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December 22, 2009

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Latest Posts from Economist's View


"Standard Models Predict That We Should Have No Safety Net"

Posted: 22 Dec 2009 12:12 AM PST

It seems that Harvard's Raj Chetty was a motivated student:

Chetty finished his bachelor's degree, wrote a prize-winning thesis, and completed the course work for a doctorate in economics — all in three years. ...

Sounds like he's some kind of human calculator:

Chetty, who just turned 30, is looking for ways to make ... mathematical economic theory more descriptive of the tangle of economics in the real world. "People are not human calculators," he said...

OK, maybe not. His goal is to "refine the economic models behind public policy ... to ... save money and align government programs more closely with everyday life." An example is his work on government safety nets for the unemployed:

Chetty's 2003 Ph.D. dissertation..., called "Consumption, Commitments, and Risk Preferences,"... [studies] the optimal level of unemployment benefits. When someone is laid off, should the government provide high benefits? Traditional theory says no, since big benefits seemingly reduce the incentive to find a job. "Standard models predict that we should have no safety net," said Chetty.
But in reality, higher benefits are more in line with actual needs, because most Americans have so much income tied up in fixed commitments, such as payments for houses, cars, and furniture. "There are a lot of things you can't adjust in the short term," he said.
So the traditional economic models that are used to determine unemployment benefits miss a simple fact: People have bills to pay. "You miss certain features of reality," said Chetty, "when you're trying to write down simple models of the world."

Unfortunately, in reality, some bills for houses, cars, furniture, etc. may not get paid:

States' jobless funds are being drained in recession, by Peter Whoriskey, Washington Post: The recession's jobless toll is draining unemployment-compensation funds so fast that ... 25 states have run out of unemployment money and have borrowed $24 billion from the federal government to cover the gaps. By 2011, according to Department of Labor estimates, 40 state funds will have been emptied by the jobless tsunami. ...
State unemployment-compensation funds are separated from general budgets, so when there is a shortfall, only two primary solutions are typically considered -- either cut the benefit or raise the payroll tax. ...
The troubles the state programs face can be traced to a failure during the economic boom to properly prepare for a downturn, experts said.
Unemployment benefits are funded by the payroll tax on employers that is collected at a rate that is supposed to keep the funds solvent. Firms that fire lots of people are supposed to pay higher rates. ... But over the years, the drive to minimize state taxes on employers has reduced the funds to unsustainable levels.
"The benefits haven't grown -- that's not the problem," said Richard Hobbie, director of the National Association of State Workforce Agencies. Even so, he said, he expects to see unemployment checks reduced. A shortfall in a state unemployment fund, he said, "usually means cuts in eligibility or benefits." ...
Wayne Vroman, an expert in unemployment insurance at the Urban Institute, said that entering the recession, state programs were on average funded at only one-third the level they should have been, according to generally accepted funding guidelines.
"If you fund a program adequately, you don't need to come to these kinds of difficult decisions," he said. Before the recession, he said, the funding guidelines "were rarely honored." ...

We can add the inadequate funding of unemployment compensation programs to the ever growing list of things that the crisis has revealed need to be fixed.

How Should the Government Debt be Financed?

Posted: 22 Dec 2009 12:06 AM PST

Andy Harless joins Rajiv Sethi in calling for more discussion about how the government debt is financed:

The Treasury's Monetary Policy, by Andy Harless: ...Treasury ... is now ... financing more of its debt long-term. If you're worried (as I am) about the persistence of a weak and potentially deflationary economic environment, then you should be critical of the Treasury's policy. By increasing its maturities the Treasury is essentially following a tight-money policy exactly when a loose-money policy is needed.
The Treasury, of course, has its reasons. Officials expect interest rates to rise over the next several years and would like to lock in today's low rates, to limit how much it will cost to service the national debt over a longer horizon. I'm skeptical, however, of the assumptions underlying these reasons.

You might argue that it's a matter of risk. When the Treasury locks in today's low interest rates, it may not end up paying less (since it gives up even lower short-term rates), but it makes the payments more predictable. Even if the Treasury is likely to end up paying more, the hedge is worth the price, because the Treasury receives some insurance for the worst case, where rates rise more than expected.

But are rising interest rates really the worst case?
Interest rates will rise when and if the economic recovery gains enough speed and traction to give the Fed and bond markets reasonable confidence in its eventual convergence toward our potential growth path. As an ordinary citizen, that's not an outcome against which I would feel a need to hedge. I don't want to buy insurance against good news. I'd rather hedge against the opposite outcome, where the recovery peters out and interest rates fall.

The US economy has been knocked far off its potential growth path, and it will take fairly rapid growth, for a fairly long period of time, to get back to it. (Either that, or we'll remain so far off the path for so long that potential will be significantly reduced, in which case we likely have many of years of low interest rates ahead of us before we get to that point.) With rapid and persistent growth, federal revenues will rise, government "bailout" investments will perform well, benefit payments will decline, and the primary federal deficit will fall. Because of higher interest rates, the government will be paying more to service its outstanding debt, but because of an improving economy the government will be accumulating less new debt, compared to the alternative case. So it's not clear to me that rising rates would be a "worst case" even for Treasury finances, let alone for the general national interest.

It is also argued that, by increasing the maturity of its debt, the Treasury is reducing the risk of default, thereby improving its credit profile and allowing it to finance at lower interest rates than otherwise. If that's true, I'm not sure it's a good thing. When the private sector is having such difficulties as it has now, wouldn't it be better to make Treasury securities more risky and thereby encourage people to put their money in private sector assets instead?

In any case, I'm not sure it's even true. For Treasury investors, inflation risk is much more important than credit risk. By refusing to be kept on a short leash, the Treasury is increasing the future incentive for the US to "inflate away" its debts. That might make Treasury securities less attractive rather than more so. Of course, as I said, making Treasury securities less attractive wouldn't necessarily be a bad thing, since it would help the private sector: but if the Treasury does so by issuing more long-term securities, the benefit gets lost, because the Treasury is then also competing with the private sector for funds.

Be that as it may, I know I'm not going to convince everyone about the specific policy that I think the Treasury should follow. I hope, however, that I have at least convinced some readers that, in today's environment, the decision is a macroeconomically important one that deserves a great deal more attention than it has gotten. I second Rajiv Sethi..., who finds it "a bit surprising that while the size of the deficit is a topic of endless controversy, there is such little debate about the manner in which the deficit is financed."

links for 2009-12-21

Posted: 21 Dec 2009 11:02 PM PST

Is Criticism of the Bernanke Fed Justified?

Posted: 21 Dec 2009 11:07 AM PST

Many of you will likely disagree with this:

Is Criticism of the Bernanke Fed Justified?, by Mark Thoma

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