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July 23, 2010

Latest Posts from Economist's View

Latest Posts from Economist's View


Paul Krugman: Addicted to Bush

Posted: 23 Jul 2010 01:08 AM PDT

Just say no:

Addicted to Bush, by Paul Krugman, Commentary, NY Times: For a couple of years, it was the love that dared not speak his name. In 2008, Republican candidates hardly ever mentioned the president still sitting in the White House. ...
The truth, however, is that the only problem Republicans ever had with George W. Bush was his low approval rating. They always loved his policies and his governing style — and they want them back. In recent weeks, G.O.P. leaders have come out for a complete return to the Bush agenda, including tax breaks for the rich and financial deregulation. They've even resurrected the plan to cut future Social Security benefits.
But they have a problem: how can they embrace President Bush's policies, given his record? ... What's a Republican to do? You know the answer. There's now a concerted effort under way to rehabilitate Mr. Bush's image on at least three fronts: the economy, the deficit and the war.
On the economy: Last week Mitch McConnell, the Senate minority leader, declared that "there's no evidence whatsoever that the Bush tax cuts actually diminished revenue. They increased revenue, because of the vibrancy of these tax cuts in the economy." ...
I guess it depends on the meaning of the word "vibrant." The actual record of the Bush years was (i) two and half years of declining employment, followed by (ii) four and a half years of modest job growth, at a pace significantly below the eight-year average under Bill Clinton, followed by (iii) a year of economic catastrophe. In 2007, at the height of the "Bush boom," such as it was, median household income, adjusted for inflation, was still lower than it had been in 2000.
But the Bush apologists hope that you won't remember all that. And they also have a theory ... that President Obama, though not yet in office or even elected, caused the 2008 slump. You see, people were worried in advance about his future policies, and that's what caused the economy to tank. Seriously.
On the deficit: Republicans are now claiming that ... the deficit is Mr. Obama's fault. "The last year of the Bush administration," said Mr. McConnell recently, "the deficit as a percentage of gross domestic product was 3.2 percent, well within the range ... most economists think is manageable. A year and a half later, it's almost 10 percent."
But that 3.2 percent figure, it turns out, is for fiscal 2008 — which wasn't the last year of the Bush administration, because it ended in September of 2008. In other words, it ended just as the failure of Lehman Brothers — on Mr. Bush's watch — ... caused the deficit to soar: By the first quarter of 2009 ... federal borrowing had already reached almost 9 percent of G.D.P. To some of us, this says that the economic crisis that began under Mr. Bush is responsible for the great bulk of our current deficit. But the Republican Party is having none of it.
Finally, on the war: ...Karl Rove now claims that his biggest mistake was letting Democrats get away with the "shameful" claim that the Bush administration hyped the case for invading Iraq. Let the whitewashing begin!
Again, Republicans aren't trying to rescue George W. Bush's reputation for sentimental reasons; they're trying to clear the way for a return to Bush policies. And this carries a message for anyone hoping that the next time Republicans are in power, they'll behave differently. If you believe that they've learned something — say, about fiscal prudence or the importance of effective regulation — you're kidding yourself. You might as well face it: they're addicted to Bush.

Fed Watch: Bernanke Post Mortem

Posted: 23 Jul 2010 12:42 AM PDT

Tim Duy looks at the Fed's likely course of action:

Bernanke Post Mortem, by Tim Duy: Federal Reserve Chairman Ben Bernanke's Congressional testimony should leave little doubt about the stance of monetary policymakers. Swift reaction came from Mark Thoma, Paul Krugman, Scott Sumner, and Joe Gagnon. Simply put, an incipient second half slowdown and fears of an outright double dip are insufficient to prod additional action on the part of the Federal Reserve. Policymakers are comfortable with the idea that neither objective of the dual mandate will be met in the foreseeable future. And even should the economy deteriorate such that they are forced into additional action, the likely policy candidates are woefully insufficient to meaningfully change the path of economic activity.

For all intents and purposes, the Fed is done. To be sure, the Fed would roll out its new set of lending facilities in response to another financial crisis. But setting the possibility of crisis aside, it is not clear what data flow short of a significant drop in activity would prompt a change of heart at the Fed.

Market participants set themselves up for disappointment. The set up began back with the Washington Post article suggesting that policymakers were actively considering the next set of policy options in light of recent data. I suggested the threshold for such actions was actually quite high, but the story fed upon itself until it became rumored that Bernanke would signal an end to providing interest on reserves. As Neil Irwin and Ryan Avent pointed out, the Fed Chair was simply not going to make a major policy announcement of that sort in Congressional testimony.

Worse, Bernanke did not appear overly concerned with the incipient second half slowdown. To be sure, he acknowledged the relatively weak data flow, but incoming information has only made the outlook "somewhat weaker," implying very little real shift in the fundamental view that the recovery is self-sustaining and sufficient to consume excess capacity over time and thus provides little reason to consider new policy options. Indeed, a substantive portion of the prepared remarks were devoted to tightening mechanisms, with the notion of additional easing left to the throwaway lines:

Of course, even as the Federal Reserve continues prudent planning for the ultimate withdrawal of extraordinary monetary policy accommodation, we also recognize that the economic outlook remains unusually uncertain. We will continue to carefully assess ongoing financial and economic developments, and we remain prepared to take further policy actions as needed to foster a return to full utilization of our nation's productive potential in a context of price stability.

Participants may also have been rattled by Bernanke's seemingly nonchalant attitude regarding additional easing options. From the Q&A:

SHELBY: Thank you.

Mr. Chairman, the minutes of the June FOMC, the Federal Open Markets Committee, meeting stated, and I'll quote, "The committee would need to consider whether further policy stimulus might become appropriate if the Outlook were to worsen appreciably," end quote.

Aside from taking the federal funds rate and the interest rate paid on reserves to zero, it's not clear to me what further policy stimulus would mean. If further stimulus were to involve more asset purchases that you alluded to by the Fed, would the Fed buy treasuries or would they try to channel credit to specific segments of the financial market, such as housing or perhaps even municipal debt?

BERNANKE: Senator, I think it's important to preface the answer by saying that monetary policy is currently very stimulative, as you, I'm sure, you're aware.

We have brought interest rates down close to zero. We have had a number of programs to stabilize financial markets. We have language which says that we plan to keep rates low for an extended period. And we have purchased more than $1 trillion in securities. So certainly, no one can accuse the Fed of not having been aggressive in trying to support the recovery.

You know, that being said, if the -- if the recovery seems to be faltering, then we would at least need to review our options, and we have not fully done that review, and we need to think about possibilities.

But broadly speaking, there are a number of things that we could consider and look at. One would be further changes or modifications of our language or our framework describing how we intend to change interest rates over time, giving more information about that. That's certainly one approach.

We could lower the interest rate we pay on reserves, which is currently one-fourth of 1 percent.

The third class of things, though, has to do with changes in our balance sheet, and that would involve either not letting securities runoff as they are currently running off, or even making additional purchases.

We have not come to the point where we can tell you precisely what -- what the leading options are. Clearly, each of these options has got drawbacks, potential costs. So we are going to continue to monitor the economy closely and continue to evaluate the alternatives that we have, recognizing that, as I said, the policy is already quite stimulative.

The aforementioned Washington Post article suggested that plans for additional easing were pretty well fleshed out. A subsequent interview with Boston Fed President Eric Rosengren in the Wall Street Journal cemented that inference. Bernanke is much less clear: "…we have not fully done that review." Why have they not fully done that review? Because they are simply less concerned about a second half slowdown than most of the rest of the free world, instead considering the flow of data to simply be choppy, not worrisome. From New York Fed President William Dudley today:

"U.S. economic activity has expanded for four consecutive quarters, but at rates that can only be described as modest when compared with early stages of past recoveries," he said. "The road to recovery is turning out to be a bit bumpy as relatively weak consumer spending and the ongoing problems in financial markets are keeping growth far less robust than we would like."

Still, like Bernanke, Dudley views policy as quite stimulative. Why are Fed officials not willing to do more in the face of what is obviously suboptimal outcomes? First, consider the three options Bernanke lays out. The first two - committing to sustained low rates and cutting the interest on reserves - are not likely to have much impact. The implicit promise of low rates is likely already reflected in the short end of the yield curve. And while in a perfect world the Fed wouldn't charge interest on reserves, that last 25bp is likely not stifling much if any lending activity. Moreover, Bernanke appears to believe it is important to market functioning:

Each of those options carries drawbacks, he told a Senate committee Wednesday. Testifying before the House Financial Services Committee today, he elaborated on the risks of doing one of them: Lowering the interest rate it pays on excess reserves — now at 0.25% — could create trouble in money markets, he said.

"The rationale for not going all the way to zero has been that we want the short-term money markets, like the federal funds market, to continue to function in a reasonable way," he said.

"Because if rates go to zero, there will be no incentive for buying and selling federal funds — overnight money in the banking system — and if that market shuts down … it'll be more difficult to manage short-term interest rates when the Federal Reserve begins to tighten policy at some point in the future."

In short, promising an extended period of low rates and ending interest on reserves would be minimally positive, but would not meet up with the expectations that would surround such moves. Indeed, the failure to meet expectations would be the real cost to the Federal Reserve. Taking these two off the table leaves expanding the balance sheet. Option 3a, not letting securities runoff, is more of an effort to maintain the status quo rather than provide additional stimulus. Again, I suspect relatively little impact. Which then brings you to Option 3b, purchase of additional securities - the only real option in my opinion. Optimally, the Fed would tie those purchases to some numerical target, such as Joe Gagnon's suggestion that the Fed purchases Treasury securities to target a 25bp target on the 3 year bond. You have to go out to three years to get some traction - at least there you have a whopping 90bps to play with.

Why will the Fed ignore Gagnon? Perhaps David Wessel has the answer:

Why wait? Put yourself in Mr. Bernanke's chair. When the Fed began buying mortgages, the gap between yields on mortgages and Treasurys was wide; now it isn't. Mortgage rates are very low and the housing sector is still moribund; it isn't clear pushing mortgage rates down another one-quarter percentage point would do much.

The Fed could buy more Treasurys, trying to push yields on 10-year Treasurys below the already low 3%. But that could backfire. With all the deficit angst around, a Fed move to buy Treasurys could provoke cries of "they're monetizing the debt" and push up long-term rates rather than lowering them.

As scary as this sounds, the Fed can't be sure of the net effect of buying more assets. It might not make things better. It would be, in short, a Hail Mary pass. And Mr. Bernanke isn't ready—yet—to throw it.

When it comes down to it, fear of the being seen as monetizing the debt will keep the Fed on the sidelines unless it becomes clear that the economy is actually trapped in a deflationary spiral. The bond vigilantes win again.

It is worth noting that the fear of high long-term rates is somewhat irrational. Wessel continues on with a discussion of inflation expectations:

Mr. Bernanke's former Princeton University colleague, Nobel laureate Paul Krugman, has become the loudest critic of Mr. Bernanke's inaction, calling the Fed "feckless" (lacking in vitality, unthinking, irresponsible) in his New York Times column. In a prescient 1998 paper about Japan, Mr. Krugman warned that other countries might similarly confront the feared "liquidity trap," the circumstance at which the central bank has cut interest rates to zero and the economy remains very weak. His advice then: "Monetary policy will be effective…if the central bank can credibly promise to be irresponsible"—by promising to create inflation in the future.

The textbook point: Interest rates that matter are the inflation-adjusted ones. In recessions, the Fed effectively pushes inflation-adjusted rates below zero. But with nominal interest rates at zero, the only way to get inflation-adjusted rates lower is to get everyone believing that inflation will go up.

So far so good. But then Wessel makes an odd detour:

The practical point: This is easier to advise than to do safely. It would, at the very least, be hard to explain to a public already suspicious of the Fed. And it, too, could backfire. Manipulating inflation expectations is hard to calibrate. And the move would mean higher nominal (though lower inflation-adjusted) long-term interest rates. And outside of economic textbooks, higher nominal rates can hurt, pinching cash-strapped households for instance. It's risky.

So economic textbooks are wrong? The nominal, not the real rate, of interest is the relevant variable? Was he sourced this view from the Fed? And would high nominal rates really pinch cash-strapped households? Perhaps we can think of an alternative view: Higher inflation expectations lifts wage growth, which in turn lowers the real cost of sustaining current debt loads and reduces the urge to reduce that debt via foregoing current consumption.

Rising long rates would indicate that policy is getting traction - that policy is actually stimulative. If there is no pressure for long rates to rise, then policy is not very stimulative. Fear of inflation and rising long nominal rates look sufficient to make policymakers accept a suboptimal outcome. Sad given that neither of these are an obvious problem now.

At the risk of making an already long post longer, I would point out a disturbing outcome of Scott Sumner's last two posts. In his review of the Bernanke testimony, Sumner opines:

The Fed has reduced its implicit inflation target below 2%, indeed below even 1.5%.

Marry that with Sumner's concerns about the Fed's pursuit of opportunistic disinflation. You quickly get to the conclusion that the Fed is not reacting to disinflation concerns because they are secretly happy, and have no intention of accelerating the healing of the labor market if that entails any risk the latest round of opportunistic disinflation is lost. So what the rest of us see as a failure to meet either of the dual mandates, the Fed really believes they are meeting the most important mandate, a strict definition of price stability.

Bottom Line: The Fed shows no sense of urgency with respect to the current economic situation, and appears prepared to endure a weaker second half with no policy shift. Moreover, even if the economy does worsen more than they expect, the likely candidates for policy action are more smoke than fire. The Fed knows this, and doesn't want to lose credibility on actions with little likelihood of success. A more aggressive policy stance Gagnon-style appears off the table as long as the Fed fears the possibility that such policy might actually work and push up long term rates. That means more significant action only after outright deflation expectations are evident. Appears extreme, but central bankers tend to be a conservative lot. Lacking a financial crisis, the need for more action is not apparent to them. They fundamentally believe they have done pretty much all that can be reasonably expected. Moreover, we need to reassess the Fed's inflation comfort level; they may think they are hitting one mandate just fine.

Tucker Punched

Posted: 23 Jul 2010 12:24 AM PDT

The misrepresentations from the reporters distorters pushing this (non)story based upon emails from Journolist continue (in addition to the examples below, there are other instances where the difference between the original emails and the versions posted at Daily Caller reveal the willingness to use distortions to tell a story that appears to resonate so well with potential readers of that site):

Should You Trust Tucker Carlson's Daily Caller on Anything? No, by Brad DeLong: In case you were wondering...

The Daily Caller:

DAVID ROBERTS, GRIST: It's all I can do not to start bawling....

JOHN BLEVINS, SOUTH TEXAS COLLEGE OF LAW: It's all I can do to hold it together.

The actual conversation on election night, which of course puts these lines in a much different and more history-conscious light:

DAVID: I've spent much of this election struggling not to contemplate what an Obama victory would mean. After the crushing disappointments of 2000 and 2004, I haven't allowed myself to feel much hope or excitement. It's been head-down, day-to-day fighting for a long, long time. Big picture stuff has been pushed out.

Yet I find that as an Obama victory seems more tangible, all that feeling is fighting its way to the surface. When I look at pictures like the one attached, it's all I can do not to start bawling. The same is true when I hear all these reports, like Rich's, about extraordinary turnout and energy in places like NC. It's true when I hear Obama's speeches. It's true when I think about the fact that people who experienced a time when blacks had separate drinking fountains are now voting for a black president....

John: David - well said. I've been experiencing the same thing -- it's all I can do to hold it together. I think the most touching moments are the interviews/accounts of elderly black people voting/volunteering/etc. Like the video below (Charles Meets Barack) -- it's just an unbelievable historical moment.

And what's truly touching is that you can really feel the weight of so many past generations who have sacrificed so much to make it possible today.

http://www.youtube.com/watch?v=TW-6DpC-mj8

And Ezra Klein writes:

Ezra Klein - When Tucker Carlson asked to join Journolist: I hoped to let my quick accounting of the constant inaccuracies in the Daily Caller's selective quotations from Journolist stand as my last word on the matter. But Tucker Carlson's sanctimonious and evasive statement on the way his site has been covering this story deserves a response. So allow me one more post.

Tucker's note doesn't bother to mention the actual questions that have been raised: That his stories have misstated fact, misled readers, and omitted evidence that would contradict his thesis. He doesn't explain how a thread in which no journalists suggested shutting down Fox News can be headlined "Liberal journalists suggest government shut down Fox News." He doesn't tell us why an article about the open letter that originated on the list left out the fact that I subsequently banned any future letters from the list. He doesn't detail why his stories haven't mentioned that one of his own reporters was on the list -- his readers would presumably be interested to know that the Daily Caller was part of the liberal media conspiracy.

Instead, Tucker says, well, trust him. "I edited the first four stories myself," he writes, "and I can say that our reporter Jonathan Strong is as meticulous and fair as anyone I have worked with."

If this series now rests on Tucker's credibility, then let's talk about something else he doesn't mention: I tried to add him to the list. I tried to give him access to the archives. Voluntarily. Because though I believed it was important for the conversation to be off-the-record, I didn't believe there was anything to hide.

The e-mail came on May 25th. Tucker didn't ask that it be off-the-record, so I'm not breaking a confidence by publishing it. Here it is, in full:

Dear Ezra,

I keep hearing about how smart the policy conversations on JournoList are, and am starting to feel like I'm missing out by not reading them. Could I join?

I realize you and I don't share the same politics, but I can promise you I have no interest in flaming anyone or even debating (I get enough of that). I'm just interested in knowing what smart progressives are saying. It strikes me that's the one thing I'm missing in my daily reading.

Please tell me what you think. If it makes you uncomfortable, ask around. I'm pretty sure we know a lot of the same people.

All best,

Tucker Carlson.

At the time, I didn't know Carlson was working on a story about Journolist. And I'd long thought that the membership rules that had made sense in the beginning had begun to feed conspiracy theories on the right and cramp conversation inside the list. I wrote him back about 30 minutes later.

We definitely have friends in common, and I'd have no worries about you joining. The problem is I need to have clear rules, as i don't want to be in the position of forcing fine-grained membership tests based on opaque criteria. Thus far, it's been center to left, just because that was how people wanted it at the beginning in order to feel comfortable talking freely. I've been meaning for some time to ask the list about revisiting that, so I'll take this opportunity and get back to you.

I then wrote this e-mail to Journolist:

As folks know, there are a couple of rules for J List membership. One is that you can't be working for the government. Another is that you're center to left of center, as that was something various people wanted back in the day. I've gotten a couple of recent requests from conservatives who want to be added (and who are people I think this list might benefit from), however, and so it seems worth asking people whether they'd like to see the list opened up. Back in the day, I'd probably have let this lie, but given that Journolist now leaks like a sieve, it seems worth revisiting some of the decisions made when it was meant to be a more protected space.

As I see it, the pro of this is that it could make for more fun conversations. The con of it is that it becomes hard to decide who to add and who to leave off (I don't want to have to make subjective judgments, but I'm also not going to let Michelle Malkin hop onto the list), and it also could create even more possible leaks -- and now, they'd be leaks with more of an agenda, which could be much more destructive to trust on the list.

I want to be very clear about what I was suggesting: Adding someone to the list meant giving them access to the entirety of the archives. That didn't bother me very much. Sure, you could comb through tens of thousands of e-mails and pull intemperate moments and inartful wording out of context to embarrass people, but so long as you weren't there with an eye towards malice, you'd recognize it for what it was: A wonkish, fun, political yelling match. If it had been an international media conspiracy, I'd have never considered opening it up.

The idea was voted down. People worried about opening the archives to individuals who could help their careers by ripping e-mails out of context, misrepresenting the nature of the ongoing conversation, and bringing the world an exclusive look into The Great Journolist Conspiracy, as opposed to the daily life of Journolist, which even Carlson describes as "actually pretty banal."

Apologetically, I went back to Tucker and delivered the bad news. But I still liked the idea of a broader e-mail list, and I offered to partner with him to start one. "There was interest," I told him, "in creating a separate e-mail forum with a more bipartisan flavor (such that Journolist could keep its character, but something else could provide the service we're talking about), and if that's something you want to do, I'd be glad to work on it with you."

He asked again if he could join Journolist, maybe on a read-only basis. He never responded to the idea of creating a bipartisan list. I was disappointed, but didn't think much of it.

My mistake, obviously. But if this series rests on Tucker's credibility, that's a soft foundation indeed. At every turn, he's known about evidence that substantially complicates his picture of an international media conspiracy. He knows I tried to let him in, odd behavior for someone with so much to hide and so much to lose. He knows I let one of his reporters remain a member. He knows I banned -- and enforced the ban -- on the sort of coordinated letter that served as example one of the list's conspiracy. He knows -- and never, to my knowledge, corrected -- that his reporter misrepresented the dates of Dave Weigel's posts to make it look like things he wrote at the Washington Independent were written at the Washington Post. And that's not even to mention the more prosaic deceptions of his selective choice of threads, truncated quotations, and misleading headlines.

When I e-mailed him to ask about some of these omissions, his response was admission mixed with misdirection. "I don't have nearly the grounding in this that Strong does, but according to him you often come off as a voice for moderation, and I'm pretty sure he will make that clear in a subsequent story." Ah, the old "we'll be more truthful later."

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

links for 2010-07-22

Posted: 22 Jul 2010 11:02 PM PDT

"Building a Science of Economics for the Real World"

Posted: 22 Jul 2010 02:07 PM PDT

An email from James Morley remarks:

Not sure if you saw this Congressional testimony from Robert Solow, but I thought it covered some familiar themes in a clearer and more concise way than I am currently capable of. Oh, to be that lucid at 85! Or any age for that matter.

Yes. Last time I saw him was at this conference where we appeared together on a panel discussing the causes of the crisis and the state of macroeconomics. At one point during the conference, he was citing theorems from papers he had first read decades ago, in one case relying on work in the appendix, and from more contemporary work. It was pretty impressive:

Building a Science of Economics for the Real World, Prepared Statement of Robert Solow Professor Emeritus, MIT, for the House Committee on Science and Technology Subcommittee on Investigations and Oversight, July 20, 2010: It must be unusual for this Committee, or any Congressional Committee, to hold a hearing that is directed primarily at an analytical question. In this case, the question is about macroeconomics, the study of the growth and fluctuations of the broad national aggregates – national income, employment, the price level, and others – that are basic to our country's standard of living. How are these fundamental aggregates determined, and how should we think about them? While these are tough analytical questions, it is clear that the answers have a direct bearing on the most important issues of public policy.
It may be unusual for the Committee to focus on so abstract a question, but it is certainly natural and urgent. Here we are, still near the bottom of a deep and prolonged recession, with the immediate future uncertain, desperately short of jobs, and the approach to macroeconomics that dominates serious thinking, certainly in our elite universities and in many central banks and other influential policy circles, seems to have absolutely nothing to say about the problem. Not only does it offer no guidance or insight, it really seems to have nothing useful to say. My goal in the next few minutes is to try to explain why it has failed and is bound to fail.
Before I go on, there is something preliminary that I want to make clear. I am generally a quite traditional mainstream economist. I think that the body of economic analysis that we have piled up and teach to our students is pretty good; there is no need to overturn it in any wholesale way, and no acceptable suggestion for doing so. It goes without saying that there are important gaps in our understanding of the economy, and there are plenty of things we think we know that aren't true. That is almost inevitable. The national – not to mention the world – economy is unbelievably complicated, and its nature is usually changing underneath us. So there is no chance that anyone will ever get it quite right, once and for all. Economic theory is always and inevitably too simple; that can not be helped. But it is all the more important to keep pointing out foolishness wherever it appears. Especially when it comes to matters as important as macroeconomics, a mainstream economist like me insists that every proposition must pass the smell test: does this really make sense? I do not think that the currently popular DSGE models pass the smell test. They take it for granted that the whole economy can be thought about as if it were a single, consistent person or dynasty carrying out a rationally designed, long-term plan, occasionally disturbed by unexpected shocks, but adapting to them in a rational, consistent way. I do not think that this picture passes the smell test. The protagonists of this idea make a claim to respectability by asserting that it is founded on what we know about microeconomic behavior, but I think that this claim is generally phony. The advocates no doubt believe what they say, but they seem to have stopped sniffing or to have lost their sense of smell altogether.
This is hard to explain, but I will try. Most economists are willing to believe that most individual "agents" – consumers investors, borrowers, lenders, workers, employers – make their decisions so as to do the best that they can for themselves, given their possibilities and their information. Clearly they do not always behave in this rational way, and systematic deviations are well worth studying. But this is not a bad first approximation in many cases. The DSGE school populates its simplified economy – remember that all economics is about simplified economies just as biology is about simplified cells – with exactly one single combination worker-owner-consumer-everything-else who plans ahead carefully and lives forever. One important consequence of this "representative agent" assumption is that there are no conflicts of interest, no incompatible expectations, no deceptions.
This all-purpose decision-maker essentially runs the economy according to its own preferences. Not directly, of course: the economy has to operate through generally well-behaved markets and prices. Under pressure from skeptics and from the need to deal with actual data, DSGE modelers have worked hard to allow for various market frictions and imperfections like rigid prices and wages, asymmetries of information, time lags, and so on. This is all to the good. But the basic story always treats the whole economy as if it were like a person, trying consciously and rationally to do the best it can on behalf of the representative agent, given its circumstances. This can not be an adequate description of a national economy, which is pretty conspicuously not pursuing a consistent goal. A thoughtful person, faced with the thought that economic policy was being pursued on this basis, might reasonably wonder what planet he or she is on.
An obvious example is that the DSGE story has no real room for unemployment of the kind we see most of the time, and especially now: unemployment that is pure waste. There are competent workers, willing to work at the prevailing wage or even a bit less, but the potential job is stymied by a market failure. The economy is unable to organize a win-win situation that is apparently there for the taking. This sort of outcome is incompatible with the notion that the economy is in rational pursuit of an intelligible goal. The only way that DSGE and related models can cope with unemployment is to make it somehow voluntary, a choice of current leisure or a desire to retain some kind of flexibility for the future or something like that. But this is exactly the sort of explanation that does not pass the smell test.
Working out a story like this is not just an intellectual game, though no doubt it is a bit of that too. To the extent that the observed economy is actually doing the best it can, given the circumstances, it is already adapting optimally to whatever expected or unexpected disturbances come along. It can not do better. It follows that conscious public policy can only make things worse. If the government has better information than the representative agent has, then all it has to do is to make that information public. If prices are imperfectly flexible, then the government can make them more flexible by attacking monopolies and weakening unions. Actually this proposition is dubious on its own.
The point I am making is that the DSGE model has nothing useful to say about anti-recession policy because it has built into its essentially implausible assumptions the "conclusion" that there is nothing for macroeconomic policy to do. I think we have just seen how untrue this is for an economy attached to a highly-leveraged, weakly-regulated financial system. But I think it was just as visibly false in earlier recessions (and in episodes of inflationary overheating) that followed quite different patterns. There are other traditions with better ways to do macroeconomics.
One can find other, more narrowly statistical, reasons for believing that the DSGE approach is not a good way to understand macroeconomic behavior, but this is not the time to go into them. An interesting question remains as to why the macroeconomics profession led itself down this particular garden path. Perhaps we can come to that later.

Security First?

Posted: 22 Jul 2010 11:10 AM PDT

Feeling more insecure than you did in the past? it's not just the recession:

Americans Are Increasingly Insecure, by Conor Dougherty: The Rockefeller Foundation has released a new "Economic Security Index" that measures the effect of income loss and rising medical costs on Americans. The verdict: The recession has made Americans a lot less secure, but security was slipping long before the recent recession.

The Economic Security Index, which was developed by Yale political scientist Jacob Hacker, measures inflation-adjusted income that's available after medical costs. It captures Americans who have had a year-over-year fall of 25% or more in income after medical costs but don't have enough savings to offset the plunge. ...

Esi
The results: The ESI was at 12.2% in 1985 and has grown steadily ever since (with year-to-year fluctuations that track the economy). In 2007, the ESI was at 13.7% and is projected to hit 20.4% for 2009. ...
There are myriad reasons why economic security has become increasingly wobbly, but Mr. Hacker points to three main culprits. One is that men's earnings have become a lot more unstable since the 1970s, and since many men are still breadwinners that has led to more erratic household income. Government transfer benefits have also become a lot more unstable. And while there are more dual-income families the extra income is not enough to offset growing insecurity. ...

The rising uncertainty is yet another dose of cold water for an economy still on the mend. Mr. Hacker says that it takes somewhere between 6 and 8 years for people to recovery from an income loss of 25% or greater, a shock that can crimp consumer spending and lead greater income inequality even after the economy recovers. ...

If you are a big bank that loses a big part of its income, the government comes to your rescue. But if you are an individual wiped out by health costs, tough luck for you.

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