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September 28, 2011

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"Wages and Recovery"

Posted: 28 Sep 2011 12:15 AM PDT

Laurence Kotlikoff misrepresents the views of Paul Krugman and Jamie Galbraith:

Five Prescriptions to Heal Economy's Ills, by Laurence Kotlikoff, Bloomberg: Desperate times call for creative measures. We're in desperate times, but we've had little creative thinking from the Obama administration on how to fix the economy. ... I see five things policy makers can do to get the economy going. ...
4. Get prices and wages unstuck.
Some prices and wages are set too high, thereby damping demand for output and for the workers needed to produce it. This is the standard sticky wage and price explanation for our economic malaise offered by Keynesian economists such as Paul Krugman and James Galbraith. I think there are fewer markets suffering from this problem than Krugman and Galbraith do, but there are enough such markets to make the case for government intervention. Indeed, the president should put these economists in charge of identifying the markets suffering from this problem and helping their participants set market-clearing prices and wages.
One example is the market for construction workers. A 1931 law called the Davis-Bacon Act effectively requires contractors using federal money to pay union wages. If the act were suspended or repealed, federal spending on much-needed infrastructure projects could create a lot more jobs.  

In comments, Jamie Galbraith corrects the record:

...I have never written, argued or believed that unemployment can be cured by cutting wages. Nor does that position have anything to do with Keynes, who wrote The General Theory to debunk this view. Keynes favored stable money wages, writing: "it is fortunate that the workers, though unconsciously, are instinctively more reasonable economists than the classical school, inasmuch as they resist reductions of money wages..."
It seems likely that Professor Kotlikoff has never read Keynes either.

Here's Paul Krugman's dismissal of this idea: Wages and recovery.

Fed Watch: Opinions and Rumors

Posted: 28 Sep 2011 12:06 AM PDT

Tim Duy:

Opinions and Rumors, by Tim Duy: Federal Reserve President Richard Fisher today attempted to defend his ongoing policy dissent. He gives plenty of material to work with, beginning with his version of research ahead of an FOMC meeting:

Before every FOMC meeting, I survey a select group of 30 or so private business and banking operators, imparting no information about monetary policy but listening carefully to their perspectives on developments in the economy as seen at the ground level. For weeks leading up to the meeting, there was speculation in the financial markets and in the press that an Operation Twist was being contemplated. I received an earful of opinions on these rumors.

A big red flag right away. He claims to listen to survey contacts on the state of the economy, but does he tell us what they said about the economy? No, of course not. Instead, he emphasizes that he heard a lot of opinions about rumors. Pay very close attention to what Fisher is saying. He is saying he does not attempt to make policy on the basis of economic fact. He believes policy should be made on the basis of random speculation. I guess it is too much work to look beyond that random speculation. He continues:

What I gleaned from those conversations was as follows:

Embarking on an Operation Twist would provide an even greater incentive for the average citizen with savings to further hoard those savings for fear that the FOMC would be signaling the economy is in worse shape than they thought.

The economy is in worst shape than the FOMC believed just months ago. Is it Fisher's contention that the Fed's best policy is to attempt to hide this fact? Apparently so – good luck establishing a credible monetary policy when the stated intent is to lie about the actual state of the economy.

They might view an Operation Twist as setting the stage for a new round of monetary accommodation―a QE3, if you will. Such a program was considered redundant by business operators given their surplus of undeployed cash holdings and bankers' already plentiful excess reserves.

Actually, apparently market participants came to exactly the opposite conclusion and, realizing the path to QE3 was longer than initially believed, bid down long-term inflation expectations. More:

In addition, such a program might frighten consumers by further driving down the yields they earn on their savings and/or lead to long-term inflation that would erode the value of those savings;

I don't know how you drive yields down any further, as the average savings account is paying nearly zero percent. And the second sentence doesn't follow from the first – if rates are near zero, it is only because the environment is decidedly non-inflationary. See the point above. Again, the lack of significant action on the part of the Federal Reserve is dragging down inflation expectations and real interest rates. Only in Fisher's fantasy land is the opposite happening. More objections:

The earning power of banks, both large and small, would come under additional pressure by suppressing the spread between what they can earn by lending at longer-term tenors and what they pay on the shorter-term deposits they take in;

I think this point gets overplayed. The prime-lending rate has been locked up at 3.25% since the beginning of 2009. The spread between the prime lending rate and short-term deposit rates:

Fisher1

Sure enough spread between the two has hovered around 300bp since 1990, holding true to the rule of thumb that the prime rate is 300bp plus the fed funds rate. Another example - the 24 month personal loan rate was 12.41% in 2006 when 1 month CD rates were 5%. Now the same loan rate is 11.47%, for a much wider spread. Same story with credit card rates, which have only come down a fraction of the amount of short rates. All of which makes me doubt this concern that Fed policy is deterring lending activity by crushing yields on Treasury debt (although I can see where it erodes the earnings on any Treasury debt held by the banking sector). Indeed, the opposite is occurring. Lending activity is on the rise for at least one segment of the market:

Fisher2

Apparently someone is lending money, although admittedly the consumer market is more challenging. If anything, the necessity of the banking community to earn a spread places a lower limit on lending rates, which explains the 3.25% prime rate which in turn would limit the uptake of loans (and justifies the use of higher inflation expectations to bring down real rates).

The ability to lend, however, is not only determined by the rate spread, but also by the demand from credit-worthy borrowers – and that demand has been sorely lacking as households deleverage. See also this note from the Wall Street Journal suggesting Operation Twist was a subsidy for banks. A final point is that looking through FDIC reports, the net interest margin has hovered within 25bp of 3.5% for the last decade. In 2Q11 it was 3.61% and in 2Q05 it was 3.49%. True enough, a few basis point lower spread is meaningful. But what is more important at this point is to see even higher loan growth to profit on that margin. And that is what the Fed is trying to induce. If the Fed allows the economy to slow and loan demand to falter, a slightly higher margin might not be sufficient to prop up earnings, not to mention the impact of additional loan-loss provisions that would come into play. In short, lots of dynamics on this issue. More from Fisher:

Pension funds would have to reassess their potential returns, with the consequence that public and private direct-benefit plans would have to set aside greater reserves that might otherwise have gone to investments stimulating job creation

Yes, low interest rates place an additional burden on pension funds, just as low rates squeeze the returns for savers. But is it the Fed driving rates lower, or is the Fed just following the economy. I think it is more the latter than the former. If the Fed was actually pursuing an aggressive monetary policy, the economy would firm and long rates rise. The problem is that, contrary to the belief at Constitution Ave., the Fed's commitment to supporting economic activity is only half-hearted. And does Fisher really believe everything would be better if the Fed hiked rates by 200bp? Would pension funds really be better off if we knocked 25% off of equity valuations? More:

Expanding the holdings of the Fed's book of longer-term debt would likely compound the complexity of future policy decisions. Perversely, the stronger the economy, the greater the losses the Fed would incur as interest rates rise in response and the prices of those longer-term holdings depreciate. The political incentive to hold rates down might then become stronger precisely when we want to initiate tighter monetary policy. This concern, of course, would be a good news/bad news issue: The good news is that it would stem from a stronger economy; the bad is that might hurt our maneuverability and, in doing so, might undermine confidence in the Fed to conduct policy independently.

This concern over the Fed's balance sheet is way overblown. First, San Francisco Federal Reserve economist Glenn Rudebusch addressed this issue earlier this year, concluding that:

Such interest rate risk appears modest, especially relative to the Fed's policy objectives of full employment and price stability

Second, then Governor Ben Bernanke already dismissed this concern in 2003, and noted very clearly it would be a mistake to allow such concerns to prevent the central bank from acting. The Fed should simply reach an agreement with Treasury to take this concern off the table entirely, otherwise Fisher and his ilk will just continue to use it as an excuse to justify inaction. And, quite frankly, rather than basing policy on "opinions on these rumors," wouldn't a real policymaker attempt to explain why such opinions are unfounded? He continues:

One other factor gave me pause and that was, and remains, the moral hazard of being too accommodative. For years, I have been arguing that monetary policy cannot solve the problem of substandard economic performance unless it is complemented by fiscal policy and regulatory reform that encourages the private sector to put to work the affordable and abundant liquidity we are able to create as the nation's monetary authority.

The argument here is that the Fed is enabling a dysfunctional fiscal process by attempting to aid the economy. In other words, according to Fisher, the Fed needs to let the economy collapse to prove a point about fiscal policy. That sounds great around the coffee table, but in reality, such wanton disregard for economic welfare only promises to leave behind a mountain of collateral damage.

Finally, Fisher channels former Federal Reserve Chairman Paul Volker:

Paul Volcker, who has the scars on his back from his Herculean effort to rein in inflation in the 1980s, wrote of this in the New York Times on Sept. 18. He reminded us that once unleashed, inflation combines with stagnation to make stagflation, the most painful of all combinations for the poor, for workers, for job seekers, for bond and stock holders and for businesses trying to navigate the economy.

I addressed this last week. Ultimately, for all his antics, this is what Fisher is about - hard money. He might claim that:

…while I remain on constant watch for signs of inflationary impulses, I believe the most urgent issue is job creation and the reduction of the scourge of unemployment.

but in reality he sees nothing but economic apocalypse in 3% inflation. He cannot wrap his mind around one simple fact – the 1970's began with 2.5% unemployment. We are currently facing unemployment above 9%. Apples and oranges. But Fisher is simply too intellectually lazy to attempt to differentiate between apples and oranges. For him, policy begins and ends with a single idea: Hard money is just morally good. And he will base policy on any "opinions on these rumors" that sound like they support his ideological conviction.

links for 2011-09-28

Posted: 28 Sep 2011 12:01 AM PDT

"The Importance of Economic History"

Posted: 27 Sep 2011 06:48 PM PDT

Kevin O'Rourke:

The importance of economic history, by Kevin O'Rourke: Paul Krugman is upset about some pretty fanciful accounts of what supposedly happened during the Great Depression, and I don't blame him. He also wonders whether economics is a progressive science (I am using the word 'science' in its German sense). Well, one of the things that philosophers of science have argued about in the past is whether, when you have a paradigm shift, you end up losing knowledge, and it's pretty clear what has happened in this instance. ... [F]or example, I have been reliably informed that a well-known department stopped teaching its undergraduates IS-LM just before the crisis hit in 2008. And the result is that you had people seriously peddling the line that austerity would be expansionary in the wake of the biggest downturn since the 1930s — and these claims were influential in Europe, it seems clear, in the fateful spring and summer of 2010.

One lesson is that it is one thing to play counter-intuitive intellectual parlour games in order to get tenure at a fancy university, but another thing entirely to say something about the real world. For that you need a little common sense.

Another lesson is that economists need at least some training in economic history. No-one with the slightest feeling for historical reality could believe that the Great Depression was due to supply side forces, for example. I observe that Krugman, along with such luminaries as Maurice Obstfeld and Ken Rogoff, did his graduate work in MIT, and I surmise (without having any inside knowledge on the matter) that all three were exposed to Charlie Kindleberger and Peter Temin. They are all distinguished theorists, but also have a historical sensitivity, and this makes them better economists — if your definition of a good economist includes the ability to say sensible things about our very messy real world.

One of the most important things that a bit of history gives you is a sense of the importance of context. A model will work very well in some technological or institutional contexts, but not in others. For example, the Reverend Malthus devised a model that did a pretty decent job of describing the world up to the point that he started writing, but which soon became essentially irrelevant in the century that followed, at least in the richer countries of the world. (He had an economist's sense of timing.) Sometimes the world is well-described by Keynesian models, and sometimes it is not. And so on.

If the only thing that economic history did was protect us from one-size-fits-all merchants, it would still be worth the price of admission.

[I'd have to agree with his points about the use of models, and about the value of economic history.]

"Should Social Security Be Progressive?"

Posted: 27 Sep 2011 10:08 AM PDT

I worry about this too, i.e. that the more progressive Social Security becomes (and hence the more income redistribution that is part of the system), the less political support it will have:

Should Social Security Be Progressive?, by James Kwak: ...Should Social Security be more progressive than it already is? The most common ways liberals want to make it more progressive are (a) eliminating the cap on taxable earnings altogether and (b) reducing benefits for high earners. For part of my brain the automatic answer is "yes," but I think there is a reasonable argument for leaving things roughly the way they are.
First, there's a straight-up political argument. Social Security is popular because people feel like they earn their benefits. If people thought it was a covert redistribution program, then the high earners would definitely be against it, and most of the middle class probably would be too because of the American allergy to welfare. In fact, there are certainly people who think it is "pure welfare", like the author of the post I criticized last time around. But it isn't..., the retirement program on its own is only modestly progressive. The really progressive parts of the program are disability insurance and survivors' benefits. The fact is that there isn't that much redistribution based solely on income level; most of the "redistribution" is based on disability or having your spouse die young, which feels more like insurance than welfare. It turns out that most Americans' instincts are right: Social Security isn't a welfare program. ...
Now some people ... say that Social Security should be more progressive. But I'm not so sure. Conceptually speaking, I think of Social Security as contributory pension system run by the federal government along with an insurance component to protect people against various risks—disability, early death of your working spouse, bad luck that prevents you from saving enough for retirement, living too long, etc. ... I think of this governmental function as different from the welfare function—the one that ensures that everyone person has the basic means of subsistence. (Wait, we don't have that in this country? Well, we should.) And that's precisely what the founders of Social Security thought; they saw it as an alternative to noncontributory old-age assistance programs, which is what the conservatives preferred. ...
So to me, it makes the most sense to have (a) a contributory pension/insurance scheme that compensates participants for losses (e.g., disability) but is not mainly about redistribution; (b) a real welfare system for the poor; and (c) a progressive tax system to fund the rest of the government. And I worry that if you make (a) too much like (b) or (c) it will become unpopular and die a slow death. But I'm open to being convinced otherwise.

I view Social Security fundamentally as a social insurance program, not welfare, and as noted above I think that's important for its political support. But if it comes down to a choice between raising the income cap or cutting benefits for middle and lower class households, I favor raising the cap. (I favor this over means testing benefits -- if we stop sending checks to part of the population, that will erode support much faster than increasing the income cap. Most people would hardly notice an increase in the cap, but they'd notice if the checks stopped. And I certainly favor this option over raising the retirement age.)

How the GOP Assault on the Fed Could Backfire

Posted: 27 Sep 2011 08:46 AM PDT

I have a new column on the need for Federal Reserve independence:

How the GOP Assault on the Fed Could Backfire

I expect disagreement on this one. The emphasis is on the long-run, but I wish I would have had the space to talk more about the short-run, i.e. that the Fed could be more aggressive in the short-run and allow inflation to rise temporarily without abandoning its commitment to long-run price stability. That's implied by the statement that "I don't think the voice of the unemployed is adequately represented in monetary policy decisions," but it may not be clear. I also wish I would have had the space to talk about why a return to the gold standard -- which is behind some of the attacks on the Fed -- is a bad idea.

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