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October 1, 2009

Economist's View - 6 new articles

U.S. Recession Probabilities

My colleague Jeremy Piger calculated new US recession probabilities based upon July 2009 data that became available today (October 1), and he notes that , "For the first time in a while, there was some action in the results, with the July probability dropping to 53%. Not a clear signal of the end yet, but something...."

Historical U.S. Recession Probabilities


Notes: Recession probabilities for the United States are obtained from a dynamic-factor Markov-switching model applied to four monthly coincident variables: non-farm payroll employment, the index of industrial production, real personal income excluding transfer payments, and real manufacturing and trade sales. For additional details, including an analysis of the performance of this model for dating business cycles in real time, see Chauvet, M. and J. Piger, "A Comparison of the Real-Time Performance of Business Cycle Dating Methods," Journal of Business and Economic Statistics, 2008, 26, 42-49. All data was obtained on October 1, 2009. Shaded areas indicate NBER recession dating.

"Multiplying Multipliers"

Paul Krugman responds to Robert Barro's claim that the government spending multiplier is much less than one, and he notes other research that comes to a different conclusion:

Multiplying multipliers, by Paul Krugman: Mark Thoma, Menzie Chinn, and The Economist all have posts on the question of the size of the fiscal multiplier.
Mark already provides links to my various commentaries on Barro. But let me repeat the gist. Barro makes a great deal of the fact that private spending fell during World War II, rather than rising the way it should in a classical Keynesian (oxymoron?) story.
What I and others immediately pointed out was that this tells us very little about what would happen under current conditions: during World War II there, um, was a war on: consumption goods were rationed, construction required special permits, and so on. The government was, in other words, deliberately suppressing private spending, through direct controls. So WWII is not a useful data point for determining what the multiplier is under other conditions.
Barro's response to this, as far as I can tell, was … nothing. I don't think he even acknowledged the nature of the complaint.
On a happier note, this piece by Ilzetzki et al is interesting, and offers a wide range of multipliers depending on a country's situation. The question for the United States is which estimate is most relevant.
I'd say it's the fixed exchange rate estimate. Yes, I know, we have a floating rate. But they explain the relatively high fixed-rate number by pointing to Mundell-Fleming, which says that fiscal policy is effective under fixed rates because it doesn't drive up interest rates (capital flows in). We're in a similar position for a different reason: fiscal expansion doesn't drive up rates because we're at the zero bound.
Oh, we're also relatively closed.
The thing is that both the fixed rate and closed multipliers are around 1.5 — which so happens to be just about the number assumed by Christina Romer in her analysis for the Obama administration. Just saying.

Pre-Commitment to Austerity?

In a recent column, David Brooks says that our recent troubles are partly the result of moral decay, and that we need to return to "our tradition of Calvinist restraint, self-denial and frugal responsibility."

But haven't consumers started showing restraint? Aren't saving rates are rising? To this, Brooks replies:

Over the past few months, those debt levels have begun to come down. But that doesn't mean we've re-established standards of personal restraint. We've simply shifted from private debt to public debt.

Is Brooks right that the recent increase in public debt is evidence of moral decay, or is the increase in the deficit actually the wise and prudent thing to do? Even though Thomas Palley wrote this before David Brooks gave us his moral lesson, it's still a pretty good response to this part of his austerity message:

The Fiscal Austerity Trap, by Thomas Palley: I Déjà vu all over again The U.S. economy is still struggling to find a bottom in face of the deepest recession since the Great Depression of the 1930s. ... Yet, even as the recession rages, much of the economic policymaking community is already back to arguing ... [that] massive budget deficits ... threaten future financial stability.
Budget deficit alarmism has been a perennial feature of the Washington policy landscape for the past thirty years, and the return of budget deficit alarmism represents a case of "déjà vu all over again." The push for fiscal austerity was the agenda of Concord Coalition Republicans and Hamilton Project New Democrats long before the crisis, and these groups have now opportunistically seized on the crisis-induced spike in the budget deficit to revive that agenda. With economic policy largely controlled by former Hamilton Project personnel, there is a grave risk the Obama Administration could go along with this renewed alarmism.
The fiscal austerity program is rooted in wrong-headed economic analysis. It was the wrong economic agenda before the economic crisis, and it is even more wrong in light of the deep economic weaknesses the crisis has revealed.
Not only is fiscal austerity the wrong economic agenda, it is also the wrong political agenda. At a time when the nation is trying to recover from three decades of laissez-faire excess, the fiscal austerity agenda revives neo-liberal anti-government sentiment by presenting profligate government as the problem. The real problem is flawed market arrangements that have promoted income inequality and financial excess that has undermined shared prosperity and can no longer deliver growth.
The fiscal austerity message does triple damage. First, it makes reform of existing flawed market arrangements more difficult by misdirecting public understanding and saying government is the source of problem. Second, it uses budget deficits as a "Trojan Horse" for launching an assault on vital public programs - including Social Security, Medicare, and spending on education and public infrastructure. Third, it threatens to create a fiscal austerity trap in which fiscal austerity lowers growth, thereby lowering tax revenues and necessitating more austerity.
Fiscal conservatives claim that closing the budget deficit represents "fiscal responsibility." That claim is absolutely wrong. The reality is fiscal austerity under current circumstances would constitute "fiscal irresponsibility." The U.S. likely confronts an extended period of economic weakness in which budget deficits will be needed to ensure adequate aggregate demand (AD).
Budget deficits also have an important role to play in spurring growth. The old growth model, based on debt and asset price inflation, is broken. That calls for a new growth model in which deficit-financed public investment should be a central part.
The economic crisis has discredited neo-liberal economics. It should also have discredited the neo-liberal obsession with fiscal austerity. The fact that the fiscal austerity agenda has managed to regain traction so easily shows how deeply ingrained are the misunderstandings of neo-liberal economics, and how far there is to go to establish a new healthier economic conversation. ...

However, there will come a time when the deficit needs to be addressed:

Hurry Up and Wait, by Christopher Beam: When it comes to the national debt, says Paul Krugman, the best advice may come from St. Augustine: "Oh Lord, make me chaste and continent—but not yet." That was the rough consensus among the economists who convened Wednesday ... for a conference held by the Center for American Progress and the Center for Budget and Policy Priorities: We absolutely have to do something about this deficit. Just not right now.
Their advice is on the merits, but it just so happens to be politically convenient. We wanted to reduce the deficit ... Democrats can say, but the experts told us not to! ...
Before the economists gave the politicians permission not to act right away, however, they established the need to do something eventually. Right now, CBPP president Robert Greenstein said, the annual deficit is about 8 percent of gross domestic product, while the national debt—the sum of all past deficits—is about 70 percent of GDP... If current policy persists, the deficit will inflate to become 20 percent of GDP by 2050, with a total national debt of 300 percent of GDP. ...
If those numbers don't scare you, maybe the practical consequences will. Princeton Professor Alan Blinder explored the possibilities. Inflation? "I don't think we're going to see that in the United States," he said, even though it happens all the time in other countries when debt mounts. Skyrocketing interest rates? That's a "very obvious candidate." But the most likely risk, he said, is a weakening dollar: "If the economy cracks, it cracks on the dollar."...
Another possibility, said Blinder, is that the political system cracks first. He cited the New Deal as an example of a good political crackup. What a mountain of debt could mean for our political system, he said, "I wouldn't even begin to forecast." A questioner, however, did just that. Recall 1992, he said, when Ross Perot ran on a platform of deficit reduction. Perot didn't win, but his influence—he drew enough votes to allow Bill Clinton to become president—produced a bipartisan obsession with deficit reduction, which occupied much of Clinton's first term. "It's highly likely we're about to see that happen again," he said.
So if the stakes are so high and the future so dire, why wait? ... Because the economy is still fragile. ... As Berkeley economist Laura Tyson put it, "We have two risks: If we do something too precipitously fast, we undermine recovery … but if we don't do something," we risk the dystopian future described above.
The first deficit-reduction measure—health care reform—is already on the table. Health care spending is by far the biggest driver of the deficit, the panelists reminded the audience. "No path to a balanced budget doesn't go through health care," said Harvard professor David Cutler. Bend the curve ("Whoever is responsible for that phrase should be shot," said Krugman) and we're well on our way to digging out.
Aside from that, we should start thinking about getting ready to maybe soon reduce the deficit. The word Tyson used was "pre-commit." The idea: Pass deficit reduction legislation now that kicks in as soon as the economy stabilizes. That would reassure creditors now that we're serious about paying off our debt. ...
There's just one problem: Deficit reduction may be politically impossible, now or later. A surprise cameo by former Treasury Secretary Robert Rubin reinforced the point. Taking the mic, Rubin reminded the panel that in 1993, during his tenure, the Deficit Reduction Act passed by a single vote in the House and required the vice president to break a tie in the Senate. "Not exactly a dramatic rallying around with respect to fiscal discipline," he said. "So what would make you think that our political system is likely to respond more effectively today?" ...
How to get around this paradox is an open question. Greenstein suggested incrementalism: a bit of deficit reduction here, a bit there. Once members realize that voting for fiscal responsibility won't kill their electoral chances, the political calculus will change. "My hope is that people don't get punished," he said. Krugman strained for optimism: "What we have to hope is that 10 years from now we will have a much saner political landscape"...

I like the idea of pre-commitment, but since we cannot bind future legislators using this device, it is, at best, a means of establishing a default option that might be politically difficult for legislators of the future to move away from. A "saner political landscape" in the future is the best hope, but trends over the last few decades don't point in that direction.

"Why the Lehman Failure Did Change Everything"

There's a lot of revisionism going on over the consequences of the Lehman's collapse. The standard view is that allowing Lehman to fail was a mistake, and hence government intervention could have lessened the severity of the crisis. Government intervention wouldn't have avoided problems altogether, but the problems wouldn't have been as bad as what we experienced.

However, a few people are now pushing the idea that the failure of Lehman wasn't a primary contributor to the problems that financial markets and the economy experienced. According to the revisionist view, government intervention would not have made any difference, the problems would have been just as bad either way. The notion that government intervention would not have helped is, of course, the main point that this group wishes to emphasize. However, the revisionist view does not hold up to closer examination:

Why the Lehman failure did change everything, by Richard Robb, Economists' Forum: For anyone who was engaged in the financial markets during the week of September 15, 2008, Lehman changed everything. It was obvious. So what could be more tempting to finance professors than to overturn this conventional wisdom? Descartes described the man of letters who takes more pride in his speculations "the more they are removed from common sense," and so showing that the Lehman collapse was inconsequential has spawned a minor literature.
The latest contribution by John Cochrane and Luigi Zingales, like others before them, rests partly on misunderstanding of the data. The authors deduce that Lehman wasn't the main cause of last autumn's turmoil by inspecting the daily movements in the spread between Overnight Interest Rate Swaps and three-month Libor, which they define as "the rate at which banks can borrow unsecured for three months."
But a better definition of Libor under the circumstances was "the rate at which banks said they can borrow". Libor is the result of a survey, not a measure of actual transactions. In the week of September 15 last year, big banks refused to settle foreign exchange with each other. They were not lending interbank for three month terms, so Libor during that week tells us little.
We could say the same thing for OIS. Volume was light to nonexistent in the week of September 15 last year. What we do know is that three-month T-bills traded at 0.04 per cent on September 17, down from 1.47 per cent on Friday September 12. These are real data that ought to impress the professors that the market was breaking down as fast as it knows how.
John Taylor, the father of the Lehman-was-no-big-deal thesis, wrote in a Wall Street Journal op-ed last year that spreads between T-bills and Libor "remained in that range [of the previous year] through the rest of the week" after Lehman's demise. In fact, in the year prior to Lehman's collapse, the peak spread was 2.05 per cent; on September 17, 2009 it reached 3.00 per cent. (Of course, any conclusions based on Libor that week are equally unreliable.)
The other principal mistake of the Lehman deniers is their assumption that the incident unfolded entirely on September 15, 2008 and any effect had to be observable by that morning. But during the final two weeks of September, the market still had to absorb the news that the Securities and Exchange Commission had no plan for an orderly transfer of client assets in the US, while Lehman Brothers International Europe would be handed over to an administration process designed for liquidating grocery stores. ...
There is plenty of room to debate the larger counterfactual: if the government had never bailed out Bear Stearns and other too-big-to-fail firms that followed, would Lehman have mattered? If the government had never bailed out anyone at all, would we be better off? But given the bailouts that preceded the Lehman failure, the Lehman failure did in fact change everything. Sometimes things that are obvious turn out to be true.

Government Spending Multipliers Once Again

Since the WSJ is, essentially, rerunning op-eds:

Stimulus Spending Doesn't Work, by Robert Barro and Charles Redlick

May as well rerun a few of the responses:

War and non-remembrance, by Paul Krugman
Spending in wartime, by Paul Krugman

Paul Krugman on Robert Barro, by Brad DeLong

Fiscal Policy and Economic Recovery, by Christina D. Romer

[See also Don't know much about history. by Paul Krugman.]

links for 2009-09-30

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