refill damaged balance sheets. Consumption levels will not return to normal until balance sheets are repaired, so tax cuts can help to bring about the end of a recession sooner than otherwise because they allow balance sheets to be repaired faster.

However, it is not clear that tax cuts are better than government spending at shortening recessions. Recently, Menzie Chinn posted evidence from this paper that government spending on consumption (as opposed to infrastructure) has a larger recession shortening effect than tax cuts, though tax cuts can also be effective at this task if they are properly constructed:

This paper assessed the effects of fiscal policy responses during 118 episodes of systemic banking crises in advanced and emerging market economies. The results indicate that timely countercyclical fiscal responses (both due to discretionary measures and automatic stabilizers), accompanied by actions to deal with financial sector weaknesses, contribute to shortening the length of crisis episodes. During crisis caused by financial sector distress, fiscal expansions increase the likelihood of earlier exit from a shock episode. ...

The composition of fiscal expansions matters for crisis length -- a point that has not been studied in the literature. Stimulus packages that rely mostly on measures to support government consumption are more effective in shortening the crisis duration than those based on public investment. A 10 percentage point increase in the share of public consumption in the budget reduces the crisis length by three to four months. Reducing the share of income taxes is less effective than consumption taxes in shortening the length of a banking crisis. These results suggest that tailoring the composition of fiscal response packages is important for enhancing the effectiveness of countercyclical fiscal measures in both advanced and emerging market economies (Spilimbergo et al., 2008; IMF, 2009).

Notice that it is government consumption, not government investment, that has the biggest effect on shortening the duration of recessions. Also note that cuts in taxes - particularly cuts in consumption taxes - also have this recession shortening effect.

Thus, the tax cut component of a stimulus package can play a useful role in shortening recessions, though apparently government consumption does even better (however, fiscal policy devoted to government consumption is politically difficult because, as I have noted many times before, government spending that does not directly increase economic growth is viewed as wasteful, or at least not as desirable as growth enhancing policies, and therefore tax cuts may be all that is available to policymakers).

As a result, policy faces a tradeoff between stimulus to short-run aggregate demand that impacts output and employment relatively fast, or delayed stimulus that has a larger impact on economic growth. For example, as the paper notes, growth enhancing policies are distinct from the policies that have an immediate impact:

The quality of the fiscal stimulus package matters most for post-crisis growth resumption, with fiscal responses relying largely on scaling up the share of public investment in the budget showing the largest positive effect on medium-term output growth. A one percent increase in the share of capital outlays in the budget raised post-crisis growth by about ⅓ of one percent per year. Income tax reductions are also associated with positive growth effects.

The results of the short-term and medium-term impacts of fiscal policy during financial crises highlight a potential trade-off between short-run aggregate demand support measures and medium-term productivity growth objectives in fiscal policy response to shocks. Implementation lags for government investment, which were documented also during the current crisis, may be, at least in part, responsible for these results. They also point to careful consideration of the composition of fiscal stimulus packages, as different short-term and medium-term fiscal multipliers can affect fiscal policy performance during the crisis and in its aftermath

So what is the bottom line to all of this? It says that fiscal policy ought to include a portfolio of government investment, government consumption, and perhaps tax cuts as well (if government consumption is difficult politically).

Tax cuts on consumption and government consumption have a relatively immediate impact both on aggregate demand and on the rate at which balance sheets are repaired, and income tax cuts along with spending on infrastructure are better at enhancing long-run growth. Thus, my view is not that the tax cut component in the current stimulus package was a complete mistake, tax cuts can help to shorten recessions as described above, and this effect occurs both because tax cuts help to repair balance sheets when the tax cuts are saved, and because they stimulate consumption. But the effectiveness of the tax cuts in the short-run could have been improved by targeting consumption rather than income, and government consumption may have had an even larger effect. What I haven't been able to determine, however, is which type of tax cut, income or consumption, has the bigger effect on balance sheet repair (saving) rather than aggregate demand (consumption), though I suspect that income tax cuts would have the larger balance sheet effect.

The biggest mistake is that the government consumption component was much too small. The package should have been much larger, and proportionately more of the package should have gone to government consumption measures (which do not have to wait until projects are "shovel-ready" before they can be implemented) rather than income tax cuts and infrastructure. The package contained more than enough measures devoted to long-run economic growth, but far too few devoted to simulating aggregate demand immediately.

Fed Watch: Is a Jobless Recovery Your Best Friend?

Tim Duy on how the Fed is likely to respond to "the cyclical turn in the US economy":

Is a Jobless Recovery Your Best Friend?, by Tim Duy: Never underestimate the power of money. Especially lots of money coming on top of a cyclical recovery that is almost textbook at least as far as the timing is concerned. To be sure, you can question the sustainability of the recovery, the breadth or health of the recovery, and the nature of job growth. I have questioned all repeatedly and fail to see that the conditions that have dominated the US economic story for the past 25 years - primarily, a continued reliance on consumer spending to propel growth - can continue in the face of massive household debt burdens and stiffer (or, more accurately, realistic) underwriting conditions. But regardless of these concerns, evidence is clearly pointing to a shift in economic conditions for the better. Moreover, I suspect it will take at least two more quarters at a minimum - and maybe closer to two more years - before the more pessimistic or optimistic visions of the future will come into clear view. Until then, it seems likely the appetite for risk will continue to climb, and all the liquidity - liquidity fueled by new guarantees that massive financial institutions are too big too fail - has to go somewhere.

Which is to say that no matter how pessimistic you are in the medium and longer term, you need to recognize the potential for massive moves in markets as risk taking perpetuates more risk taking. And as long as that risk taking flows in directions that do not fundamentally change the US jobs and, by extension, wage picture, it is difficult to imagine the Federal Reserve will do anything but let the party roll on.

The second quarter GDP report (Jim Hamilton and Menzie Chinn at Econbrowser discuss the details) confirmed what was already well known - the pace of deterioration slowed markedly, setting the stage for a growth rebound in the second half of this year. The game now is upping near term growth forecasts accordingly - not a fool's errand at all, considering the inventory correction is running its course and new residential construction is mostly likely at the bottom (seriously, we were never moving to an economy where zero houses would be built). Moreover, as Calculated Risk reports, it looks like we hit the bottom of car sales, with no small boost being provided by the Cash for Clunkers program. Say what you like about the economic wisdom of this program or its potential to magnify a double-dip by borrowing from future growth, it will goose the third quarter numbers and advance the pace of inventory correction in the auto industry. And, let's be honest, buying new cars is a whole bunch more fun than just writing massive checks to keep the industry afloat.

The July ISM manufacturing report only adds to the cyclical rebound story. The headline number is flirting with the all important 50 mark, while the new orders component surged into expansion territory. Production, export, and import components all gained. Even the employment reading rose higher, although it continues to signal ongoing job declines. All in all, a report that is predicting recovery in a time frame consistent with the deep cyclical plunges of late last year.

On a more somber note, labor market weakness continues to weigh on paychecks, a phenomenon confirmed by the employment cost index for the second quarter. Wages and salaries for private workers climbed a scant 0.2%. To be sure, this raises concerns about the durability of consumer spending going forward, especially when combined with fears of a jobless recovery. Indeed, I have argued that most if not all of the jobs in the manufacturing sector simply are not coming back. My suspicion is that firms will use the recession to expand overseas supply chains wherever possible. Moreover, firms will not be in a rush to hire back without a clear resurgence of growth, which seems unlikely to occur given precarious household debt burdens.

Now comes the tricky part - what does the evolving economic dynamic imply for financial markets? I am increasingly of the mind that although a jobless recovery will be a dreary fate for the American people, it offers the best outcome for financial markets for one simple reason: The jobless recovery offers the greatest probability that the Fed remains on the sidelines. The jobless recovery is what keeps the Fed goose laying the golden eggs.

True, one should be cautious about reading too much into near-term market action. Macro man puts it succinctly:

The problem that some so-called perma-bears have is is recognizing the temporary importance of such asset flow, and how far it can push asset prices. By the same token, the problem that some of the flow-of-funds, risk-on crowd have is is failing to recognize that buying something just because other people do is nothing more than an exercise in greater fool theory. And while the market may well be a voting machine in the short run, as Benjamin Graham observed it is a weighing machine in the long run.

With the Armageddon trade off the table, market participants need to move the mass of money provided by the Fed somewhere, and it is showing up in all the predictable places. US equities, commodities, oil, and foreign exchange. Indeed, without the Fed threatening to raise rates, there is no rush to exit Treasuries, which could explain the failure of the ten year bond to retake the 4% mark even as equities sure higher.

To be sure, these trades might collapse under their own weight, but the probability of finding a self-sustaining move, like the US housing boom earlier this decade, is higher the longer the Fed keeps rates at a rock bottom level. And the farther that money flows from the US the better for financial market participants; too much money close to home would raise the prospect of stronger growth and tighter monetary policy. Andy Xie (hat tip to Big Picture) believes he has found one such place in China:

Chinese stock and property markets have bubbled up again. It was fueled by bank lending and inflation fear. I think that Chinese stocks and properties are 50-100% overvalued. The odds are that both will adjust in the fourth quarter. However, both might flare up again sometime next year. Fluctuating within a long bubble could be the dominant trend for the foreseeable future. The bursting will happen when the US dollar becomes strong again. The catalyst could be serious inflation that forces the Fed to raise interest rate.

When will that bubble burst? Possibly 2012, after the Fed can no longer keep interest rates low:

It is not too hard to understand when the bubble would burst. When the dollar becomes strong again, liquidity could leave China sufficiently to pop the bubble. What's occurring in China now is no different from what happened in other emerging markets before. Weak dollar always led to bubbles in emerging economies that were hot at the time. When the dollar turns around, the bubbles inevitably burst.

It is difficult to tell when the dollar will turn around. The dollar went into a bear market in 1985 after the Plaza Accord and bottomed ten years later in 1995. It then went into a bull market for seven years. The current dollar bear market began in 2002. The dollar index ('DXY') has lost about 35% value since. If the last bear market is of useful guidance, the current one could last until 2012. But, there is no guarantee. The IT revolution began the last dollar bull market. The odds are that another technological revolution is needed for the dollar to enter a sustainable bull market.

However, monetary policy could start a short but powerful bull market for the dollar. In the early 1980s Paul Volker, the Fed Chairman then, increased interest rate to double digit rate to contain inflation. The dollar rallied very hard afterwards. Latin American crisis had a lot to do with that.

The current situation resembles then. Like in the 1970s the Fed is denying the inflation risk due to its loose monetary policy. The longer the Fed waits, the higher the inflation will peak. When inflation starts to accelerate, it would cause panic in financial markets. To calm the markets, the Fed has to tighten aggressively, probably excessively, which would lead to a massive dollar rally. This would be the worst possible situation: a strong dollar and a weak US economy. China's asset markets and the economy would almost surely go into a hard landing.

Bottom Line: Incoming data continue to confirm the cyclical turn in the US economy. But that cyclical turn is supported by a massive amount of government intervention, in and of itself a testament to the fragility of the recovery. The Fed will be in no rush to withdraw that liquidity - especially if a jobless recovery emerges. Indeed, it is easy to tell a story where the Fed holds rates near zero into 2011. That also means the Fed will not rock any boats. Thus, the jobless recovery is almost a dream come true for those trades dependent on easy Fed policy - which seem to be virtually all trades at the moment. Although there has been talk of the Fed acting preemptively to curtail bubbles, I am skeptical that any such action would be taken with US unemployment staring at double-digits. And there certainly would be no rush to react if low US interest rates fueled bubbles outside US borders; that, after all, would be the responsibility of foreign policymakers.

links for 2009-08-04

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