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May 21, 2010

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Paul Krugman: Lost Decade Looming?

Posted: 21 May 2010 02:34 AM PDT

Remember when people who don't like the New Keynesian model, would claim there is no Phillips curve, i.e. that inflation does not depend upon the output gap (e.g., here, or here)? They're looking pretty foolish:

Lost Decade Looming?, by Paul Krugman, Commentary, NY Times: Despite a chorus of voices claiming otherwise, we aren't Greece. We are, however, looking more and more like Japan.

For the past few months, much commentary on the economy — some of it posing as reporting — has had one central theme: policy makers are doing too much. Governments need to stop spending, we're told. Greece is held up as a cautionary tale, and every uptick in the interest rate on U.S. government bonds is treated as an indication that markets are turning on America over its deficits. Meanwhile, there are continual warnings that inflation is just around the corner, and that the Fed needs to pull back from its efforts to support the economy and get started on its "exit strategy," tightening credit by selling off assets and raising interest rates.

And what about near-record unemployment, with long-term unemployment worse than at any time since the 1930s? .... [T]he truth is that policy makers aren't doing too much; they're doing too little. Recent data don't suggest that America is heading for a Greece-style collapse of investor confidence. Instead, they suggest that we may be heading for a Japan-style lost decade,... a prolonged era of high unemployment and slow growth.

Let's talk first about those interest rates. On several occasions over the past year, we've been told, after some modest rise in rates, that ... America had better slash its deficit right away or else. Each time, rates soon slid back down. ... I wish I could say that falling interest rates reflect a surge of optimism about U.S. federal finances. What they actually reflect, however, is a surge of pessimism about the prospects for economic recovery, pessimism that has sent investors fleeing ... into the perceived safety of U.S. government debt.

What's behind this new pessimism? It partly reflects the troubles in Europe... But there are also warning signs at home, most recently Wednesday's report on consumer prices, which showed a key measure of inflation falling below 1 percent, bringing it to a 44-year low.

This isn't really surprising: you expect inflation to fall in the face of mass unemployment and excess capacity. But it is nonetheless really bad news. Low inflation, or worse yet deflation,... encourages people to hoard cash rather than spend, which keeps the economy depressed, which leads to more deflation. That vicious circle isn't hypothetical: just ask the Japanese, who entered a deflationary trap in the 1990s and, despite occasional episodes of growth, still can't get out. And it could happen here.

So ... we should really be asking ... what we're doing to avoid turning Japanese. And the answer is, nothing.

It's not that nobody understands the risk. I strongly suspect that some officials at the Fed see the Japan parallels all too clearly and wish they could do more... But in practice it's all they can do to contain the tightening impulses of their colleagues, who (like central bankers in the 1930s) remain desperately afraid of inflation... I also suspect that Obama administration economists would very much like to see another stimulus plan. But they know that such a plan would have no chance of getting through a Congress that has been spooked by the deficit hawks.

In short, fear of imaginary threats has prevented any effective response to the real danger facing our economy.

Will the worst happen? Not necessarily. Maybe the economic measures already taken will end up doing the trick, jump-starting a self-sustaining recovery. Certainly, that's what we're all hoping. But hope is not a plan.

"More on the European Impact"

Posted: 21 May 2010 01:17 AM PDT

More reactions from Tim, this time in response to various comments on his recent post claiming that the European debt crisis might help the US:

More on the European Impact, by Tim Duy: Some clarification and expansion of my recent off-consensus analysis of the implications of the European debt crisis is in order. In short, I noted that lower energy costs and interest rates were generally positive for the US. Responses came from Scott Sumner, Felix Salmon, Ryan Avent, and Paul Krugman.

The context in which I considered my remarks are well described by Michael Pettis, in his rebuttal to claims that China should avoid currency revaluation in light of the Euro's decline. He argues that the Euro's decline makes the a shift in Chinese currency policy all the more critical. In his summary:

5. If Europe's current account surplus grows, there must be one or both of two automatic consequences. Either the current account surplus of surplus countries like China and Japan must contract by the same amount, or the current account deficits of deficit countries like the US must grow by that amount, or some combination of the two.

6. If the Chinas and Japans of the world lower interest rates, slow credit contraction, and otherwise try to maintain their exports – let alone try to grow them – most of the adjustment burden will be shifted onto countries that do not intervene in trade directly. The most obvious are current account deficit countries like the US.

A collapsing trade surplus in Europe needs to be met with an expanding trade surplus somewhere else, and my view is that the US is the most likely candidate, especially as the trend is already in place - the external sector is a drag on growth, despite all expectations that a sustained rebalancing will occur in the wake of the US financial crisis.

I think that the decline in oil prices and interest rates is one mechanism by which markets essentially offset some the contractionary consequences of the European debt crisis. Like the declining Euro, they are price signals that correspond to propping up demand elsewhere, such as the US, thereby allowing the US to absorb the European contraction via an expansion in the US current account deficit. Thus, the surprising effect of the crisis is that US demand growth is higher than would otherwise be the case, even as global growth in aggregate suffers.

Pettis argues, I think correctly, that this sets the stage for a rather nasty increase in trade tensions:

I don't really see how the numbers are going to work. Europe, China and Japan are all implicitly demanding that the US trade deficit rise to help them through their domestic employment problems. The US has its own domestic employment problems and is determined to bring the trade deficit down. Both sides cannot win and there doesn't seem to be much serious attempt at global coordination. In fact the easiest part of any global coordination – that between surplus Europe and deficit Europe – has already degenerated into a nasty round of accusations, counter-accusations and insults.

Note that Pettis is hinting at one of Ryan Advent's criticisms regarding domestic employment problems:

For another, it seems unreasonable to expect personal consumption to power recovery all the way back to full employment, no matter what interest rates or oil prices do. Household balance sheets are simply too stressed. Consumption can act as a bridge from government-driven growth to export- and investment-driven growth, but little more, and export- and investment-driven growth is looking dicier now than it was a month ago.

I agree - it seems ludicrous to expect the US consumer to continue to power forward sufficiently to hold the US economy and the global economy together. Yet, I suspect that it is the course of least resistance, or at least appears to be at the moment. For what it's worth, consumer spending growth has been on something of a tear - a trend that stretches back to the middle of last year. One can argue that this spending is simply propped up by the expansion of government debt rather than private debt, but note that that dynamic becomes more sustainable given lower interest rates. It is almost as if market participants are encouraging the US government to take over where the Greeks, Spanish, etc. let off. Indeed, it seems to be clear evidence that public debt is nowhere near crowding out private spending in the US. Room for more, not less.

Is this economically healthy? No, no, no. Felix points out that an expansion of the US imbalance now only implies higher interest rates later. The adjustment will come, and will only be more difficult in the future. That is a story I have told many times, but I have to add this - going bearish on US debt has been risky. Like Japan, economists keep saying the end is near, but it has not yet happened. Timing is everything.

Sumner argues that declining commodity prices in response to demand shock are rarely a good thing, and the recent episode is another reason to believe that central bankers are failing to support nominal GDP growth. With respect to my earlier argument, I see no reason why a decline in energy prices due to a demand drop in Europe cannot be a net positive for the US. But, nonetheless, I agree with Sumner's broader point regarding the need for more aggressive monetary policy:

It's true that US exports to Europe are modest, but if the strong dollar is symptomatic of unintentional tightening of monetary policy, despite low rates, then it may not be good news at all.

He reiterates the point here. The European Central Bank, in particular, should be working more aggressively to counter deflationary pressures internally. But, alas, policymakers don't want to be seen as bailing out weaker members for fear of losing credibility. One of the cut of your nose to spite your face situations. Likewise, with the US facing ongoing disinflationary pressures, the Fed arguably should be expanding policy more aggressively. In theory, the two expansions could leave the relative currency prices unchanged, yet sink both against other trading partners.

This, of course, brings us back to the apparently intractable Chinese currency issue. A Dollar and Euro depreciation against the renminbi and other emerging market currencies looks like a nobrainer approach to preventing an intensification of global imbalances. Moreover, it just makes economic sense given relative inflation trends. Consider today's Wall Street Journal:

U.S. inflation slid last month to its lowest level in 44 years, highlighting a potentially troublesome unevenness in the global recovery.

Inflation has sped up in booming economies such as China and Brazil, while in many developed nations like the U.S., prices remain tame, even flirting with deflation in some cases.

The U.S. government reported Wednesday that consumer prices, excluding volatile food and energy, rose a meager 0.9% in April from a year earlier. It is the latest sign that high unemployment and excess production capacity are holding down wages and prices in much of the developed world.

At the same time, emerging economies are taking steps to contain high inflation in their booming markets—moves that some economists worry could dampen demand for exports, which many developed countries are depending on to help fuel their recoveries.

Note that US Treasury Secretary Timothy Geithner said again this week that Chinese currency policy is set for a change:

The Treasury chief also yesterday reiterated his call that China will abandon its exchange-rate peg. The government is moving toward changes in currency policy that would allow market forces to play a greater role, he told reporters after the speech.

Of course, Geithner says things like this a lot. And one gets the expected pushback from China:

Yuan forwards weakened for a second day after Chinese officials said the nation won't yield to global calls to end a 22-month peg, damping speculation next week's U.S.-China trade talks would trigger appreciation.

China won't succumb to external pressure and will modify the currency based on the economic situation, Assistant Finance Minister Zhu Guangyao said in Beijing today. Stability between the world's major reserve currencies will aid the global economic recovery, he said at a briefing to discuss the May 24- 25 Strategic & Economic Dialogue in Beijing…

"Only the authorities of a sovereign country have the right to decide how to form the exchange rate," Zhu said. Countries should "work to maintain the stability of exchange rates between currencies so as to create a favorable environment for the global economic recovery," he said.

Note that Chinese policymakers hold all the cards regarding any policy shifts. They know that Geithner is not going to push for capital controls, nor will he request the Fed to beginning stockpiling renminbi on Treasury's behalf. The latter policy - a tit for tat response to Chinese dollar accumulation - would be interesting to say the least, but no US policymaker wants to be accused of initiating a chain of competitive devaluations that will only end badly.

Sorry if this is rambled; external adjustment stories on a global scale tend to get messy. Which I imagine is why we have yet find a sustainable path to resolving imbalances.

Fed Watch: Fed Disconnect

Posted: 21 May 2010 01:08 AM PDT

Tim Duy reacts to Federal Reserve Governor Daniel Tarullo's recent testimony on the European debt crisis:

Fed Disconnect, by Tim Duy: Federal Reserve Governor Daniel Tarullo's recent testimony on the European debt crisis illustrates a significant inconsistency with between the Fed's outlook and its policy.  Honestly, if Tarullo actually believes with he says, the Fed needs to be pursuing a much more aggressive policy.  But the FOMC is actually debating the opposite - when and how to reverse its swelling balance sheet.

Tarullo highlights the two obvious negative channels by which the European crisis will feed into the US economy.  The first is financial:

These effects on U.S. markets underscore the high degree of integration of the U.S. and European economies and highlight the risks to the United States of renewed financial stresses in Europe. One avenue through which financial turmoil in Europe might affect the U.S. economy is by weakening the asset quality and capital positions of U.S. financial institutions...

...In addition to imposing direct losses on U.S. institutions, a heightening of financial stresses in Europe could be transmitted to financial markets globally. Increases in uncertainty and risk aversion could lead to higher funding costs and liquidity shortages for some institutions, and forced asset sales and reductions in collateral values that could, in turn, engender further market turmoil. In these conditions, U.S. banks and other institutions might be forced to pull back on their lending, as they did during the period of severe financial market dysfunction that followed the bankruptcy of Lehman Brothers.

 The second is via trade linkages:

Another means by which an intensification of financial turmoil in Europe could affect U.S. growth is by reducing trade. Collectively, Europe represents one of our most important trading partners and accounts for about one-quarter of U.S. merchandise exports. Accordingly, a moderate economic slowdown across Europe would cause U.S. export growth to fall, weighing on U.S. economic performance by a discernible, but modest extent. However, a deeper contraction in Europe associated with sharp financial dislocations would have the potential to stall the recovery of the entire global economy, and this scenario would have far more serious consequences for U.S. trade and economic growth. A resultant slowdown in the United States and abroad would likely also feed back into the health of U.S. financial institutions.

Tarullo acknowledges that the European crisis is largely a European problem, while the Fed is reduced to a limited supporting role.  What caught my attention was first this section regarding the potential for financial disruption:

The timing of such an event in the current instance would be unfortunate, as banks generally have only recently ceased tightening lending standards, and have yet to unwind from the considerable tightening that has occurred over the past two years. Moreover, aggregate bank lending, particularly to businesses, continues to contract. The result would be another source of risk to the U.S. recovery in an environment of still-fragile balance sheets and considerable slack. Although we view such a development as unlikely, the swoon in global financial markets earlier this month suggests that it is not out of the question.

The fact that aggregate bank lending continues to contract, that the Fed is obviously aware of this, and that, according to Tarullo, the European crisis has the potential to aggravate an already existing problem all clearly point toward a more aggressive quantitative easing program than in place.  Actually, what is happening is the Fed is considering a quantitative tightening program:

Meeting participants agreed broadly on key objectives of a longer-run strategy for asset sales and redemptions. The strategy should be consistent with the achievement of the Committee's objectives of maximum employment and price stability. In addition, the strategy should normalize the size and composition of the balance sheet over time. Reducing the size of the balance sheet would decrease the associated reserve balances to amounts consistent with more normal operations of money markets and monetary policy. Returning the portfolio to its historical composition of essentially all Treasury securities would minimize the extent to which the Federal Reserve portfolio might be affecting the allocation of credit among private borrowers and sectors of the economy.

Tarullo also presses for a hawkish fiscal stance:

The United States is in a very different position from that of the European countries whose debt instruments have been under such pressure. But their experience is another reminder, if one were needed, that every country with sustained budget deficits and rising debt--including the United States--needs to act in a timely manner to put in place a credible program for sustainable fiscal policies.

Interestingly, Tarullo seems to suggest that the US response to fiscal problem in Europe should be to tighten US fiscal policy on roughly the same timetable the Fed is looking forward to tightening US monetary policy.

To summarize, the Fed believes we are facing another threat to demand, either via financial or real trade linkages, at a time when lending activity continues to fall, suggesting that monetary policy is too tight to begin with.  But the Fed stance is to believe that monetary policy is on the verge of being too loose, and, if anything, planning needs to be made to tighten policy.  At the same time, Fed policymakers also believe fiscal policy needs to turn toward tightening as well. Meanwhile, unemployment hovers just below 10%, nor is it expected to decline rapidly,  and inflation continues to trend downward.

All of which together suggests that the Fed's policy stance is seriously out of whack with policymaker's interpretation of actual and potential economic developments.  And I have trouble explaining the disconnect.

"The Orthodox Loss of Faith"

Posted: 21 May 2010 12:42 AM PDT

Nick Rowe on the "silent shift in macroeconomic thought":

The orthodox loss of faith, by Nick Rowe: I think we are witnessing the biggest silent shift in macroeconomic thought since the Second World War. For 70 years we have taught, and believed, that we would never again need to suffer a persistent shortage of demand. We promised ourselves the 1930's were behind us. We knew how to increase demand, and would do it if we needed to.
The orthodox have lost faith in that promise; only the heterodox still believe it. And the heterodox have nothing in common, except for keeping the faith.
The orthodox haven't lost hope. They hope that monetary and fiscal policy will be enough to get us out of this recession, and that the limits on monetary and fiscal policy will not be binding this time around. And they are probably right. But they have lost faith that monetary and/or fiscal policy will always be enough - that there are no limits.
And if the Eurozone too turns Japanese, they may start to lose even that hope.
There are two types of macroeconomist.
The first says "What do you mean you can't increase aggregate demand? You run out of paper? Ink? You scared of inflation?"
The second says "But monetary policy won't work at the zero lower bound. And there are limits on fiscal policy, because we daren't let the national debt get too big."
Scott Sumner and Modern Monetary Theorists are examples of the first type of macroeconomist. They have nothing in common, except that one thing. But that one thing is more important than all their differences. And they are heterodox.
Traditional Keynesians and monetarists, the competing schools of the old orthodoxy, belonged to the first type of macroeconomist. They differed only on tactics. They kept the faith. But they have now gone, and only monetary cranks sing the old religion.
The second type of macroeconomist represents the new orthodoxy. Few orthodox macroeconomists today will admit point-blank to having lost the faith, any more than a bishop, no matter how liberal, will admit to being an atheist. But if you believe that monetary policy is ineffective at the zero bound, and that there are limits to how long you can have a big fiscal deficit, it comes to the same thing. You have lost faith that you can always and everywhere increase demand by whatever it takes for as long as is needed.
Losing faith in monetary and fiscal policy, the orthodox turn to financial policy. "If we had better regulation and/or supervision of financial markets and institutions, we wouldn't have gotten into this mess in the first place". That's probably true, but it's also a distraction from the loss of faith. Financial markets and institutions are inherently unstable. They borrow short and lend long; they borrow safe and lend risky; they borrow liquid and lend illiquid; they borrow simple and they lend complex. Finance is magic; you know it can't really be done. Regulation and supervision can never eliminate financial instability. If your faith is contingent on being able to prevent financial crises, you have lost the faith.
Good financial regulation and supervision are important in their own right. A good financial system will better serve the interests of borrowers and lenders. It will create benefits on the supply side. And financial crises will almost certainly cause demand to fall. But just because something causes demand to fall doesn't mean monetary and fiscal policy can't work. The whole point of Keynesian policy was that when (not if) something did cause demand to fall, monetary or fiscal policy could and should be used to increase it back again.
Even suppose the financial system totally collapsed. Why should that prevent monetary and fiscal policy working to increase demand? The biggest flaw of orthodox macroeconomic models is that they have no financial sector. So, if the financial system disappeared, that ought to mean those models would work even better.
This is what I sensed to be the overarching but unspoken theme of a conference at Carleton on the economic and financial crisis. I may do subsequent posts on more specific topics.

"Educational Attainment in the World, 1950–2010"

Posted: 21 May 2010 12:31 AM PDT

Robert Barro and Jong-Wha Lee use a new data set to measure the rate of return to an additional year of schooling on output and find that is "quite high":

Educational attainment in the world, 1950–2010, by Robert Barro and Jong-Wha Lee, Vox EU: It is widely accepted that human capital, particularly attained through education, is crucial to economic progress. An increase in the number of well-educated people implies a higher level of labour productivity and a greater ability to absorb advanced technology from developed countries (Acemoglu 2009). Empirical investigations of the role of human capital require accurate and internationally-comparable measures of human capital across countries and over time.

Our earlier studies (1993, 1996, and 2001) constructed measures of educational attainment of the adult population for a broad group of countries. This column introduces a new data set (available at barrolee.com) providing improved estimates for 146 countries at 5-year intervals from 1950 to 2010. The data are disaggregated by sex and by 5-year age groups among the population aged 15 years and over (see Barro and Lee 2010).

The new data improve on our widely used earlier information by using more observations of censuses, surveys, and enrolment-rate figures and by employing better methodology. We use consistent census and survey data compiled from UNESCO, Eurostat, and other sources to provide benchmarks for school attainment by gender and age group. We use enrolment-rate data to fill in missing observations at 5-year intervals by forward and backward extrapolation from the benchmark statistics. As part of this analysis, we construct new estimates of mortality rates by age and education level. We also use estimates of completion ratios applicable to each country and level of schooling.

In 2010, the world population aged 15 and over had an average 7.8 years of schooling, increasing steadily from 3.2 years in 1950 and 5.3 years in 1980. The rise in average years of schooling from 1950 to 2010 was from 6.2 to 11.0 years in high-income countries and from 2.1 to 7.1 years in low-income countries. Thus in 2010 the gap between rich and poor countries in average years of schooling remained at 4 years, having narrowed by less than 1 year since 1960 (see Figure 1). In 2010 the level and distribution of educational attainment in developing countries are comparable to those of the advanced countries in the late 1960s.

Figure 1. Average years of schooling by education level (population over age 15)

Barrovox1

We use the new data to estimate the relationship between education and output based on a production-function approach. Our findings confirm that schooling has a significantly positive effect on output. Our estimates of rates of return for an additional year of schooling range from 5% to 12%. These estimates control for the simultaneous determination of human capital and output by using the 10-year lag of parents' education as an instrumental variable for the current level of schooling. These estimates are close to typical Mincerian return estimates found in the labour literature.

Estimates of rates of return to education vary across regions (Figure 2). The estimates for the group of advanced countries, East Asia and the Pacific, and South Asia are the highest at 13.3%. In contrast, the estimated rates of return are only 6.6% in Sub-Saharan Africa and 6.5% in Latin America.

Figure 2. Rates of return to an additional year of schooling, by region

Barrovox2

Source: Country fixed-effects instrumental variable (IV) estimation in Table 6 of Barro and Lee (2010).

Results confirm that the rate of return to schooling varies across levels of education. The estimated rate of return is higher at the secondary (10.0%) and tertiary (17.9%) levels than at the primary level, which differs insignificantly from zero. The results imply that, on average, the wage differential between a secondary-school and a primary-school graduate is around 77% and that between a college and a primary-school graduate is around 240%.

Our improved dataset on educational attainment should be helpful for a variety of empirical work. For example, our previous estimates have been used to study the linkages across countries between education and important economic and social variables, such as economic growth, fertility, income inequality, institutions, and political freedom. We anticipate that the new data will help to improve the reliability of these types of analyses.

Disclaimer: The views expressed in this article are those of the authors and do not necessarily reflect the views and policies of the Asian Development Bank or its Board of Governors or the governments they represent.

References

Acemoglu, Daron (2009), "Modern economic growth", VoxEU.org, 27 February.
Barro, RJ and JW Lee (1993), "International Comparisons of Educational Attainment", Journal of Monetary Economics, 32:363-394.
Barro, RJ and JW Lee (1996), "International Measures of Schooling Years and Schooling Quality", American Economic Review, 86:218-223.
Barro, RJ and JW Lee (2001), "International Data on Educational Attainment: Updates and Implications", Oxford Economic Papers, 53:541-563.
Barro, RJ and JW Lee (2010), "A New Data Set of Educational Attainment in the World, 1950-2010", NBER Working Paper 15902, (accompanying data are available at www,barrolee.com).

links for 2010-05-20

Posted: 20 May 2010 11:03 PM PDT

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