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October 11, 2010

Latest Posts from Economist's View

Latest Posts from Economist's View

Paul Krugman: Hey, Small Spender

Posted: 11 Oct 2010 12:48 AM PDT

Government spending as stimulus hasn't failed, how could it when it hasn't even been tried?:

Hey, Small Spender, by Paul Krugman, Commentary, NY Times: Here's the narrative you hear everywhere: President Obama has presided over a huge expansion of government, but unemployment has remained high. And this proves that government spending can't create jobs.
Here's what you need to know: The whole story is a myth. There never was a big expansion of government spending. In fact, that has been the key problem with economic policy in the Obama years: we never had the kind of fiscal expansion that might have created the millions of jobs we need. ...
To be fair, spending on safety-net programs, mainly unemployment insurance and Medicaid, has risen — because, in case you haven't noticed, there has been a surge in the number of Americans without jobs and badly in need of help. And there were also substantial outlays to rescue troubled financial institutions, although it appears that the government will get most of its money back. But when people denounce big government, they usually have in mind the creation of big bureaucracies and major new programs. And that just hasn't taken place. ...
This fact, however, raises two questions. First, we know that Congress enacted a stimulus bill in early 2009; why didn't that translate into a big rise in government spending? Second, if the expansion never happened, why does everyone think it did?
Part of the answer to the first question is that the stimulus wasn't actually all that big compared with the size of the economy. Furthermore, it wasn't mainly focused on increasing government spending. Of the roughly $600 billion cost of the Recovery Act in 2009 and 2010, more than 40 percent came from tax cuts, while another large chunk consisted of aid to state and local governments. Only the remainder involved direct federal spending.
And federal aid to state and local governments wasn't enough to make up for plunging tax receipts in the face of the economic slump. So states and cities, which can't run large deficits, were forced into drastic spending cuts, more than offsetting the modest increase at the federal level.
The answer to the second question — why there's a widespread perception that government spending has surged, when it hasn't — is that there has been a disinformation campaign from the right, based on the usual combination of fact-free assertions and cooked numbers. And this campaign has been effective in part because the Obama administration hasn't offered an effective reply.
Actually, the administration has had a messaging problem on economic policy ever since its first months in office, when it went for a stimulus plan that many of us warned from the beginning was inadequate given the size of the economy's troubles. You can argue that Mr. Obama got all he could — that a larger plan wouldn't have made it through Congress (which is questionable), and that an inadequate stimulus was much better than none at all (which it was). But that's not an argument the administration ever made. Instead, it has insisted throughout that its original plan was just right, a position that has become increasingly awkward as the recovery stalls.
And a side consequence of this awkward positioning is that officials can't easily offer the obvious rebuttal to claims that big spending failed to fix the economy — namely, that thanks to the inadequate scale of the Recovery Act, big spending never happened in the first place.
But if they won't say it, I will: if job-creating government spending has failed to bring down unemployment in the Obama era, it's not because it doesn't work; it's because it wasn't tried.

Fed Watch: The Final End of Bretton Woods 2?

Posted: 11 Oct 2010 12:24 AM PDT

Tim Duy:

The Final End of Bretton Woods 2?, by Tim Duy: The inability of global leaders to address global current account imbalances now truly threatens global financial stability. Perhaps this was inevitable - the dollar has not depreciated to a degree commensurate with the financial crisis. Moreover, as the global economy stabilized the old imbalances made a comeback, sucking stimulus from the US economy and leaving US labor markets crippled. The latter prompts the US Federal Reserve to initiate a policy stance that will undoubtedly resonate throughout the globe. As a result we could now be standing witness to the final end of Bretton Woods 2. And a bloody end it may be.

Of course, the end of Bretton Woods 2 has been long prophesied. Back in October 2008, Brad Setser foresaw its imminent demise:

I increasingly suspect that the combination of falling oil prices and falling demand for imported goods will produce significant fall in the US trade and current account deficit in the fourth quarter, with a corresponding fall in the emerging world's combined surplus. The Bretton Woods 2 system – where China and then the oil-exporters provided (subsidized) financing to the US to sustain their exports – will come close to ending, at least temporarily. If the US and Europe are not importing much, the rest of the world won't be exporting much….
And rather than ending with a whimper, Bretton Woods 2 may end with a bang….
….If Bretton Woods 2 ends in 2009 – if US demand for imports falls sharply in the last part of 2008 and early 2009, bringing the US trade deficit down – it won't have ended in the way Nouriel and I outlined back in late 2004 and early 2005. We postulated that foreign demand for US debt would dry up – pushing up US Treasury rates and delivering a nasty shock to a housing-centric economy... it didn't quite play out that way. The US and European banking system collapsed before the balance of financial terror collapsed.

But Bretton Woods 2 was soon reborn, as the steady improvement to the US current account deficit was soon reversed:


Bretton Woods 2 simply morphed forms. Rather than a reliance on US financial institutions to intermediate the channel between foreign savers and US households, a modified Bretton Woods 2 - Bretton Woods 2.1 - relied on the US government to step into the void created by the financial mess and become the intermediary, either by propping up mortgage markets via the takeover of Freddie and Fannie, or the fiscal stimulus, or a dozen of other programs initiated during the financial crisis.

In essence, a nasty surprise awaited US policymakers - after two years of scrambling to find the right mix of policies, including an all out effort to prevent a devastating collapse of financial markets and a what Administration officials believed to be a substantial fiscal stimulus, the US economy remains mired at a suboptimal level as stimulus flows out beyond US borders. The opportunity for a smooth transition out of Bretton Woods 2 was lost.

How has it come to this? To understand the challenge ahead, we need to begin with two points of general agreement. The first is that the US has a significant and persistent current account deficit, which implies that domestic absorption of goods and services, by all sectors, exceeds potential output. In other words, we rely on a steady inflow of goods and services to satisfy our excess demand, a situation we typically find acceptable during a high growth phase when domestic investment exceeds domestic saving. The second point of agreement is that high unemployment implies that actual output is far below potential output. We clearly have unused capacity.

Points one and two appear that they should be mutually exclusive, but they are not. The fact that they are not begs an explanation. Paul Krugman sends us to Paul Samuelson to provide that explanation:

Here's what he [Samuelson] wrote in his 1964 paper "Theoretical notes on trade problems": "With employment less than full and Net National Product suboptimal, all the debunked mercantilist arguments turn out to be valid." And he went on to mention the appendix to the latest edition of his Economics, "pointing out the genuine problems for free-trade apologetics raised by overvaluation".

I think Samuelson is correct; an excessively high dollar is the explanation for the simultaneous existence of a sizable current account deficit and excessive unemployment. Indeed, there appears to be a externally determined downward limit to real value of the Dollar, and we are close to pushing against it:


The US appears to have little control over that minimum level. Foreign central have repeatedly acted to limit Dollar depreciation. Over the years, US policymakers have happily accepted this state of affairs (the steady financial inflow certainly helped support structural fiscal deficits), all the while ignoring the very real structural outcomes of blind adherence to the idea of a strong Dollar. spencer at Angry Bear succinctly lays out the structural impact:
The first chart is of imports market share, or imports as a share of what we purchase in the US. In the second quarter of this year imports market share rebounded to about where it was at the pre-recession peak, or about 16% of consumption. Since the early 1980's when the US started borrowing abroad to finance its two structural deficits -- federal and foreign--trades share of consumption has risen from about 6% to some 16%. Normally this has a small negative impact on the US economy, but sometimes you get quarters like the last quarter. Last quarter real domestic consumption rose at a 4.9% annual rate. That was an increase of $162.6 billion( 2005 $). But real imports also increased $142.2 billion (2005 $). That mean that the increase in imports was 87.5% of the increase in domestic demand.
To apply a little old fashion Keynesian analysis or terminology, the leakage abroad of the demand growth was 87.5%. It does not take some great new "freshwater" theory to explain why the stimulus is not working as expected, simple old fashioned Keynesian models explain it adequately.

Years of current account deficits - deficits induced not by the decisions of private savers looking to maximize returns but by foreign public sector entities seeking to maintain export growth - has literally resulted in a US economy that, on net, is unable to produce the goods its citizens want to consume. Hence a blast of stimulus flows overseas , the rising trade deficit heralded as a sign of strong US demand despite the inconvenient truth of little net job creation.

Which brings us to this observation by Simon Johnson:

The main reason the U.S. isn't bouncing back so fast is because of exports and the dollar. South Korea, Russia, and other emerging markets that go through severe crises usually undergo a sharp depreciation in the inflation-adjusted value of the currency, making them hypercompetitive, at least for a while. This makes it easier to replace imports with domestic goods and services and much more attractive to export.
In contrast, the global financial crisis actually strengthened the U.S. dollar as it was seen as a haven, although the dollar has fallen somewhat from its recent peak against major trading partners.

Currency depreciation - of substantial magnitude - is a mechanism by which economies recover from financial crisis. But we shouldn't underestimate that challenges that accompany such an adjustment. If it happens to quickly - a sudden stop of capital - the most likely short run outcome is that the current account deficit will be resolved with import compression via a sharp drop in demand. This would be painful, to say the least. It is not the optimal path.

Neither, though, is the current path - a painstakingly slow Dollar depreciation. The result so far is persistently high US unemployment, with no relief in sight. In frustration, policymakers lash out against the wrong target, free trade. Krugman's frustration rises to the level that he supports the Levin bill as the only remaining option:

Finally, the idea that what we need is a mature discussion of global rebalancing strikes me as reasonable — if you have been living in a cave the past three or four years. We've been reasoning, and reasoning, and reasoning, and nothing changes. Clearly, China does not want to act — not out of national interest, but because of the political influence of its export industries. It won't change its behavior unless it faces an additional incentive — like the prospect of countervailing duties.

But I don't want to make this piece about China. It is more than China at this point. It became more than China the instant US Federal Reserve policymakers woke up one morning and decided they needed to take the dual mandate seriously. And seriously means quantitative easing. Brad DeLong suggests that when the Fed actually acts on November 3, it will be too little too late. But if it is too little, more will be forthcoming.

Put simply, the Federal Reserve is positioned to declare war on Bretton Woods 2. November 3, 2010. Mark it on your calendars.

So perhaps Bretton Woods does not end because foreign governments are unwilling to bear ever increasing levels of currency and interest rate risk or due to the collapse of private intermediaries in the US, but because it has delivered the threat of deflation to the US, and that provokes a substantial response from the Federal Reserve. A side effect of the next round of quantitative easing is an attack on the strong dollar policy.

The rest of the world is howling. The Chinese are not alone; no one wants it to end. From Bloomberg:

Leaders of the world economy failed to narrow differences over currencies as they turned to the International Monetary Fund to calm frictions that are already sparking protectionism….
….Days after Brazilian Finance Minister Guido Mantega set the tone for the gathering by declaring a "currency war" was underway, officials held their traditional battle lines. U.S. Treasury Secretary Timothy F. Geithner and European Central Bank President Jean-Claude Trichet were among those to signal irritation that China is restraining the yuan to aid exports even as its economy outpaces those of other G-20 members.
"Global rebalancing is not progressing as well as needed to avoid threats to the global economic recovery," Geithner said. "Our initial achievements are at risk of being undermined by the limited extent of progress toward more domestic demand- led growth in countries running external surpluses and by the extent of foreign-exchange intervention as countries with undervalued currencies lean against appreciation."
At the same time, officials from emerging economies including China complained that low interest rates in the U.S. and its developed-world counterparts mean investors are pouring capital into their markets, threatening growth by forcing up currencies and inflating asset bubbles. The MSCI Emerging Markets Index of stocks has soared 13 percent since the start of September...
..."Near-zero interest rates and rapid monetary expansion are geared at stimulating domestic demand but also tend to produce a weakening of their currencies," Mantega said Oct. 9. As a result, developing countries will continue to build up reserves in foreign currency to avoid "volatility and appreciation."

Consider the enormity of the situation at hand. The Federal Reserve is poised to crank up the printing press for the sake of satisfying their domestic mandate. One mechanism, perhaps the only mechanism, by which we can expect meaningful, sustained reversal from the current set of imbalances is via a significant depreciation of the dollar. The rest of the world appears prepared to fight the Fed because they know no other path.

Bad things happen when you fight the Fed. You find yourself on the wrong side of a whole bunch of trades. In this case, I suspect it means that Bretton Woods 2 finally collapses in a disorderly mess. There may really be no other way for it to end, because its end yields clear winners and losers. And the losers, in this case largely emerging markets, and not prepared to accept their fate.

Moreover, there is no agreement on what should be the post-Bretton Woods 2 rules of the game for international finance. Is there even a meaningful policy discussion? Perhaps a little hope via Bloomberg:

Suggestions for how to resolve currency differences were vague in Washington, with French Finance Minister Christine Lagarde proposing better coordination and more diversification, while Canada's Jim Flaherty suggested that new "rules of the road" be outlined.

Of course, in the next sentence hope is dashed:

European Central Bank Executive Board member Lorenzo-Bini Smaghi suggested the G- 20 may be too big to find a compromise.
Unless checked in South Korea, the discord may snap the G- 20's united front formed to fight the financial crisis and recession.

And don't expect that the International Monetary Fund is prepared to deal with this crisis:

Unable to find common ground themselves, governments agreed the IMF should serve as currency cop by preparing reports which show how the policies of one economy affect others. The studies will focus on the U.S., China, the U.K. and the euro area.
"The need to have this kind of spillover report has been discussed for months and now it's part of our toolbox," IMF Managing Director Dominique Strauss-Kahn said.

Well, thank the Heavens above, the IMF stands ready to produce a report. Now I can sleep easy.

Bottom Line: The time may finally be at hand when the imbalances created by Bretton Woods 2 now tear the system asunder. The collapse is coming via an unexpected channel; rather than originating from abroad, the shock that sets it in motion comes from the inside, a blast of stimulus from the US Federal Reserve. And at the moment, the collapse looks likely to turn disorderly quickly. If the Federal Reserve is committed to quantitative easing, there is no way for the rest of the world to stop to flow of dollars that is already emanating from the US. Yet much of the world does not want to accept the inevitable, and there appears to be no agreement on what comes next. Call me pessimistic, but right now I don't see how this situation gets anything but more ugly

links for 2010-10-10

Posted: 10 Oct 2010 11:01 PM PDT

Is It Really the Money?

Posted: 10 Oct 2010 11:50 AM PDT

Greg Mankiw complains that if taxes go up for people with incomes as high as his, he won't work as hard and that means he won't be able to leave as much for his kids. Incentives matter he says. If that's the case, I wonder why someone who is trying to take away the incentive for his kids to work hard and be successful on their own doesn't leave academia and become a high paid consultant.

I'm sure Greg Mankiw could clean up as a consultant. The same effort he puts into academics would be much more highly compensated somewhere else. The fact that he decided to become an academic in the first place indicates that it's not all about the money. 

As Greg Mankiw makes clear every chance he gets, he's at Harvard. That tells me that the return to his ego is every bit as important as the financial return. I'd further guess that even if the New York Times stopped paying him for his column, he'd write it anyway. It's a boost to his ego and reputation that he'd want even without whatever small payment he gets for each column (he could make more by using the time to prepare a talk "to a business group, consulting on a legal case, [or] giving a guest lecture," so the opportunity cost of the column is quite high).

But, I suppose we will see. If taxes do go up, I expect Greg Mankiw to give up his NY Times column -- he's implied it just won't be worth it -- so we shall see if he really means what he says:

Now you might not care if I supply less of my services to the marketplace — although, because you are reading this article, you are one of my customers.

If taxes do go up and he doesn't give up the column, then we'll know he was mostly blowing smoke.

Oh, and did you hear that Greg Mankiw is at Harvard?

Update: Brad DeLong:

Greg Mankiw Quits the New York Times?, by Brad DeLong: An email from Mark Thoma saying that it sounds like Greg Mankiw is giving up his New York Times Economic View column because President Obama does not want to extend the temporary Bush tax cut on the marginal rates applied to high incomes.

It certainly sounds like it. The New York Times pays $650 a column and, Greg says, at anything less than the temporary Bush marginal rates on high incomes, that just is not enough:

Greg Mankiw:: AN important issue dividing the political parties is whether to raise taxes on those earning more than $250,000 a year. Democrats say these taxpayers can afford to chip in a bit more. Republicans say raising taxes on those who already face the highest marginal tax rates will hurt the economy. So I thought it might be useful to do a case study on one of these high-income taxpayers. Fortunately, I have one handy: me....

I can afford to pay more in taxes.... I have been very lucky.... I don't have trouble making ends meet.... I am almost completely sated.... I don't aspire for much more than a typical upper-middle-class lifestyle....

[B]ut I [do] hope to put some money aside for my three children. They will never lead lives of leisure, but I hope they won't have to struggle to find down payments to buy their own homes or to send their kids to college. Suppose that some editor offered me $1,000 to write an article.... If I invested it in the stock of a company that earned, say, 8 percent a year on its capital, then 30 years from now... assuming that the Bush tax cuts expire, I would pay 39.6 percent in federal income taxes... the phaseout of deductions adds 1.2 percentage points... Medicare... 3.8 percent... 5.3 percent in state income taxes... the corporation in which I have invested pays a 35 percent corporate tax.... the estate tax.... Most likely... my kids will get... $1,000....

[W]ithout the tax increases advocated by the Obama administration... that writing assignment would yield my kids about $2,000....

Now you might not care if I supply less of my services to the marketplace — although, because you are reading this article, you are one of my customers. But I bet there are some high-income taxpayers whose services you enjoy.... Like me, these individuals respond to incentives. (Indeed, some studies report that high-income taxpayers are particularly responsive to taxes.) As they face higher tax rates, their services will be in shorter supply...

I think that this is a big mistake for two reasons: one moral-political and one economic-analytical.

Let me deal with the economic-analytical reason first:

First, start with the fact that tax on Greg's current writing earnings because he wants to leave more to his children in thirty years will be higher than today's current Bush-era tax rates. But they will not be higher because of anything Barack Obama has done or failed to do. They will be higher for three reasons. First, George W. Bush and his advisors--of whom Greg Mankiw was one--failed to find any spending offsets in order to pay for the temporary Bush reductions in tax rates. Second, George W. Bush and his advisors--of whom Greg Mankiw was one--enacted a very large long-term spending increase without figuring out any way to pay for it: Medicare Part D. Third, George W. Bush and his advisors--of whom Greg Mankiw was one--enacted a second very large spending increase when they responded to Al Qaeda by greatly increasing the size of a conventional military which is of not much use in our current struggle, and also did so without figuring out any way to pay for it.

As Milton Friedman liked to say, and as he did say when he--I am told--yelled at George W. Bush during his 90th birthday celebration at the White House--to spend is to tax. Will the spending, and you will the taxes. If somebody claims to have cut your taxes without cutting spending, do not believe them: all they have done is to shift taxes forward into the future, and made taxes on current consumption lower while making taxes on long-term transfers of wealth into the future higher.

The sooner taxes are raised in order to pay for Medicare Part D, the expanded U.S. military, other pieces of Medicare and Medicaid spending growth, and to offset the revenue lost over the past decade of the Bush temporary tax cuts, the lower the taxes on Greg's saving for his children's inheritance will be. That Barack Obama is taking some steps to restore fiscal sanity should diminish his view of the risk-adjusted taxes his long-run savings will pay, and make him more willing to write for the New York Times--not less.

But there is more. The two biggest long-run policies that Barack Obama has set in motion over the past two years have been (a) the entrenchment of future reductions in Medicare spending growth designed by the Independent Payment Authorization Board so that they can only be overturned by affirmative congressional supermajority votes to prevent them, and (b) the enactment of a growing and eventually very large tax on high-cost health-insurance plans. Now these policy changes may not survive--the Republicans are pledged, to a sophont, to repeal both of them. But if they do they greatly reduce the amount by which income and other taxes must rise over the next generation. And so they make the expected taxes on Greg's saving-for-his-children's-inheritance significantly lower.

If Greg wrote one column a month before Obama took these big steps to restore long-run fiscal balance to the U.S. federal government, the prospect of lower tax rates on his saving-for-his-children's-inheritance should induce him to write three columns a month now.

Second, Greg says that it's worth it for him to write columns if they generate $2000 in net bequeathed wealth in 2040 but not if they generate $1,000. But that shouldn't be why anybody writes columns. Indeed, if people write columns not because they are driven to inform and educate their readers but rather because it is a way to make money to leave to their children--well, then those columns will be written not to inform but to entertain, and so they will be worthless as sources of information and education (rather than as sheer entertainment) to their readers.

I do not think society can survive if the voices writing on political-economic issues in our public sphere are doing so not to inform but merely to entertain. I think that society can only survive if those who write columns are driven by a geas to make Americans better-educated citizens but rather to leave more wealth to your children. We ought to write columns not because we think our children will need extra money in thirty years, but because we think our fellow-citizens need better information now.

Indeed, I don't think America can long survive if we treat our contracts with newspapers merely as ones in which we craft words qnd they pay us money, and in which we craft our words to make as much money as we can.

Edmund Burke, I think, put it best when he said that society can only survive if at the very least it is a long-term partnership, and ought to have much more of social gift-exchange than that. As Burke wrote, we ought not to speak of a "social contract" in which each narrowly counts their contributions and benefits. And if we do speak of a "social contract," we must recognize that that is far from being a complete description:

Subordinate contracts for objects of mere occasional interest may be dissolved at pleasure; but the state ought not to be considered as nothing better than a partnership agreement in a trade of pepper and coffee, calico or tobacco, or some other such low concern, to be taken up for a little temporary interest, and to be dissolved by the fancy of the parties. It is to be looked on with other reverence; because it is not a partnership in things subservient only to the gross animal existence of a temporary and perishable nature. It is a partnership in all science, a partnership in all art, a partnership in every virtue and in all perfection. As the ends of such a partnership cannot be obtained in many generations, it becomes a partnership not only between those who are living, but between those who are living, those who are dead, and those who are to be born. Each contract of each particular state is but a clause in the great primeval contract of eternal society, linking the lower with the higher natures, connecting the visible and invisible world, according to a fixed compact sanctioned by the inviolable oath which holds all physical and all moral natures each in their appointed place...

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