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July 15, 2010

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"Push Back"

Posted: 15 Jul 2010 12:42 AM PDT

Tim Duy responds to Ryan Avent:

Push Back, by Tim Duy: Free Exchange pushes back on my concerns about the widening trade deficit and the declines in manufacturing capacity. I appreciate that - I am well aware that I am taking an unpopular position. Not quite so sure it is "lazy," but definitely unpopular.

Regarding my disbelief that higher paid grocery clerks are the answer to declining manufacturing capacity, Avent writes:

This is a lazy and unpersuasive assessment of what's involved in service sector activity. Obviously there is much more to service employment, including work in financial, information, education, and health services, much of which is (and will increasingly be) tradable.

True enough, I oversimplified service sector jobs. Maybe. Yes and no. To begin with, it is not exactly clear that the expansion of the financial sector has yielded a good outcome, unless you believe that greater financial volatility and widening income inequality is good. More importantly, Avent is arguing that service jobs are just as tradable as manufacturing jobs, and therefore a job is a job. Refer to Alan Blinder's hypothesis back in 2007:

We economists assure folks that things will be all right in the end. Both Americans and Indians will be better off. I think that's right. The basic principles of free trade that Adam Smith and David Ricardo taught us two centuries ago remain valid today: Just like people, nations benefit by specializing in the tasks they do best and trading with other nations for the rest. There's nothing new here theoretically.

But I would argue that there's something new about the coming transition to service offshoring. Those two powerful forces mentioned earlier -- technological advancement and the rise of China and India -- suggest that this particular transition will be large, lengthy and painful.

It's also going to be large. How large? In some recent research, I estimated that 30 million to 40 million U.S. jobs are potentially offshorable. These include scientists, mathematicians and editors on the high end and telephone operators, clerks and typists on the low end. Obviously, not all of these jobs are going to India, China or elsewhere. But many will.

Avent is essentially arguing that the US has a comparative advantage in service sector jobs. Blinder views these jobs as very vulnerable to offshoring, suggesting a lack of comparative advantage. If Blinder is right, then America apparently has little left in the comparative advantage department.

Avent continues:

As far as I can tell, Mr Duy seems to want to embrace a crash programme of protectionism against China. I don't know how this is supposed to boost America's long-term economic fortunes or what evidence he can present that it will. I don't know why Mr Duy is convinced that another spurt of manufacturing capacity growth, similar to that observed in the 1990s, isn't a possibility. And I have no idea why he is so confident that a return to the manufacturing economy observed in the immediate postwar decades—a time when technologies were vastly different, when the global economy was vastly different, and when a much larger share of the world's population lived in dire poverty—is a good idea.

I will deal with the protectionism argument later. I don't view American manufacturing as incapable of rebounding. But there are no price signals to prompt that rebound. That price signal should be delivered via currency values. The dollar should adjust to spur a net increase in export and import competing industries. It is not complicated. For some reason, however, that process is not happening. Something is interfering with the adjustment. That interference prompts American firms to expect that any new innovation needs a China strategy for production, if you believe the Andy Grove hypothesis.

Also, whenever you stick your neck out and say that manufacturing might be important, you suddenly get accused of being a barbarian trying to reinvent the 1950s. Of course manufacturing technology has fundamentally changed, as well as the mix of goods produced. But in the past, that productivity growth yielded more overall output and more manufacturing employment, even if the proportion of manufacturing jobs decreased relative to overall jobs. I can even buy into that story when capacity is rising and employment is stagnant. But something very different happened this decade. Capacity stagnated as millions of jobs were lost.

Avent continues:

This is simply a very empty and disappointing view of the evolution of economic activity. Mr Duy is implying that there is only so much producing of good stuff that can go on, and America used to have most of it and now China is taking it all and America needs to fight to get it back. He's wrong. The movement of some kinds of economic activity to China is creating new opportunities in America. America's problem isn't that some jobs are leaving. It's that it's doing a poor job of preparing its workers to take advantage of the new opportunities.

If that is true, then there should be millions of jobs available to soak up the workers released from manufacturing, and wages should be soaring because we have a structural flaw in economy - the skills of the released workers do not match those needed by expanding sectors. That structural flaw should be sufficient to encourage workers to gain more education and employers to provide more on the job training. While I am sure that is true in a few sectors, in aggregate real wages and nonfarm payrolls have been stagnant for a decade. Where are these high wage paying jobs? Or even median wage paying jobs at this point? Silly me, I actually believe the unapologetic and unquestioning supporters of free trade need to answer this question. We are millions of jobs below trend, and we have lost millions of jobs in manufacturing - the manufacturing of goods that we still consume, no less. Moreover, these two trends occurred in the same decade, in concert with a third trend - the sharp rise in foreign official reserve accumulation. How can you not be even allowed to suggest that there just might be a connection?

As always, questioning the nature of trade patterns this decade means you are an ignorant protectionist. Blinder tried to get ahead of this argument:

What else is to be done? Trade protection won't work. You can't block electrons from crossing national borders. Because U.S. labor cannot compete on price, we must reemphasize the things that have kept us on top of the economic food chain for so long: technology, innovation, entrepreneurship, adaptability and the like. That means more science and engineering, more spending on R&D, keeping our capital markets big and vibrant, and not letting ourselves get locked into "sunset" industries.

What is amusing about the whole analysis is that I believe free trade works, but I also believe we don't really have free trade. In reality, foreign central banks manipulate currency levels such they accumulate massive amounts of foreign exchange reserves that effectively recycle Dollars back into the US to support consumption activities, and thus impact the dynamics of trade flows in an obviously mercantilistic fashion. This has been accomplished with the full acceptance and even cooperation of the US Treasury. It was an outcome of the strong Dollar policy, and it is why China has not been named a currency manipulator since 1994. But those central banks are immune from criticism on free trade because they interfere in the financial side of the external accounts, not the current transactions side. Indeed, one cannot even question the negative impacts of this dynamic. Avent essentially falls back on the same argument I lamented about last week:

... every right minded economist and policymaker knows unequivocally that free trade is good, and to even question that assumption makes one an ignorant heretic who has never heard of Smoot-Hawley. Therefore, the examination ends. Manufacturing's decline simply cannot be a problem if it is consequence of international trade because everyone knows international trade is good.

Another version of this argument: International trade is driven by comparative advantage. If manufacturing jobs are lost from international trade, is must be the result of a relative comparative disadvantage. The financial side of the account is irrelevant.

If you fall back on the pro-free trade argument that service sector jobs will compensate for the offshoring in manufacturing, you ignore the fact that the currency manipulation that impacted manufacturing will have the same impact on the service sector jobs if they are truly tradable. If service sector jobs are just as offshorable as manufacturing jobs, then Blinder's prescription is destined to fail unless there is a concerted, sustained effort to control the accumulation of reserves among foreign central banks.

I very much recommend Michael Pettis for an another view of what I consider to be the same problem:

...As net capital exporters try desperately to maintain or increase their capital exports, and deficit Europe sees net capital imports collapse, the only way the world can achieve balance without a sharp contraction in the capital-exporting countries is if US net capital imports surge. And at first they will surge. Foreigners, in other words, will buy more dollar assets, including USG bonds, than before.

But remember that an increase in net US imports of capital is just the flip side of an increase in the US current account deficit. This means that the US trade deficit will inexorably rise as Germany, Japan and China try to keep up their capital exports and as European capital imports drop.

I have little doubt that as the US trade deficit rises, a lot of finger-wagging analysts will excoriate US households for resuming their spendthrift ways, but of course the decline in US savings and the increase in the US trade deficit will have nothing to do with any change in consumer psychology or cultural behavior. It will be the automatic and necessary consequence of the capital tug-of-war taking place abroad.

The US, in other words, is not likely to face the "nuclear option" of a Chinese disruption of the US Treasury bond market. It is far more likely to be swamped by a tsunami of foreign capital. This tsunami will bring with it a corresponding surge in the US trade deficit and, with it, a rise in US unemployment. It will also force the US Treasury to increase the fiscal deficit as more of the jobs created by its spending leak abroad.[Emphasis added]

Therein lies the problem. A reduction in net foreign capital inflows means a welcome decline in the US trade deficit, but the US is likely to see just the opposite. Foreign capital will push desperately into US markets and as an automatic consequence the US trade deficit will surge. So the problem isn't too little capital inflow or a sudden boycott of USG bonds. On the contrary, the US will see too much capital inflow.

All this may turn out to be very bad for the US economy, but in the past massive capital recycling has usually been very good for asset markets. Might we see a surge in the US asset markets, at least until next year when Congress starts getting tough on the trade deficit? I would be willing to bet that we do.

The patterns of capital flows and how those flows have impacted production and consumption location outcomes is a critically important issue. Even more so if the flows into the US are simply supporting consumption spending via fiscal deficits but creating relatively few jobs because that spending is quickly directed overseas, and the pace of that direction accelerates as industrial capacity contracts. Yet if you even suggest the shift in production outcomes is creating very serious and long lasting problems, your thoughts are considered "fairly poorly reasoned."

Bottom Line: When I express concerns over free trade, I am really expressing immense frustration over an international financial architecture that sustains and maintains global imbalances that yield outcomes that I believe are very difficult to justify and yet are accepted due to a blind faith in free trade. In essence, the ability to manipulate capital flows has made a mockery of the free trade crowd. I know. I used to be in that crowd, and in many ways still am. But I can no longer wrap myself in the free trade flag to justify the negative impacts of financial account manipulation. And if the US cannot seriously address financial account manipulation on a global basis - and if the Pettis article is correct, the US Treasury will fall short of what is needed even with the announced adjustment to Chinese currency policy - what choices are you left with? Either accept continued economic stagnation, or act unilaterally on the current transactions (tariffs) or financial (reciprocative devaluation or capital controls) side of the accounts. None of which are pleasant options.

Fed Watch: The Dance Continues

Posted: 15 Jul 2010 12:33 AM PDT

This is the second of three consecutive posts from Tim Duy. He said he had a lot of coffee today:

The Dance Continues. by Tim Duy: The Fed dance continued today with the release of the minutes. In most ways, the content of the minutes was largely expected, as reported by Free Exchange. Forecasts for growth and inflation were knocked down, while the forecast for unemployment was edged up. Overall, the Fed concluded that:

The economic outlook had softened somewhat and a number of members saw the risks to the outlook as having shifted to the downside. Nonetheless, all saw the economic expansion as likely to be strong enough to continue raising resource utilization, albeit more slowly than they had previously anticipated. In addition, they saw inflation as likely to stabilize near recent low readings in coming quarters and then gradually rise toward more desirable levels. In sum, the changes to the outlook were viewed as relatively modest and as not warranting policy accommodation beyond that already in place.

They did inject some uncertainty over the path of policy:

However, members noted that in addition to continuing to develop and test instruments to exit from the period of unusually accommodative monetary policy, the Committee would need to consider whether further policy stimulus might become appropriate if the outlook were to worsen appreciably

Still, the minutes read as if additional policy stimulus is a remote chance. As has been reported, recent Fedspeak has been decidedly more mixed.

Paul Krugman bemoans the fact that the Fed understands and is largely comfortable with meeting neither of its dual objectives. The minutes are quite clear on this point:

A number of participants expressed the view that, over the next several years, both employment and inflation would likely be below levels they consider to be consistent with their dual mandate, but they anticipated that, with appropriate monetary policy, both would rise over time to levels consistent with the Federal Reserve's objectives.

I guess you are not all that worried about high unemployment for "several years" when you have a 13 year appointment. Two additional gems in the minutes:

Participants also noted that several uncertainties, including those related to legislative changes and to developments in global financial markets, were generating a heightened level of caution that could lead some firms to delay hiring and planned investment outlays.


Reportedly, employers were still cautious about adding to payrolls, given uncertainties about the outlook for the economy and government policies.

These two lines imply that some Fed members are buying the story that the lack of business confidence is due to all the uncertainty created by the Obama Administration. Convenient excuse to avoid additional stimulus. Nothing we can do, this is a problem caused by those silly fiscal policymakers.

And another point I find odd:

Participants also noted a risk that continued rapid growth in productivity, though clearly beneficial in the longer term, could in the near term act to moderate growth in the demand for labor and thus slow the pace at which the unemployment rate normalizes.

Rapid productivity growth should never be a problem. It is only a problem if policymakers hold demand unnecessarily low such that the additional potential output cannot be absorbed. Answer: Do more to stimulate demand.

Bottom Line: The minutes paint a picture of monetary policymakers slightly more concerned about an already questionable outlook, but not concerned enough to do anything about it. This stance appears a bit more vulnerable in light of flow of data since the last FOMC meeting, and that flow of data may be exactly what recently pushed some Fed officials to emphasize the "we can do more" story. In effect, a preemptive effort to alleviate the seemingly hawkish stance of the minutes. Hopefully, Federal Reserve Chairman Ben Bernanke will provide additional clarity of the Fed's stance with regard to additional easing at next week's semi-annual testimony.

"Back to Trend Growth, Not Trend"

Posted: 15 Jul 2010 12:24 AM PDT

Tim Duy on the retail sales report for June:

Back to Trend Growth, Not Trend, by Tim Duy: The retail sales report for June was weak, as expected. From Bloomberg:

Sales at U.S. retailers dropped in June for a second month, indicating the economic recovery dissipated heading into the second half of 2010.

Purchases decreased 0.5 percent, more than projected, after declining 1.1 percent in May, Commerce Department figures showed today in Washington. Excluding auto dealers, demand fell 0.1 percent, matching the median forecast of economists surveyed by Bloomberg News...

..."The consumer is losing some momentum," said Harm Bandholz, chief U.S. economist at UniCredit Group in New York. "Job gains are not enough to bring the unemployment rate down. It means the recovery goes on, just at a slower pace."

Looks like the pent-up demand was been satisfied. Retail sales excluding gasoline have now reverted back to the pre-recession growth rate (growth rates are log approximations):


For those counting, the gap between prerecession trend and actual sales now exceeds a trillion dollars - correct, a trillion dollars of foregone spending relative to the previous trend. That gap is growing by over $50 billion each month. One can argue that the previous trend wasn't sustainable, but where would sales be if unemployment rates were closer to 5% rather than 10%?

Just more evidence that the US economy is settling into a suboptimal equilibrium.

Helicopter Money

Posted: 15 Jul 2010 12:15 AM PDT

I sent an email to Brad DeLong. He gives me more credit than I deserve:

DeLong Smackdown Watch: Mark Thoma: Mark Thoma writes to inquire why I am endorsing a helicopter drop--a money printing-financed mass mailing of tax rebate checks--when a money printing-financed increase in government purchases dominates it from an economic point of view. Aren't I surrendering to the dysfunctionality of our political system rather than fighting it?

Mark Thoma snarks:

I am very simplistic.

When you trade money for bonds, it simply changes the composition of what people have in savings. Before it was bonds, now its cash. No effect on real activity. You need actual demand, or the prospect of it, to create expected inflation.

When you drop money from helicopters, the people who need it most scramble for it, and then rush to spend it before everyone else spends their money and drives up prices (expected inflation) or causes stock-outs. It has real effects. And I don't think the people willing to fight for $100 bucks when the helicopter comes each day give a damn about future taxes.

But instead of simply dropping it, why not buy something on the first step? Print money, buy labor (the labor then spends the "found", i.e. earned, money). Print money, buy goods and services. Because this is too slow. Deciding what labor should do, hiring, etc. takes way too much time and political effort, as does figuring out what to buy.

So save this time by just letting the money rain down on people and letting them figure out what to do with it. I'd guess that money falling in a city would begin to see effects on aggregate demand, oh, a matter of minutes, if that long.

But I know this is too simple.

links for 2010-07-14

Posted: 14 Jul 2010 11:04 PM PDT

"A Roosevelt Moment for America’s Megabanks?"

Posted: 14 Jul 2010 02:25 PM PDT

Simon Johnson is happier than I expected he'd be with the Dodd-Frank financial reform bill:

A Roosevelt Moment for America's Megabanks?, by Simon Johnson, Commentary, Project Syndicate: Just over a hundred years ago, the United States led the world in terms of rethinking how big business worked – and when the power of such firms should be constrained. In retrospect, the breakthrough legislation ... was the Sherman Antitrust Act of 1890. The Dodd-Frank Financial Reform Bill, which is about to pass the US Senate, does something similar – and long overdue – for banking.
Prior to 1890, big business was widely regarded as more efficient and generally more modern than small business. Most people saw the consolidation of smaller firms into fewer, large firms as a stabilizing development that rewarded success and allowed for further productive investment. The creation of America as a major economic power, after all, was made possible by giant steel mills, integrated railway systems, and the mobilization of enormous energy reserves through such ventures as Standard Oil.
But ever-bigger business also had a profound social impact, and here the ledger entries were not all in the positive column. The people who ran big business were often unscrupulous, and in some cases used their dominant market position to drive out their competitors – enabling the surviving firms subsequently to restrict supply and raise prices. ... Big business brought major productivity improvements, but it also increased the power of private companies to act in ways that were injurious to the broader marketplace – and to society.
The Sherman Act itself did not change this situation overnight, but, once President Theodore Roosevelt decided to take up the cause, it became a powerful tool that could be used to break up industrial and transportation monopolies. By doing so, Roosevelt and those who followed in his footsteps shifted the consensus. ...
Why are these antitrust tools not used against today's megabanks...? The answer is that the kind of power that big banks wield today is very different from what was imagined by the Sherman Act... The banks do not have monopoly pricing power in the traditional sense, and their market share – at the national level – is lower than what would trigger an antitrust investigation in the non-financial sectors. ...
Now, however, a new form of antitrust arrives – in the form of the Kanjorski Amendment, whose language was embedded in the Dodd-Frank bill. Once the bill becomes law, federal regulators will have the right and the responsibility to limit the scope of big banks and, as necessary, break them up when they pose a "grave risk" to financial stability. ...
Representative Paul Kanjorski ... recently [said], "The key lesson of the last decade is that financial regulators must use their powers, rather than coddle industry interests." ... Regulators can do a great deal, but they need political direction from the highest level in order to make genuine progress. Teddy Roosevelt, of course, preferred to "Speak softly and carry a big stick." The Kanjorski Amendment is a very big stick. Who will pick it up?

One argument against breaking up large banks, one I've given myself, is that it won't necessarily eliminate systemic risk. A shock that pushes a large bank into bankruptcy could just as easily cause a large number of smaller firms engaged in the same business to fail. This could create just as much trouble for the financial system as the failure of a single bank encompassing the smaller entities. In fact, it could be even harder for regulators to figure out how to address the failure of, say, one hundred small firms rather than just one large firm. Thus, breaking up large banks may do little to reduce systemic risk, but, as the argument goes, there is a chance that efficiency will fall. If so, then this is not a good policy.

But I think there are several counterarguments to this. First, there maybe some shocks that would take a single, large bank down, but might not do the same to the smaller banks derived from it. The key here is that the smaller banks pursue diversified strategies so that only some of them are vulnerable to a particular type of shock. If they all do the same thing as the large bank did before it was broken up, then they will still face common risks. However, even so, I'd still worry that there is not that much safety from braking banks up, i.e. that most shocks that would take down large banks will also take down enough small banks to create similar problems. So it's not clear to me that the benefit from breaking banks up to reduce systemic risk is very large.

But what about the costs? The second point is that the question of the efficient scale for banks has never been satisfactorily addressed so far as I can tell. How much efficiency would be lost if we cut the largest bank into two independent pieces? If the answer is zero, or very little, then we should break these banks up. After all, their large size gives them considerable political clout, enough that they have the ability to influence legislation and regulation on their behalf. That gives large banks an economic advantage that they shouldn't have. If there is no cost to breaking them up, and if it helps to reduce their economic and political power, power that gives then an advantage over their smaller rivals, then we should do so.

Third, I am not convinced that traditional antitrust law could not have been applied in many instances. I fully agree that existing anti-trust law was not comprehensive enough, and that new legislation was needed. But I also believe that some markets were highly concentrated economically so that traditional law would have applied, and that this concentration was the source of the systemic risk (AIG and insurance markets come to mind here).

This is why I think the point about leadership is essential. We have been through several decades where the prevailing attitude among those with the power to affect pubic opinion and, more importantly, to affect the enforcement of anti-trust law was that markets could take care of themselves. The build up of market power was not something to worry about, market forces would solve the problem, or so it was believed. This belief allowed economic power and the political power that comes with it to become far too concentrated, and market forces did not counteract this tendency. The power is now entrenched and difficult to dislodge. We need leadership to change this, and if the financial sector is the opening salvo in that effort, I'm all for it. But I suspect the actual implementation of both new and old laws designed to curtail economic and political power will, in the end, come up far short of what many of us are hoping for.

"The Uncertainty Excuse Needs to Come to an End"

Posted: 14 Jul 2010 10:44 AM PDT

Barbara Kiviat says it's time for businesses to stop whining:

The uncertainty excuse needs to come to an end, by Barbara Kiviat: Health care reform passed. Now it looks like financial re-regulation will, too. For a long time, businesses have been complaining that they can't hire and they can't invest because of all the uncertainty the Obama Administration has injected into the system. Who can make plans when no one knows what the American health care system will look like or how various prongs of our financial system will be forced to change?
Well, increasingly, we have answers to those questions. So maybe it's time to stop blaming the government for the state of the economy and job creation.
Maybe, instead, it's time for business leaders to—ahem—lead and make some decisions about the futures of their companies. Jeffrey Immelt, the CEO of General Electric, said as much yesterday on CNBC. When asked about Administration-generated uncertainty, he gave the standard line—that business people like clarity and certainty, and that big new pieces of legislation take things in the other direction. Then he added: "Look, GE has a lot of cash. Investments like the one we're making today, $200 million in clean energy, you know, we're going to do that with or without the government. I think it's wrong for us to use that as an excuse." ...
Now, I am sympathetic to businesses being somewhat hamstrung by economic uncertainty. Are we coming out of this recession once and for all, or are we headed toward a double dip? That is the sort of thing that makes it tough to decide whether or not to hire or open a new plant. ... Executives love to ... talk about how the President should show more confidence in the economy. That probably wouldn't hurt. But you know what would actually help? If these same executives did that themselves by going out, taking some risks (what they're paid millions of dollars to do!) and expanding their companies. ...
Private enterprise is what will ultimately save the economy and create jobs. It's easy for the people at the wheel to come up with excuses about why they aren't doing that. Fundamentally, though, the power resides with them.

The claim that uncertainty over legislation was holding firms back is not a serious complaint, it's an attempt to put up every possible obstruction to new legislation that might impact the private sectors ability to conduct themselves as they have in the past.

As for confidence, I have argued for a long time that one sign that we are finally in a self-sustaining recovery will be private money coming off the sidelines and taking risks without government inducements to do so. So far, we aren't seeing that to any significant degree. The president can talk all he wants about how confident we should be in the economy (perhaps at risk to his own credibility since it's obvious we still have problems to solve), but confidence won't build until the private sector takes the lead. The mistake has been that the government has not done enough to prime the economic pump so that the private sector can then take over on its own, not that it has done too much.

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