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January 31, 2009

Economist's View - 3 new articles

Cyclists versus Structuralists

Robert Reich:

Once the Stimulus Kicks In, the Real Fight Begins, by Robert B. Reich, Commentary, Washington Post: The real stimulus debate hasn't even started yet. Congress will pass President Obama's stimulus package in the next two weeks... But when the economy starts to turn up again, perhaps as early as next year, the president will have the real tough decisions to make. He'll have to choose which spending will continue -- or whether any of it will continue at all. ...

Those who support the stimulus as a desperate measure to arrest the downward plunge in the business cycle might be called cyclists. Others, including me, see the stimulus as the first step toward addressing deep structural flaws in the economy. We are the structuralists. These two camps are united behind the current stimulus, but may not be for long. Cyclists blame the current crisis on a speculative bubble that threw the economy's self-regulating mechanisms out of whack. They say that we can avoid future downturns if the Fed pops bubbles earlier by raising interest rates when speculation heats up.

But structuralists see it very differently. The bursting of the housing bubble caused the current crisis, but the underlying problem began much earlier -- in the late 1970s, when median U.S. incomes began to stall. Because wages got hit then by the double-whammy of global competition and new technologies, the typical American family was able to maintain its living standard only if women went into the workforce in larger numbers, and later, only if everyone worked longer hours.

When even these coping mechanisms were exhausted, families went into debt -- a strategy that was viable as long as home values continued to rise. But when the housing bubble burst, families were no longer able to easily refinance and take out home-equity loans. The result: Americans no longer have the money to keep consuming. When you consider that consumers make up 70 percent of the economy, the magnitude of the problem becomes apparent.

What happened to the money? According to researchers Thomas Piketty and Emmanuel Saez, since the late 1970s, a greater and greater share of national income has gone to people at the top of the earnings ladder. ... But the rich don't spend as much of their income as the middle class and the poor do... That's why the concentration of income at the top can lead to a big shortfall in overall demand and send the economy into a tailspin. ...

Other structural problems are growing as well. One is climate change and our dependence on oil. Another is the United States' growing reliance on foreign capital, mostly from China, Japan and the Middle East. Neither is sustainable.

Meanwhile, our broken health-care system drains more of our dollars yet delivers less care. ... Most cyclists acknowledge these problems, but they tend to think of them as separate from the current crisis -- issues to be tackled after the economy has recovered, and then only to the extent that we can afford to do so.

But structuralists like myself don't believe that the economy can fully recover unless these underlying problems are addressed. Without policies that put the nation on the path to higher median incomes, higher productivity, renewable energy and a more accessible and efficient health-care system, we'll face deeper and more prolonged recessions...

As early as next year, the business cycle may hit bottom and begin climbing. At that point, cyclists and structuralists will want two different things -- and which side the president chooses will be ... the "central drama" of the Obama administration. ...

There's also another type of structuralist found on the conservative side of debate who focuses almost exclusively on economic growth (though some see that as a facade for upward redistribution of income). Curiously, however, the only way to get growth is tax cuts, government investments in infrastructure - something the left sees as productive investment in public goods - are not generally favored by this group.

However, I want to make a different point that doesn't deal directly with Reich's arguments, but it's a point that is being overlooked too often in the debate about the recovery package. Most observers are marking the turnaround in the economy as the point where GDP begins to turn upward, i.e. after the trough in GDP, and expressing worry that the stimulus package might extend beyond that point.

But looking to the last two recessions for guidance, the trough in employment came much later than the trough in output, the traditional one quarter lag between the upturn in GDP and the upturn in employment was extended considerably, and once employment did turnaround, the recovery of employment was sluggish relative to the recovery in GDP (overall job growth during the Bush years was relatively weak).

So marking the turnaround in GDP as the turning point in the economy rather than looking at the behavior of GDP in conjunction with other measures such as the behavior of employment can lead policymakers to pull back on the recovery effort too fast. If employment follows same path it followed in the last two recessions and lags GDP considerably, the need for stimulus in employment will extend far beyond the point where GDP begins to recover. Thus, if some infrastructure projects cannot be completed before GDP turns upward, and instead take a year or longer to complete - something we're hearing a lot of worry about - that won't be a problem, just the opposite as it will provide a helpful and needed boost to employment.

Buy American?

Nick Rowe explains why the "buy American" provision of the economic recovery package "will not shift demand towards domestic goods":

"Buy domestic" policies are individually irrational too, by Nick Rowe: Most (all?) economists agree that in a global recession, when each country wants to boost demand for the goods it produces, policies which steer demand to domestically-produced goods are individually rational (provided other countries don't retaliate), but collectively irrational when all countries do the same.

I think most economists are wrong. It's not just collectively irrational, but individually irrational as well, at least for countries with flexible exchange rates.

I hear that the US fiscal stimulus contains restrictions on buying imported goods. One could perhaps argue that the Canadian fiscal stimulus also concentrates demand on non-traded goods, and so does sort of the same thing, but in a manner which is less provocative (or more devious, if you prefer). This is dangerous. ... I don't have anything new to say about the collective dangers if all countries end up restricting trade as they did in the 1930's.

But I do have something to say about the benefits to an individual country of following this policy. Even if no other country retaliates, it is irrational for an individual country with flexible exchange rates to follow this policy. ...

In normal times, outside of a liquidity trap, an expansionary fiscal policy will put upward pressure on interest rates... An increase in domestic interest rates will cause a capital account inflow, which causes the exchange rate to appreciate. The exchange rate appreciation will cause net exports to fall. The fall in net exports offsets the expansionary fiscal policy. Under imperfect capital mobility the offset will be partial. Under perfect capital mobility there will be full offset, for a small open economy. So in normal times, part or all of the increased demand from an expansionary fiscal policy will be lost due to a decline in net exports. Some or all of the extra demand just leaks out to foreign countries.

But these are NOT normal times. An expansionary fiscal policy will not cause an increase in the rate of interest. Central banks won't let it happen. The perfectly interest-elastic demand for money won't let it happen either.

An expansionary fiscal policy ... will cause total spending to increase, and some proportion of this increased total spending will be on imports. But an increased demand for imports will cause an excess demand for foreign exchange on the current account of the balance of payments. Nothing happens on the capital account, because interest rates don't change. The excess demand for foreign exchange causes the exchange rate to depreciate (the exact opposite of the normal case). The exchange rate depreciation causes net exports to rise. This will fully offset the increased imports from increased income and spending (it has to, if the capital account stays the same). So, in the new equilibrium, all of the increased spending goes to increased demand for domestic goods. None leaks out to increased demand for foreign goods.

A "buy domestic" policy will not shift demand towards domestic goods. If it did, so that imports fell and net exports increased, the current account surplus would merely cause the exchange rate to appreciate so that net exports fell to their original level. The current account must stay the same, because the capital account stays the same, because the interest rate differential stays the same, because interest rates stay the same.

My argument does not apply within the Eurozone of course. The countries share a common currency and so there are no exchange rates to adjust. ... And it does not apply to countries on fixed exchange rates, where the foreign country will intervene in the foreign exchange market to prevent its currency appreciating against our currency.

[Brad Delong: "Buy American": A Very Bad Move in the Stimulus Package.]

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January 30, 2009

Economist's View - 5 new articles

"White House Fact Sheet on Stimulus"

Jonah Gelbach:

White House Fact Sheet on Stimulus, by Jonah Gelbach: The White House released a fact sheet explaining its support for fiscal stimulus plan. Here's an excerpt:

The President's economic plan has three main goals:

  • Encourage consumer spending that will continue to boost the economic recovery and create jobs.
  • Promote investment by individuals and businesses that will lead to economic growth and job creation.
  • Deliver critical help to unemployed citizens.

No surprise there, right? After all, President Obama has been quite clear about his support for a stimulus plan to achieve these goals, all of which are textbook Keynesian stuff.

Gotcha! The White House fact sheet in question was released in the name of former President George W. Bush, on January 7, 2003. You can read the whole thing here (lots of plugs for tax cuts, of course).

Here's an entertaining chunk of text from a page A1 story in the LA Times the next day:

With Democrats criticizing Bush's plan for its effect on the deficit, Republicans – who for years pushed for a balanced budget – are in the unusual position of arguing that deficits do not matter.

"What we need to do for an economic stimulus package is not look at what the cost is but what the impact will be on the economy," said Sen. Rick Santorum (R-Pa.).

How things change.

FRBSF: Labor Supply Responses to Changes in Wealth and Credit

How much does labor supply respond to changes in wealth and credit? If this research is correct, the recent declines in wealth and credit may cause increased entry into the labor market, resulting in an even higher unemployment than is currently being forecast:

Labor Supply Responses to Changes in Wealth and Credit, by Mary Daly, Bart Hobijn, and Joyce Kwok, FRBSF Economic Letter: Recent declines in house prices and the stock market have led to the most substantial contraction in household wealth since the Great Depression. From the third quarter of 2007 through the third quarter of 2008, household wealth shrank by $6.7 trillion (Federal Reserve Board of Governors 2008). Further declines in financial markets and house prices in the fourth quarter undoubtedly made losses for the full year 2008 even greater. At the same time, the severe disruptions in financial markets have made credit unavailable or too expensive for many households. Indeed, the third quarter of 2008 was the first time in the postwar period that household borrowing was negative. The combination of wealth declines and increased liquidity constraints is having a profound effect on household and aggregate consumption. In this Economic Letter we examine how it may also be affecting household and aggregate labor supply. Using monthly data from the Household Survey of the Current Employment Situation Report, we find evidence suggestive that sharply reduced wealth and liquidity are prompting certain demographic groups to enter the labor force in greater numbers.

Labor supply models and aggregate trends

The standard economic model of labor supply suggests that each individual experiences a trade-off between consumption and leisure, both of which are desirable goods. Individuals fund consumption through income received from working in the labor market or from flows from assets such as housing and financial investments. These flows can come from current returns on investments, loans against accumulated principal (for example, home equity loans), or from loans against expected returns (such as student loans). Individuals can also borrow to fund consumption today and pay debts back later with interest (e.g., credit cards). When deciding to take a job or search for work), individuals consider the state of the labor market, the value they place on leisure, and their ability to fund consumption through flows from wealth and borrowing.

Figure 1: Historical labor force participation rateWhen the labor market is weak but asset values are high and credit is available, individuals may decide to withdraw from the labor market and invest in school or enjoy leisure, a pattern that characterized the previous two U.S. recessions in the early 1990s and in 2001. Figure 1 plots the 12-month moving average of the U.S. labor force participation rate (LFPR) over the past two decades, defined as the percentage of the civilian non-institutionalized population 16 or older that is working or actively looking for work. The recessions of the early 1990s and 2001 were both relatively modest by historical standards. And, while stock markets were hit hard in 2000, neither recession saw the combination of substantial declines in financial markets and house prices accompanied by severe tightening of credit conditions for average households. Indeed, the 2001 recession was accompanied by large increases in housing wealth. Consumption growth remained remarkably strong over the entire economic decline. With other means to fund consumption, labor force participation fell over both of these periods as individuals returned to school, focused on home production, or enjoyed time away from work.

By contrast, in the current downturn, the decline in housing wealth and credit availability is nearly unprecedented. Since the downturn began, housing values have fallen by 6.8% by one measure and households' financial wealth has declined by 8.5% (Federal Reserve Board of Governors 2008. In addition, a significant fraction of Americans appears to be unable to access credit card lines or acquire mortgages or student loans at affordable rates (Dash 2008, Shiskin 2008). Labor supply theory suggests that this contraction of household income from sources other than work would result either in severe reductions in consumption or substantial changes in labor supply, or, more likely, some combination of both. Moreover, reduced access to credit means many households must generate labor income rather than borrow to finance current consumption.

Indeed, we have seen steep declines in consumption in recent months. At the same time though, the LFPR has been holding up relative to past downturns and even rising for some groups, despite notable difficulties in the labor market. Data on job losses suggest that the decline in labor market opportunities has been as large as the deep recessions of the early 1980s. Still, the aggregate LFPR has not fallen as in previous recessions. In spite of declining labor market opportunities, more people actually are deciding to pursue them. This apparent effect of lost wealth and access to credit on households' labor supply decisions is much less often emphasized than the effect on consumption. This is a missed opportunity since, unlike data on consumption, for which only monthly aggregates are released, monthly labor market data are available for different groups of households.

A closer look at labor supply behavior by group

We use monthly data to look more closely at the labor market decisions of population subgroups that might be especially sensitive to recent wealth declines and reduced access to credit. First, we break the population into six age and age/gender subgroups and plot changes in LFPRs for the current and previous two recessions.

Figure 2: Change in LFPR during 1990 and 2001 recessions and since December 2007As Figure 2 shows, there is considerable variation across subgroups underlying the aggregate trend in Figure 1. For example, teenagers and men aged 25-54 have been withdrawing from the labor force at the same pace or faster than in the previous two recessions. The key drivers of the anomalous pattern of LFPR are young people 20-24, women 25-54, and workers 55 and older. These groups have either increased their participation during this period or, in the case of the 20-24 group, have not withdrawn to the same extent as in the previous two recessions.

Labor force participation rates of these groups may be more robust during the current downturn than in the previous downturns for several reasons. First, the decrease in the supply of credit to students and the decline in housing and financial wealth of their parents likely put pressure on young people to take jobs to pay for their studies. Second, the hit to household balance sheets as well as the rapid deterioration in employment opportunities for males stemming from declines in construction and manufacturing likely prompted other household members to enter the labor market. Finally, the abnormally large declines in housing equity and financial wealth could delay retirement dates for older workers, increasing their participation rates relative to previous downturns.

For more evidence, we look at the recent behavior of students aged 20-24, married women, and workers aged 55 to 64.

Figure 3: LFPR trends for selected groupsCollege-age students. Figure 2 shows that during the past two recessions, the LFPR of young adults dropped considerably, by 1.3 percentage points on average. Such declines were driven by a fall in the LFPR of students, many of whom decided to focus exclusively on school as job prospects worsened (Figure 3). Since June 2008, however, more than 20 banks have suspended their student loan programs and the $260 billion market for student loan asset-backed securities has come to a virtual standstill. The decrease in the supply of credit to students and the fall in housing and financial wealth of their parents have led to a much smaller decrease in the LFPR of young adults (0.1%) and, more notably, a substantial increase in the labor force participation of students (0.5%).

Married women 25-54. In the 2001 recession, the LFPR of prime-age women fell significantly, by 0.8 percentage point. Relative to prime-age men, women were more likely to exit the labor market as economic conditions worsened. During the current downturn, however, the gender trends reversed. The LFPR of prime-age women increased by 0.3 percentage point, while that of prime-age men decreased by 0.6 percentage point. This appears to be driven by the behavior of married women, who have been increasing their participation in the labor force since around 2005, when the pace of home price appreciation first started to slow. Surprisingly, this trend has continued in spite of the severe decline in the job market. (Figure 3). Additional household members may enter the labor force during a downturn to increase the savings and wealth of households, and perhaps to assist in funding education.

Workers aged 55 and older. Finally, the abnormally large declines in housing equity and financial wealth may have boosted the LFPR of older workers by delaying their retirement dates. While the LFPR of older workers has been rising for some time, the degree to which older workers participate in the labor market is strongly and negatively correlated with asset returns generally and stock market performance specifically, especially since 2000. By contrast, the LFPR change of younger workers is weakly and positively correlated with such returns. The sensitivity of older workers to stock market performance is not surprising given the shift over the past 15 years from employer-run defined benefit plans to employee-managed defined contribution plans. As the reliance of retirees and near retirees on returns from investments has risen, so has the sensitivity of their labor market behavior to changes in stock market wealth. As in the 2001 recession, the LFPR of those 55-64 increased by more than 1 percentage point, coinciding with an almost 40% drop in stock prices over the past year.

Looking ahead

The data suggest that recent shocks to wealth and the rollback of household credit are affecting the labor supply of individuals. Should these changes persist, the countercyclical inflow of workers into the labor market could cause unemployment rates to exceed forecasts, since many entrants into the workforce might be unable to find jobs. We expect that these anomalous labor force participation patterns will persist until the underlying drivers, including depressed asset prices and impaired access to consumer credit, return to normal. Unfortunately, making stronger connections between recent developments and the LFPR is difficult because of such factors as noisy data on LFPR for specific cohorts and the effects of other factors on LFPR, such as the Temporary Extended Unemployment Compensation. Ongoing research, including drawing upon a variety of other data sets, could help clarify our results.


Federal Reserve Board of Governors. 2008. "Flow of Funds Accounts of the United States."

Dash, Eric. 2008. "Banks Trimming Limits for Many on Credit Cards." New York Times, June 21.

Shiskin, Philip. 2008. "Painful Choices as College Bills Wallop Families." Wall Street Journal, December 11.

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco or of the Board of Governors of the Federal Reserve System. 

Paul Krugman: Health Care Now

Now is not the time to back off of the push for health care reform:

Health Care Now, by Paul Krugman, Commentary, NY Times: The whole world is in recession. But the United States is the only wealthy country in which ... millions of people will lose their health insurance along with their jobs, and therefore lose access to essential care.

Which raises a question: Why has the Obama administration been silent ... about one of President Obama's key promises...—... guaranteed health care for all Americans? ...

Just about all economic forecasts ... say that we're in for a prolonged period of very high unemployment. And high unemployment means a sharp rise in the number of Americans without health insurance. ... Why, then, aren't we hearing more about ensuring health care access?

Now, it's possible that those of us who care about this issue are reading too much into the administration's silence. But let me address three arguments that I suspect Mr. Obama is hearing against moving on health care, and explain why they're wrong.

First, some people are arguing that a major expansion of health care access would just be too expensive ... given the vast sums we're about to spend trying to rescue the economy.

But ... achieving universal coverage with a plan similar to Mr. Obama's campaign proposals would add "only" about $104 billion to federal spending in 2010 — not a small sum,... but not large compared with, say, the tax cuts in the Obama stimulus plan.

It's true that the cost of universal health care will be a continuing expense... But ... Mr. Obama has always claimed that his health care plan was affordable. The temporary expenses of his stimulus plan shouldn't change that calculation.

Second, some people in Mr. Obama's circle may be arguing that health care reform isn't a priority right now, in the face of economic crisis.

But helping families purchase health insurance ... would be at least as effective a way of boosting the economy as the tax breaks that make up roughly a third of the stimulus plan — and it would have the added benefit of ... ending one of the major sources of Americans' current anxiety.

Finally — and this is, I suspect, the real reason for the administration's health care silence — there's the political argument that this is a bad time to be pushing fundamental health care reform, because the nation's attention is focused on the economic crisis. But if history is any guide, this argument is precisely wrong. ...

F.D.R. was able to enact Social Security in part because the Great Depression highlighted the need for a stronger social safety net. And the current crisis presents a real opportunity to fix the gaping holes that remain in that safety net, especially with regard to health care.

And Mr. Obama really, really doesn't want to repeat the mistakes of Bill Clinton, whose health care push failed politically partly because he moved too slowly...

One more thing. There's a populist rage building ... as Americans see bankers getting huge bailouts while ordinary citizens suffer.

I agree ... financial bailouts are necessary (though I have problems with the specifics). But I also agree with Barney Frank ... who argues that — as a matter of political necessity as well as social justice — aid to bankers has to be linked to a strengthening of the social safety net, so that Americans can see that the government is ready to help everyone, not just the rich and powerful.

The bottom line, then, is that this is no time to let campaign promises of guaranteed health care be quietly forgotten. It is, instead, a time to put the push for universal care front and center. Health care now!

Fed Watch: More Will They or Won't They or When Will They

Tim Duy:

More Will They or Won't They or When Will They, by Tim Duy: Thursday's action in the Treasury market – which saw the yield on the 10-year bond leap 18 basis points – has triggered another debate of when will the Fed begin wholesale purchase of Treasuries to hold yields close to zero and openly expand the monetary base. John Jansen thinks it is only a matter of time:

One trader noted, and I concur, that traders are now engaged in a game of financial chicken with Federal Reserve as traders attempt to force the Fed's hand. The Fed has no desire for higher rates and the higher rates defeats the intent of the myriad of plans it has implemented to fight the financial crisis. I do not know what level on 5 year or 10 year notes would invite Federal Reserve coupon purchases. However, in this fragile environment such a level does exist and I think that the street will now probe to discern that level.

And more:

The Federal Reserve has purchased several hundred billion mortgages and is significantly underwater for all its efforts. They have bought big chunks of FNMA 4s between 100 and 101. Those bonds currently trade around 99.

I mentioned in the preceding post that I thought that the street would force the Fed's hand regarding purchases of Treasuries. The debacle in the Treasury market has erased the gains in the mortgage market. The Fed will not wait long to buy Treasuries as dilatory action will only lead to higher mortgage rates.

Earlier I wrote that the Fed's last statement, however, appears to say that the Fed is not yet targeting the level of long rates. Instead, the Fed, using the asset side approach to balance sheet policy, is only interested in outright Treasury purchases if deemed supportive of maintaining normal credit market functioning. On this point, CR revives his series on credit crisis indicators, and concludes that we have already seen significant improvement. Moreover, his chart of the yields on the 10-year Treasury reminds us that Treasuries remain at historically LOW levels, and could rise quite a bit and still be "low." Another sign of normality:

The difference between 10-year Treasury Inflation Protected Securities and nominal Treasuries rose to one percent for the first time in more than three months as traders brace for government-induced inflation.

As markets heal, we would expect investors to move out of low-yield risk-free assets and into other, higher yielding assets, thereby improving yield spreads. A rise in the 10-year Treasury back to 4%, in such an environment, should be seen as a welcome indication of improving financial health. But that might entail rate increases in some consumer loans as well, including all important mortgages. Therein lays the conundrum – if markets conditions normalize, will the Fed breath sigh of relief, pat themselves on the back, and walk away? Or will Fed Chairman Ben Bernanke climb aboard his helicopter?

Moreover, we have been working on the assumption that governments around the world can turn the fiscal faucets on full blast because there are endless amounts of excess saving that can be sucked up and put to productive use. I would not throw away that story just yet; I think in a normalizing financial environment rates could back up to 4% without cause for alarm. But the US government alone is asking markets to absorb an ever rising amount of debt. And the US still runs a current account deficit, meaning we still need external financing resources. So I would not be surprised to see rates start to rise; I have said before that the key to getting fiscal stimulus right is listening to the market signals; if rates start moving steadily upward beyond 4%, authorities should carefully consider the possibility that they have gone overboard.

If rates are rising simply due to financial healing or obvious strains on the capacity of the debt markets to absorb endless trillions of US debt (which, by the way, would be something of a surprise given the steady willingness to absorb seemingly endless debt since the Reagan Administration), the room for policy error is great. If the Federal Reserve chooses to lean against the market and start effectively monetizing fiscal spending, I think we could all agree that we would be moving into an inflationary environment. Sell the Dollar, buy commodities. On the upside, some serious inflation would reduce the debt overhang in real terms.

Note that I am not saying we are at this point; it is just one risk in a range of possibilities. A fresh bout of financial fever could send rates back toward the 2% mark, and that would end this story entirely.

In short, the Fed opened something of a can of worms by offering up Treasury purchases as an option in the monetary policy arsenal – they left open the question of what would trigger them to use that weapon. Only if necessary for the smooth functioning of financial markets? Or to hold rates artificially low? By my read, the most recent statement suggests the former. But I will also be the first to admit that Bernanke has tended to error on the side of more policy is better.

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January 29, 2009

Economist's View - 5 new articles

The Fear of Fear

This week's edition of The Economist has the Blanchard Roundtable featuring a Economic Focus column by Olivier Blanchard:

"(Nearly) nothing to fear but fear itself."

There are responses to the column by

There will be additional responses, and I'll update this as they appear.

Sachs: 21st-Century Capitalism

Jeff Sachs seems to be pleased with the new administrations commitment to "a new age of sustainable development":

Rewriting the rulebook for 21st-century capitalism, by Jeffrey Sachs, CIF, The Guardian: One of President Barack Obama's historic contributions will be a grand act of policy jujitsu - turning the crushing economic crisis into the launch of a new age of sustainable development. ... Obama is already setting a new historic course by reorienting the economy from private consumption to public investments directed at the great challenges of energy, climate, food production, water and biodiversity.

The new president has taken every opportunity to underscore that the economic crisis will not slow, but rather will accelerate, the much-needed economic transformation to sustainability. ... The fiscal stimulus ... will lay down the first steps of a massive generation-long technological overhaul...

Obama has started with the most important first step: a team of scientific and technological advisers of stunning quality... He has also focused on two core truths of sustainable development: that technological overhaul lies at the core of the challenge, and that such an overhaul requires a public-private partnership for success. Taking shape, therefore, is nothing less than a new 21st-century model of capitalism ... committed to the dual objectives of economic development and sustainability...

Consider the challenge of a bankrupt automobile sector... In the Obama strategy, GM will not be closed to punish it... It's worth far too much as a world leader in the electric vehicles of the 21st century. ...

Conservatives are aghast. The bail-out of the auto industry was hard enough to swallow. Government investments in infrastructure and research and development are viewed with scorn, compared with the tried and true (if disastrously failed) tax cuts of the Bush era. Rightwing pundits bemoan the evident intention of Obama and team to "tell us what kind of car to drive". Yet that is exactly what they intend to do (at least with regard to the power source under the hood), and rightly so. Free-market ideology is an anachronism in an era of climate change, water stress, food scarcity and energy insecurity. Public-private efforts to steer the economy to a safe technological harbour will be the order of the new era.

There is plenty of room for blunders... Government activism can founder on the shoals of massive budget deficits, tax-cutting populism pushed by the right, politically motivated investments such as corn-based ethanol..., and more. Yet Obama is absolutely correct that we have no choice but to try. ...

The Global Crisis Debate

Vox EU is conducting a Global Crisis Debate:

The Global Crisis Debate: is partnering with the UK government to collect the views of economists from around the world on what we should do to fix the global economy. The analysis and proposals that appear on Vox's "Global Crisis Debate" page will feed directly into the UK's preparation for the summit of world leaders in London in April. This debate will be featured on the UK government's own web site,

  • Macroeconomics Moderator: Philip Lane - What macro polices are needed to combat recession and global imbalances?
  • Institutional reform Moderator: Francesco Giavazzi - How should institutions be reformed to improve global economic governance?
  • Financial rescue and regulation Moderator: Luigi Zingales - What is needed to strengthen financial sectors in the short and medium term?
  • Development and the crisis Moderator: Dani Rodrik - How is the crisis different for developing and emerging nations, how should they and the G20 react?
  • Open markets Moderator: VoxEditor - What should be done to maintain open markets and promote an environmentally sound recovery?

Help us make this the global debate on the global crisis The Editors invite all professional economists to write 200-1000 word Commentaries on the crisis. These need not be original (for example you might cut-and-paste-and-update a recent column posted or published elsewhere); our aim is to agglomerate all the best thinking in one place to better foster dialog and exchange. [Rules for contributing.]

Here's a sample contribution, one of the lead essays for the Macroeconomics section:

Getting past the blame game, by Eswar Prasad: Who's to blame for the worldwide financial crisis? The list of potential culprits for the meltdown of the US financial system is long and the rogues' gallery will no doubt expand a great deal before the economy is out of the woods. But a worldwide crisis calls for a global villain. And there is indeed one at hand – global macroeconomic imbalances, characterised by large current account deficits in the US and a few other advanced industrial countries, with these deficits financed by excess savings in China and many other emerging market economies.

Do these imbalances constitute the proximate cause of the crisis?

That depends on whom you ask.

Whatever the right answer, however, we must guard against the risk that these imbalances could actually worsen during the global recovery – whenever that comes – and set the stage for the global economy to stumble again in the future.

The view from the US, which has been at the epicentre of the crisis, is interesting. In its waning days, the Bush White House issued a statement that in part reads "…the President highlighted a factor that economists agree on: that the most significant factor leading to the housing crisis was cheap money flowing into the US from the rest of the world, so that there was no natural restraint on flush lenders to push loans on Americans in risky ways. This flow of funds into the US was unprecedented. And because it was unprecedented, the conditions it created presented unprecedented questions for policymakers." In other words, it's all the foreigners' fault.

This builds on Bernanke's saving glut hypothesis, and officials in the new administration seem to have picked up the theme. These statements invariably end up either implicitly or overtly laying the blame at the feet of China for its currency management policies that have created a current account surplus that could amount to about $350 billion, or about 9% of GDP, in 2008.

Global imbalances and US financial problems

There is no doubt that global imbalances allowed problems in the US financial system to fester. Excess savings in Asian and other emerging markets and the bloated revenues of oil-exporting countries were recycled into the US financial markets. The resulting low interest rates in the US created incentives for financial shenanigans in the US and blocked self-correcting mechanisms such as rising interest rates due to higher government borrowing. What could have been a bubble that would sooner or later have popped instead turned into a blimp that soared heavenward before crashing back to earth.

The Chinese, for their part, have reacted with scorn to the notion that anyone but the US bears central blame for the crisis. In any event, whether or not one regards global imbalances as the root cause of the crisis, the underlying policies that generated those imbalances were clearly not in the long-term interests of the countries concerned.

US fiscal profligacy and consumption binge

US fiscal profligacy and a financial system that encouraged the consumption binge helped bring on the financial instability. For its part, China has done itself no favours with a currency regime that has tied its hands on macroeconomic policy, kept its economy dependent on exports (most of which go the US and the EU), and hindered a much-needed rebalancing of growth towards private consumption. In a cruel irony, the thriftiness of the Chinese has come back to haunt them with the collapse in the demand for their exports.

Indeed, there is an even richer set of ironies in the way the crisis has played out.

  • First, the global macro imbalances are not unravelling in the way that many economists had expected (present company included).
  • Rather than experiencing a decline in the value of the dollar, the US current account deficit may apparently adjust with just a massive contraction in private consumption.
  • Second, the epicentre of the crisis has become the safe haven, with the flight to quality around the world turning into a flight to US treasury bonds.
  • Third, and most worryingly, the rest of the world still seems to be counting on the US as a demander of last resort.
  • Fourth, all signs are that the global crisis may lead to emerging markets rethinking old notions of reserve adequacy and consider building up even larger stocks of reserves.

In short, as the world economy pulls out of the crisis, the imbalances that created much of the problem could intensify rather than dissipate. This is why the solutions need to be global as well. Moreover, while much has been said about how to redesign financial regulation, this has to be supported by a clear focus on macroeconomic policies.

Some of the necessary steps are as follows.

  • Additional macroeconomic stimulus measures are clearly going to be needed in all of the major economies. These should be coordinated in order to prevent the stimulus in any one country from seeping out and reducing the overall bang for the buck. Moreover, coordination would also bolster business and consumer confidence that governments are serious about stimulating their economies with all tools available and enlightened enough to do this in a cooperative manner.
  • The major world economies need to map out and forcefully communicate their strategies to solve their domestic problems. For instance, the US needs clear plans to bring its public finances under control over a reasonable horizon after the recovery gets going and to retool its financial regulatory mechanisms. The Chinese need to have an effective strategy to rebalance their economy towards private consumption and away from investment and exports. This will require greater social spending and a more flexible exchange rate.
  • A revamp of global governance is essential. The IMF (or an equivalent institution) needs to be given the teeth to call not just emerging markets but also the rich industrial economies to the woodshed when they run policies that might be in their apparent short-term self-interest but against the collective long-term interests of the world economy. It also needs to have enough resources and sufficient legitimacy among emerging markets that they can count on it as an insurer, and thereby save themselves the trouble and costs of self-insuring by building up large stocks of reserves.

Reform of financial regulation in the US and elsewhere is also essential. Reform of the international arrangements for macroeconomic policy surveillance and the international financial architecture are equally urgent priorities. Otherwise, we will be back where we started, with a perfectly good crisis gone to waste.

"Refugee Run"

From William Easterly's new blog:

And Now For Something Completely Different: Davos Features "Refugee Run", by Bill Easterly:


When somebody sent me this invitation from Antonio Guterres, the UN High Commissioner for Refugees, I thought at first it was a joke from the Onion. What do you think of the Davos rich and powerful going through the "Refugee Run" theme park re-enactment of life in a refugee camp?

Can Davos man empathize with refugees when he or she is not in danger and is going back to a luxury banquet and hotel room afterwards? Isn't this just a tad different from the life of an actual refugee, at risk of all too real rape, murder, hunger, and disease?

Did the words "insensitive," "dehumanizing," or "disrespectful" (not to mention "ludicrous") ever come up in discussing the plans for "Refugee Run"?

I hope such bad taste does not reflect some inability in UNHCR to see refugees as real people with their own dignity and rights.

Of course, I understand that there were good intentions here, that you really want rich people to have a consciousness of tragedies elsewhere in the world, and mobilize help for the victims. However, I think a Refugee Theme Park crosses a line that should not be crossed. Sensationalizing and dehumanizing and patronizing results in bad aid policy – if you have little respect for the dignity of individuals you are trying to help, you are not going to give THEM much say in what THEY want and need, and how you can help THEM help themselves? ...

Here's a resolution to be proposed at Davos: we rich people hereby recognize each and every citizen of the globe as an individual with their own human dignity equal to our own, regardless of their poverty or refugee status. And Davos man: please give Refugee Run a pass.

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January 28, 2009

Economist's View - 6 new articles

Fed Watch: Quick Note on the FOMC Statement

Tim Duy reacts to today's statement from the FOMC:

Quick Note on the FOMC Statement, by Tim Duy: Many will parse today's FOMC statement; I will keep my comments focused on the sentence:

The Committee also is prepared to purchase longer-term Treasury securities if evolving circumstances indicate that such transactions would be particularly effective in improving conditions in private credit markets.

Conventional wisdom has that any Fed action to purchase longer-term Treasuries would be done with the intent of holding interest rates low, thereby stimulating economic activity. That, however, is not the implication of this sentence. Instead, the Fed views Treasury purchases only as a mechanism to support effective functioning of credit markets, which suggest that the Fed is not worried about controlling the level of longer term interest rates, but the spread between Treasuries and other assets.

This also suggests that the Fed is not particularly interested in expanding the balance sheet further via Treasury purchases. They may be willing to, but I am not sure how Treasury purchases will improve market functioning. To date, improving credit market efficiency has meant purchasing or holding as collateral risky assets, or even safe assets that the market currently shuns, not riskless Treasuries. What factors would cause a reversal of that position?

Moreover, one should also question the willingness of the Fed to fight against rising interest rates if those rising rates were the result of a shift to riskier assets and credit spreads fell to more normal levels. Presumably, this would correspond to a loosening of credit conditions, which in and of itself would be stimulative even if rates edged upward.

In short, as long as the Fed is focused on the issue of improving credit markets – what they view as the asset side of the balance sheet – they are not likely to engage in Treasury purchases that effectively shift policy to the liabilities side of the balance sheet. This shift, however, is what Richmond Fed President Jeffery Lacker wants to see:

Voting against was Jeffrey M. Lacker, who preferred to expand the monetary base at this time by purchasing U.S. Treasury securities rather than through targeted credit programs.

Lacker views the Fed's adherence to its asset side approach as an encroachment on the role of the fiscal authorities (not to mention a power grab by the Board). He would prefer the Fed conduct straightforward monetary policy – drive up the monetary base, effectively monetizing deficit spending. His colleagues are not there yet.

An Ideological Turf War

Paul Krugman:

Fiscal policy formalities (wonkish), by Paul Krugman: There seems to be an amazing amount of misunderstanding of the basics of fiscal policy, even among people who should know better. Leave on one side the remarkable parade of economists who think that the savings-investment identity proves that government action can't increase spending; PGL points us to a higher-level fallacy: the widespread belief that Ricardian equivalence doesn't just say that tax cuts have no effect — which it does — it also says that private consumption automatically offsets any rise in government spending, which is just wrong.

Justin Wolfers suggests that this is because economists just haven't been thinking and writing about fiscal policy. Maybe. But in my own neck of the woods, that isn't true. In the New Open Economy Macroeconomics, which dates back to classic work by Obstfeld and Rogoff in the early 90s, both fiscal and monetary policy are usually analyzed.

And by the way: these are extremely buttoned-down models, with lots of intertemporal maximization, careful attention to budget constraints, and at most some assumption of temporary price rigidity. Nobody who was at all familiar with this literature could make the logic mistakes that are coming fast and furious from the fresh-water economists.

What this reveals, I think, is just how insular part of the macroeconomics profession has become. They just don't read anything that doesn't come from their cult circle; they just weren't aware of major bodies of work that didn't happen to be in their preferred style.

This insularity is asymmetric. Ask a PhD student at Princeton what a real business cycle theorist would say about something, and he or she can do that; ask a student at one of the freshwater schools what a new Keynesian would say, and I doubt that he or she could answer. They've been taught that there is one true faith, and have been carefully protected from heresy.

It's a sad story.

It's even sadder. The two groups have lots to offer, New Keynesians can learn from RBC theorists, and the reverse is true as well, but ideological hard-headedness driven by a turf war among the leaders in each group, a war that is really about a quest for for professional fame has, I think, kept these two groups in opposition to the detriment of the profession.

A post from last August looked at this question:

"The State of Macro": Exactly three years ago, I wrote:

There is currently a movement within the economics profession to [synthesize real business cycle and new Keynesian models]. Real business cycle models, i.e. supply-side models, are adequate models of the long-run but do not explain demand side short-run economic fluctuations very well. Because of this, they are limited in their applicability. Models with wage and price rigidities, New Keynesian models, do have the ability to explain such short-run fluctuations but pay scant attention to long-run issues. Combining these two models, a real business cycle model for the long-run and a New Keynesian model of wage and price rigidity for the short-run, is a promising avenue for explaining macroeconomic fluctuations.

Olivier Blanchard explores this idea in more detail in "The State of Macro." Here's a bit of the paper (I can't find an open link - Update: open link - click on "choose download location" at top of page):

The State of Macro, by Olivier J. Blanchard, NBER Working Paper No. 14259, August 2008: The editors of this new Journal asked me to write about "The Future of Macroeconomics". ...

The theme is that, after the explosion (in both the positive and negative meaning of the word) of the field in the 1970s, there has been enormous progress and substantial convergence. For a while - too long a while - the field looked like a battlefield. Researchers split in different directions, mostly ignoring each other, or else engaging in bitter fights and controversies. Over time however, largely because facts have a way of not going away, a largely shared vision both of fluctuations and of methodology has emerged. Not everything is fine. Like all revolutions, this one has come with the destruction of some knowledge, and suffers from extremism, herding, and fashion. But none of this is deadly. The state of macro is good.[2] ...

1 A Brief Review of the Past

When they launched the "rational expectations revolution", Lucas and Sargent (1978) did not mince words:

That the predictions [of Keynesian economics] were wildly incorrect, and that the doctrine on which they were based was fundamentally flawed, are now simple matters of fact, involving no subtleties in economic theory. The task which faces contemporary students of the business cycle is that of sorting through the wreckage, determining what features of that remarkable intellectual event called the Keynesian Revolution can be salvaged and put to good use, and which others must be discarded.

They predicted a long process of reconstruction:

Though it is far from clear what the outcome of this process will be, it is already evident that it will necessarily involve the reopening of basic issues in monetary economics which have been viewed since the thirties as "closed" and the reevaluation of every aspect of the institutional framework within which monetary and fiscal policy is formulated in the advanced countries. This paper is an early progress report on this process of reevaluation and reconstruction.

They were right. For the next fifteen years or so, the field exploded. Three groups dominated the news, the new-classicals, the new-Keynesians, and the new-growth theorists (no need to point out the PR role of "new" here), each pursuing a very different agenda:

The new-classicals embraced the Lucas-Sargent call for reconstruction. Soon, however, the Mencheviks gave way to the Bolcheviks, and the research agenda became even more extreme. Under Prescott's leadership, nominal rigidities, imperfect information, money, and the Phillips curve, all disappeared from the basic model, and researchers focused on the stochastic properties of the Ramsey model (equivalently, a representative agent Arrow-Debreu economy), rebaptized as the Real Business Cycle model, or RBC. Three principles guided the research:

Explicit micro foundations, defined as utility and profit maximization; general equilibrium; and the exploration of how far one could go with no or few imperfections.

The new-Keynesians embraced reform, not revolution. United in the belief that the previous vision of macroeconomics was basically right, they accepted the need for better foundations for the various imperfections underlying that approach.

The research program became one of examining, theoretically and empirically, the nature and the reality of various imperfections, from nominal rigidities, to efficiency wages, to credit market constraints. Models were partial equilibrium, or included a trivial general equilibrium closure: It seemed too soon to embody each one in a common general equilibrium structure.

The new-growth theorists simply abandoned the field (i.e. fluctuations). Lucas' remark that, once one thinks about growth, one can hardly think about something else, convinced many to focus on determinants of growth, rather than on fluctuations and their apparently small welfare implications. ...

Relations between the three groups - or, more specifically, the first two, called by Hall "fresh water" and "salt water" respectively (for the geographic location of most of the new-classicals and most of the new-Keynesians) - were tense, and often unpleasant. The first accused the second of being bad economists, clinging to obsolete beliefs and discredited theories. The second accused the first of ignoring basic facts, and, in their pursuit of a beautiful but irrelevant model, of falling prey to a "scientific illusion." (See the debate between Prescott and Summers (1986)). One could reasonably despair of the future of macro (and, indeed, some of us came close (Blanchard 1992)).

This is still the view many outsiders have of the field. But it no longer corresponds to reality. Facts have a way of eventually forcing irrelevant theory out (one wishes it happened faster). And good theory also has a way of eventually forcing bad theory out. The new tools developed by the new-classicals came to dominate.

The facts emphasized by the new-Keynesians forced imperfections back in the benchmark model. A largely common vision has emerged, which is the topic of the next section.

2 Convergence in Vision

2.1 The role of aggregate demand, and nominal rigidities

It is hard to ignore facts. One major macro fact is that shifts in the aggregate demand for goods affect output substantially more than we would expect in a perfectly competitive economy. More optimistic consumers buy more goods, and the increase in demand leads to more output and more employment. Changes in the federal funds rate have major effects on real asset prices, from bond to stock prices, and, in turn, on activity.

These facts are not easy to explain within a perfectly competitive flexible-price macro model. ...

Attempts to explain these effects through exotic preferences or exotic segmented-market effects of open market operations, while maintaining the assumption of perfectly competitive markets and flexible prices, have proven unconvincing at best. This has led even the most obstinate new-classicals to explore the possibility that nominal rigidities matter. ...

The study of nominal price and wage setting is one of the hot topics of research in macro today. ... The cast of characters involved ... nicely makes the point that the old fresh water/salt water distinction has become largely irrelevant: While research on the topic started with new-Keynesians, recent research has been largely triggered by an article by Golosov and Lucas (2007), itself building on earlier work on aggregation of state-dependent rules by Caplin and by Caballero, among others.

2.2 Technological shocks versus technological waves

One central tenet of the new-classical approach was that the main source of fluctuations is technological shocks. The notion that there are large quarter-to-quarter aggregate technological shocks flies however in the face of reason. Except in times of dramatic economic transition,... technological progress is about the diffusion and implementation of new ideas, and about institutional change, both of which are likely to be low-frequency movements. No amount of quarterly movement in the Solow residual will convince the skeptics: High frequency movements in measured aggregate TFP must be due to measurement error.[3]

This does not imply, however, that technological progress does not play an important role in fluctuations. Though technological progress is smooth, it is certainly not constant. There are clear technological waves. ...

2.3 Towards a general picture, and three broad relations

The joint beliefs that technological progress goes through waves, that perceptions of the future affect the demand for goods today, and that, because of nominal rigidities, this demand for goods can affect output in the short run, nicely combine to give a picture of fluctuations which, I believe, many macroeconomists would endorse today.

Fifty years ago, Samuelson (1955) wrote:

In recent years, 90 per cent of American economists have stopped being "Keynesian economists" or "Anti-Keynesian economists." Instead, they have worked toward a synthesis of whatever is valuable in older economics and in modern theories of income determination. The result might be called neo-classical economics and is accepted, in its broad outlines, by all but about five per cent of extreme left-wing and right-wing writers.

I would guess we are not yet at such a corresponding stage today. But we may be getting there. ...

When I first posted this, I agreed. The two sides seemed to be converging and I thought that was a good development. But the current crisis has reopened old debates, exposed divisions that have never been fully healed, and we seem as far apart as ever.

I want to end with this quote from Lucas:

The task which faces contemporary students of the business cycle is that of sorting through the wreckage, determining what features of that remarkable intellectual event called the Keynesian Revolution can be salvaged and put to good use, and which others must be discarded.

What's different this time, and it's a difference I hope will bring about some humility, is that the wreckage is not from the Keynesian model crashing, this time it is the Classical formulation of the world that is being called into question. Once the proponents of these models are willing to concede that point, something they are currently resisting, maybe we can come together and get somewhere useful.

FOMC Statement

No change in the target rate:

Press Release: Release Date: January 28, 2009

The Federal Open Market Committee decided today to keep its target range for the federal funds rate at 0 to 1/4 percent. The Committee continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.

Information received since the Committee met in December suggests that the economy has weakened further. Industrial production, housing starts, and employment have continued to decline steeply, as consumers and businesses have cut back spending. Furthermore, global demand appears to be slowing significantly. Conditions in some financial markets have improved, in part reflecting government efforts to provide liquidity and strengthen financial institutions; nevertheless, credit conditions for households and firms remain extremely tight. The Committee anticipates that a gradual recovery in economic activity will begin later this year, but the downside risks to that outlook are significant.

In light of the declines in the prices of energy and other commodities in recent months and the prospects for considerable economic slack, the Committee expects that inflation pressures will remain subdued in coming quarters. Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.

The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. The focus of the Committee's policy is to support the functioning of financial markets and stimulate the economy through open market operations and other measures that are likely to keep the size of the Federal Reserve's balance sheet at a high level. The Federal Reserve continues to purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand the quantity of such purchases and the duration of the purchase program as conditions warrant. The Committee also is prepared to purchase longer-term Treasury securities if evolving circumstances indicate that such transactions would be particularly effective in improving conditions in private credit markets. The Federal Reserve will be implementing the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses. The Committee will continue to monitor carefully the size and composition of the Federal Reserve's balance sheet in light of evolving financial market developments and to assess whether expansions of or modifications to lending facilities would serve to further support credit markets and economic activity and help to preserve price stability.

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; Dennis P. Lockhart; Kevin M. Warsh; and Janet L. Yellen.  Voting against was Jeffrey M. Lacker, who preferred to expand the monetary base at this time by purchasing U.S. Treasury securities rather than through targeted credit programs.

Rebecca Wilder:

This is likely a FIRST for an FOMC statement (and I only say "likely" because I am not planning to sift through each and every meeting announcement since Volcker):

Voting against was Jeffrey M. Lacker, who preferred to expand the monetary base at this time by purchasing U.S. Treasury securities rather than through targeted credit programs.

Put it another way: Voting against was Jeffrey M. Lacker, who preferred to directly monetize the government debt, rather than expand the monetary base through targeted credit programs.

The other news is that the Fed is "prepared to purchase longer-term Treasury securities if evolving circumstances indicate that such transactions would be particularly effective in improving conditions in private credit markets." The goal would be to simulate investment by lowering long-term interest rates.

Sachs: A Fiscal Straitjacket

Jeff Sachs is worried that the stimulus package, especially the components involving tax cuts, will do more harm than good by starving the economy of the revenues needed to fund vital programs:

A fiscal straitjacket, by Jeffrey Sachs, Commentary, Financial Times: The US debate over the fiscal stimulus is remarkable in its neglect of the medium term – that is, the budgetary challenges over a period of five to 10 years. ... Without a sound medium-term fiscal framework, the stimulus package can easily do more harm than good...

The most obvious problem with the stimulus package is that it has been turned into a fiscal piƱata – with a mad scramble for candy on the floor. We seem all too eager to rectify a generation of a nation saving too little by saving even less – this time through expanding government borrowing. ..

The White House and Congress have stated an amount – $825bn to be spent mostly over two years... Many of the details of allocating the $825bn are being left to Congress with the aim of reaching a bipartisan consensus. The result is shaping up to be an astounding mish-mash of tax cuts, public investments, transfer payments and special treats for insiders.

What we need is a medium-term fiscal framework, one that lays out an anticipated schedule of taxes and spending consistent with the needs of the economy and government functions. Rather than soundbites about ending pork-barrel projects or scouring the budget for waste, or about the relative multipliers of tax cuts versus spending increases..., we should be reflecting on certain basic fiscal facts, the most important of which is that the US government faces huge and potentially debilitating structural deficits as far as the eye can see. ...

If the present stimulus package is adopted without a medium-term plan, it will ... put the US into a fiscal straitjacket that could paralyze public sector action in critical areas for a decade or more to come. This is especially true if we allow further tax cuts during a time of fiscal hemorrhage, or give into "bipartisan" demands to make the Bush tax cuts permanent, even for the rich, as seems increasingly likely.

There are many valuable things proposed in President Barack Obama's spending plans – such as the sums to be spent on energy, healthcare and education – but these should be incorporated into medium-term strategies rather than a grab bag of hasty short-run spending. The tax cuts that he is likely to approve..., and the extension of Bush-era tax cuts if that comes to pass, could close the door to these longer-term programs; haphazard spending on these vital programs could do the same. ...

[T]here is certainly a cyclical case for deficit- financed public spending, but accompanied by phased-in tax increases to provide proper financing of crucial government functions in the medium term.

Fed Watch: Passing the Baton

Tim Duy:

Passing the Baton, by Tim Duy: The Federal Reserve will offer up the results of its two day meeting this afternoon. It is hard to find much to argue with Rebecca Wilder's conclusion that not much has changed in the past six weeks, and hence we should expect little from today's statement. CR opines on the possibility that Bernanke & Co. might update us on their evaluation of the potential benefit of purchasing longer dated Treasuries. Economists at Merrill Lynch suggested earlier this week the Fed may be forced to pursue that option sooner rather than later if yields keep rising (although some think that bonds are about to make a technical turn in direction anyway).

It seems, however, that outright purchases of Treasuries to hold rates lower would shift the Fed's attention from the asset side of the balance sheet to the liabilities side, which would put them in the realm of their definition of quantitative easing. It doesn't seem like they are quite ready to go there; just six weeks ago they made an effort to differentiate between their policy and Japanese style quantitative easing. Seems too quick for a reversal given the relative calm of credit markets since the December meeting. Given the lack of Fed preconditioning to expect a significant policy shift, today's statement is not expected to move markets, and will be carefully dissected to see how, if any, the Fed's view of the economy or credit markets have changed.

So what now is the ultimate intention of policymakers? What do they hope to accomplish?

Caroline Baum at Bloomberg thinks she has that answer – a recreation of all that caused the massive economic dislocations to occur in the first place:

Fast forward one year, the crisis is still going strong, the villains are still under attack, yet something curious has happened: The policies and actions responsible for the economy's illness are now being prescribed as cures.

I think it is easy to sympathize with Baum's position; I was particularly stymied by the path of policy in the first half of 2008, which appeared directed at doing everything and anything to prevent an unstoppable adjustment away from externally supported growth. I thought the Fed was pursuing a questionable policy path especially considering superheated global growth. In the end, the Fed likely threw fuel onto one final bubble – commodities – before the whole house of cards came crashing down. The degree to which this bubble (and the concurrent destabilizing dollar carry trade) worsened the domestic and global situations will be a matter for the historians.

Now it is difficult to argue that policymakers actually believe that they can recreate the conditions that brought the housing bubble to fruition. Federal Reserve Chairman Ben Bernanke does not appear to be under any delusions:

The proximate cause of the crisis was the turn of the housing cycle in the United States and the associated rise in delinquencies on subprime mortgages, which imposed substantial losses on many financial institutions and shook investor confidence in credit markets.  However, although the subprime debacle triggered the crisis, the developments in the U.S. mortgage market were only one aspect of a much larger and more encompassing credit boom whose impact transcended the mortgage market to affect many other forms of credit.  Aspects of this broader credit boom included widespread declines in underwriting standards, breakdowns in lending oversight by investors and rating agencies, increased reliance on complex and opaque credit instruments that proved fragile under stress, and unusually low compensation for risk-taking.

I tend to believe the key to reigniting the credit bubble – if at all possible – is the last sentence. Lower rates, in and of themselves, cannot compensate for tighter underwriting standards. And those tighter standards, such as a reversion to making home mortgages based upon a reasonable percentage of income, are likely more permanent than temporary. Until the government is ready to revert to encouraging lending practices where everyone with a pulse gets a jumbo loan, tighter credit is simply the new reality.

So if the Fed cannot recreate the credit bubble, what are policymaker's trying to accomplish with all of their financial machinations? Rather than focus on the individual types of assets supported, we can first simplify the Fed's goal as attempting to provide the support necessary to keep the economy at full employment (alternatively, the prevention of deflation if you prefer that framework).

But what about patterns of demand at full employment? The main criticism of the current economic regime is leveled by Baum:

The government wants to ensure that consumers, whose spending accounts for about 70 percent of gross domestic product, can borrow and spend. This makes as little sense as using easy money and housing incentives to cure the effects of easy money and over-investment in housing.

I think many believe that the US economy is fundamentally out of balance. Too much consumption, too little investment, too much dependence on foreign production. Sustainable growth requires an adjustment, and the government should support that adjustment, not prevent it (I have been particularly worried about the consequences of the failure of the external accounts to adjust). Here though, is where the Fed has run into trouble by supporting markets for such things as housing and consumer debt. The Fed in these examples appears to be supporting a specific pattern of economic activity, rather than being agnostic about the composition of activity under full employment. Hence the charge that policymakers are attempting to maintain a broken system. From their perspective, the credit crunch does not swallow those still willing and able to borrow, regardless of the ultimate demand supported.

Ultimately, however, if there are questions about the patterns of economic activity, these are best suited for fiscal policymakers to address. Which underscores the importance of fiscal policy – not only is the Fed's effectiveness at supporting full employment in question, but it lacks the tools to both support growth and cushion any structural adjustment. The fiscal authority, in contrast can cushion the increase in saving by providing public investment where the private investment opportunities are currently insufficient (the economy will not shift patterns of activity overnight). That doesn't mean the fiscal authorities will get the job done perfectly right (I still think that tax cuts have an outsized place in the stimulus package), but it is their job, performed through the political process, not the Fed's.

In short, I have come to view Fed policy as less of an attempt to maintain the status quo and more of a series of desperate acts to prevent the system from outright collapse. They will slowly try to extricate themselves from financial markets as opportunities arise, and act to hold rates low across the yield curve, buying longer dated Treasuries if necessary. Beyond that, the heavy lifting is left to the fiscal authorities. Hopefully, the combination will allow the economy to move sideways while consumer and banking balance sheets heal. If that healing does not occur, then the Fed would be forced to step back front and center with a plan for outright inflation. Hopefully we don't have to go there.

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