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August 2, 2009

Economist's View - 5 new articles

"Deep Recession Calls for Healthy Dose of Fiscal Stimulation"

A colleague, George Evans, discusses the need for aggressive policy to combat the recession:

Deep recession calls for healthy dose of fiscal stimulation, by George Evans, Commentary, Register Guard: ...The business cycle, with expansions occasionally interrupted by recessions, is an enduring feature of market economies. Asset price bubbles and crashes also appear to be intrinsic to markets. It is important to recognize that recessions are usually ... a surprise, resulting from large shocks that could not be offset in time by policy.

Economists do, however, have a set of policies to avoid or minimize the impact of recessions and to promote recovery. The standard policy tools for dealing with recessions are two-fold: 1) easing monetary policy by reducing interest rates, and 2) allowing normal fiscal "stabilizers" to work: in recession tax collections naturally decline and unemployment benefits and welfare payments naturally increase. At the federal level this can and should be financed by temporary increases in deficits. ...

When a recession is very large, as now, the usual anti-recessionary policies are insufficient, and aggressive fiscal policies are needed. When recessions are accompanied by a financial crisis, as now, special interventions are required to prevent a complete financial meltdown and ensure that credit remains available. Regulatory reforms are also needed... Experience has shown that recessions precipitated by financial crises are usually longer and deeper than typical recessions.

The reason why aggressive fiscal policies are essential ... is that the adverse shock has been so large that monetary policy is inadequate: cutting short-term interest rates to zero is not enough to ensure recovery. Without sizable fiscal stimulus there is the possibility of a destabilizing spiral of deflation and falling output.

The combination of aggressive monetary easing and sufficiently aggressive fiscal stimulus should be enough to stabilize the economy and eventually lead to recovery. This recovery will raise tax revenues and, with appropriate long-term fiscal planning, debt levels relative to GDP will gradually return to normal levels. As the recovery begins, the monetary authorities will start to unwind current policy ... to prevent inflation from becoming a problem.

It is possible that yet more fiscal stimulus will be needed... If so, additional stimulus should avoid across-the-board temporary reductions in personal income taxes, since these have small aggregate demand effects. More effective are temporary increases in government spending ... and additional funding to states and localities... Temporary investment tax credits to firms can also be effective...

We must avoid retreating to the economics of Herbert Hoover. The argument that government should behave like families in recessions, reducing spending because times are hard, is misguided, because the proximate cause of current high levels of unemployment and low levels of GDP is a collapse of the aggregate demand... This is a Keynesian moment in history, and in this situation, temporary increases in government spending lead to higher incomes and more jobs. Households may anticipate higher future taxes to pay for the deficit spending, but the net effect on GDP and incomes is positive and substantial, and this prevents a dangerous slide into deflation. If the government spending is on infrastructure, broadly construed, then this also lays the foundation for a more productive recovery.

Is the current federal stimulus program sufficient? There is no simple answer. Policy affects the economy after a delay that is long, variable and uncertain. ... The lags and uncertainties make policy difficult.

In this situation the guiding principles are as follows. [T]he biggest risk is a 1930s type depression triggered by a negative feedback loop of deflation, high "real" interest rates after correcting for deflation, and reduced private sector spending. We appear to have avoided this outcome, but ... policy needs to be continually revisited. The Federal Reserve Open Market Committee meets every six weeks to review monetary policy. U.S. fiscal policy should also be reviewed frequently. The next several months may indicate the start of recovery or they may suggest that further action is needed. Finally, we also need a long-term plan to ensure that, after the recovery is under way, total publicly held federal debt will eventually return to its normal range of, say, 30 percent to 70 percent of GDP. ...

Although reasonable people can disagree on the appropriate role and size of government spending, we can agree that spending should be as productive as possible and that tax rates should be set to finance this spending on average. However, whatever the choice of overall level, there is a strong macroeconomic case for maintaining government spending during recessions and for temporary increases in government expenditures in deep recessions.

I should make clear that George cannot be accused of applying old fashioned theory to modern problems. The commentary above is based upon his recent research -- here's a brief description of some of his recent papers:

We examine global economic dynamics under learning in a New Keynesian model in which the interest-rate rule is subject to the zero lower bound. Under normal monetary and fiscal policy, the intended steady state is locally but not globally stable. Large pessimistic shocks to expectations can lead to deflationary spirals with falling prices and falling output. To avoid this outcome we recommend augmenting normal policies with aggressive monetary and fiscal policy that guarantee a lower bound on inflation.

And here are links to the papers themselves (the first two are technical, the third was written more for general economists and central bank policymakers):

Thus, this gives a fairly simple policy prescription - guarantee a lower bound on inflation - that is grounded in modern New Keynesian structures augmented with the models of learning that George, Seppo, and others have been developing. In the models with learning, there are stable and unstable regions, and large shocks can push you into the unstable region. The guarantee of a lower bound for inflation prevents inflationary expectations (which are formed through learning) from entering the region where deflationary spirals with falling prices and falling output are possible.

Here's a bit more from the conclusion to the third paper above:

The recent theoretical literature on the zero lower bound to nominal interest rates has emphasized the possibility of multiple equilibria and liquidity traps when monetary policy is conducted using a global Taylor rule. Most of this literature has focused on models with perfect foresight or fully RE. We take these issues very seriously, but our findings for these models under adaptive learning are quite different and in some ways much more alarming than suggested by the RE viewpoint. We have shown that under standard monetary and fiscal policy, the steady-state equilibrium targeted by policymakers is locally stable. In normal times, these policies will appropriately stabilize inflation, consumption, and output. However, the desired steady state is not globally stable under normal policies. A sufficiently large pessimistic shock to expectations can send the economy along an unstable deflationary spiral.

To avoid the possibility of deflation and stagnation, we recommend a combination of aggressive monetary and fiscal policy triggered whenever inflation threatens to fall below an appropriate threshold. Monetary policy should immediately reduce nominal interest rates, as required, even (almost) to the zero net interest rate floor if needed, and this should be augmented by fiscal policy, if necessary, in the form of increased government purchases. Intriguingly, using an aggregate output threshold in the same way will not always successfully reverse a deflationary spiral.

When aggressive fiscal policy is necessary, this will lead to a temporary buildup of government debt. However, government spending and debt will gradually return to their steady-state values. An earlier implementation of the recommended policies will mitigate the use of government spending, and if our recommended policy is already in place at the time of the shocks, the immediate use of aggressive monetary policy can in some (but not all) cases entirely avoid the need to use fiscal policy. Raising the inflation target π* is an alternative way of reducing the likelihood of needing to employ fiscal policy, but this may be undesirable for other reasons.

We Need Jobs

Following up on some of the issues raised in the post above this one, here's a quote from today's NY Times that summarizes my view on whether we should intervene with policy:

Mark A. Thoma, an economist at the University of Oregon, says the financial crisis would have been worse if the government hadn't rapidly intervened.

"I completely disagree with the idea that letting the markets heal themselves is the best idea," he says. "We tried that in the '30s, and it didn't work out so well."

The second part of the quote doesn't express what I was trying to say very well. Brad DeLong expresses it a bit better:

[W]henever governments largely ... let financial markets work their way out of a panic out by themselves – 1873 and 1929 in the United States come to mind – things turned out badly. But whenever government stepped in or deputized a private investment bank to support the market, things appear to have gone far less badly.

And, since I'm quoting myself, here's one more from yesterday at CNN Money on whether the fiscal stimulus in place already has worked:

The true test of the stimulus package will come in the fall, when the government reports economic activity for the third quarter. The administration is working to get the money out the door quicker, as complaints mount that stimulus is not having its promised effect.

"The third quarter will be a critical time period for assessing the stimulus package," said Mark Thoma, an economics professor at the University of Oregon.

As to whether we need more fiscal stimulus, if we wait until we know for sure it will be too late. I've been worried that employment would lag behind output once the economy recovered, and that the fiscal stimulus package we put in place was not sufficiently devoted to the employment recovery problem for quite awhile now, and I haven't changed my mind. From last June at MarketPlace:

Fiscal policymakers should have recognized that employment has tended to recover sluggishly in recent recessions and implemented policies that are known to create jobs. But they didn't...

We need policies that put people back to work immediately. Unfortunately, when the first fiscal stimulus package was being formulated, stimulus programs that hire people to do things that don't enhance long-run growth was a difficult sale politically, so we were left trying to stimulate employment largely with infrastructure projects that were difficult to bring online quickly (which will be even more true if there is another round). I would have preferred that more of the original stimulus package be devoted to projects that created immediate employment, and if we do another stimulus package, as we should given the shape that labor markets are in, I hope we pay more attention to the employment problem.

Update: Along these lines, recently, Brad DeLong wrote:

The Changing Nature of the American Business Cycle, by Brad DeLong: ...It used to be the case that businesses hoarded labor in recessions because they did not want their skilled workers to wander off and to have to train new ones....

Now it is really beginning to look as though businesses take recessions as opportunities to greatly slim down their workforces without making the workers they retain too angry and depressed. We saw this in 2002-2003. We saw it before in 1992-1993. The fact that productivity is no longer strongly procyclical countercyclical in recessions is good news in the long run--it means that our average long-run rate of productivity growth is higher than we used to think. But it also means that there is more headroom for expansionary policy, and more need.

Thus statements like this one from the very sharp Allan Sinai:

Phil Izzo reports:: "The mother of all jobless recoveries is coming down the pike," said Allen Sinai of Decision Economics. But he doesn't favor more stimulus now, saying "lags in monetary and fiscal policy actions" should be allowed to "work through the system..."

make me pound my head against the wall. If as the policies we have now in train to support the economy work their way through the system we find that we still have "the mother of all jobless recoveries," then we should be acting now to provide additional government support. A jobless recovery is not a good thing. And we should avoid it if we can figure out how in time.

For more, see:

Productivity in the Recession and Going Forward, by Paul Bauer and Michael Shenk, FRB ClevelandIn contrast to previous postwar recessions that tended to see sharply lower labor productivity growth, if not outright declines, the 2001 and the current recessions have had relatively strong labor productivity growth. In 2001, year-over-year productivity never dropped below 2.0 percent. In the current recession, productivity has remained over 1.9 percent. The sustainability of this productivity growth has implications for monetary policy, the affordability of the Federal deficit, and ultimately our living standards in the long run.


Gains in labor productivity (output per hour) come from three sources: increasing the amount of capital per worker (capital intensity); increasing workers' average level of skill, education, and training (labor composition); and a residual (multifactor productivity) that picks up economy-wide gains in knowledge and organizational methods not captured by the previous two effects. Only annual estimates are available for the breakdown in labor productivity. The post-1995 resurgence in labor productivity has been spurred largely by capital intensity and multifactor productivity. However, the growth for 2007 to 2008 was fueled more by capital intensity and a bit less multifactor productivity. ... [full article]

Global Rebalancing

Free Exchange says "many of the things you know about China are wrong":

Many things that you know about China are wrong, Free Exchange: If you think you understand the dynamics underlying global imbalances and the role China plays in generating them, have a good look at this piece, from this week's print edition. It challenges many of the ideas that pass for conventional wisdom on the subject. For instance, it is a commonplace that China depresses domestic demand to boost its exports. But in fact:

China's current-account surplus will fall to under 6% of GDP this year and 4% in 2010, down from a peak of 11% in 2007. Exports amounted to 35% of GDP in 2007; this year, reckons Mr Cavey, that ratio will drop to 24.5%. ...

In fact, the popular perception that China has always relied on export-led growth is rather misleading. Its current-account surplus did soar from 2005 onwards but until then was rather modest. And over the past ten years net exports accounted, on average, for only one-tenth of its growth.

The problem is that too little of domestic demand growth goes to consumption. Rather, investment accounts for a rising proportion of Chinese output. But this isn't because consumption is growing slowly, as is widely believed:

It is often argued that China runs a current-account surplus because its consumer spending has been sluggish. On the contrary, China has the world's fastest-growing consumer market, increasing by 8% a year in real terms in the past decade. ... Even so, China's consumer spending has grown more slowly than the overall economy. As a result consumption as a share of GDP has fallen and is extremely low by international standards: only 35%, compared with 50-60% in most other Asian economies and 70% in America.

Investment has just grown ... too fast for consumption to keep pace. It's also assumed that China has pursued export-led growth because it must create jobs for its many people. And yet:

The more important reason why consumption has fallen is that the share of national income going to households (as wages and investment income) has fallen, while the share of profits has risen. Workers' share of the cake has dwindled because China's rapid growth has generated surprisingly few jobs. Growth has been capital-intensive, focusing on heavy industries such as steel rather than more labour-intensive services. Profits (the return to capital) have outpaced wage income.

Capital-intensive production has been encouraged... The government has also favoured manufacturing over services...

It's ironic; by favouring capital-intensive manufacturing exportables, the government has missed out on opportunities to grow more labour-intensive retail and service sectors which could employ more workers. It often seems as though economists believe that simply by allowing its currency to appreciate, China can begin to break down many of the world's structural imbalances. Certainly, that would help. But it also appears ... China will have to pursue serious internal reforms—strengthening its financial sector, improving its social safety net, and removing burdensome regulations designed to generate massive investment in manufacturing industries. In other words, rebalancing isn't as easy as it looks.

[Traveling all day today, so I probably won't be able to do much. Update: So nice to get to the airport and find out your flight is canceled. It's going to be a long day. Update: Now I'll be happy to leave the airport in Ithaca. First flight canceled, second delayed. All night in the Philadelphia airport, if I can get there. So much fun.]

"The True Value of Economists"

Another response to the Queen:

Royal flush, by Robert Shrimsley, Commentary, FT:


When you visited us last year you asked why economists were so useless – although you were kind enough not to put it that way. ...

You asked why we failed to predict the credit crunch. ...[L]et us assume that we had predicted the credit crunch.

What would have been the result? Would bankers have heeded our warnings? Would regulators have confronted the banks? Would craven politicians have acted to limit a popular credit boom? We think not.

So we cannot be said to have failed ... since the outcome would have been the same. To speak up, therefore, would have been an inefficient use of our resources.

With no incentive to deliver the warning, we instead all went off and wrote books like Freakonomics about how economics can explain the real world. They may not have done much to avert the crunch but they did very nicely for us, thank you.

So the question, your Majesty, is not why did we fail to predict the crunch but why did you all fail to incentivise us to predict it?

In highlighting the right question to ask, we hope we have shown you the true value of economists. ...

links for 2009-08-02

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