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December 17, 2009

Latest Posts from Economist's View

Latest Posts from Economist's View

"President Obama Largely Inherited Today’s Huge Deficits"

Posted: 17 Dec 2009 01:06 AM PST

What is the cause of large and continuing budget deficits? The Bush tax cuts, the wars in Iraq and Afghanistan, and the economic downturn explain "explain virtually the entire deficit over the next ten years." 


Notice the tiny contribution of Tarp, Fannie, and Freddie (shaded red) and the stimulus package (shaded yellow, just below the red area) to the deficit from 2012 onward. These are not the source of our long-term budget problems.

For more, see the source of the graph: President Obama Largely Inherited Today's Huge Deficits, CBPP.

"The Great Moderation: What Caused It and Is It Over?"

Posted: 17 Dec 2009 12:45 AM PST

The paper below says that, contrary to what you might think, the Great Moderation is not over. What is the Great Moderation? From the paper:

The idea of "the Great Moderation" came to widespread public attention in a 2004 speech by then-Federal Reserve Governor Ben Bernanke.1 He began his speech with a statement of empirical fact: "One of the most striking features of the economic landscape over the past twenty years or so has been a substantial decline in macroeconomic volatility."
This empirical fact was established in two influential academic papers by Kim and Nelson (1999) and McConnell and Perez-Quiros (2000).2 Both papers presented evidence of a large reduction in the volatility of U.S. real GDP growth over the past half-century. Furthermore, both papers found that the reduction was sudden and estimated to have occurred in 1984Q1.
This sudden reduction in volatility is visible to the naked eye in Figure 1, which plots seasonally-adjusted quarterly U.S. real GDP growth for the period of 1947Q2-2009Q3.

Let me repeat a list of factors from a previous post that have been proposed to explain the Great Moderation:

  • Better technology, e.g. information processing allowing better inventory control and management
  • Better policy, e.g. inflation targeting
  • Good luck so that no big shocks hit the economy
  • Financial innovation and deregulation
  • Globalization leading to dispersed risk
  • Better business practices (this is less common, here's the link)
  • Increased rationality of participants in financial markets
  • Demographic shifts (again, since this less commonly offered as an explanation, here's the link)

Much of the literature prior to the crisis found that monetary policy was at least a contributing factor, if not the major factor behind this change (e.g. empirical evidence from Clarida, Gali, and Gertler of a large increase in the coefficient on inflation in the Taylor rule that, in New Keynesian models, would lead to a more stable economy). However, this paper focuses on the "good luck" explanation and finds that "smaller economic shocks related to oil prices, productivity, and inventories explain much of the Great Moderation." In addition, the paper finds that our good fortune may not be over:

The Great Moderation: What Caused It and Is It Over?, by James Morley: In this Macro Focus, our resident time series econometrician, James Morley, tries to rehabilitate the "Great Moderation." His findings are both surprising and encouraging:
Contrary to conventional wisdom, the Great Moderation was not a myth. There has been a very real, broad-based decline in U.S. macroeconomic volatility since the mid-1980s.
The reduction in volatility does not appear to be primarily the result of better policy or changes in the structural response of the economy to shocks.
Instead, the Great Moderation appears to be mostly due to smaller economic shocks (e.g., oil price shocks, productivity shocks, and inventory mistakes).
The technological basis for the smaller shocks means that the prognosis for the continuation of the Great Moderation is much better than you might think.
Given the financial and economic turmoil of the past few years, it would be easy to believe the "Great Moderation" was a myth based on wishful thinking. Many commentators have proclaimed as much and even many of us who study the phenomenon have started to wonder whether it was all too good to be true.
Despite these doubts, a dispassionate examination of the data suggests that the stabilization of economic activity since the mid-1980s was very much a reality. The more legitimate question is whether or not it is now over. This Macro Focus seeks to answer this question through careful analysis of what caused the Great Moderation. The finding that it was largely due to smaller economic shocks for technological reasons implies a surprisingly optimistic prognosis for its continuation. ... [paper]

Laissez-Faire and Inequality

Posted: 17 Dec 2009 12:33 AM PST

I wonder if this has anything to do with Hong Kong's laissez-faire attitude toward regulation and government intervention? (The Heritage Foundation has named Hong Kong the freest economy in the world, but as noted below, it also has the "widest income gap of all the world's most advanced economies"):

HK cage homes capture stark inequality, by Justine, Financial Times: Tang Man-wai ... lives on one level of a bunk bed sectioned off by metal mesh, occupying a so-called "cage home" [picture] in a small, shabby flat subdivided between 10 men. ...
In a city of office towers and shopping malls, cage homes are a reminder that while Hong Kong has the highest number of billionaires in Asia..., almost 1.24m people, 18 per cent of the population, live below the poverty line.
According to the United Nations, Hong Kong has the widest income gap of all the world's most advanced economies. The wealthiest 10 per cent of people share more than a third of the city's total income while the bottom 10 per cent account for just 2 per cent. The gap has been widening. ...

FTC Files Antitrust Suit against Intel

Posted: 17 Dec 2009 12:14 AM PST

Maybe I was wrong when I said that the administration is all talk and no action when it comes to reining in market power. Hope so:

F.T.C. Accuses Intel of Trying to Stifle Competition, by Steve Lohr, NY Times

links for 2009-12-16

Posted: 16 Dec 2009 11:02 PM PST

"Some Further Comments on Nominal Wage Flexibiliy"

Posted: 16 Dec 2009 02:27 PM PST

Rajiv Sethi follows up on the post about the folly of reducing the minimum wage to generate jobs:

Some Further Comments on Nominal Wage Flexibiliy, by Rajiv Sethi: Tyler Cowan thinks that we should cut minimum wage, and links to Bryan Caplan for an explanation. And Caplan thinks that it's all quite elementary:
Cutting wages increases the quantity of labor demanded. If labor demand is elastic, total labor income rises as a result of wage cuts. 
Even if labor demand is inelastic, moreover, wage cuts reduce labor income by raising employers' income.  So unless employers are unusually likely to put cash under their matresses, wage cuts still boost aggregate demand.
Let's take this step by step. First, consider the claim that cutting wages increases the quantity of labor demanded. Through what mechanism does this occur? Consider a firm (McDonald's, say) that can now pay its workers less. It will certainly do so. But will it increase the size of its workforce? Not unless it can sell more burgers and fries. Otherwise its newly expanded workforce will produce a surplus of happy meals that will (unhappily) remain unsold. And this will not only waste the expense of hiring and training new workers, it will also waste significant quantities of meat, potatoes and cooking oil. So the firm will make do with its existing workforce until it sees an uptick in demand. And no cut in the minimum wage will automatically provide such an increase in demand. As a result, the immediate effect of a cut in the minimum wage will be a decline in total labor income.
Employer income, of course, will rise. Some of this will be spent on consumption, but less than would have been spent if the same income had been received by low wage earners. The net effect here is lower aggregate demand. But wait, what will happen to the remainder of the increase in employer income? It will not be placed under mattresses, on this point I agree with Caplan. It will be used to accumulate assets. If these are bonds, then long rates will decline, and this might induce increases in private investment. Then again, it might not, unless firms believe that additions to productive capacity will be utilized. And right now they do not: private investment is not being held down by high rates of interest on long-term debt.
Finally, what if employers use the unspent portion of their augmented income to buy shares? We would have a run up in stock prices not unlike that we have seen in recent months. Note that this would not be a speculative bubble: the higher prices would be warranted given that firms have lower labor costs. But would this asset price appreciation stimulate private investment in capital goods? Again, not unless the additional capacity is expected to be utilized.
Mark Thoma has more on this, as does Paul Krugman. I discussed the opposing views of Becker and Tobin in an earlier post. What I cannot understand is why people of considerable intelligence persist in conducting a partial equilibrium Walrasian analysis of the labor market, as we were dealing with the market for oranges. Please stop it.

FOMC Press Release

Posted: 16 Dec 2009 12:43 PM PST

The Fed's assessment of the economy is slightly more upbeat as compared to the press release after its last FOMC meeting, but economic conditions are still bad, and there's no signal that the course of policy will change anytime soon. The target interest rate will remain near zero for the foreseeable future, and the Fed will slowly unwind its special facilities [See also: WSJ, NYT, FT, Bloomberg]:

FOMC Press Release for December 16, 2009: Information received since the Federal Open Market Committee met in November suggests that economic activity has continued to pick up and that the deterioration in the labor market is abating. The housing sector has shown some signs of improvement over recent months. Household spending appears to be expanding at a moderate rate, though it remains constrained by a weak labor market, modest income growth, lower housing wealth, and tight credit. Businesses are still cutting back on fixed investment, though at a slower pace, and remain reluctant to add to payrolls; they continue to make progress in bringing inventory stocks into better alignment with sales. Financial market conditions have become more supportive of economic growth. Although economic activity is likely to remain weak for a time, the Committee anticipates that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a strengthening of economic growth and a gradual return to higher levels of resource utilization in a context of price stability.
With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time.
The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period. To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve is in the process of purchasing $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt. In order to promote a smooth transition in markets, the Committee is gradually slowing the pace of these purchases, and it anticipates that these transactions will be executed by the end of the first quarter of 2010. The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets.
In light of ongoing improvements in the functioning of financial markets, the Committee and the Board of Governors anticipate that most of the Federal Reserve's special liquidity facilities will expire on February 1, 2010, consistent with the Federal Reserve's announcement of June 25, 2009. These facilities include the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, the Commercial Paper Funding Facility, the Primary Dealer Credit Facility, and the Term Securities Lending Facility. The Federal Reserve will also be working with its central bank counterparties to close its temporary liquidity swap arrangements by February 1. The Federal Reserve expects that amounts provided under the Term Auction Facility will continue to be scaled back in early 2010. The anticipated expiration dates for the Term Asset-Backed Securities Loan Facility remain set at June 30, 2010, for loans backed by new-issue commercial mortgage-backed securities and March 31, 2010, for loans backed by all other types of collateral. The Federal Reserve is prepared to modify these plans if necessary to support financial stability and economic growth.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.

Cutting Wages Won't Help

Posted: 16 Dec 2009 09:09 AM PST

Conservatives are using the recession to revive their long-standing opposition to the minimum wage. The argument they are making this time is that cutting the minimum wage will add substantially to employment, and this is starting to get some attention in the press. But a cut in the minimum wage would likely make things worse, not better.

Why? There's a more sophisticated story below, and I may be oversimplifying too much, but basically when things are bad -- when firms cannot sell all that they are (or could be) producing -- a cut in the wage does not generate any new employment, it simply reduces income. Why hire more people when you aren't selling anywhere near to existing capacity (in the story below, even if interest rates did fall as a result of the wage cut, I don't think it would generate much investment due to the excess capacity that firms have)? In fact, the reduction in income from the fall in wages makes it even harder to sell the goods that are (or could be) produced, and that will cause firms to lay off even more workers, which lowers income even more, and a downward spiral ensues.

The point is that in a severe recession, a cut in the wage rate may not generate any new employment, instead it simply lowers income and demand, and that makes things even worse.

Here's a more detailed version of the story:

Would cutting the minimum wage raise employment?, by Paul Krugman: It seems that more and more Serious People (and Fox News) are rallying around the idea that if Obama really wants to create jobs, he should cut the minimum wage.
So let me repeat a point I made a number of times back when the usual suspects were declaring that FDR prolonged the Depression by raising wages: the belief that lower wages would raise overall employment rests on a fallacy of composition. In reality, reducing wages would at best do nothing for employment; more likely it would actually be contractionary.
Here's how the fallacy works: if some subset of the work force accepts lower wages, it can gain jobs. If workers in the widget industry take a pay cut, this will lead to lower prices of widgets relative to other things, so people will buy more widgets, hence more employment.
But if everyone takes a pay cut, that logic no longer applies. The only way a general cut in wages can increase employment is if it leads people to buy more across the board. And why should it do that?
Well, the textbook argument — illustrated in this little writeup — runs like this: lower wages lead to a lower overall price level. This increases the real money supply, and therefore liquidity. As people try to make use of their excess liquidity, interest rates go down, leading to an overall rise in demand.
Even in this case, it's hard to see the point of cutting wages: you could achieve the same effect, much more easily, simply by having the Fed increase the money supply.
But what if we're in a liquidity trap, with short-run interest rates at zero? Then the Fed can't achieve anything by increasing the money supply; but by the same token, wage cuts do nothing to increase demand.*
Wait, it gets worse. A falling price level raises the real value of debt. To the extent that debtors are more likely to cut spending in such a case than creditors are to increase it — which seems likely — the effect of the wage cuts will actually be a fall in demand.
And one more thing: to the extent that people expect further declines in wages and prices, this raises real interest rates, which is even more contractionary.
So proposing wage cuts as a solution to unemployment is a totally counterproductive idea. Not that I expect any of this discussion to make any impact on those proposing it.
* Somebody is going to ask, what about the real balance effect? Doesn't a falling price level make people wealthy, by raising the real value of the money they hold. The answer is, consider the magnitudes. Before the crisis, the monetary base — the system's "outside money" — was around $800 billion. (It's a much more confusing situation now, so I won't try to parse the current numbers here). This means that even a 10 percent fall in the price level, which is very hard to achieve, would raise real wealth by only $80 billion. Compare this with the effects of the decline in housing and stock prices, which reduced household wealth by $13 trillion in 2008. The real balance effect is totally trivial.

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