Redirect


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

August 9, 2009

Economist's View - 5 new articles

Fed Watch: The Recovery Edges Forward

Tim Duy reviews the state of the economy in anticipation of the Federal Reserve meeting scheduled for Tuesday and Wednesday of this week:

The Recovery Edges Forward, by Tim Duy: Data flow continues to support those who argue that if the recession is not already over as of July, it soon will be. The July jobs report - while not exactly cheery news for those still losing their jobs - is another clear indicator that the employment picture is turning. Still, excitement over the end of the recession aside, the data also reveal that the economy is recovering in fits and starts, with tell-tale signals that the consumer orgy of this decade is not likely to be repeated.

The July employment report in many ways spoke for itself. Possibly most important is the clear improvement in the pace of job losses:

FEDWATCH0809092

This serves as confirmation of what we already knew from initial claims - the worst damage to the job market is in the rearview mirror. Other positive signs included a rise in manufacturing hours and stability in aggregate hours. To be sure, not all is perfect. The decline in the unemployment rate was driven by an exodus from the labor force - not exactly a sign of improving conditions. And a key leading indicator of employment, temporary help payrolls, continues to decline. If the recession did in fact end in June, and we see evidence of that end in the July industrial production report to be released this week, the decline in temporary help employment is clearly a disappointment. Indeed, coupled with rising production, it would simply reek of jobless recovery.

Other data supported the notion of weak recovery as well. While industrial activity may be close to turning a corner on the back of inventory reduction and the cash for clunkers program, not all is well in the service sector. The ISM read on nonmanufacturing activity actually edged downward for the month, with declines in not only the headline number, but also business activity, new orders, and employment. Better than the freefall of last year, but nothing to suggest that a V-shaped recovery is imminent.

Perhaps the lack of enthusiasm in the service sector is a reflection of what is clearly a subdued consumer. The June personal income and outlays report reveals that consumer spending declined in for the month:

FEDWATCH0809091

The impact of a weakened consumer is evident in a spate of stories and data during the week. For example, the first read on retail sales for July:

Retailers endured another tough month in July -- the worst since January -- as weaker consumer spending signaled a tough time for back-to-school sales, the second-biggest retail season after Christmas.

And note that where consumer activity is occurring, it tends to be at a lower price point:

Procter & Gamble Co., under assault by penny-pinching consumers, has quietly rolled out a version of Tide detergent that the company freely admits isn't "new and improved."

The product, Tide Basic, is currently for sale in about 100 stores throughout the South. It lacks some of the cleaning capabilities of the iconic brand -- and costs about 20% less. Its very existence is one of the most telling signs to date of how the sour U.S. economy is forcing mass marketers to shift course. On Wednesday, the company reported an 18% plunge in fiscal fourth-quarter profits as sales of its premium-priced brands shrank amid tightened consumer budgets.

The decision to develop Tide Basic didn't come easily. For decades, P&G had held fast to a strategy of promoting new features to convince shoppers to pay a premium for detergent, shampoo and other household staples. Then, as cheaper store brands gained traction in the aisles, P&G began offering lower-priced versions of some products -- Charmin toilet paper, Bounty paper towels -- to suit leaner budgets.

The trend is not limited to consumer staples. In what I think is an underreported story, the new housing market too is shifting toward the low end:

Frugal first-time buyers are driving the new-home market with purchases of low-priced houses with no frills. Sales of new homes costing less than $200,000 jumped to 47 percent of all transactions in June, up from 39 percent in May, U.S. Commerce Department data show. Homes under $200,000 accounted for almost half of the sales in the first six months of this year, the biggest share for a first half in five years.

It is often forgotten that the composition of new home construction is likely to change as builders shift to producing what people can actually afford, which is very different from what was being produced during the height of the housing bubble. The new housing will yield thinner profit margins for everyone in the supply chain, and will not generate as much wealth when they do appreciate at some point in the future. Moreover, a rebounding new home market for all housing types will place severe downward pressure on existing home prices, as builders will benefit from now lower land and construction costs. The point of which is that a recovery in new home sales is not a recovery for housing or the economy overall.

And if you had any residual doubt that household spending was still challenged, that doubt should be dispelled by the Federal Reserve read on consumer credit:

Consumer credit in the U.S. declined in June for a fifth straight month as banks maintained tough lending terms and households remained reluctant to borrow money for major purchases.

Consumer credit fell $10.3 billion, or 4.92 percent at an annual rate, to $2.5 trillion, according to a Federal Reserve report released today in Washington. Credit dropped by $5.38 billion in May, more than previously estimated. The series of declines is the longest since 1991.

To be sure, the pace of the decline should lessen in July as the impact of the cash for clunkers sales becomes more evident, but this would really be further evidence of consumer weakness - the only way to induce households to loosen the purse strings is to give them free money. Like the improvements seen in new home sales, an ongoing testament to the importance of government spending in keeping the economy afloat. It is not clear that all sectors realize that importance. An interesting local tidbit:

Production has resumed at Monaco RV, eight months after the plant was idled, a spokesman said Thursday.

About 400 workers are back at work at the Coburg factory, producing about seven recreational vehicles per day, said Roy Wiley, spokesman for Illinois-based Navistar International, the new parent company of Monaco RV. He said he wasn't sure if workers were building towable RVs, motor coaches or a combination of both.

Even though there are no indications that the RV market has begun to recover, Navistar decided to resume production at the plant about two weeks ago because "you need inventory," Wiley said.

Apparently, Navistar plans to increase inventory on the "if you build it they will buy it" philosophy. But like overpriced housing and luxury goods, RV sales are dependent on cheap credit and bad judgment. At least with a house you have hope of recovering your nominal losses if you hold on long enough; not so with RVs, which are only an exercise in depreciation tables.

The pattern of data and anecdotal evidence on the consumer is that the worst fears of a return to Depression-era spending patterns have not been realized, households have measurably changed their behavior, which coupled with what are likely permanently stricter underwriting conditions, point to a very real structural change in the evolution of economic activity going forward. It is simply increasingly difficult to believe we can return to a pattern of growth dependent on escalating importance of consumer spending in the mix of economic activity. Structural change is at hand, which will leave some dangerous economic waters to navigate.

Which leads us to the policy event of the week, the Federal Reserve meeting scheduled for Tuesday and Wednesday. The subsequent statement will have to address the improving economic data without setting expectations that a rate hike is imminent, or even under consideration for early next year as some suspect. To be sure, there will be some V-shapers on the FOMC looking to roll back policy accommodation at first hint of economic growth. But I have to imagine that Federal Reserve Chairman Ben Bernanke walked away with not one, but two basic rules from his studies on the Great Depression and Japan. The first is to respond forcefully at the first stages of a financial crisis. The second is to recognize the fragility of the subsequent recovery and NOT rush to normalize policy, thereby setting the stage for stop-start policy efforts. No one should be under the delusion that the current economic environment is the product of anything other than the massive efforts of federal authorities to keep the system afloat. Low interest rates, support of securitization markets, free money for cars and houses, fiscal stimulus, etc. Bernanke simply will not be inclined to rock the boat at such an early stage of the recovery.

What the Fed is likely to signal is that they do not intend to extend the Treasury purchase program at its expiration:

The Federal Reserve is set to halt its purchases of up to $300 billion in U.S. Treasuries in mid- September as scheduled, and will probably announce the decision next week, two former central bank governors said.

Still, I would not discount the possibility that the program could make a fresh appearance in the future; the future of monetary policy is dependent on the path of job growth. Six months of jobless recovery as the economy limps along could easily prompt the Fed into additional easing. Remember, that was the pattern in the wake of the 2001 recession, a recession that did not end for many until the housing bubble took hold. It is tough to see a fresh domestic bubble emerging, and thus tough to see how sustainable, organic growth develops. And thus tough to see a Fed not more inclined to offer additional gas rather than step on the brake.

Bottom Line: For those still fretting that the economy remains poised for the ultimate end-times collapse, you need to remember the following: In aggregate, nothing truly bad will happen as long as the Federal Reserve can print money and the US Treasury can spend it. We simply have not hit that wall yet (although one can see it coming, as the history of monetary policy for the last two decades is one of diminishing returns - it apparently takes more to accomplish less). At the same token, acceptance of the reality that the recession is set to end does not oblige one to adopt a V-shaped outlook. Far from it, as patterns of consumer spending and labor market activity, not to mention the undeniable impact of government support, all point to a tepid recovery characterized by a jobless recession. Such an outcome, however, will not be proven or denied by the end of the year at the earliest.


"The White House's Deal With Big Pharma Undermines Democracy"

Robert Reich says the administration's promise not to use the government's purchasing power to lower the price of drugs in return for a large, pharmaceutical industry sponsored ad campaign in support of health care reform undercuts and threatens the democratic process:

How the White House's Deal With Big Pharma Undermines Democracy, by Robert Reich: I'm a strong supporter of universal health insurance, and a fan of the Obama administration. But I'm appalled by the deal the White House has made with the pharmaceutical industry's lobbying arm to buy their support.

Last week,... the White House confirmed it has promised Big Pharma that any healthcare legislation will bar the government from using its huge purchasing power to negotiate lower drug prices. That's basically the same deal George W. Bush struck in getting the Medicare drug benefit, and it's proven a bonanza for the drug industry. ... Let me remind you: Any bonanza for the drug industry means higher health-care costs for the rest of us...

In return, Big Pharma isn't just supporting universal health care. It's also spending a lots of money on TV and radio advertising... Big Pharma has budgeted $150 million for TV ads promoting universal health insurance, starting this August (that's more money than John McCain spent on TV advertising in last year's presidential campaign), after having already spent a bundle through advocacy groups like Healthy Economies Now and Families USA.

I want universal health insurance. And having had a front-row seat in 1994 when Big Pharma and the rest of the health-industry complex went to battle against it, I can tell you first hand how big and effective the onslaught can be. So I appreciate Big Pharma's support this time around...

But I also care about democracy, and the deal between Big Pharma and the White House frankly worries me. It's bad enough when industry lobbyists extract concessions from members of Congress, which happens all the time. But... [a]n industry is using its capacity to threaten or prevent legislation as a means of altering that legislation for its own benefit ... at the highest reaches of our government, in the office of the President.

When the industry support comes with an industry-sponsored ad campaign in favor of that legislation, the threat to democracy is even greater. Citizens end up paying for advertisements designed to persuade them that the legislation is in their interest. In this case, those payments come in the form of drug prices that will be higher than otherwise...

I don't want to be puritanical about all this. Politics is a rough game... Perhaps the White House deal with Big Pharma is a necessary step to get anything resembling universal health insurance. But if that's the case, our democracy is in terrible shape. How soon until big industries ... have become so politically powerful that secret White House-industry deals ... are prerequisites to any important legislation? When will it become standard practice that such deals come with hundreds of millions of dollars of industry-sponsored TV advertising designed to persuade the public...? (Any Democrats and progressives ... should ask themselves how they'll feel when a Republican White House cuts such deals to advance its own legislative priorities.)

We're on a precarious road -- and wherever it leads, it's not toward democracy.


"A Missed Opportunity on Climate Change"

In discussing proposed climate change legislation below, Greg Mankiw says:

To those who view climate change as an impending catastrophe and the distorting effects of the tax system as a mere annoyance, an imperfect bill is better than none at all. To those not fully convinced of the enormity of global warming but deeply worried about the adverse effects of high current and prospective tax rates, the bill is a step in the wrong direction.

He then goes on to say "As for me, I hope the president refuses to sign a bill that fails to auction most of the allowances..., sometimes good is not good enough" which, given his categorization of those supporting and opposing the bill, I interpret to mean that he is more worried about distortions from taxes than he is about global warming:

A Missed Opportunity on Climate Change, by N. Gregory Mankiw, Commentary, NY Times: During the presidential campaign of 2008, Barack Obama distinguished himself on the economics of climate change, speaking far more sensibly about the issue than most of his rivals. Unfortunately, now that he is president, Mr. Obama may sign a climate bill that falls far short of his aspirations. Indeed, the legislation making its way to his desk could well be worse than nothing at all. ...

The textbook solution for dealing with negative externalities is to use the tax system to align private incentives with social costs and benefits. ... A carbon tax is the remedy for climate change that wins overwhelming support among economists and policy wonks.

When he was still a candidate, Mr. Obama did not exactly endorse a carbon tax. He wanted to be elected... What Mr. Obama proposed was a cap-and-trade system for carbon, with all the allowances sold at auction. ... Such a system is tantamount to a carbon tax. The auction price of an emission right is effectively a tax on carbon. ...

So far, so good. The problem occurred as this sensible idea made the trip from the campaign trail through the legislative process. Rather than auctioning the carbon allowances, the bill that recently passed the House would give most of them away to powerful special interests.

The numbers involved are not trivial. From Congressional Budget Office estimates, one can calculate that if all the allowances were auctioned, the government could raise $989 billion in proceeds over 10 years. But in the bill as written, the auction proceeds are only $276 billion. ...

How much does it matter? For the purpose of efficiently allocating the carbon rights, it doesn't. Even if these rights are handed out on political rather than economic grounds, the "trade" part of "cap and trade" will take care of the rest. ...

The problem arises in how the climate policy interacts with the overall tax system. ... The price of carbon allowances will eventually be passed on to consumers in the form of higher prices for carbon-intensive products. But if most of those allowances are handed out rather than auctioned, the government won't have the resources to cut other taxes and offset that price increase. The result is an increase in the effective tax rates facing most Americans...

The hard question is whether, on net, such a policy is good or bad. Here you can find policy wonks on both sides. To those who view climate change as an impending catastrophe and the distorting effects of the tax system as a mere annoyance, an imperfect bill is better than none at all. To those not fully convinced of the enormity of global warming but deeply worried about the adverse effects of high current and prospective tax rates, the bill is a step in the wrong direction.

What everyone should agree on is that the legislation making its way through Congress is a missed opportunity. President Obama knows what a good climate bill would look like. But despite his immense popularity and personal charisma, he appears unable to persuade Congress to go along.

As for me, I hope the president refuses to sign a bill that fails to auction most of the allowances. Some might say a veto would make the best the enemy of the good. But sometimes good is not good enough.

What he doesn't mention, and I'm not sure why, is that the permit giveaways are scheduled to end after after 10-15 years. That's not as good as auctioning the permits from day one, but it does put a plan for auctions in place. So in the long-run, the intent is to auction 100% of the permits just as Greg desires, the giveaways at the beginning are an attempt to get the bill passed. There are lots of problems with the bill as currently formulated, and a key consideration is how credible you view the promise to auction permits in the future. Going on a diet tomorrow is easy to plan, but when tomorrow comes will the plan be executed? I hope so, but have my doubts.

Update: Ryan Avent comments here.


Solow: Dumb and Dumber in Macroeconomics

Continuing with the discussion on the state of macroeconomics, this is Robert Solow from an October 25, 2003 address at Joe Stiglitz' 60th birthday conference. Solow gets extra credit for saying these things before the crisis hit, e.g. " I start from the presumption that we want macroeconomics to account for the occasional aggregative pathologies that beset modern capitalist economies, like recessions, intervals of stagnation, inflation, "stagflation," not to mention negative pathologies like unusually good times. A model that rules out pathologies by definition is unlikely to help." (Let me also point to a comment by Ping Chen at Free Exchange in response to the Lucas essay which I may highlight more explicitly later. Update: See also Jamie Galbraith's remarks at the Stiglitz conference):

Dumb and Dumber in Macroeconomics, by Robert M. Solow: So how did macroeconomics arrive at its current state? The answer might provide a lead as to where it ought to go.

The original impulse to look for better or more explicit micro foundations was probably reasonable. It overlooked the fact that macroeconomics as practiced by Keynes and Pigou was full of informal microfoundations. (I mention Pigou to disabuse everyone of the notion that this is some specifically Keynesian thing.) Generalizations about aggregative consumption-saving patterns, investment patterns, money-holding patterns were always rationalized by plausible statements about individual--and, to some extent, market--behavior. But some formalization of the connection was a good idea. What emerged was not a good idea. The preferred model has a single representative consumer optimizing over infinite time with perfect foresight or rational expectations, in an environment that realizes the resulting plans more or less flawlessly through perfectly competitive forward-looking markets for goods and labor, and perfectly flexible prices and wages.

How could anyone expect a sensible short-to-medium-run macroeconomics to come out of that set-up? My impression is that this approach (which seems now to be the mainstream, and certainly dominates the journals, if not the workaday world of macroeconomics) has had no empirical success; but that is not the point here. I start from the presumption that we want macroeconomics to account for the occasional aggregative pathologies that beset modern capitalist economies, like recessions, intervals of stagnation, inflation, "stagflation," not to mention negative pathologies like unusually good times. A model that rules out pathologies by definition is unlikely to help. It is always possible to claim that those "pathologies" are delusions, and the economy is merely adjusting optimally to some exogenous shock. But why should reasonable people accept this? During the past three years, unemployment has increased by three million with real wages stagnant and productivity growing, possibly abnormally fast. Capacity utilization has fallen by 10 percent, with trivial inflation and some prices falling. Real business investment in equipment peaked in the third quarter of 2000, fell by 20 percent to the first quarter of 2002, and has risen by a scant five percent since then. Is this a stagnation pattern? Does it reflect large-scale, perhaps irrational, overinvestment in the 1990s? Should it not be studied as such? Why should anyone take it as the solution of an Euler equation? It would not be hard to imagine a better path for the economy. Why should the burden of proof fall on those who see an ordinary standard pathology here? The odd thing is to regard this history as the working out of an other-worldly model.

What is needed for a better macroeconomics? My crude caricature of the Ramsey-based model suggests some of the gross implausibilities that need to be eliminated. The clearest candidate is the representative agent. Heterogeneity is the essence of a modern economy. In real life we worry about the relations between managers and shareowners, between banks and their borrowers, between workers and employers, between venture capitalists and entrepreneurs, you name it. We worry about those interfaces because they can and do go wrong, with likely macroeconomic consequences. We know for a fact that heterogeneous agents have different and sometimes conflicting goals, different information, different capacities to process it, different expectations, different beliefs about how the economy works. Representative-agent models exclude all this landscape, though it needs to be abstracted and included in macro-models.

I also doubt that universal rational expectations provide a useful framework for macroeconomics. One understands the appeal. Think of it this way: Herb Simon was surely right about bounded rationality; no one would deny that most economic agents are actually like that, and natural selection does not work fast enough to eliminate them. Why did the notion of "satisficing" never catch on? I think it is because the assumption of complete rationality tells the modeller what to do, whereas bounded rationality only tells the modeller what not to do. That is not helpful. Something similar is true about rational expectations. If there were a nice parametric family of alternative ways to model expectations, it might catch on. Most of us would happily go along with the notion of expectational equilibrium: if specific underlying expectations generate an outcome in which those expectations are systematically and non-trivially violated, that situation can not be an equilibrium. It is what happens then that needs thought. The situations that agents need to anticipate need not even be probabilistic, surely not stationary. The popular device used to be adaptive expectations; that may have been inadequate. Maybe this is a case for the application of psychological research (and sociological research as well, because the formation of expectations is a social process). Maybe experiments can be designed. Heterogeneity across agents and classes of agents is certainly important precisely here. One would like a simple, definite way to proceed, if that is possible. A good example of the sort of thing I mean is the way the Dixit-Stiglitz model made monopolistic competition easy. (The trouble is that we are dealing with an unobservable.)

Although I am going to take this back in a moment, it is certainly worthwhile mentioning the problems connected with real and/or nominal wage and price inflexibility and its sources in market structure, limitations of information, human nature, the specialness of zero, etc. This is an old issue in economics, macro and micro, and a lot of progress has been made in measuring and understanding it. Mere sluggishness is part of the picture, and that is easily modelled, but there is surely more that is less easily modelled. The devil finds work for idle hands to do, as you may have noticed.

Now here is a peculiar thing. When I was in advanced middle age, I suddenly woke up to the fact that my colleagues in macroeconomics, the ones I most admired, thought that the fundamental problem of macro theory was to understand how nominal events could have real consequences. This is just a way of stating some puzzle or puzzles about the sources for sticky wages and prices. This struck me as peculiar in two ways.

First of all, when I was even younger, nobody thought this was a puzzle. You only had to look around you to stumble on a hundred different reasons why various prices and factor prices should be much less than perfectly flexible. I once wrote, archly I admit, that the world has its reasons for not being Walrasian. Of course I soon realized that what macroeconomists wanted was a formal account of price stickiness that would fit comfortably into rational, optimizing models. OK, that is a harmless enough activity, especially if it is not taken too seriously. But price and wage stickiness themselves are not a major intellectual puzzle unless you insist on making them one.

The second peculiarity was that the path from nominal events to real consequences was not my idea of the fundamental problem of macro theory anyway. All along, I had been thinking--and this may be a Keynesian inheritance, though I doubt it because I may have picked it up from Gottfried Haberler's Prosperity and Depression, where my generation learned about business-cycle theory before "macroeconomics" had been invented--that the main problem was to understand why real shocks that took the economy out of some satisfactory equilibrium led to such a prolonged and sometimes unsatisfactory adjustment. These are medium-run problems--the capital stock moves--and there clearly are medium-run fluctuations in modern industrial economies. (This is documented for the U.S. in a recent paper by Comin and Gertler.)

Keynes claimed to have found the way to account for this: he thought he had a theory of unemployment equilibrium. The reason adjustment took so long, or never really happened, is that the depressed state was actually an equilibrium. Most of us today think that Keynes failed in that effort; he lacked the tools. The exception was the case of wage rigidity, but we knew that all along. In my youth, we thought that macro-pathologies were disequilibrium phenomena, and then the puzzle was: why is the process so slow?

This choice between equilibrium and disequilibrium thinking may be a false choice. If I drop a ripe watermelon from this 15th-floor window, I suppose the whole process from t0 to the mess on the sidewalk could be described as some sort of dynamic equilibrium. But that may not be the most fruitful--sorry--way to describe the falling-watermelon phenomenon.

So I would hope that macro theory could get back to focusing on the adaptation-to-real-disturbance problem, without falling into the implausibilities of real-business-cycle theory. (Even RBC theorists may fight their way out of that paper bag.) The Ur-Problem may be: start in a situation of growth equilibrium (not necessarily a steady state, but don't get me started on that one), and imagine a real shock, perhaps a failure of real effective demand (!). What happens next? That may be the story of the period from 2000 to now, the real shock having been massive overinvestment in response to unrealistic profit expectations (accompanied by accounting swindles, just to make Joe happy).


links for 2009-08-09

No comments: