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October 28, 2009

Economist's View - 5 new articles

Woodford on Financial Markets

Part of an interview of Michael Woodford:

Q&A: Economist Woodford on Fed and Rate Expectations, RTE: ...Given the importance of financial stability for the wider economy, do you think financial stability should play a greater or explicit role in the Federal Reserve's policy strategy?
Woodford: No doubt, the Fed should give greater attention to financial stability than it did in the past. One should try and set up a framework to safeguard financial stability, and it may very well be that ... central banks should play a key role. But, ideally, one would be scrutinizing the risks developing and adjust capital requirements accordingly, rather than using monetary policy to respond to these risks. You've got to realize that pretending you can do everything with one tool means you won't do any of them too well.
Should the Fed be more reactive — leaning against the wind -toward sharp moves in asset prices, such as house prices and equities? Should the Fed include a broader range of asset prices in its policy strategy?
Woodford: I'm not too sympathetic of that way of putting things. Using monetary policy to prevent certain moves in asset prices wouldn't be a terribly effective tool. And to the extent that it would be effective, it'd involve important costs for the rest of the economy. It'd be particularly bad for the Fed to be saying "we have a view on where asset prices should be, and we're going to get them there by using monetary policy." Instead, the focus of the Fed's investigation should be on what kind of risks financial institutions get themselves into — not on asset prices as such.
The Fed has downgraded the role of money and credit aggregates in its policy strategy. Given the more recent developments, do you think it's now time to reconsider, or reverse the move?
Woodford: The issue that deserves more attention is monitoring risks to financial stability and identifying possible systemic risks. Unfortunately, traditional monetary and credit statistics aren't that closely related to the things you really ought to be measuring. For example, lending by non-bank entities has played an important role in the recent real-estate euphoria. Given the emergence of new kinds of institutions and financing arrangements, you cannot simply revert to the old statistics people used to look at decades ago. There should be more research on understanding which measures are in fact the valuable indicators.

The last section is important. Many people have said that we cannot tell when a bubble is inflating (and thus when risks are increasing), but how hard have we actually tried? Have we seriously looked at data on, to name just one element of what I have in mind, leverage cycles? Do we know how leverage cycles relate to crises, that kind of knowledge that years of hard work by a variety of researchers brings about? Some people likely know the answer to this, or at least have some idea about this, but it's not data you'll find in standard sources such as FRED. As another example, what about measures and data on the degree of financial market connectedness? This can be measured in principle, but little effort has been devoted to doing so. Even traditional measures such as P/E ratios and Q-ratios haven't received the attention they deserve.

Until we dig in and try seriously to develop new empirical measurements that can monitor and identify risks, measures intended to inform us when risks are increasing to dangerous levels, we won't know if we can identify bubbles or not. I understand that financial theory says such predictions are impossible, and this has led people to shy away from such work, but that result relies upon assumptions that may not be true. The crisis has revealed the shaky foundation those models rest upon, so it's no longer an excuse for not trying, or, as in the past, for dismissing work along these lines as unimportant and a waste of time.

"Labor's Share"

Spencer at Angry Bear on the "secular decline in labor's share of the pie":

Labor's Share, by Spencer: The issue of a jobless recovery is getting a lot of attention recently. I've found the best way to look at the issue is to compare the change in real growth and productivity over the long run. There have been three periods of different productivity trends in modern US economic history. Prior to about 1973 productivity growth averaged 2.8%. In the second or low productivity era, running from 1974 to 1995, productivity growth slowed to 1.5% before rebounding to 2.4% since 1995. But real GDP growth also slowed over this period. ... Basically, real GDP growth equals productivity growth plus hours worked or employment growth. A consequence of stronger productivity in an era of weaker GDP growth this suggests that each percentage point increase in real GDP growth generates a much weaker increase in hours worked or employment. ...
But to a certain extent comparing productivity and real GDP is comparing apples to oranges. To be accurate one should look at productivity versus output in the nonfarm sector. GDP includes the farm sector of course, but also the nonprofit and government sectors where productivity is assumed to be zero. If you look at what happened in the 1990s and early 2000s recoveries in the nonfarm business sector, you see that productivity growth significantly outpaced output growth in the early recovery phase of the cycle. As a consequence hours worked or employment fell, generating the jobless recoveries. It looks like the problem in these two cycles was much weaker growth rather than strong productivity. ... This shift to an environment of stronger productivity and weaker real growth generated an interesting development that has received little attention among economists or in the business press.
This development was a secular decline in labor's share of the pie. Prior to the 1982 recession there was a strong cyclical pattern of labor's but it was around a long term or secular flat trend. But since the early 1980s labor's share of the pie has fallen sharply by about ten percentage points. Note that the chart is of labor compensation divided by nominal output indexed to 1992 = 100. That is because the data for each series is reported as an index number at 1992=100 rather than in dollar terms. So the scale is set to 1992 =100 rather than in percentage points. But it still shows that labor payments as a share of nonfarm business total output has declined sharply over the last 20 years and prior to the latest cycle we did not even see the normal late cycle uptick in labor's share.

If this chart gets a lot of attention it will be interesting to see how the libertarian and/or conservative analysts who keep coming up with all types of excuses to explain away the weakness in real labor compensation in recent years explain this away. If you really want to raise a stink you could look at this as a great example of the Marxist immiseration of labor that Marx believed was one of the internal contradictions of capitalism that would eventually lead to its self destruction.

I'll just add that the point at which the decline begins (in the early 1980s) is generally associated with the onset of the Great Moderation.

"A Clunker of a Climate Policy"

Jeff Sachs says we need to be sure that climate control legislation is not captured by powerful special interest groups:

A Clunker of a Climate Policy, by Jeffrey D. Sachs, Commentary, Scientific American: The Cash for Clunkers program offers a cautionary tale for the future of climate change control. ... The broad principle of climate change mitigation is to reduce greenhouse gas emissions ... to target levels at the minimum net cost to society. There are many ways to reduce emissions: drive more efficient or electrically powered vehicles; produce electricity with renewable energy sources; capture CO2 from power plants and store it geologically; restart the nuclear power sector; weatherproof homes... The list is long, with different time horizons, costs and uncertainties.
Clearly, not every method of reducing emissions makes equal sense. ...McKinsey & Company has recently published estimates of the abatement costs of various technologies. Highly efficient lighting, appliances and vehicles, along with better insulation and other technologies, can save more in energy costs during their lifetime than the upfront capital for installing them: they are better than free to society. Other options—notably, renewable energy sources, forest conservation programs and carbon capture and storage—tend to come in below $60 per ton of avoided CO2 emissions.
Some carbon-reduction ideas are so expensive they should play no part in the policy mix. Yet because lobbyists overrun our legislative processes,... lots of terrible ideas will no doubt be advocated.
Let's make a rough calculation of how much mitigation per dollar the Cash for Clunkers program really achieved. ...[calculations]... The net annual cost of the CO2 reduction is therefore ... $141 per ton of CO2. ... This crude calculation is subject to many refinements but shows that Cash for Clunkers represented a very high cost per ton of CO2 avoided. Countless ways to reduce CO2 emissions are less expensive than smashing up autos five years before their natural demise.
We will blunder badly and repeatedly in climate change control unless we put some transparent control systems in place. We should rely heavily on price signals rather than one-by-one subsidized programs, except for the subsidies needed to bring new technologies such as electric vehicles to the commercial phase. An economy-wide tax on each ton of CO2 emissions, programmed to rise gradually over time at an appropriate social discount rate, would induce the marketplace to take actions that are less expensive per ton than the tax and to leave behind measures such as Cash for Clunkers or corn to ethanol. A carbon tax would be far more effective in this regard than the cumbersome cap-and-trade system proposed by the House of Representatives.
We'll need to spend trillions of dollars over time to save the planet from climate change. All the more reason not to let lobbyists make a financial game out of this deadly serious effort.

"Pro-Market Populism"

Luigi Zingales is worried that populist anger might fall into the hands of evil Democrats rather than Republicans who would, of course, use this strong populist force for good:

Pro-Market Populism Is GOP's Out, by Luigi Zingales, Commentary, ...[T]he financial crisis has created significant discontent. In a survey taken last December, 60% of Americans declared themselves "angry" or "very angry" about the economic situation.
If Republicans ignore this popular anger, as the party establishment did last autumn, they leave a powerful and potentially disruptive force in the hands of Democrats. The Democrats could channel popular anger into protectionism, 90% tax rates and onerous new market constraints.
In Republican hands, populism could become a strong force for positive change.

And Republicans would do this by adopting Democratic ideas:

The Republican Party has to move from a pro-business strategy that defends the interests of existing companies to a pro- market strategy that fosters open competition and freedom of entry.
While the two agendas sometimes coincide, they are often at odds. Established firms are threatened by competition and frequently use their political muscle to restrict new entries into their industry, strengthening their positions but putting their customers at a disadvantage.

Reducing market power through regulation and is something Democrats have long advocated, but Republicans have argued that the market takes care of this itself, there's no need for government to intervene. So how would Republicans solve the problem in, say, the financial industry?

A pro-market strategy aims to encourage the best conditions for doing business, for everyone. Large banks benefit from trading derivatives (such as credit default swaps) over the counter, rather than in an organized exchange. ... For this reason, they oppose moving such trades to organized exchanges, where transactions would be conducted with greater transparency, liquidity and collateralization — and so with greater financial stability. This is where a pro-market party needs the courage to take on the financial industry on behalf of everyone else.

Again, that sounds like what Democrats have been saying, that these markets need to be regulated.

What else is involved in this pro-market strategy that will save the Republican party?

A pro-market strategy rejects subsidies because they're a waste of taxpayers' money and because they prop up inefficient firms, delaying the entry of new and more efficient competitors.
And a pro-market approach holds companies financially accountable for their mistakes — an essential policy if free markets are to produce sound decisions.
A pro-market party will fight tirelessly against letting firms become so big that they cannot be allowed to fail, since such firms may take risks that ordinary companies would never dream of.

I can imagine a few people on the left supporting some types of subsidies, but generally I don't think you'll get much disagreement here either (e.g. see Sachs on subsidies in the post above this one). The accountability thing sounds like a jab at government intervention to save the bank (as does the first point), but take a look at the latest proposal from Democrats that attempts to put the cost of bailouts on the companies themselves while still protecting the economy (as opposed to just letting it melt down). But go on...

A pro-market party should favor a robust safety net — for people, not companies. Of course, this safety net should be run on market principles as much as possible. Unemployment insurance should retain incentives for people to look for work, and the health-insurance industry should be opened up to competition. But defenders of markets cannot ignore the importance of providing such security for citizens.

The details would differ a bit, e.g. the health insurance competition part certainly differs from a Medicare for all structure many Democrats endorse (but not all), but the general idea of a "robust safety net" for people seems consistent with Democratic ideas, less so with Republican principles.

Besides robust safety nests, what else is on the long-time concern of Republican's list?

They also cannot ignore the nation's growing income inequality and the widespread loss of confidence that the future will be better than the past. The knee-jerk Democratic reaction is to give these poorer citizens entitlements disguised as rights.
The Republican response should focus on providing opportunities. Parents should have access to good schools for their kids, regardless of their financial means or where they live. The best way to deliver on that promise is through a voucher system.

Entitlements disguised as rights? Such as? The general idea that some kids are disadvantaged by the education they receive has been a mainstay within the Democratic party for a long time, and quite a few Democrats endorse vouchers as part of the solution (even breaking up teacher's unions in some cases). And concern over inequality? From Republicans? Generally Republicans argue that inequality isn't really increasing or as bad as you think (the attack the data when you don't like the answer approach), or that it's necessary to fuel the engine of capitalism.

What's next on the list of Democratic ideas disguised as Republican concerns?

Students should have better access to loans to finance their education because everyone gains from a better-educated work force. The unemployed should have access to retraining, which can also be designed through a voucher system.

Student loans, help with finding new employment? Yet again, strong Democratic ideas. The only thing new is to toss in a voucher system, but that's a debate about how best to reach the goal, not what the goal is (and again, vouchers aren't automatically rejected by all Democrats). I suppose you'll want to adopt health care as a Republican idea as well?

Health care should be available in the marketplace. The current system, in which only employers get a tax deduction for health insurance, reduces labor mobility and increases the cost of becoming unemployed.

What is the goal here? If it's to make health care affordable and available to everyone, simple saying it ought to be "in the marketplace" is far from enough. The incompleteness of the proposal makes this hard to evaluate (but given the proposals so far, you have to think the work "vouchers" would be involved in the solution).


The U.S. has been the inspiration for all who believe in freedom, both political and economic. Its identity, however, is predicated on maintaining a political consensus that supports market values.
Growing income inequality, the financial crisis and the perceived unfairness of the market system are undermining this consensus. If Republicans don't stand up for markets, who will?

If standing up for markets means -- running down the list above in order -- reducing market power, regulating financial markets, eliminating subsidies, breaking up too big to fail firms, providing a robust safety net, overcoming income inequality, fixing schools, increasing the availability of student loans, providing retraining, and providing health care, then the answer is Democrats.

links for 2009-10-27

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