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July 12, 2010

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Paul Krugman: The Feckless Fed

Posted: 12 Jul 2010 12:39 AM PDT

Frustration with the Fed:

The Feckless Fed, by Paul Krugman, Commentary, NY Times: Back in 2002, a professor turned Federal Reserve official by the name of Ben Bernanke gave a widely quoted speech titled "Deflation: Making Sure 'It' Doesn't Happen Here." Like other economists, myself included, Mr. Bernanke was deeply disturbed by Japan's stubborn, seemingly incurable deflation, which in turn was "associated with years of painfully slow growth, rising joblessness, and apparently intractable financial problems." This sort of thing wasn't supposed to happen to an advanced nation with sophisticated policy makers. Could something similar happen to the United States?
Not to worry, said Mr. Bernanke: the Fed had the tools required to head off an American version of the Japan syndrome, and it would use them if necessary.
Today, Mr. Bernanke is the Fed's chairman — and his 2002 speech reads like famous last words. We aren't literally suffering deflation (yet). But inflation is ... trending steadily lower; it's a good bet that by some measures we'll be seeing deflation by sometime next year. Meanwhile, we already have painfully slow growth, very high joblessness, and intractable financial problems. And what is the Fed's response? It's debating — with ponderous slowness — whether maybe, possibly, it should consider trying to do something..., one of these days.
The Fed's fecklessness is, to be sure, not unique. It has been astonishing and infuriating, as the economic crisis has unfolded, to watch America's political class... Washington seems to feel absolutely no sense of urgency. Are hopes being destroyed, small businesses being driven into bankruptcy, lives being blighted? Never mind, let's talk about the evils of budget deficits.
Still, one might have hoped that the Fed would be different. For one thing, the Fed, unlike the Obama administration, ... doesn't need 60 votes in the Senate; the outer limits of its policies aren't determined by ... senators from Nebraska and Maine. Beyond that, the Fed was supposed to be intellectually prepared for this situation. Mr. Bernanke has thought long and hard about how to avoid a Japanese-style economic trap, and the Fed's researchers have been obsessed for years with the same question.
But here we are, visibly sliding toward deflation — and the Fed is standing pat.
What should it be doing? Conventional monetary policy, in which the Fed drives down short-term interest rates..., has reached its limit:... short-term rates are already near zero... But the message of Mr. Bernanke's 2002 speech was that there are other things the Fed can do. It can buy longer-term government debt. It can buy private-sector debt. It can try to move expectations by announcing that it will keep short-term rates low for a long time. It can raise its long-run inflation target, to help convince the private sector that borrowing is a good idea and hoarding cash a mistake.
Nobody knows how well any one of these actions would work. The point, however, is that there are things the Fed could and should be doing, but isn't. Why not? ...
The closest thing I've seen to an explanation is a recent speech by Kevin Warsh of the Fed's Board of Governors, in which he declared that doing what Mr. Bernanke recommended back in 2002 risked undermining the Fed's "institutional credibility." But how, exactly, does it serve the Fed's credibility when it fails to confront high unemployment, while consistently missing its own inflation targets? How credible is the Bank of Japan after presiding over 15 years of deflation?
Whatever is going on, the Fed needs to rethink its priorities, fast. Mr. Bernanke's "it" isn't a hypothetical possibility, it's on the verge of happening. And the Fed should be doing all it can to stop it.

Fed Watch: Ahead of a Busy Week

Posted: 12 Jul 2010 12:33 AM PDT

Tim Duy:

Ahead of a Busy Week, by Tim Duy: Policymakers are increasingly stuck between a rock and a hard place. It is likely the recovery remains intact, but at a pace that will fall short of policymakers expectations. Just how far short? That is the key question. In the absence of a fresh financial crisis, in my mind the most likely outcome is that the US economy limps along not unlike the path in the wake of the 2001 recession. Recall that what ultimately pulled the economy off its feet earlier this decade was the housing bubble. There is likely no bubble to pull us out this time.

And an economy that just limps along will put both monetary and fiscal policymakers in a tight position. With interest rates already at rock bottom, monetary policy options of any significance are limited unless the Fed is ready to pump up the money supply via either a commitment to higher inflation or the targeting of long term interest rates. And on the fiscal side, policy is limited by deficit fears. Lacking a clear downward turn in the economy, there is no willpower for large scale stimulus. Which means this: An economy that limps along is on a certain path to a lost decade if policymakers remain incapable of decisive action.

Last week was light on data which, as Calculated Risk opined, may have provided support for equities markets. No chance of "no news is good news" this week. The economic calendar is full, with an important update on the US consumer with Wednesday's release of the Retail Sales report. Note the Wall Street Journal ran a cautionary tale on retail sales last Friday:

Consumers aren't stepping up spending at the pace many retailers expected just a few months ago, raising the specter that stores will be stuck with piles of unsold goods later this year.

This dimming retail picture is part of a larger downshift in growth occurring across the economy. Consumer confidence slumped last month and the job market remains weak. On Thursday, the Federal Reserve reported consumer borrowing fell in May, another sign that they are wary about their finances.

All this bodes poorly for the kind of snapback in spending many stores anticipated only a few months ago. Last year's holiday sales were strong and many retailers expected robust growth to continue through this year, fueled in part by pent-up demand for washing machines and clothes that weren't bought during the recession.

The "robust growth" retailers were looking for was reflected in the trend as recently as April:

FW051710

Pent-up demand released as job losses came to an end supported that stronger trend - a trend that likely pleased policymakers, as it provided hope that the previous trend could be reached within the scope of current policy. But there might have been less pent-up demand than retailers expected. The May sales drop pulled retailers back closer to the pre-recession trend:

FW071310

We can even question the sustainability of that trend given weak job growth and declining consumer credit. In any event, the anecdotal evidence presented by the WSJ suggests we should expect the June data to track more closely to the lower trend. Would growth just below expectations be enough to force a policy shift more than an ongoing commitment to ZIRP?

While the Retail Sales report will be especially important, plenty of other interesting data will be in play. Tuesday we get the May International Trade report. Note that the Obama Administration is counting on exports to fuel the US recovery. Note too that they appear to have forgotten about imports; on net, the international sector has reduced GDP the past three quarters. Will it continue to do so? If the external deficit continues to widen, watch for pressure to extend the renminibi's pitiful advance. On that topic, note that China's trade surplus rose again in June - interesting, given the Chinese statement:

With the BOP account moving closer to equilibrium, the basis for large-scale appreciation of the RMB exchange rate does not exist.

Also in the line up are a host of data on the manufacturing sector, with Industrial Production, the Producer Price Index, and regional reports from the New York and Philadelphia Feds on the docket for Thursday. We are looking for more evidence that the pace of the manufacturing recovery is fading as producers need to rely on final demand, not inventory correction, to fuel new orders - consistent with the drop in the new orders component of the June ISM manufacturing report.

Finally, the big focus of the week might not be Retail Sales, but the Consumer Price report set for Friday. Any signs of increased disinflationary pressure will weigh heavily on Federal Reserve policymakers, increasing the divide between those who are dead set against further action, a position held most formidably by Kansas City Federal Reserve President and serial FOMC dissenter Thomas Hoenig and more pragmatic policymakers. The question remains: How much disinflation would the Fed be willing to tolerate before they pull out the stops on asset purchases - policy that will look a lot like debt monetization.

Simply put, what we are looking for is data to define what is shaping up to be a disappointing second half relative to excessive expectations formed as the economy lifted itself off the recession floor. Market participants are waking up to the reality that the recovery is falling far short of the fabled V. Policymakers are beginning to realize the same. Surprising it has taken so long for this realization to sink in. The pace of growth has never been sufficient to rapidly eliminate the gaping output gap. Compare the growth in real final sales over the past three quarters to that of the mid 1980's:

FW0701102

Excluding inventory dynamics, the pace of activity is falling far short of that necessary to fulfill expectations of a rapid snap back to trend. Paul Krugman reports:

But based on public reporting, like the Ryan Lizza article on Larry Summers — which reads rather differently now that we know how things are really working out, or more accurately not working out — it looks as if top advisers convinced themselves that even in the absence of stimulus the slump would be nasty, brutish, but not too long….So all policy needed to do was meliorate the worst, while we waited for the economy to recover spontaneously.

Policymakers may try to place the blame at the feet of Europe:

The president suggested that troubles in Europe have led to "skittishness and nervousness on the part of the markets and on the part of business and investors." In brief remarks, the Fed chairman pressed the need to take a global outlook. "I think, very importantly, we also talked a lot about the international context. What's happening around the world in emerging markets, in Europe affects us here in the United States, and it's important for us to take that global perspective as we discuss the economy," Bernanke said

To the extent that Europe is a drag (and at least one Fed official suggests it isn't, and note that lower interest rates a fueling a mini refinancing boom), quite frankly, it is only icing on the cake. The lack of a V-shaped recovery was baked into that cake from day one, a story that Calculated Risk, for example, has reiterated multiple times. The basic of components of that story remain the same: The lingering impact of financial crisis, the ineffectiveness of monetary policy at the zero bound, and the lack of recovery in the housing market. One does not need to turn to Greece to explain the relative weakness of this recovery.

In short: This week will be data rich. Will that data paint a picture of an economy limping into the second half of 2010, growing, but not swiftly enough to return output to trend and lift rapidly lift employment? Such an outcome should pressure policymakers into additional action. But short of an outright double-dip, will we get anything more than a token policy response? My concern is that policymakers will view a retrenchment in growth as a natural "pause," simply a delay on the path the strong rebounds that have traditionally followed deep recessions.

links for 2010-07-11

Posted: 11 Jul 2010 11:01 PM PDT

"Comes a Moment to Decide"

Posted: 11 Jul 2010 04:23 PM PDT

Another quick one -- this is from David Warsh -- again on the path forward for Obama: First, I didn't realize that nancy Pelosi "brought the American war in Iraqi to a foreseeable end":
Comes a Moment to Decide, by David Warsh: ...Here's something else that EP knows, which the president knows too, or should know, since he was there, though it is not exactly common knowledge.  It was Speaker of the House Nancy Pelosi (D-Calif.), not Gen. David Petraeus, who brought the American war in Iraqi to a foreseeable end.  Pelosi's elevation after the Democrats regained control of the House in November 2006 led to a series of budget skirmishes in early 2007 that made it clear she had the votes to shut down funding of the war.
Bush responded with his surge, not as a demonstration of credible resolve – that was the cover story – but to obscure the fact that the situation had changed decisively and that the Americans would soon be leaving. The strategy was daring and clever. It gave everyone a chance to take a deep breath and regroup. It permitted the "Anbar awakening" (a Sunni militia financed by the US) to shut down Al Qaeda factions and enlist ad-hoc insurgents. The current fragile truce among Sunnis, Shiites and Kurds emerged. Iraq grasped the opportunity to reclaim itself. It was the fig leaf the Americans needed.
Something like this presumably is the rationale behind the 30,000 more US troops that Obama committed to the Afghan campaign last December after a laborious and showy review, with a promise to begin withdrawals in July 2011. But that's where the logic breaks down. ...

The main topic of the article is:

Comes a Moment to Decide, by David Warsh: As a (sometimes) shadow newspaper columnist, one who joined the Obama bandwagon before the Iowa caucuses made the Illinois Senator a favorite, Economic Principals feel obligated and/or entitled to keep track of the shifting tides of his presidency. ...
Obama is approaching a decision that will make or break his presidency, not in the long view of history, but now, in real time. He must summon the courage to begin to leave Afghanistan next year, however ignominiously, and accept the nearly certain defeat of most American war aims that will ensue, perhaps in advance of the 2012 election.
I haven't done a very good job of representing the post -- you should read the original -- but here's the closing:
Senior military commanders, at least some of them, still think that they could "win this thing" if they just had another decade or two – that's just what Gen. Creighton Abrams argued forty years ago in Vietnam. ... Probably only a few hard-rock conservatives expect that the US-led NATO forces can remain in Afghanistan indefinitely. US elections later this year and in 2012 will provide the test. ...
The United States has been at war in Afghanistan for nine years. Nobody has been a more perspicacious critic of American foreign policy in that time than Andrew Bacevich, the former US Army colonel turned teacher and author. ...
On The New Republic blog last week, Bacevich taunted the president, arguing that Obama "lacks the guts to get out."  The White House has bought into the conventional wisdom about American power: "It's all so complicated.  There are risks involved. Things might go wrong. There's an election to think about."  When Americans look to Washington, he wrote, "they see a cool, calculating, dispassionate president whose administration lacks a moral core."
Here's hoping that Bacevich is wrong. With its bias towards hope, EP expects that Obama will rise to the occasion. But either way, it has come to this:  as the old hymn has it (written in 1845 by James Russell Lowell to protest the US war with Mexico), Once to every man and nation comes a moment to decide.

The Third Bush Term?

Posted: 11 Jul 2010 11:52 AM PDT

My parents are visiting this weekend, so looking for quick hits. What do you think about this?:

Will we someday be saying that it took the Democratic Obama administration to bring elements of the G. W. Bush revolution to fruition?

See here.

"America Needs a Growth Strategy"

Posted: 11 Jul 2010 09:20 AM PDT

I am not fully familiar with the things Michael Spence has written in the past, but from what I know I was surprised to hear him call the Andrew Grove article thoughtful, and also surprised by his call for industrial policy:

America needs a growth strategy, by Michael Spence, Commentary, Financial Times: ...America's economy shows worrying signs of weakness. Worse, and in common with other developed countries, it also lacks a credible strategy for longer-term growth. ...
The real issue is employment: not just stubbornly high unemployment, but a bigger problem described recently in a thoughtful article by Andy Grove... He argued that manufacturing is vanishing in the US, a trend that must be reversed. The question is how.
There is little doubt that America's social contract is starting to break. It had on one side an open, flexible economy, and on the other the promise of employment and rising incomes for the motivated and diligent. It is the second part that is unraveling.
Incomes in the middle-income range for most Americans have stagnated for more than 20 years. Manufacturing jobs are moving offshore. Globally the set of goods and services that is tradable is expanding, but the US and other advanced countries are not competing successfully...
The availability of low-cost, disciplined labor forces in developing countries reduces the incentive for ... companies to invest in technologies that enhance labor productivity in the tradable sectors of the advanced economies. As a result, the evolving composition of advanced economies is increasingly weighted towards the non-tradable sector, combined with a set of high-end tradable services where both human capital and proximity matter. The rest of the tradable sector is shrinking.
The shrinkage creates problems. ... Spillovers between R&D, product development and manufacturing will be lost... Employment will stagnate. Income distribution will move adversely and the social contract will erode further.
Solutions to these problems are not easy to find. The unequal distribution of income can be dealt with through the tax system, although this does not attack the underlying problem. Protectionism could alter the pattern of out-migration of manufacturing, but only by imposing costs on domestic consumers and risking the breakdown of the open global economy model.
To avoid an outbreak of protectionism, there has to be an alternative. President Barack Obama's new export council ... is a step in the right direction. But a bolder move is needed: a broad public-private partnership to invest in the development of ... the tradable sector where there are opportunities to make advanced countries competitive. The goal must be to create capital-intensive jobs that have labor productivity levels consistent with advanced country incomes. ...
We are already on a lengthy and bumpy road to a new normal. That is unavoidable. The risk is that without a new direction in American economic policy, the new normal may be as unpleasant as the journey.

There appears to be a change in thinking underway among economists on these issues, particularly industrial policy. There are some who will oppose this change with all the shrillness they can muster. If this trend continues, and it looks like it will, there will be big fight within the profession -- more so than now -- about these ideas.

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