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July 31, 2009

Economist's View - 6 new articles

"Forecasts vs. Mechanisms in Economics"

Putting up another post all too quickly between conference sessions:

Forecasts vs mechanisms in economics, by Chris Dillow: This discussion between Edmund Conway and Andrew Lilico on the Today programme on the alleged crisis in economics seems to me to rest upon a misunderstanding of what economics is.

Conway says the crisis has been "an earthquake for economic thought" and Lilico says we need "new theories." This, though, seems to regard economics as a settled but inadequate body of knowledge and theory. It's not. It is instead a vast number of diverse insights. What's more, all of the insights that help explain the current economic crisis were, in truth, well known to economists before 2007, for example:

  1. Risk cannot be simply described by a bell curve. But we learnt about tail risk on October 19 1987. And we learnt from the collapse of LTCM in 1998 that correlation risk, liquidity risk and counterparty risk are all significant.
  2. Assets can be mispriced. But we've known about bubbles for centuries - since at least 1637. Their existence does not disprove the efficient market hypothesis; as I've said, the EMH is not the rational investor hypothesis. Nor, contrary to Conway's implicit claim, is the EMH inconsistent with the possibility that behaviour can be swayed by emotions; the EMH allows for the possibility of time-varying risk premia*
  3. Long periods of economic stability can lead to greater risk-taking. We've known this since (at least) Hyman Minsky.
  4. Banks can suffer catastrophic losses - which are correlated across banks. We learnt this - not for the first time - in the Latin American debt crisis of the early 80s and in the crises in Japan and the Nordic countries in the early 90s. Banking crises are a regular feature of even developed economies.
  5. Institutions, such as banks, can be undermined by badly designed incentives. But there's a huge literature on the principal-agent problem.
  6. The current crisis, then, has not thrown up much that economists didn't know. Instead, our problem is a different one. It's that what we have are lots of mechanisms, capable of explaining why things happen and the links between them. What we don't have are laws which generate predictions. In his book, Nuts and Bolts for the Social Sciences, Jon Elster stressed this distinction. The social sciences, he said:

Can isolate tendencies, propensities and mechanisms and show that they have implications for behaviour that are often surprising and counter-intuitive. What they are more able to do is to state necessary and sufficient conditions under which the various mechanisms are switched on.

This is precisely the problem economists had in 2007. We knew that there were mechanisms capable of generating disaster. What we didn't know is whether these were switched on. The upshot is that, although we didn't predict the crisis, we can more or less explain it after the fact. As Elster wrote:

Sometimes we can explain without being able to predict, and sometimes predict without being able to explain. True, in many cases one and the same theory will enable us to do both, but I believe that in the social sciences this is the exception rather than rule.

The interesting question is: will it remain the exception? My hunch is that it will; economists will never be able to produce laws which yield systemically successful forecasts.

What's more, I am utterly untroubled by this. The desire for such laws is as barmy as the medieval search for the philosopher's stone. If you need to foresee the future, you are doing something badly wrong. * The basic insight of efficient market theory is that you cannot out-perform the market except by taking extra risk. I am sick and tired of hearing people who still have to work for a living trying to deny this.

I think the statements on prediction are overly broad. If you raise the price of a good, in all but a few cases such as when price is interpreted as a signal of quality, we can predict what will happen, quantity demanded will fall. By exactly how much will quantity demanded fall? In some microeconomic applications, the bounds can be fairly tight. For example, I suspect Hal Varian at Google - who has access to vast amounts of data and the ability to conduct all else equal type experiments - has a fairly tight estimate of important parameters that indicate how, say, changing the price of an ad will impact Google's revenue stream. He has also been doing some interesting work on prediction, e.g. see Predicting Initial Claims for Unemployment Benefits. But in other cases, particularly in macroeconomics and the prediction of turning points, success has been much more modest (or absent altogether). However, I am not as pessimistic as Chris that we will never be able to do predict the course of the economy, but it will require that we begin to better understand how pressures build within the macroeconomic system, how to measure and monitor these pressures (e.g. measures such global and sectoral imbalances or price rent ratios, but those are hardly sufficient in and of themselves), and ultimately how to relieve the pressures when they begin to build to threatening levels.


Paul Krugman: Health Care Realities

When it comes to health care, "government involvement is the only reason our system works at all":

Health Care Realities, by Paul Krugman, Commentary, NY Times: At a recent town hall meeting, a man stood up and told Representative Bob Inglis to "keep your government hands off my Medicare." The congressman, a Republican from South Carolina, tried to explain that Medicare is already a government program — but the voter, Mr. Inglis said, "wasn't having any of it."

It's a funny story — but it illustrates the extent to which health reform must climb a wall of misinformation. It's not just that many Americans don't understand what President Obama is proposing; many people don't understand the way American health care works right now. They don't understand, in particular, that getting the government involved in health care wouldn't be a radical step: the government is already deeply involved, even in private insurance.

And that government involvement is the only reason our system works at all.

The key thing you need to know about health care is that it depends crucially on insurance. You don't know when or whether you'll need treatment — but if you do, treatment can be extremely expensive, well beyond what most people can pay... Triple coronary bypasses, not routine doctor's visits, are where the real money is, so insurance is essential.

Yet private markets for health insurance, left to their own devices, work very badly: insurers deny as many claims as possible, and they also try to avoid covering people who are likely to need care. Horror stories are legion...

And in their efforts to avoid ... paying medical bills, insurers spend much of the money taken in through premiums ... on "underwriting" — screening out people likely to make insurance claims. In the individual insurance market,... so much money goes into underwriting and other expenses that only around 70 cents of each premium dollar actually goes to care.

Still, most Americans do have health insurance, and are reasonably satisfied... How is that possible, when insurance markets work so badly? The answer is government intervention.

Most obviously, the government directly provides insurance via Medicare and other programs. ... Medicare — which is ... one of those "single payer" systems conservatives love to demonize — covers everyone 65 and older. And surveys show that Medicare recipients are much more satisfied with their coverage than Americans with private insurance.

Still, most Americans under 65 do have some form of private insurance. The vast majority, however, don't buy it directly: they get it through their employers. There's a big tax advantage to doing it that way... But to get that tax advantage employers have to follow a number of rules; roughly speaking, they can't discriminate based on pre-existing medical conditions or restrict benefits to highly paid employees.

And it's thanks to these rules that employment-based insurance more or less works, at least in the sense that horror stories are a lot less common than they are in the individual insurance market.

So here's the bottom line: if you currently have decent health insurance, thank the government. ...

Which brings us to the current debate over reform.

Right-wing opponents of reform would have you believe that President Obama is a wild-eyed socialist, attacking the free market. But unregulated markets don't work for health care — never have, never will. To the extent we have a working health care system at all right now it's only because the government covers the elderly, while a combination of regulation and tax subsidies makes it possible for many, but not all, nonelderly Americans to get decent private coverage.

Now Mr. Obama basically proposes using additional regulation and subsidies to make decent insurance available to all of us. That's not radical; it's as American as, well, Medicare.


The Courage to Click

Brad DeLong asks Do I Dare Click Through on This article by Jonah Goldberg? He then answers "No. I do not. I will remain forever ignorant..."

I dared to click through. Next time, I won't bother, and let me save you the trouble. The argument is that we don't spend enough to fight the threat of asteroids, so we must be spending too much fighting global warming, but one doesn't follow from the other. I see now why I can't remember the last time I read an article by Goldberg.

Maybe this sudden bout of timidity from Brad DeLong is my fault (though there is a sign he is recovering). Last night, I was the one who didn't dare click through on an article, so I sent the link to Brad saying "I just couldn't read this. Maybe tomorrow." Looks like that may have sent him over the edge:

Someone Is Saying Something Wrong on the Internet in the Pages of the Wall Street Journal, by Brad DeLong: Someone Is Saying Something Wrong on the Internet in the Pages of the Wall Street Journal!

My friend Mark Thoma is trying to diminish my quality of life by emailing me links to Donald Luskin writing in the Wall Street Journal:

Luskin: President Barack Obama proposed last month that the Fed act as an overall "systemic risk" regulator, with consolidated supervisory responsibility over "large, interconnected firms whose failure could threaten the stability of the system." Now William C. Dudley, the ex-Goldman Sachs economist just appointed president of the New York Federal Reserve, has upped the ante.... Mr. Dudley is effectively asking for the power to control asset prices...

Sigh.

Sigh.

Sigh.

The Federal Reserve is not "asking for the power to control asset prices." It already has the power to control--or, rather, profoundly influence--asset prices already. When the Federal Reserve carries out an expansionary open-market operation, the whole point of the exercise is that it boosts bond and stock prices. The Federal Reserve buys bonds for cash. There are then fewer bonds out there for the private sector to hold. By supply and demand, the prices of those bonds goes up, and their yields--the interest rates quoted in the financial press--go down. Also by supply and demand, when bonds are yielding less investors are willing to pay more for substitute assets like equities and real estate, and their prices go up as well.

When the Federal Reserve carries out a contractionary open market operation, the same process works in reverse: the whole point of the exercise is that it lowers bond and stock prices. The Federal Reserve sells bonds for cash. There are then more bonds out there for the private sector to hold. By supply and demand, the prices of those bonds goes down, and their yields--the interest rates quoted in the financial press--go up. Also by supply and demand, when bonds are yielding more investors are willing to pay less for substitute assets like equities and real estate, and their prices go down as well.

For Luskin to claim that Dudley is asking for something new--that there is an extraordinary increase in the big, bad government's power to regulate financial markets contained in Dudley's "effectively asking for the power to control asset prices" is to demonstrate a degree of cluelessness that takes my breath away. The Federal Reserve already has the power to control asset prices. It has had this power since its founding in 1913. That's the point. That's what a central bank does. That's what it's for: it's an island of central planning power seated in the middle of the market economy.

If you don't like it, call for its abolition. But don't pretend that it isn't there--don't pretend that "Mr. Dudley... asking for the power to control asset prices" is some wild change in our current system.

Jeebus save us...

So what did Federal Reserve Bank of New York President William Dudley say at the 8th Annual BIS Conference in Basel last June 26?

He said:

  1. We had not understood that interconnection had breached the firewalls of the banking system--that it was no longer enough to guarantee the stability of the financial system that the FDIC guaranteed deposits and the Federal Reserve supervised commercial banks, as we saw when the disruption of the securitization marktes of the shadow banking system quickly transmitted itself to the entire financial sector and caused the biggest globl economic decline since the Great Depression. Thus "the U.S. Treasury is right in proposing a systemic risk regulator as part of their regulatory reform plan... we shouldn't kid ourselves about how difficult this will be to execute.... It will take the right people, with the right skill sets, operating in a system with the right culture and legal framework. I don't believe creating this oversight process will be an easy task"...

  2. We need to try to "engineer out of the financial system" destabilizing positive-feedback mechanisms like: (a) collateral tied to credit ratings; (b); collateral and haircuts; (c) compensation "tied to short-term revenue generation, rather than long-term profitability over the cycle"; (d) incentives for banks to fail to "raise sufficient capital to be able to withstand bad states of nature... many banks did not hold sufficient capital and market participants knew this"...

  3. Specifically, we need to add debt that automatically converts to equity on the downside

  4. And, specifically, we need CDOs and other securitized obligations that are easier to value, and we need more public reporting of exposures.

It's only after this that Dudley gets to monetary policy and asset bubbles, and his belief that we need "a critical reevaluation of the [Greenspanist] view that central banks cannot identify or prevent asset bubbles, they can only clean up after asset bubbles burst." There is an opportunity for the government to "lean against the wind" in real time, Dudley believes, and cites as an example that "the compressed nature of risk spreads and the increased leverage in the financial system was very well known going into 2007."

The problem with "leaning against the wind" to some degree to try to curb the growth of asset bubbles, Dudley says, is that the standard tool that the Federal Reserve uses to affect asset prices are open-market operations directed at the short end of the yield curve, and "the instrument of short-term interest rates... is not well-suited to deal with asset bubbles." The problem is that using short-term interest rates to manipulate asset prices raises or lowers all asset prices together, which means that one risks curbing the bubble by attacking the economy and causing the recession one wants to avoid. In a bubble the Federal Reserve does not want to lower all asset prices but, rather, just the prices of those risky assets that are affected by the bubble.

One way to think about it is that standard Fed tools allow it to affect the market rate of time preference and thus the level of asset prices, but that the configuration of asset prices is actually a two-dimensional animal in which both the rate of time preference and the premium on risk are important. The Fed then needs two different policy instruments to do its job. Open-market operations that affect the rate of time preference are one. And Dudley thinks that banking collateral regulatory policy--"we might give a systemic risk regulator the authority to establish overall leverage limits or collateral and collateral haircut requirements... limit leverage and more directly influence risk premia..."

But nobody should believe the Wall Street Journal when it tells us that Dudley wants to move us into a world in which for the first time the Federal Reserve "is effectively asking for the power to control asset prices." That's not what is going on at all.

Why oh why can't we have a better press corps?


"Savings Rate Could Stay High"

Andy Harless explains why he believes that much of the recent increase in the savings rate will be permanent, while Brad DeLong thinks "only a small part" will be permanent. My own view is somewhere between Andy's "much" and Brad's "small part":

Savings Rate Could Stay High, by Andy Harless: Mark Thoma shows us a historical chart of the personal savings rate since 1960 and asks how much of the recent increase (from an average of about 0.5% from 2005 through 2007 to a peak of almost 7% in May of this year) is permanent? One must, of course, take the May figure with a grain of salt: the savings rate rose in May largely because tax withholding was reduced; unless that attempt at a stimulus is completely ineffective, we should expect the savings rate to decline as people start taking advantage of the new disposable income. But even before May the savings rate this year was running consistently above 4%, which is a dramatic change from a few years ago. Let's use the April figure – 5.6% – as a guesstimate of what the "true" savings rate is right now and ask how much of that will be permanent. Not much, thinks Brad DeLong:

I would guess that only a small part of the rise in the savings rate is permanent. Financial distress was and is much greater than in past post-WWII recessions, and financial distress is associated with transitory rises in the savings rate.

I'm inclined to disagree. Undoubtedly the savings rate will fall somewhat as the degree of financial distress declines, but I think there's a good case to be made that much of the increase is permanent.

For one thing, from the point of view of households, "financial distress" may be extremely slow to lift. If the Japanese experience is any guide, it is a very slow process to get a severely distressed banking system to start lending normally again, and it's not clear that things are going to be any easier for the US. Meanwhile, most forecasts expect the unemployment rate to remain quite high for several years. It could take 3 years, or 5 years, or 10 years, or 20 years before the financial distress lifts.

Granted, even 20 years is not forever, and 3 years is certainly not forever, but it's long enough to stop thinking about household behavior as being continuous over time. We can reasonably surmise that, even without so much financial distress, the savings rate would have trended upward over time. Presumably households would gradually have come to recognize that they weren't saving enough. (Can zero be anywhere near enough?) And as baby boomers' children settle into their own careers, they would cease to be a drag on their parents' savings, and at the same time those parents would have to start worrying seriously about retirement. The financial distress messed up this scenario (or maybe just speeded it up), but the underlying trend should still be going on "beneath the surface." By the time the distress lifts, there will be other reasons for the savings rate to be higher than it was in 2006.

That argument is rather speculative, I admit, but there are more solid reasons to expect the savings rate to remain high.

While the current, comparatively high savings rate may reflect the effects of financial distress, the low savings rates of the 2005-2007 period did not merely represent the absence of financial distress. What is the opposite of financial distress? Financial ease? The degree of financial ease during that period (which was the culmination of a process that had been building on and off for a couple of decades) was well beyond normal, and well beyond what we can expect in the coming years, even if recent sources of distress are resolved fairly quickly. Consumption was supported (and aggregate saving accordingly reduced) by a fountain of credit that will not re-emerge with such force unless people in Washington and on Wall Street make some big mistakes.

The ready availability of credit to consumers was in large part the result of lax regulation, careless investing, and the assumption that home prices would never decline significantly on a nationwide basis. With respect to regulation, the pendulum is clearly swinging in the other direction now. Careless investors have learned their lesson for a generation. And housing prices have disproven the earlier assumption.

After the collapse of housing prices, not only will lenders be more cautious: borrowers also won't have as much collateral. It will be quite a while before typical homeowners have as much equity as they did in 2006.

Moreover, the meltdown may have shaken confidence in the concept of securitization to the point where it will take a decade or more to restore even healthy securitization markets (if they can be restored at all), let alone the severely intoxicated ones that we were seeing in 2006. It won't be easy for households to borrow money for consumption in the coming years. The ones that had negative savings rates will be much less common, while the ones that had positive savings rates will still be there. I expect we'll be seeing savings rates noticeably higher than zero for years to come.


Why Wasn't an RTC-like Institution Set up for TARP?

Where are the technocratic institutions?:

Why wasn't an RTC-like institution set up for TARP?, by Economics of Contempt: Brad DeLong asks...:

I do have one big question. The US government especially, but other governments as well, have gotten themselves deeply involved in industrial and financial policy during this crisis. They have done this without constructing technocratic institutions like the 1930's Reconstruction Finance Corporation and the 1990's RTC, which played major roles in allowing earlier episodes of extraordinary government intervention into the industrial and financial guts of the economy to turn out relatively well, without an overwhelming degree of corruption and rent seeking. ...

So I wonder: why didn't the US Congress follow the RFC/RTC model when authorising George W. Bush's and Barack Obama's industrial and financial policies?

...I think it's an interesting question..., so I'll take this chance to offer my response. With regard to TARP, I think Congress didn't set up an RTC-like institution because the feeling was that there simply wasn't enough time. Neither the RTC nor the RFC were set up during market panics. By the time the RTC was set up in 1989, the S&L crisis had been raging for several years, and the 1987 stock market crash had come and gone. Similarly, the RFC was created in January 1932—over 2 years after the stock market crash of '29.

Time was of the essence back in September, and in order to respond with the necessary speed and force, more discretion had to be given to the executive branch. The RTC, for example, was run by a board of directors and a separate oversight board. In a crisis, policy-by-committee doesn't work. The market had to be confident that help was coming soon, and wouldn't be held up by internal government bickering (think Sheila Bair).

Why wasn't an RTC-like institution created once the financial markets more or less stabilized, and time was no longer of the essence? That's easy: because Congress already gave the executive branch the money. In the administration's view (which I largely share), there's no real benefit from creating a separate "technocratic" institution to administer TARP. Treasury is a highly "technocratic" institution itself, as DeLong no doubt knows, having worked in the Clinton Treasury. I have great confidence in Tim Geithner's competence—in fact, I don't think there's anyone I'd rather have in charge of TARP.


links for 2009-07-31

July 30, 2009

Economist's View - 7 new articles

What Caused Foreclosures?

Richard Green:

Michael Lacour-Little says it's all about the refinances, by Rickard Green: He points me to:

Why are so many homeowners underwater on their mortgages?

In crafting programs to prevent foreclosures, policymakers have assumed that the primary reason homeowners owe more on their home than it is worth is that they bought at the top of the market. In other words, they've lost equity primarily through forces beyond their control.

A new study challenges this premise and finds that excessive borrowing may have played as great a role.

Michael LaCour-Little, a finance professor at California State University at Fullerton, looked at 4,000 foreclosures in Southern California from 2006-08. He found that, at least in Southern California, borrowers who defaulted on their mortgages didn't purchase their homes at the top of the market. Instead, the average acquisition was made in 2002 and many homes lost to foreclosure were bought in the 1990s. More than half of all borrowers who lost their homes had already refinanced at least once, and four out of five had a second mortgage.

The original loan-to-value ratio for these borrowers stood at a reasonable 84%, but second and third liens left homeowners with a combined loan-to-value ratio of about 150% by the time of the foreclosure sale date.

Borrowers, meanwhile, took out around $2 billion in equity from their homes, or nearly eight times the $262 million that they put into their homes. Lenders lost around four times as much as borrowers, seeing $1 billion in losses.

"[W]hile house price declines were important in explaining the incidence of negative equity, its magnitude was more strongly influenced by increased debt usage," writes Mr. LaCour-Little. "Hence, borrower behavior, rather than housing market forces, is the predominant factor affecting outcomes."

If other housing markets across the country offer similar findings, then the study argues that current "policies aimed at protecting homeowners from foreclosure are misguided" because lenders, and not borrowers, have born the lion's share of economic losses.

Borrowers that bought homes without ever putting any or little equity in their homes could have seen huge returns on investment simply by extracting cash through refinancing. "Why such borrowers should enjoy any special government benefits such as waiver of the income taxation on debt forgiveness or subsidized loan modifications to reduce their borrowing costs is at best unclear," the authors write.

Michael is a co-author of mine (and was a student at Wisconsin while I taught there), and has a gift for slicing up mortgage data. On the policy question, we might think about treating the half who did not refinance differently, as they were drowned by the flood.

[I'm at a conference and posted this on my way out the door (hence the long, rambling introduction). I was running late and had to catch the shuttle bus to dinner and didn't have time to check the post after I hit the save button, and I left my iPhone in an airport so I couldn't check it en route. Of course, since I couldn't check it, that meant there'd be a problem. Sorry about the formatting - it has been fixed.]


To Page this Person, Press Five Now...

From my son Paul:

Take Back the Beep Campaign, Pogue's Posts: ...I've been ranting about one particularly blatant money-grab by U.S. cellphone carriers: the mandatory 15-second voicemail instructions.

Suppose you call my cell to leave me a message. First you hear my own voice: "Hi, it's David Pogue. Leave a message, and I'll get back to you"–and THEN you hear a 15-second canned carrier message.

  • Sprint: "[Phone number] is not available right now. Please leave a detailed message after the tone. When you have finished recording, you may hang up, or press pound for more options."
  • Verizon: "At the tone, please record your message. When you have finished recording, you may hang up, or press 1 for more options. To leave a callback number, press 5. (Beep)"
  • AT&T: "To page this person, press five now. At the tone, please record your message. When you are finished, you may hang up, or press one for more options."
  • T-Mobile: "Record your message after the tone. To send a numeric page, press five. When you are finished recording, hang up, or for delivery options, press pound."

(You hear a similar message when you call in to hear your own messages...)...

[UPDATE: iPhone owners' voicemail doesn't have these instructions--Apple insisted that AT&T remove them. And Sprint already DOES let you turn off the instructions message, although it's a buried, multi-step procedure...]

These messages are outrageous for two reasons. First, they waste your time. Good heavens: it's 2009. WE KNOW WHAT TO DO AT THE BEEP.

Do we really need to be told to hang up when we're finished!? Would anyone, ever, want to "send a numeric page?" Who still carries a pager, for heaven's sake? Or what about "leave a callback number?" We can SEE the callback number right on our phones!

Second, we're PAYING for these messages. These little 15-second waits add up–bigtime. If Verizon's 70 million customers leave or check messages twice a weekday, Verizon rakes in about $620 million a year. That's your money. And your time: three hours of your time a year, just sitting there listening to the same message over and over again every year.

In 2007, I spoke at an international cellular conference in Italy. The big buzzword was ARPU–Average Revenue Per User. The seminars all had titles like, "Maximizing ARPU In a Digital Age." And yes, several attendees (cell executives) admitted to me, point-blank, that the voicemail instructions exist primarily to make you use up airtime, thereby maximizing ARPU.

Right now, the carriers continue to enjoy their billion-dollar scam only because we're not organized enough to do anything about it. But it doesn't have to be this way. ... Let's push back... Send them a complaint, politely but firmly. Together, we'll send them a LOT of complaints. [List of addresses for complaints in full post.] If enough of us make our unhappiness known, I'll bet they'll change. ... I have a feeling that the volume of complaints will be too big for them to ignore. ...


Fed Watch: More Confirmation of Steady Monetary Policy

Tim Duy sees, among other things, the possibility of another bubble:

More Confirmation of Steady Monetary Policy, by Tim Duy: Green shoots - or, as President Obama says - the beginning of the end of the recession aside, the Fed will not be ready to reverse their accommodative policy stance anytime soon. New York Federal Reserve President William Dudley said as much in a speech today:

If the recovery does, in fact, turn out to be lackluster, the unemployment rate is likely to remain elevated and capacity utilization rates unusually low for some time to come. This suggests that inflation will be quiescent. For all these reasons, concern about "when" the Fed will exit from its current accommodative monetary policy stance is, in my view, very premature.

The Fed continues to expect that low levels of resource utilization will keep a lid on inflation. While some might object that emerging market economies can have both weak growth and high inflation, those economies still have an important transmission mechanism between higher prices and higher wages that appears to be missing in the US. Indeed, while the press focused on the old news "recession is ending" angle of the Beige Book, the money quote for policymakers was:

The weakness of labor markets has virtually eliminated upward wage pressure, and wages and compensation are steady or falling in most Districts; however, Boston cited some manufacturing and business services firms raising pay selectively, and Minneapolis said wage increases were moderate. Boston, Cleveland, Richmond, Chicago, Dallas, and San Francisco cited a range of methods firms are using to limit compensation, including cutting or freezing wages or benefit contributions, deferral of future salary increases, trimming bonuses and travel allowances, reducing hours, temporary shutdowns, periodic furloughs, and unpaid vacations.

Until economic growth is sufficient to propel wages upward, any residual price pressures are likely to be snuffed out by deteriorating real wage growth. Will the job market improve anytime soon? We get a fresh look at initial unemployment claims tomorrow morning, but the July consumer confidence report from the Conference Board indicates that households see a deteriorating jobs picture:

The share of consumers who said jobs are plentiful dropped to 3.6 percent, the lowest level since February 1983. The proportion of people who said jobs are hard to get climbed to 48.1 percent from 44.8 percent.

Lacking a story that leads to strong wage growth in the near - or even medium - term, the Fed is almost certainly on hold at least through this year and likely well into 2010, allowing the size of the balance sheet to adjust according to the needs of the financial markets while keeping interest rates at rock bottom levels. That doesn't mean all that easy money will not show up somewhere - technical analysts are looking for US equities to explode on the basis of recent market action. But will the Fed lean against such an explosion without clear and convincing evidence that the labor market is poised for strong, sustainable improvement? I doubt it - and for those looking for it, therein lies the ingredients for making the next big bubble.


Sluggish Wages and Employment

Following up briefly on part of Tim's post, once the economy turns the corner, for wages to increase two things must happen. First, there is a lot of expansion that can come from currently employed workers through expanded hours, reversing temporary shutdowns, eliminating forced furloughs, no longer allowing unpaid vacations, those sorts of things. These bring hours and other work conditions back to normal and hence do not place much if any upward pressure on wages. There is a lot of slack in hours alone that can be taken up before the existing workforce is fully utilized, and adding back hours that have been taken away does not require an increase in wages. (There are some cases where the wage rate was cut instead of hours, and even some cases where both happened, but because the proportion of firms that cut wages is relatively small, even if those wage cuts are reversed it would not have much of an effect on the overall wage rate, and it would be a one-time change in wages in any case, not continuous upward wage pressure).

Second, even if the existing workforce reaches normal (full) employment conditions, there are still a lot of workers who are unemployed, and they can be hired at the existing wage rate. It is not until the existing workforce returns to normal and the unemployed find new jobs that wages come under pressure. When the economy is at full employment, expanding the number of workers in a particular firm requires that they be bid away from other opportunities, and that pushes wages up. But when there is unemployment, there are no alternative opportunities and hence no upward pressure on wage rates.

Finally, note that when there is slack in the existing labor force due to a decline in hours worked, etc., there will be a delay between the time the economy turns around and the time when employment begins increasing. This isn't the only reason there is a delay in the response of employment, but it contributes to it.


"Some Thoughts on Wages and Competitiveness"

Another follow-up to Tim's post gleaned from a post by Karl Whelan at The Irish Economy:

Some Thoughts on Wages and Competitiveness, by Karl Whelan: There's a lively debate going on about ... competitiveness and recovery...

Despite what seems to me to be an exceptionally strong attitude in this country [Ireland] of calling on the government to solve every possible problem, we are largely a market economy and wage rates are set in a relatively decentralised fashion compared with other European countries. And despite the faith of many that unregulated labour markets should always clear to produce full employment, we have plenty of macroeconomic evidence that this is not the case.

The reality is that, in all economies, negative macroeconomic shocks tend to raise unemployment because wages never adjust quickly enough to get the labour market back to full employment. This has been a mainstream theme in macroeconomics since, at least, the General Theory.

In more recent decades, New Keynesian macroeconomic theorists have put forward a plethora of models to explain why the labour market does not operate according to the simple market-clearing fashion (efficiency wages, implicit contract theory, bargaining models based on "holdups"). More recently, behavioural economists have documented the importance of "money illusion'' which makes workers particularly resistant to cuts in nominal wages. The result is a significant amount of empirical evidence demonstrating the existence of nominal and real wage rigidity.

This is not to argue that wages are completely rigid or that the labour market does not have mechanisms to bring unemployment down after a negative shock. Macroeconomic data generally show good fits for Phillips Curve relationships such that wage growth is low when unemployment is high. But governments will generally not want to rely only on this mechanism to restore macroeconomic equilibrium because the pace of recovery will be too slow. Instead, they prefer, where possible, to use countercyclical fiscal and monetary policy. ...

I should note that the argument in the full post gives more credence to wage cuts as a recession fighting strategy that I would. Here's Paul Krugman on the topic:

[W]e may be facing the paradox of wages: workers at any one company can help save their jobs by accepting lower wages, but when employers across the economy cut wages at the same time, the result is higher unemployment.

Here's how the paradox works. Suppose that workers at the XYZ Corporation accept a pay cut. That lets XYZ management cut prices, making its products more competitive. Sales rise, and more workers can keep their jobs. So you might think that wage cuts raise employment — which they do at the level of the individual employer.

But if everyone takes a pay cut, nobody gains a competitive advantage. So there's no benefit to the economy from lower wages. Meanwhile, the fall in wages can worsen the economy's problems on other fronts.

In particular, falling wages, and hence falling incomes, worsen the problem of excessive debt: your monthly mortgage payments don't go down with your paycheck. America came into this crisis with household debt as a percentage of income at its highest level since the 1930s. Families are trying to work that debt down by saving more than they have in a decade — but as wages fall, they're chasing a moving target. And the rising burden of debt will put downward pressure on consumer spending, keeping the economy depressed.

Things get even worse if businesses and consumers expect wages to fall further in the future. John Maynard Keynes put it clearly, more than 70 years ago: "The effect of an expectation that wages are going to sag by, say, 2 percent in the coming year will be roughly equivalent to the effect of a rise of 2 percent in the amount of interest payable for the same period." And a rise in the effective interest rate is the last thing this economy needs.

Concern about falling wages isn't just theory. Japan — where private-sector wages fell an average of more than 1 percent a year from 1997 to 2003 — is an object lesson in how wage deflation can contribute to economic stagnation.


"Surprising Comparative Properties of Monetary Models"

I need to read this paper:

Surprising Comparative Properties of Monetary Models: Results from a New Data Base, by John B. Taylor and Volker Wieland, May 2009 [open link]: Abstract: In this paper we investigate the comparative properties of empirically-estimated monetary models of the U.S. economy. We make use of a new data base of models designed for such investigations. We focus on three representative models: the Christiano, Eichenbaum, Evans (2005) model, the Smets and Wouters (2007) model, and the Taylor (1993a) model. Although the three models differ in terms of structure, estimation method, sample period, and data vintage, we find surprisingly similar economic impacts of unanticipated changes in the federal funds rate. However, the optimal monetary policy responses to other sources of economic fluctuations are widely different in the different models. We show that simple optimal policy rules that respond to the growth rate of output and smooth the interest rate are not robust. In contrast, policy rules with no interest rate smoothing and no response to the growth rate, as distinct from the level, of output are more robust. Robustness can be improved further by optimizing rules with respect to the average loss across the three models.


links for 2009-07-30

July 29, 2009

Economist's View - 5 new articles

"How Wars, Plagues, and Urban Disease Propelled Europe's Rise to Riches"

[Note: Travel day today, so I am letting things that are posted do most of the talking. I'll add what I can along the way. Update: Off to a great start - left my iPhone at the last airport ... grrr. Update: Sitting in Detroit airport, hungry, and just dropped my sandwich on the floor. I really want to eat it anyway, but won't. ... grrr. Update: I made it to Ithaca, someone found my phone and turned it in to lost and found, and I got another sandwich. Plus, amazingly, the shuttle to the hotel was waiting when I walked out to get a taxi. Yeah! Now the only problem is that I usually go to sleep pretty late - 3 a.m. is not unusual - and that's about when I have to get up given the time change. Hmmm. That won't help my talk. ... back to grrr.]

"This column explains why Europe's rise to riches in the early modern period owed much to exceptionally bellicose international politics, urban overcrowding, and frequent epidemics."

Cruel windfall: How wars, plagues, and urban disease propelled Europe's rise to riches, by Nico Voigtländer and Hans-Joachim Voth, Vox EU: In a pre-modern economy, incomes typically stagnate in the long run. Malthusian regimes are characterised by strongly declining marginal returns to labour. One-off improvements in technology can temporarily raise output per head. The additional income is spent on more (surviving) children, and population grows. As a result, output per head declines, and eventually labour productivity returns to its previous level. That is why, in HG Wells' phrase, earlier generations "spent the great gifts of science as rapidly as it got them in a mere insensate multiplication of the common life" (Wells, 1905).

How could an economy ever escape from this trap? To learn more about this question, we should look more closely at the continent that managed to overcome stagnation first. Long before growth accelerated for good in most countries, a first divergence occurred. European incomes by 1700 exceeded those in the rest of the world by a large margin. We explain the emergence of this income gap by a number of uniquely European features – an unusually high frequency of war, particularly unhealthy cities, and numerous deadly disease outbreaks.

The puzzle: The first divergence in worldwide incomes

European incomes by 1700 were markedly higher than they had been in 1500. According to the figures compiled by Angus Maddison (2001), all European countries including Mediterranean ones saw income growth of 35% to 180%. Within Europe, the northwest did markedly better than the rest. English and Dutch real wages surged during the early modern period.

How exceptional was this performance? Pomeranz (2000) claimed that the Yangtze Delta in China was just as productive as England. Detailed work on output statistics suggests that his claims must be rejected. While real wages in terms of grain were some 15-170% higher in England, English silver wages exceeded those of China by 120% to 550%. Since grain was effectively an untraded good internationally before 1800, the proper standard of comparison is the silver wage. Estimates for India suggest a similar gap vis-à-vis Europe (Broadberry and Dasgupta, 2006).

Urbanisation figures support this conclusion. They serve as a good proxy since people in towns need to be fed by farmers in the countryside. This requires a surplus of food production, which implies high labour productivity. Since agriculture is the largest single sector in all pre-modern economies, a productive agricultural sector is equivalent to high per capita output overall. Figure 1 compares European and Chinese urbanisation rates after the year 1000 AD. Independent of the series used, European rates increase rapidly during the early modern period. Our preferred measure – the DeVries series – increases from 5% to nearly 10% between 1500 and 1800. The contrast with China is striking. There, urbanisation stagnated near the 3% mark.

Figure 1. Europe versus China urbanisation rates, 1000-1800

Voxx1

In a Malthusian world, a divergence in living standards should be puzzling. Income gains from one-off inventions should have been temporary. Even ongoing productivity gains cannot account for the "first divergence" – TFP growth probably did not exceed 0.2%, and cannot explain the marked rise in output per capita.

The answer: Rising death rates and lower fertility

In a Malthusian world, incomes can increase if birth rates fall or death rates increase (Clark, 2007). Figure 2 illustrates the basic logic. Incomes are pinned down by the intersection of birth and death schedules (denoted b and d). The initial equilibrium is E0. If death rates shift out, to d', incomes rise to the new equilibrium Ed1. Similarly, lower birth rates at any given level of income will lead to higher per capita incomes. In combination, shifts of the birth and death schedules to b' and d' will move the economy to equilibrium point E2.

Figure 2. Birth and death rates, and equilibrium per capita income

Voxx2

We argue that there were three factors – which we call the "Three Horsemen of Riches" – that shifted Europe's death schedule outwards: wars, epidemics, and urban disease. Wars were unusually frequent. Epidemics were common, with devastating consequences. Finally, cities were particularly unhealthy, with death rates there exceeding birth rates by a large margin – without in-migration, European cities before 1850 would have disappeared.

Figure 3 shows the percentage of the European population affected by wars (defined as those living in areas where wars were fought). It rises from a little over 10% to 60% by the late seventeenth century. Tilly (1992) estimated that, on average, there was a war being fought somewhere in nine out of every ten years in Europe in the early modern period.

Political fragmentation combined with religious strife after 1500 to form a potent mix that produced almost constant military conflict. While the fighting itself only killed few people, armies marching across Europe spread diseases. It has been estimated that a single army of 6,000 men, dispatched from La Rochelle to fight in the Mantuan war, killed up to a million people by spreading the plague (Landers, 2003).

Figure 3. Share of European population in war zones

Voxx3

European cities were much unhealthier than their Far Eastern counterparts. They probably had death rates that exceeded rural ones by 50%. In China, the rates were broadly the same in urban and rural areas. The reason has to do with differences in diets, urban densities, and sanitation:

  • Europeans ate more meat, and hence kept more animals in close proximity,
  • European cities were protected by walls due to frequent wars, which could not be moved without major expense, and
  • Europeans dumped their chamber pots out of their windows, while human refuse was collected in Chinese cities and used as fertiliser in the countryside.

Epidemics were also frequent. The plague did not disappear from Europe after 1348. Indeed, plague outbreaks continued until the 1720s, peaking at over 700 per decade in the early 17th century. In addition to wars, epidemics were spread by trade. The last outbreak of the plague in Western Europe occurred in Marseille in 1720; a merchant vessel from the Levant spread the disease, causing 100,000 men and women to perish. Since Europe has much greater variety in terms of geography and climate than China, disease pools remained largely separate. When they became increasingly connected as a result of more trade and wars, mortality spiked.

Triggering European "exceptionalism"

In combination, the "Three Horsemen" – war, urbanisation, and trade-driven disease – probably raised death rates by one percentage point by 1700. Once death rates were higher, incomes could remain at an elevated level even in a Malthusian world. The crucial question then becomes why Europe developed such a particular set of factors driving up mortality.

We argue that the Great Plague of 1348-50 was the key. Between one third and one half of Europeans died. With land-labour ratios now higher, per capita output and wages surged. Since population losses were massive, they could not be compensated quickly. For a few generations, the old continent experienced a "golden age of labour". British real wages only recovered their 1450s peak in the age of Queen Victoria (Phelps-Brown and Hopkins, 1981).

Temporarily higher wages changed the nature of demand. Despite having more children, people had more income than necessary for mere subsistence – population losses were too large to be absorbed entirely by the demographic response. Some of the surplus income was spent on manufactured goods. These goods were mainly produced in cities. Thus, urban centres grew in size. Higher incomes also generated more trade. Finally, the increasing number and wealth of cities expanded the size of the monetised sector of the economy. The wealth of cities could be taxed or seized by rulers. Resources available for fighting wars increased – war was effectively a superior good for early modern princes. Therefore, as per capita incomes increased, death rates rose in parallel. This generates a potential for multiple equilibria. Figure 4 illustrates the mechanism. The death rate increases over some part of the income range, which maps into urbanisation rates. Starting at E0, a sufficiently large shock will move the economy to point EH, where population is again stable.

Figure 4. Equilibria with "Horsemen effect"

Voxx4

In the discussion paper, we calibrate our model. The effect of higher mortality on living standards is large. We find that we can account for more than half of Europe's precocious rise in per capita incomes until 1700.

Conclusions

To raise incomes in a Malthusian setting, death rates have to rise or fertility rates have to decline. We argue that a number of uniquely European characteristics – the fragmented nature of politics, unhealthy cities, and a geographically heterogeneous terrain – interacted with the shock of the 1348 plague to create exceptionally high mortality rates. These underpinned a high level of per capita income, but the riches were bought at a high cost in terms of human lives.

At the same time, there are good reasons to think that it is not entirely accidental that the countries (and regions) that were ahead in per capita income terms in 1700 were also the first to industrialise. How the world could escape the Malthusian trap at all has become a matter of intense interest to economists in recent years (Galor and Weil, 2000, Jones, 2001, Hansen and Prescott, 2002). In a related paper, we calibrate a simple growth model to show why high per capita income at an early stage may have been key for Europe's rise after 1800 (Voigtländer and Voth, 2006).

In the "Three Horsemen of Riches", we ask how Europe got to be rich in the first place. Our answer is best summarised by the smuggler Harry Lime, played by Orson Welles in the 1948 classic "The Third Man":

"In Italy, for thirty years under the Borgias, they had warfare, terror, murder, bloodshed, but they produced Michelangelo, Leonardo da Vinci and the Renaissance. In Switzerland, they had brotherly love; they had 500 years of democracy and peace – and what did that produce? The cuckoo clock."

We argue that a similar logic held in economic terms before the Industrial Revolution. Europe's exceptional rise to early riches owed much to forces of destruction – war, aided by frequent disease outbreaks and deadly cities.

References

Bairoch, P., J. Batou, and P. Chèvre (1988). La Population des villes Europeennes de 800 à 1850: Banque de Données et Analyse Sommaire des Résultats. Geneva: Centre d'histoire economique Internationale de l'Université de Genève, Libraire Droz.

Broadberry, S. and B. Gupta (2006). "The Early Modern Great Divergence: Wages, Prices and Economic Development in Europe and Asia, 1500-1800". Economic History Review 59, 2–31.

Chow, G. C. and A. Lin (1971). "Best Linear Unbiased Interpolation, Distribution, and Extrapolation of Time Series by Related Series". Review of Economics and Statistics 53(4), 372–375.

Clark, G. (2007). A Farewell to Alms: A Brief Economic History of the World. Princeton: Princeton University Press.

de Vries, J. (1984). European Urbanization 1500-1800. London: Methuen.

Galor, O. and D. N. Weil (2000). "Population, Technology and Growth: From the Malthusian Regime to the Demographic Transition and Beyond". American Economic Review 90(4), 806–828.

Hansen, G. and E. Prescott (2002). "Malthus to Solow". American Economic Review 92(4), 1205–1217.

Jones, C. I. (2001). "Was an Industrial Revolution Inevitable? Economic Growth Over the Very Long Run". Advances in Macroeconomics 1(2). Article 1.

Landers, J. (2003). The Field and the Forge: Population, Production, and Power in the Pre-Industrial West. New York: Oxford University Press.

Maddison, A. (2001). The World Economy. A Millennial Perspective. Paris: OECD.

McEvedy, C. and R. Jones (1978). Atlas of World Population History, Facts on File. New York.

Pomeranz, K. (2000). The Great Divergence: China, Europe, and the Making of the Modern World Economy. Princeton, N.J.: Princeton University Press.

Phelps-Brown, H. and S. V. Hopkins (1981). A Perspective of Wages and Prices. London. New York, Methuen.

Tilly, C. (1992). Coercion, Capital, and European States, AD 990-1992. Oxford: Blackwells.

Voigtländer, N. and H.-J. Voth (2008). "The Three Horsemen of Growth: Plague, War and Urbanization in Early Modern Europe". CEPR discussion paper 7275.

Voigtländer, N. and H.-J. Voth (2006). "Why England? Demographic Factors, Structural Change and Physical Capital Accumulation during the Industrial Revolution". Journal of Economic Growth 11, 319–361.

Wells, H. G. (1905). A Modern Utopia.


"Why had Nobody Noticed that the Credit Crunch Was on its Way?"

A letter to the Queen attempting to explain why economists missed the financial crisis:

Her Majesty The Queen Buckingham Palace London SW1A 1AA

MADAM,

When Your Majesty visited the London School of Economics last November, you quite rightly asked: why had nobody noticed that the credit crunch was on its way? The British Academy convened a forum on 17 June 2009 to debate your question... This letter summarises the views of the participants ... and we hope that it offers an answer to your question.

Many people did foresee the crisis. However, the exact form that it would take and the timing of its onset and ferocity were foreseen by nobody. ...

There were many warnings about imbalances in financial markets... But the difficulty was seeing the risk to the system as a whole rather than to any specific financial instrument or loan. Risk calculations were most often confined to slices of financial activity, using some of the best mathematical minds in our country and abroad. But they frequently lost sight of the bigger picture.

Many were also concerned about imbalances in the global economy ... known as the 'global savings glut'. ... This ... fuelled the increase in house prices both here and in the USA. There were many who warned of the dangers of this.

But against those who warned, most were convinced that ... the financial wizards had found new and clever ways of managing risks. Indeed, some claimed to have so dispersed them through an array of novel financial instruments that they had virtually removed them. It is difficult to recall a greater example of wishful thinking combined with hubris. There was a firm belief, too, that financial markets had changed. ... A generation of bankers and financiers deceived themselves and those who thought that they were the pace-making engineers of advanced economies.

All this exposed the difficulties of slowing the progression of such developments in the presence of a general 'feel-good' factor. Households benefited from low unemployment, cheap consumer goods and ready credit. Businesses benefited from lower borrowing costs. Bankers were earning bumper bonuses... The government benefited from high tax revenues... This was bound to create a psychology of denial. It was a cycle fuelled, in significant measure, ... by delusion.

Among the authorities charged with managing these risks, there were difficulties too. ... General pressure was for more lax regulation – a light touch. ...

There was a broad consensus that it was better to deal with the aftermath of bubbles ... than to try to head them off in advance. Credence was given to this view by the experience, especially in the USA ... when a recession was more or less avoided after the 'dot com' bubble burst. This fuelled the view that we could bail out the economy after the event.

Inflation remained low and created no warning sign of an economy that was overheating. ... But this meant that interest rates were low by historical standards. And some said that policy was therefore not sufficiently geared towards heading off ... risks. ... But on the whole, the prevailing view was that monetary policy was best used to prevent inflation and not to control wider imbalances in the economy.

So where was the problem? Everyone seemed to be doing their own job properly... And according to standard measures of success, they were often doing it well. The failure was to see how collectively this added up to a series of interconnected imbalances over which no single authority had jurisdiction. This, combined with the psychology of herding and the mantra of financial and policy gurus, lead to a dangerous recipe. Individual risks may rightly have been viewed as small, but the risk to the system as a whole was vast.

So in summary, Your Majesty, the failure..., while it had many causes, was principally a failure of the collective imagination of many bright people, both in this country and internationally, to understand the risks to the system as a whole. ...

We have the honour to remain, Madam, Your Majesty's most humble and obedient servants

Professor Tim Besley, FBA Professor Peter Hennessy, FBA

[See also At your own risk and Economists were beholden to the long boom.]


Exchequer Tallies

The "first experiment with derivative financial instruments":

Theory of Games and Economic Misbehavior, by George Dyson, Edge: ...There are numerous precedents for [the derivatives now haunting us].

As early as the twelfth century it was realized that money ... can be made to exist in more than one place at a single time. An early embodiment of this principle, preceding the Bank of England by more than five hundred years, were Exchequer tallies — notched wooden sticks issued as receipts for money deposited with the Exchequer for the use of the king. "As a financial instrument and evidence it was at once adaptable, light in weight and small in size, easy to understand and practically incapable of fraud," wrote Hilary Jenkinson in 1911. ...

A precise description was given by Alfred Smee... "The tally-sticks were made of hazel, willow, or alder wood, differing in length according to the sum required to be expressed upon them. They were roughly squared, and one end was pointed; and on two sides of that extremity, the proper notches, showing the sum for which the tally was a receipt, were cut across the wood." 11

On the other two sides of the tally were written, in ink and in duplicate, the name of the party paying the money, the account for which it was paid, and the date of payment. The tally was then split in two, with each half retaining the notched information as well as one copy of the inscription. "One piece was then given to the party who had paid the money, for which it was a sufficient discharge," Smee continues, "and the other was preserved in the Exchequer. Rude and simple as was this very ancient method of keeping accounts, it appears to have been completely effectual in preventing both fraud and forgery for a space of seven hundred years. No two sticks could be found so exactly similar ... when split in the coarse manner of cutting tallies; and certainly no alteration of the ... notches and inscription could remain undiscovered when the two parts were again brought together. ..." 12

Exchequer tallies were ordered replaced in 1782 by an "indented cheque receipt," but the Act of Parliament (23 Geo. 3, c. 82) thereby abolishing "several useless, expensive and unnecessary offices" was to take effect only on the death of the incumbent who, being "vigorous," continued to cut tallies until 1826. "After the further statute of 4 and 5 William IV the destruction of the official collection of old tallies was ordered," noted Hilary Jenkinson. "The imprudent zeal with which this order was carried out caused the fire which destroyed the Houses of Parliament in 1834." 13

The notches were of various sizes and shapes corresponding to the tallied amount: a 1.5-inch notch for £1000, a 1-inch notch for £100, a half-inch notch for £20, with smaller notches indicating pounds, shillings, and pence, down to a halfpenny, indicated by a pierced dot. The code was similar to bar-coding... And the self-authentication achieved by distributing the information across two halves of a unique piece of wood is analogous to the way large numbers, split into two prime factors, are used to authenticate digital financial instruments today. Money was being duplicated: the King gathered real gold and silver into the treasury through the Exchequer, yet the tally given in return allowed the holder to enter into trade, manufacturing, or other ventures, producing real wealth with nothing more than a wooden stick.

Until the Restoration tallies did not bear interest, but in 1660, on the accession of Charles II, interest-bearing tallies were introduced. They were accompanied by written orders of loan which, being made assignable by endorsement, became the first negotiable interest-bearing securities in the English-speaking world. Under pressure of spiraling government expenditures the order of loan was soon joined by an instrument called an order of the Exchequer, drawn not against actual holdings but against future revenue and sold at a discount to the private goldsmith bankers whose hard currency was needed to prop things up. In January 1672, unable to meet its obligations, Charles II declared a stop on the Exchequer. At the expense of the private bankers, this first experiment with derivative financial instruments came to an end. ...


Wealth Inequality

Daniel Little on wealth inequality:

Wealth inequality, by Daniel Little: When we talk about inequality in the United States, we usually have a couple of different things in mind. We think immediately of income inequality. Inequalities of important life outcomes come to mind (health, housing, education), and, of course, we think of the inequalities of opportunity that are created by a group's social location (race, urban poverty, gender). But a fundamental form of inequality in our society is a factor that influences each of these: inequalities of wealth across social groups. Wealth refers to the ownership of property, tangible and intangible: for example, real estate, stocks and bonds, savings accounts, businesses, factories, mines, forests, and natural resources. Two facts are particularly important when it comes to wealth: first, that wealth is in general very unevenly distributed in the United States, and second, that there are very striking inequalities when we look at the average wealth of major social groups.

Edward Wolff has written quite a bit about the facts and causes of wealth inequality in the United States. A recent book, Top Heavy: The Increasing Inequality of Wealth in America and What Can Be Done About It, Second Edition, is particularly timely; also of interest is Assets for the Poor: The Benefits of Spreading Asset Ownership. Wolff summarizes his conclusion in these stark terms:

The gap between haves and have-nots is greater now--at the start of the twenty-first century--than at anytime since 1929. The sharp increase in inequality since the late 1970s has made wealth distribution in the United States more unequal than it is in what used to be perceived as the class-ridden societies of northwestern Europe. ... The number of households worth $1,000,000 or more grew by almost 60 percent; the number worth $10,000,000 or more almost quadrupled. (2-3)

The international comparison of wealth inequality is particularly interesting. Wolff provides a chart of the share of marketable wealth held by the top percentile in the UK, Sweden, and the US, from 1920 to 1992. The graph is striking. Sweden starts off in 1920 with 40% of wealth in the hands of the top one percent, and falls fairly steadily to just under 20% in 1992. UK starts at a staggering 60% (!) in the hands of the top 1 percent in 1920, and again, falls steadily to a 1992 level of just over 20%. The US shows a different pattern. It starts at 35% in 1920 (lowest of all three countries); then rises and falls slowly around the 30% level. The US then begins a downward trend in the mid-1960s, falling to a low of 20% in the 1970s; and then, during the Reagan years and following, the percent of wealth rises to roughly 35%. So we are roughly back to where we were in 1920 when it comes to wealth inequalities in the United States, by this measure.

Why does this kind of inequality matter?

Partly because significant inequalities of wealth have important implications for such things as the relative political power of various groups; the opportunities that groups have within and across generations; and the relative security that various individuals and groups have when faced with economic adversity. People who own little or nothing have little to fall back on when they lose a job, face a serious illness, or move into retirement. People who have a lot of wealth, by contrast, are able to exercise a disproportionate amount of political influence; they are able to ensure that their children are well educated and well prepared for careers; and they have substantial buffers when times are hard.

Wolff offers a good summary of the empirical data about wealth inequalities in the United States. But we'd also like to know something about the mechanisms through which this concentration of wealth occurs. Several mechanisms come readily to mind. People who have wealth have an advantage in gathering the information necessary to increase their wealth; they have networks of other wealth holders who can improve their access to opportunities for wealth acquisition; they have advantages in gaining advanced professional and graduate training that increase their likelihood of assuming high positions in wealth-creating enterprises; and they can afford to include high-risk, high-gain strategies in their investment portfolios. So there is a fairly obvious sense in which wealth begets wealth.

But part of this system of inequality of wealth ownership in the United States has to do with something else: the workings of race. The National Urban League publishes an annual report on "The State of Black America." One of the measures that it tracks is the "wealth gap" -- the differential in home ownership between black and white adults. This gap continues to persist, and many leaders in the effort towards achieving equality of opportunity across racial groups point to this structural inequality as a key factor. Here is a very good study on home ownership trends for black and white adults done by George Masnick at the Joint Center for Housing Studies at Harvard (2001). The gap in the 1990s fluctuated around 28% -- so, for example, in 1988-1998 about 52% of blacks between 45 and 54 were home owners, whereas about 80% of non-Hispanic whites in this age group were homeowners (figure 5). Historical practices of mortgage discrimination against specific neighborhoods influence home ownership rates, as do other business practices associated with the workings of residential segregation. Some of these mechanisms are illustrated in Kevin Kruse and Thomas Sugrue's The New Suburban History, and Kevin Boyle's Arc of Justice: A Saga of Race, Civil Rights, and Murder in the Jazz Age provides an absorbing account of how challenging "home ownership" was for professional black families in Detroit in the 1920s.

So what are the remedies for the very high level of wealth inequality that is found in the United States? Wolff focuses on tax remedies, and certainly these need to be a part of the story. But remedying the social obstacles that exist for disadvantaged families to gain property -- most fundamentally, disadvantages that derive from the educational opportunities that are offered to children and young people in inner-city neighborhoods -- is crucial as well. It seems axiomatic that the greatest enhancement that can be offered to a young person is a good education; and this is true in the question of wealth acquisition no less than the acquisition of other socially desirable things.


links for 2009-07-29