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January 31, 2011

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Paul Krugman: A Cross of Rubber

Posted: 31 Jan 2011 12:36 AM PST

Central bank authorities should not give in to demands for higher interest rates:

A Cross of Rubber, by Paul Krugman, Commentary, NY Times: Last Saturday, reported The Financial Times, some of the world's most powerful financial executives were going to hold a private meeting with finance ministers in Davos... The principal demand of the executives ... would be that governments "stop banker-bashing." Apparently bailing bankers out after they precipitated the worst slump since the Great Depression isn't enough — politicians have to stop hurting their feelings, too.
But the bankers also had a more substantive demand: they want higher interest rates ... because they say that low rates are feeding inflation. And what worries me is the possibility that policy makers might actually take their advice.
To understand the issues, you need to know that we're in the midst of ... a "two speed" recovery, in which some countries are speeding ahead, but ... advanced nations — the United States, Europe, Japan — have barely begun to recover. ... To raise interest rates under these conditions would be to undermine any chance of doing better; it would mean, in effect, accepting mass unemployment as a permanent fact of life.
What about inflation? High unemployment has kept a lid on the measures of inflation that usually guide policy. ... But food and energy prices — and commodity prices in general — have ... been rising lately. Corn and wheat prices rose around 50 percent last year; copper, cotton and rubber prices have been setting new records. What's that about?
The answer, mainly, is growth in emerging markets ... — China in particular — ... has created ... sharply rising global demand for raw materials. Bad weather ... has also played a role in driving up food prices.
The question is, what bearing should all of this have on policy at the Federal Reserve and the European Central Bank? First of all, inflation in China is China's problem, not ours. ... Neither China nor anyone else has the right to demand that America strangle its nascent economic recovery just because Chinese exporters want to keep the renminbi undervalued.
What about commodity prices? The Fed normally focuses on "core" inflation, which excludes food and energy... And this focus has served the Fed well in the past. ... It's hard to see why the Fed should behave differently this time...
So why the demand for higher rates? Well, bankers have a long history of getting fixated on commodity prices. Traditionally, that meant insisting that any rise in the price of gold would mean the end of Western civilization. These days it means demanding that interest rates be raised because the prices of copper, rubber, cotton and tin have gone up, even though underlying inflation is on the decline.
Ben Bernanke clearly understands that raising rates now would be a huge mistake. But Jean-Claude Trichet, his European counterpart, is making hawkish noises — and both the Fed and the European Central Bank are under a lot of external pressure to do the wrong thing.
They need to resist this pressure. Yes, commodity prices are up — but that's no reason to perpetuate mass unemployment. To paraphrase William Jennings Bryan, we must not crucify our economies upon a cross of rubber.

Fed Watch: Underappreciated Data

Posted: 31 Jan 2011 12:24 AM PST

Tim Duy sees optimistic signs in the 4th quarter GDP report:

Underappreciated Data, by Tim Duy: I must admit that I surprised by the tepid response to the advance release of the 4q2010 GDP data. Mark Thoma catalogues the most common critiques – the negative contribution from government spending and the minimal reduction in the output gap. My review of the data differs. In my opinion, this is the first GDP report since the recession "ended" that offers a certain optimism, a glimmer of hope that perhaps that light at the end of the tunnel is not simply an oncoming train. If it is an oncoming train, it not the train of sagging government spending, but instead a train of imports blasting forward.
It is no secret that this recovery, to date, has been anything but vigorous. Certainly nothing like the "Morning in America" of the mid-80's. Real final sales – GDP excluding inventory effects – outperformed for quarter after quarter during that period as demand clearly outstrip the pace of capacity growth. In comparison, real final sales during the most recent recovery has been almost laughable:

Finalsales1

But real final sales surged in the final quarter of 2010:

Finalsales2

A 7.1 percent gain is nothing to sneeze at – and, realistically, in the scope of that kind of surge in final demand, the 0.11 percentage point reduction from the government sector is little more than a rounding error (I would be more worried about the loss of services than the contractionary impact in the context of 7.1 percent final demand growth). This is exactly the kind of final demand growth needed to lift us out of this morass.

But is it sustainable? What is apparent from this report is the potential for external support to generate real improvement in the US economy. The sharp drop in imports meant that firms were forced to sharply reduce the pace of inventory growth. Will those inventories be replenished with domestic or foreign production? James Hamilton is not optimistic:

But the fact that a huge negative contribution of inventories coincided with a huge positive contribution of imports does not seem to be a coincidence. There's a clear pattern in the recent data that when one of these makes a positive contribution to GDP growth, the other makes an offsetting negative contribution. Although we often think of inventories as a substitute for production (you could either produce a good or sell it out of inventories), in the current environment inventories seem to act more as a substitute for imports (you could either import the good, or sell it out of inventories). So although inventories shouldn't be the same drag on GDP in 2011, I expect imports to go back up and exert a drag of their own.

Sadly, the story of this recovery continues to circle around the external accounts. Absent a resolution of the global rebalancing story, faith in fiscal stimulus is somewhat misplaced – much government spending will simply leak abroad as evident in previous GDP reports. Of course, the alternative, fiscal policy that ignores the recession, is not exactly an endearing policy course. If rebalancing continues to be delayed in the months ahead, US policymakers simply must accept the trade deficit will reduce the effectiveness of their efforts.

Moreover, the resistance to rebalancing is nothing less than sadly ironic, as rebalancing produces the only possible win-win scenario in the global economy. Consider that concerns of emerging market inflation suggest that demand is surging ahead of capacity, while deflation in the US suggests the opposite, excess capacity. It seems that these problems are two sides of the same coin, with an obvious optimal solution – greater currency flexibility. Emerging markets could satisfy higher rates of domestic demand growth via declining net exports, while rising net exports allows for higher capacity utilization in the US. In effect, global consumption power would be redirected toward relatively poor economies and away from a relatively rich economy. It seems quite reasonable.

Alas, instead we are faced with the challenges of rising inflation in some nations, and increasingly disturbing hoarding behavior in others. While stories of a massive stock of empty housing in China have long circulated, the Wall Street Journal reports that the hoarding has reached a new level:

The amount of cotton held in hamlets throughout China is unknown, but, with 25 million cotton farmers, a Chinese cotton agency estimates it could amount to about 9% of the world's cotton supply. And the situation is occurring throughout the supply chain. Many ginners and merchants in China are keeping warehouses full, according to the agency, in an attempt to obtain higher prices.

Expectations that prices will rise are driving the apparent stockpiling, which causes short-term shortages and leads prices to rise further. The situation is complicating an already volatile picture for cotton, which has jumped to 140-year highs in the U.S. and has become a symbol of brewing commodity inflation around the globe.

Included in the story is a picture of a farmer storing 7,700 pounds of cotton in his home (I suspect my wife would object should I start taking a long position in hog bellies via physical possession in the living room). To be sure, such behavior, like stockpiling empty houses, makes sense in an inflationary environment in which agents are desperate to find adequate stores of value.

Regarding other data, last week we also saw the December durable goods report. While there was some concern over the headline numbers, it is generally safer to go straight to the core figures, capital goods excluding defense and air:

Durablegoods

Looks like the economy shook off the summer slowdown, putting order back on the uptrend. Somewhat disappointing was the partial reversal of recent improvement in initial unemployment claims. That said, looking at the four-week moving average, the downtrend looks intact:

Initialclaims

Of course, if final demand is growing at a 7.1 percent pace, the overall improvement in the final months of 2010 should come as no surprise. Finally, also not surprisingly, the Case-Shiller Index reported ongoing home price weakness. Housing has offered almost nothing to the recovery and, quite frankly, is yesterday's story. Housing is returning to its appropriate place in the economy – a product that provides a service, not an investment or, worse yet, a gamble.
Bottom Line: The GDP report revealed what could be, the glimmers of hope of a V-shaped recovery. If final demand even near the 4q2010 could be maintained, Federal Reserve policymakers makers would be forced to take notice by mid-year. Still, setting aside the usual risk factors (including the fresh possibility that Mideast unrest triggers a fresh oil shock) the sustainability of this final demand is directly dependent upon the evolution of the external accounts. If this demand surge is satisfied with an import surge in coming quarters, we can expect the recovery will remain tepid in comparison to previous deep recessions. If rebalancing were to maintain some traction, this could be simply the first in a long-waited string of data that would proved a clear exit to the current period of relative economic stagnation.

links for 2011-01-30

Posted: 30 Jan 2011 10:01 PM PST

"Do for Households What the Fed Sought for the Banks"

Posted: 30 Jan 2011 10:08 AM PST

Vernon Smith, who is not a fan of government intervention, makes familiar arguments about how to escape from balance sheet recessions:

Mired in Disequilibrium, by Vernon Smith, Newsweek: ...Some 23 percent of homeowners owe more than their home is worth on the market, and their demand for goods is restrained by the need to pay down debt. This is the essence of a balance-sheet recession, and is what underlies the so-called Keynesian liquidity trap. ...
There are three routes to restoring equilibrium:
• Inflate the prices of all other goods, including labor, while housing demand remains stuck in its negative equity loop. Fed policy has been consistent with this objective since 2008 with no evidence of success, as is typical in severe balance-sheet recessions.
• Allow the household deleveraging process to grind through an extended period of low GDP growth and high unemployment until we gradually recover. This option will surely succeed in due course, but not without high annual opportunity cost in terms of lost wealth creation. This was the path followed in the Depression.
• Do for households what the Fed sought for the banks: the Treasury (facilitated by Fed monetary ease and bank capital requirements) finances the banks to restate the principal on current negative-equity mortgage loans, restoring them to new mark-to-market zero-equity baselines.
The last option, in principle, seeks to reboot homeowners' damaged balance sheets in an effort to arrest a prolonged deleveraging process and more quickly restore household demand to levels no longer dominated by negative home equity. It is analogous to a mortgage "margin call" with public funding of the restored household balance sheets.
I regard the third option as far better than the stimulus, while recognizing that forgiving debt—whether bank or household debt—is never good policy. But please keep in mind that we have had no good options. (Since total negative equity is now about $700 billion, it is cheaper than was the stimulus.) ...

Where we differ is that I would do this in addition to fiscal policy, rather than dropping fiscal stimulus and doing this instead. That is, I see this as a complement rather than a substitute for other policies.

One more note. I have made similar arguments, but I've come to believe that household relief must be broad based in order to receive the public support it needs (the proposal above addresses all households that are in a negative equity position, not just those near or at default, so it is broader based than many competing proposals along these lines). If we only bail out the households who made the worst choices and are in danger of default, and do nothing for the households who have taken large losses through no fault of their own, but are still surviving and making payments, the public resentment will undermine the policy.

Taxes and Labor Supply

Posted: 30 Jan 2011 09:45 AM PST

Chris Dillow:

Taxes and labour supply: more evidence, by Chris Dillow: Do tax cuts boost labour supply and hence tax revenues? Here's some evidence that they don't. Pierre Cahuc and Stephane Carcillo report on an experiment in France:

The detaxation of overtime hours introduced in October 2007 was intended to allow individuals in France to work more so as to earn more. The evaluation conducted in this article indicates that the detaxation of overtime hours has not, in fact, had any significant impact on hours worked…

Detaxation is a measure costly for the public purse, without any ascertained impact on hours worked.

We can put this alongside the evidence we have for footballers and New York cabbies, which suggests that we are on the positive side of the Laffer curve, where tax cuts do not increase revenues. ...

Now, this is not to deny that Laffer curves exist. No doubt, there is a point at which higher taxes would be counter-productive and tax cuts would pay for themselves. ... But where is the hard evidence that, at tax rates around current levels, there are such effects? Do the glibertarians  have anything more than prejudice, half a theory, and the post hoc ergo propter hoc fallacy?

January 30, 2011

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links for 2011-01-29

Posted: 29 Jan 2011 10:01 PM PST

Cowen: Innovation Is Doing Little for Incomes

Posted: 29 Jan 2011 03:06 PM PST

I need to think about this more before responding:

Innovation Is Doing Little for Incomes, by Tyler Cowen, Commentary, NY Times: My grandmother, who was born in 1905, spoke often about the immense changes she had seen, including the widespread adoption of electricity, the automobile, flush toilets, antibiotics and convenient household appliances. Since my birth in 1962, it seems to me, there have not been comparable improvements. ...[C]ompared with what my grandmother witnessed, the basic accouterments of life have remained broadly the same.
The income numbers for Americans reflect this slowdown in growth. From 1947 to 1973 — a period of just 26 years — inflation-adjusted median income in the United States more than doubled. But in the 31 years from 1973 to 2004, it rose only 22 percent. And, over the last decade, it actually declined. ...
Although America produces plenty of innovations, most are not geared toward significantly raising the average standard of living. It seems that we are coming up with ideas that benefit relatively small numbers of people, compared with the broad-based advances of earlier decades, when the modern world was put into place. ...
Sooner or later, new technological revolutions will occur, perhaps in the biosciences, through genome sequencing, or in energy production, through viable solar power, for example. But these transformations won't come overnight, and we'll have to make do in the meantime. Instead of facing up to this scarcity, politicians promote tax cuts and income redistribution policies to benefit favored constituencies. Yet these are one-off adjustments and, over time, they cannot undo the slower rate of growth in average living standards.
It's unclear whether Americans have the temperament to make a smooth transition to a more stagnant economy. After all, we've long thought of our country as the land of unlimited opportunity. In practice, this optimism has meant that we continue to increase government spending, whether or not we can afford it.
In the narrow sense, the solution to the stagnation of median income will not be a political one. And one of the hardest points to grasp about this quandary is that no one in particular is to blame. Scientific progress has never proceeded on an even, predictable basis, even though for part of the 20th century it seemed that it might.
Science should be encouraged with subsidies for basic research, as well as private charity, educational reform, a business culture geared toward commercializing inventions, and greater public appreciation for the scientific endeavor. A lighter legal and regulatory hand could ease the path of future innovations.
Nonetheless, advancing discovery is not a goal to be reached by the mere application of will. Precisely because there is no obvious villain and no simple fix, and many complex factors behind success, science as a general topic doesn't play a big role in American political discourse. When it comes to understanding our macroeconomic predicament, we often seem to be missing the point.
Until science has a greater impact again on average daily living standards, the political problem will be in learning to live within our means. Because neither major party seems to support a plausible path to fiscal balance, or to acknowledge how little control politicians actually have over future income growth, we unscientifically keep living in an age of denial.

I can't help myself -- one quick response: The uneven technological progress described above seems to provide a good reason for the government to be the agent of intertemporal transfers from the booming times to the times that are stagnating. In essence, this is just a business cycle with a long and uncertain periodicity, so the same types of stability arguments apply (particularly since "Scientific progress has never proceeded on an even, predictable basis," i.e. being alive during a boom time is mostly due to luck, not an individual's superior skill). Thus, while the argument above is that we are at a low point of the cycle, therefore the government should be less active, I think there is just as strong or stronger argument on the other side, i.e. that this is when government needs to become more active (both in terms of promoting innovation and in terms of smoothing the income variation due to uneven growth in productivity). The difference between us, perhaps, is that Tyler sees the technological plateau as permanent, or at least very long-lived (though he does say that sooner or later technological advances will come). I do not, I see the plateau -- if it exists at all -- as part of a longer up and down cycle.

Okay, that's not the strongest argument ever made, so one more quick response: More importantly, I also can't resist wondering whose incomes are stagnating and why. The economy will continue to grow. Yes, we've had a recent recession. But GDP has not and will not be stagnant over a longer time frame. Productivity increases will still drive economic growth. The question is how that growth will be shared.

The stagnation of income for typical (median) households in recent decades has little to due with stagnating productivity -- productivity has still been rising. It has much more to do with how the gains from rising productivity have been divided up. This is yet another reason why complaints about active government and "income redistribution policies to benefit favored constituencies" ring hollow. When you leave out that a mal-distribution of income already exists, i.e. when your implicit underlying assumption is that the people who did get the growth over the last few decades deserved every penny of it (despite bubbles giving false gains to people at the top, and many other problems), of course you'll oppose redistributive policies. But I tend to think that the gains were not distributed according to changes in productivity -- labor did not get its share -- and government intervention to correct that is appropriate.

Divine Coincidence and the Fed's Dual Mandate

Posted: 29 Jan 2011 11:07 AM PST

John Taylor says the Fed should adopt a single mandate. In his view, which seems to be fairly common on the political right, the Fed should abandon targeting the output gap and restrict its attention it keeping the inflation rate stable:

Former U.S. Treasury Department undersecretary John Taylor on Wednesday called for overhauling the Federal Reserve's dual mandate of ensuring stable prices and maximum employment, saying that the central bank should focus on prices.
"It would be better for economic growth and job creation if the Fed focused on the goal of "long run price stability within a clear framework of economic stability,'" Taylor told the House Financial Services Committee. ...
Taylor said that "too many goals blur responsibility and accountability." ...

Robert Barbera, a fellow at John Hopkins, sends an email making the case that a single mandate is a bad idea, particularly near the zero bound. It is based upon an IMF paper showing that deflation does not generally occur when there are large output gaps. Instead, downward price and wage rigidities cause inflation to stabilize at low rates, and this is part of the reason for a suboptimal response under a single mandate.

Note that the term "divine coincidence" used in the email refers to a situation where stabilizing inflation is the same as stabilizing output. When particular assumptions are imposed on theoretical NK DSGE models, there is no difference in terms of household welfare between a single and a dual mandate. Unfortunately, the assumptions that are required for the existence of divine coincidence are relatively strict and we shouldn't expect it to hold generally. (The wide adoption of a single mandate in Europe is due, in large part, to the difficulties of targeting output gaps when multiple countries are involved. Thus, it's based more on politics than on economics. Suppose, for example, that Germany is doing well and does not favor expansionary policy, but Ireland is struggling and wants help. Whose interests should prevail?).

Here's Robert's email:

IMF did a bang up working paper on Persistent Large Output Gaps, looking at 20 or so nations over 30 years. A super short version of their conclusions? PLOGS weigh on price pressures for years, even amid strong recoveries--a standard Keynesian conclusion. Two, PLOGS lose much of their deflationary power, the closer inflation gets to zero--a not so common conclusion. It seems slowing pay and price increases is much easier than actually cutting wages and prices...
Now imagine a two nation world near zero inflation amid PLOG circumstances. Imagine further that one nation has a dual mandate and the other is an inflation targeter. What happens?
The dual mandate CB sees high joblessness keeps pedal to the metal till strong growth arrives. The other CB fails to see deflation appear and therefore is less stimulative. As the big ease in nation #1 succeeds, stronger growth lifts it's currency. A touch of adverse terms of trade lifts price pressures in nation #2 just enough to confirm, in the CB inflation nutter one track minds, that they are doing "the right thing". They stick to their guns, and over time cyclical joblessness becomes structural. In other words, they are unwitting agents of hysteresis.
Thus the divine coincidence categorically fails amid near zero inflation. More to the point, single focused CBs are quite likely to pursue suboptimal policy.

The argument is not that the Fed will remain passive under a single mandate. When inflation is below target -- as it would be near the zero bound -- there is still a response from the Fed. The Fed will still try to hit its inflation target and hence should ease up. However, because the Fed pursues a single rather than a dual target, and because of the effects on the terms of trade, the response will be smaller than it would be under a dual mandate, and hence suboptimal (there is a result in the background showing that the variance of output is lower under the dual mandate unless, again, restrictive assumptions are made).

Note: A good description of the special conditions that are needed for divine coincidence comes from this paper by Jordi Gali and Olivier Blanchard:

...In this paper, we show that this divine coincidence is tightly linked to a specific property of the standard NK model, namely the fact that the gap between the natural level of output and the efficient (first-best) level of output is constant and invariant to shocks. This feature implies that stabilizing the output gap the gap between actual and natural output is equivalent to stabilizing the welfare-relevant output gap the gap between actual and efficient output. This equivalence is the source of the divine coincidence: The NKPC implies that stabilization of inflation is consistent with stabilization of the output gap. The constancy of the gap between natural and efficient output implies in turn that stabilization of the output gap is equivalent to stabilization of the welfare-relevant output gap.
The property just described can in turn be traced to the absence of non trivial real imperfections in the standard NK model. This leads us to introduce one such real imperfection, namely real wage rigidities. The existence of real wage rigidities has been pointed to by many authors as a feature needed to account for a number of labor market facts (see, for example, Hall [2005]).We show that, once the NK model is extended in this way, the divine coincidence disappears.
The reason is that the gap between natural and efficient output is no longer constant, and is now affected by shocks. Stabilizing inflation is still equivalent to stabilizing the output gap, but no longer equivalent to stabilizing the welfare-relevant output gap. Thus, it is no longer desirable from a welfare point of view. ...

Suppose, for example, that firms have market power. Then the natural rate of output will be lower than the welfare maximizing level (because market power leads to lower output and higher prices than is socially optimal). So long as the gap between the two stays constant, then divine coincidence will exist. However, it is very easy to make this gap variable and, in fact, realism within our models demands it (divine coincidence can fail for reasons besides a variable gap due to wage rigidities, so this does not exhaust the resons why divine coincidence can fail).

Thus, theory tells us that a single mandate is a bad idea except under conditions that are unlikely to exist. Since the conditions are special, and since inappropriately adopting a single mandate leads to too much unemployment and potential hysteresis, the burden of proof that the special conditions required for a single mandate are present, at least approximately, is on the proponents of the single mandate -- and they simply have not made the case.

Update: I forgot that Paul Krugman wrote about "PLOGS" in August:

The Price Stability Trap, by Paul Krugman: There's an important new paper from the IMF about inflation in the face of Prolonged Large Output Gaps — yes, PLOGs. You can think of it as a careful, multi-country version of the quick-and-dirty analysis of US experience I did recently, with an assist from Tim Duy. What the analysis shows is that prolonged periods of economic weakness are, with almost no exceptions, associated with falling inflation rates.

The analysis also suggests something else, however: as the inflation rate goes toward zero, it seems to become "sticky": in the modern world, rapid deflation doesn't happen, and in fact slight positive inflation often persists in the face of an obviously depressed economy:

DESCRIPTIONIMF

The authors discuss several possible explanations, but it does seem as if downward nominal rigidity is playing a role.

And this raises the specter what I think of as the price stability trap: suppose that it's early 2012, the US unemployment rate is around 10 percent, and core inflation is running at 0.3 percent. The Fed should be moving heaven and earth to do something about the economy — but what you see instead is many people at the Fed, especially at the regional banks, saying "Look, we don't have actual deflation, or anyway not much, so we're achieving price stability. What's the problem?"

And the slump will just go on.

January 29, 2011

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Egypt Links

Posted: 29 Jan 2011 12:36 AM PST

I'm hoping your comments will help me to understand what is going in in Egypt, and how it is realted to more general political developments in the area, e.g. the protests in Iran:

links for 2011-01-28

Posted: 28 Jan 2011 10:01 PM PST

Feldstein: The End of China’s Surplus,

Posted: 28 Jan 2011 01:44 PM PST

Martin Feldstein argues that China's current-account surplus is likely to shrink dramatically over the next few years:

The End of China's Surplus, by Martin Feldstein, Commentary, Project Syndicate: China's current-account surplus ... is the largest in the world. ...China's external surplus stands at $316 billion, or 6.1% of annual GDP.
Because the current-account surplus is denominated in foreign currencies, China must use these funds to invest abroad, primarily by purchasing government bonds issued by the United States and European countries. As a result, interest rates in those countries are lower than they would otherwise be.
That may all be about to change. ... It is possible that, before the end of the decade, China's current-account surplus will move into deficit... If that happens, China will no longer be a net buyer of US and other foreign bonds, putting upward pressure on interest rates in those countries.
Although this scenario might now seem implausible, it is actually quite likely to occur. ... China's national saving rate ... is now about 45% of its GDP, which is the highest rate in the world. But, looking ahead, the five-year plan will cause the saving rate to decline...
The plan calls for a shift to higher real wages so that household income will rise as a share of GDP. Moreover, state-owned enterprises will be required to pay out a larger portion of their earnings as dividends. And the government will increase its spending on consumption services like health care, education, and housing....
Since China's current-account surplus is now 6% of its GDP, if the saving rate declines from the current 45% to less than 39% – still higher than any other country – the surplus will become a deficit.
This outlook for the current-account balance does not depend on what happens to the renminbi's exchange rate... But the fall in domestic saving is likely to cause the Chinese government to allow the renminbi to appreciate more rapidly. Higher domestic consumer spending would otherwise create inflationary pressures. ... A stronger renminbi would ... cause a shift from exports to production for the domestic market, thereby shrinking the trade surplus, in addition to curbing inflation.
...Americans are eager for China to reduce its surplus and allow its currency to appreciate more rapidly. But they should be careful what they wish for, because a lower surplus and a stronger renminbi imply a day when China is no longer a net buyer of US government bonds. The US should start planning for that day now.

Plans are not action. I hope the Chinese government moves to raise the standard of living and to provide more social services, but I'll believe it when I see it happen. For now, interest rates remain very low -- markets are not worried about this -- and it's not the time to panic about the deficit, impose large budget cuts, and endanger the recovery.

Advance Estimate: GDP Grew 3.2% in the Fourth Quarter

Posted: 28 Jan 2011 09:45 AM PST

The advance estimate from the BEA has GDP growing by 3.2% in the third quarter:

Real gross domestic product -- the output of goods and services produced by labor and property located in the United States -- increased at an annual rate of 3.2 percent in the fourth quarter of 2010, (that is, from the third quarter to the fourth quarter), according to the "advance" estimate released by the Bureau of Economic Analysis.

That's better than slower growth, but not enough to make up for past losses. Paul Krugman puts it this way:

growth at 3.2 percent closes less than 1 percentage point of that gap each year. So, yippee: we're on track to restore full employment circa 4th quarter 2018. Why am I not happy?

Ryan Avent adds details (see Calculated Risk as well):

Of the 3.2% total growth pace, 3.02 percentage points were contributed by personal consumption. Gains were also attributable to a nice improvement in exports. Net exports contributed positively to growth for the first time all year. But for the first time in almost two years, federal government spending joined state and local spending as a drag on growth. This trend will continue; generally speaking, future growth will have to come despite government cuts rather than thanks to government supports.

Cutbacks in federal, state, and local spending will provide a strong headwind to growth. We have a large gap to make up, and growth is not yet fast enough to get the job done in a reasonable amount of time. Thus, we need help with growth from the federal government -- balanced budget requirements and poor economic conditions tie the hands of state and local governments -- not a strong headwind working against us. So let's hope Congressional gridlock or good sense (unlikely) prevails and forestalls deficit reduction until the economy is on more robust footing.

[Also posted at MoneyWatch.]

January 28, 2011

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Paul Krugman: Their Own Private Europe

Posted: 28 Jan 2011 12:42 AM PST

Contrary to claims by Paul Ryan in his response to President Obama's State of the Union address, the experience in Europe "actually refutes the current Republican narrative":

Their Own Private Europe, by Paul Krugman, Commentary, NY Times: President Obama's State of the Union address was a ho-hum affair. But the official Republican response, from Representative Paul Ryan, was really interesting. And I don't mean that in a good way.
Mr. Ryan made highly dubious assertions about employment, health care and more. But what caught my eye, when I read the transcript, was what he said about other countries: "...Greece, Ireland, the United Kingdom and other nations in Europe ... didn't act soon enough; and now their governments have been forced to impose painful austerity measures: large benefit cuts to seniors and huge tax increases on everybody."
It's a good story: Europeans dithered on deficits, and that led to crisis. Unfortunately, while that's more or less true for Greece, it isn't at all what happened either in Ireland or in Britain, whose experience actually refutes the current Republican narrative. ...
American conservatives have long had their own private Europe of the imagination... So we shouldn't be surprised by ... tall tales about European debt problems. Let's talk about what really happened in Ireland and Britain.
On the eve of the financial crisis, conservatives had nothing but praise for Ireland... Ireland was running a budget surplus, and had one of the lowest debt levels in the advanced world.
So what went wrong? The answer is: out-of-control banks; Irish banks ran wild ... creating a huge property bubble. When the bubble burst, revenue collapsed, causing the deficit to surge, while public debt exploded because the government ended up taking over bank debts. And harsh spending cuts, while they have led to huge job losses, have failed to restore confidence.
The lesson of the Irish debacle, then, is very nearly the opposite of what Mr. Ryan would have us believe. It doesn't say "cut spending now, or bad things will happen"; it says that balanced budgets won't protect you from crisis if you don't effectively regulate your banks... Have I mentioned that Republicans are doing everything they can to undermine financial reform?
What about Britain? Well, contrary to what Mr. Ryan seemed to imply, Britain has not, in fact, suffered a debt crisis. True, David Cameron ... has made a sharp turn toward fiscal austerity. But that was a choice...
And underlying that choice was ... adherence to the same theory offered by Republicans to justify their demand for immediate spending cuts here — the claim that slashing government spending in the face of a depressed economy will actually help growth rather than hurt it.
So how's that theory looking? Not good..., there's certainly no sign of the surging private-sector confidence that was supposed to offset the direct effects of eliminating half-a-million government jobs. ...
American conservatives have long used the myth of a failing Europe to argue against progressive policies in America. More recently, they have tried to appropriate Europe's debt problems on behalf of their own agenda, never mind the fact that events in Europe actually point the other way.
But Mr. Ryan is widely portrayed as an intellectual leader within the G.O.P., with special expertise on matters of debt and deficits. So the revelation that he literally doesn't know the first thing about the debt crises currently in progress is, as I said, interesting — and not in a good way.

How Much Freedom?

Posted: 28 Jan 2011 12:15 AM PST

Continuing the discussion in these two posts, Richard Green explains how government intervention can expand choices -- and why it needs to do so:

How much freedom to choose?, by Richard Green: Ed Glaeser argues that the "moral heart of economics" is "freedom" and in particular the "freedom to choose:"

Improvements in welfare occur when there are improvements in utility, and those occur only when an individual gets an option that wasn't previously available. We typically prove that someone's welfare has increased when the person has an increased set of choices.
When we make that assumption (which is hotly contested by some people, especially psychologists), we essentially assume that the fundamental objective of public policy is to increase freedom of choice.

I will leave to others to dispute the notion that more choices are always better than fewer. But I can't help but think that it is to easy for those of us who are tenured professors to extoll the virtue of free choice, for the simple reason that we get so many, well choices. We get to choose what we write, we to a large extent get to choose what we teach inside our classes, and we can piss our deans off and pay fairly little in the way on consequences. We might not get a raise or we might have to teach a class that we would rather not, but this is all small beer. We can make an awful lot of choices and still be economically secure.

Now consider the administrative assistant at a corporation who has a boorish boss and a sick kid. The company she (he) works for has a good health insurance plan, but if she were to leave, she would find herself unable to get coverage at a reasonable price. Does she really have choice?

Consider the West Virginia coal miner who goes into a dangerous mine every day, and whose life expectancy is shortened with each hour worked underground. Now consider the fact that the miner grew up in a West Virginia town with a poor school in an environment where going to college was a rare phenomenon. Does that miner have a choice?

I could go on, but I think the point is fairly clear. There are times when government intervention could expand the choice set up a large number of people.

Ed does point out how government can improve choice sets, and for that he deserves credit. But the more fundamental problem is that market economies produce large institutions that have limited markets inside of them, and therefore sometimes have hierarchies that can be as inhospitable to personal liberty as government bureaucracies. Elinor Ostrom's Nobel win in 2009 shows that the economics profession is beginning to recognize this problem, but I am not sure Ph.D. students are broadly encouraged to study it.

links for 2011-01-27

Posted: 27 Jan 2011 10:01 PM PST

DeLong: Intelligent Economic Design

Posted: 27 Jan 2011 10:42 AM PST

Brad DeLong on the "debate over whether its economy evolves or is designed":

Intelligent Economic Design, by J. Bradford DeLong, Commentary, Project Syndicate: As Stephen Cohen, with whom I wrote The End of Influence: What Happens When Other Countries Have the Money, likes to say, economies do not evolve; they are, rather, intelligently designed. He also likes to say that, though there is an intelligence behind their design, this does not mean that the design is in any sense wise.
The first claim is, I think, incontrovertible. Since long before Croesus, King of Lydia, came up with the game-changing idea of standardized "coinage," what governments have done and not done to structure, nudge, and put their thumbs on the scales has been decisively important for economic development.
Just look around you. Notice the hundred-fold divergence across political jurisdictions in relative levels of economic productivity and prosperity? I dare anyone to claim that the overwhelming bulk of that disparity springs from causes other than history and the current state of governance.
The second claim is also, I think, true. To say that economies are the products of intelligent design means only that some human intelligence or intelligences lies behind the design. It does not mean that the design is smart or optimal. ...[continue reading]...

New Claims for Unemployment Insurance Increase Sharply and Unexpectedly

Posted: 27 Jan 2011 10:12 AM PST

Here's a reaction to today's news that new claims for unemployment insurance increased substantially last week:

New Claims for Unemployment Insurance Increase Sharply and Unexpectedly

January 27, 2011

Latest Posts from Economist's View

Latest Posts from Economist's View


"What Caused the Financial Crisis?"

Posted: 27 Jan 2011 01:08 AM PST

Bill Thomas, Keith Hennessey, and Douglas Holtz-Eakin have a dissenting statement in response to the final report of the Financial Crisis Inquiry Commission:

What Caused the Financial Crisis, by Bill Thomas, Keith Hennessey, and Douglas Holtz-Eakin, Commentary, WSJ: Today, six members of the Financial Crisis Inquiry Commission ... are releasing their final report. Although the three of us served on the commission, we were unable to support the majority's conclusions and have issued a dissenting statement. ...
We recognize that ... other ... narratives have popular appeal:... Had the government not supported housing subsidies (the first narrative) or had policy makers implemented more restrictive financial regulations (the second) there would have been no calamity.
Both of these views are incomplete and misleading. ... We believe the crisis was the product of 10 factors. Only when taken together can they offer a sufficient explanation of what happened:
Starting in the late 1990s, there was a broad credit bubble in the U.S. and Europe and a sustained housing bubble in the U.S. (factors 1 and 2). Excess liquidity, combined with rising house prices and an ineffectively regulated primary mortgage market, led to an increase in nontraditional mortgages (factor 3) that were in some cases deceptive, in many cases confusing, and often beyond borrowers' ability to pay.
However, the credit bubble, housing bubble, and the explosion of nontraditional mortgage products are not by themselves responsible for the crisis. Our country has experienced larger bubbles—the dot-com bubble of the 1990s, for example—that were not nearly as devastating... Losses from the housing downturn were concentrated in highly leveraged financial institutions. Which raises the essential question: Why were these firms so exposed? Failures in credit-rating and securitization transformed bad mortgages into toxic financial assets (factor 4). Securitizers lowered the credit quality of the mortgages they securitized, credit-rating agencies erroneously rated these securities as safe investments, and buyers failed to look behind the ratings and do their own due diligence. Managers of many large and midsize financial institutions amassed enormous concentrations of highly correlated housing risk (factor 5), and they amplified this risk by holding too little capital relative to the risks and funded these exposures with short-term debt (factor 6). They assumed such funds would always be available. Both turned out to be bad bets.
These risks within highly leveraged, short-funded financial firms with concentrated exposure to a collapsing asset class led to a cascade of firm failures. ... We call this the risk of contagion (factor 7). In other cases, the problem was a common shock (factor 8). A number of firms had made similar bad bets on housing...
A rapid succession of 10 firm failures, mergers and restructurings in September 2008 caused a financial shock and panic (factor 9). Confidence and trust in the financial system evaporated, as the health of almost every large and midsize financial institution in the U.S. and Europe was questioned. The financial shock and panic caused a severe contraction in the real economy (factor 10). ...
[I]t is dangerous to conclude that the crisis would have been avoided if only we had regulated everything a lot more, had fewer housing subsidies, and had more responsible bankers. Simple narratives like these ignore the global nature of this crisis, and promote a simplistic explanation of a complex problem. Though tempting politically, they will ultimately lead to mistaken policies.

I don't think the conclusion that better regulation would not have stopped the crisis follows from the factors they list.

By their own admission, the reason that factors 1 and 2 led to factor 3 was "an ineffectively regulated primary mortgage market." So right away better regulation could have stopped the chain of events the led to the crisis. 

Factor 3 was "nontraditional mortgages that were in some cases deceptive, in many cases confusing, and often beyond borrowers' ability to pay." Sure seems like regulation might help to prevent deception and confusion (through, among other things, a financial protection agency). One thing is clear in any case. The market didn't prevent these things on its own.

On to factor 4: Securitizers lowering credit standards, a failure of credit agencies, and buyers failing to do their own due diligence. Once again, regulation can help where the private market failed. The ratings agencies exist because they help to solve an asymmetric information problem. The typical purchaser of financial assets does not have the resources needed to assess the risk of complex financial assets (which is why saying that they should have performed their own due diligence misses the mark). Instead, they rely upon ratings agencies to do the assessment for them. Unfortunately, the ratings agencies didn't do their jobs -- perhaps due to bad incentives arising from to how they were paid -- and this is where regulation has a role to play.

Factor 5 is the accumulation of correlated risk -- again something a regulator can stop once the accumulation or risk is evident. This seems like an easy one -- when regulators see this type of risk building up, they should do something about it. The question, however, is how to give regulators better tools for assessing these risks. Backing off on regulation, as implied above, won't help with this.

Factor 6 is "holding too little capital relative to the risks and funded these exposures with short-term debt." Too little capital? Mandating higher capital requirements is the solution to this problem. Basel II is one example, but it doesn't go far enough. (The other part of factor 6 is essentially too much exposure to risk which is covered in the previous paragraph.)

Factors 7 and 8 are risk contagion and widespread exposure to a common shock. The private sector didn't prevent these risks from getting too high so, again, why wouldn't we want a regulator to do something about excessive risks of this type? False positives is one worry -- reacting to problems that aren't there -- but that is a matter of how high to set the threshold for action, not an argument against regulation itself. If anything, the threshold for action was too low prior to the crisis.

Factor 9 is "A rapid succession of 10 firm failures, mergers and restructurings in September 2008 that endangered the financial system." Too big to fail? Guess who can fix that?

Finally, factor 10 is the effects on the real economy. I'll concede that regulation could not have helped much here. Once the financial system crashed in the way that it did, the real economy was sure to follow. But remember, these factors are, for the most part, a chain of events. If the chain had been broken by more effective regulation anywhere along the way, the chain of events is interrupted and factor 10 does not come into play.

For almost every factor mentioned above, regulation could have reduced or completely eliminated the risk. Thus, it's hard to see how a conclusion that " it is dangerous to conclude that the crisis would have been avoided if only we had regulated everything a lot more" can possibly follow.

links for 2011-01-26

Posted: 26 Jan 2011 10:01 PM PST

The "Anti-Willie Sutton"

Posted: 26 Jan 2011 05:51 PM PST

Bill Craighead at Twenty Cent Paradigms:

SOTU, by Bill Craighead: A couple of thoughts on the "State of the Union"-
As an economist, I don't find the rhetoric of "competitiveness" very appealing (see Paul Krugman's classic on this).  International trade is mutually beneficial* - not a zero sum struggle to beat other countries to the "good jobs."  From an economist's point of view, the rapid growth in China is a great story about an dramatic increase in human welfare.  However, while competitiveness rhetoric can be used to justify bad policies like subsidies and tariffs, Obama is employing it to promote policies like investment in infrastructure, basic research and education that are beneficial regardless of what is going on in other countries.  Though it is a mistake to feel threatened by the success of other countries, Obama seems to be exploiting this sentiment to embarrass us into getting our act together, which isn't entirely a bad thing.  He's like our national "Tiger mother."
Unfortunately, President Obama appears to have conceded the rhetorical war on two important fronts: global warming and the budget deficit.
On global warming, which is the most important policy issue we face, the President chose not to even mention it directly.  So much for having "adult conversations" in our politics...  Even if the towel has been thrown in on cap-and-trade, the administration does appear to be trying to confront the problem, sotto voce, in other, less efficient ways.  At least, that is how I interpret the call that 80% of energy should come from "clean sources" by 2035.
As for the deficit, the idea that the government is like a family that needs to "tighten its belt" seems to have won out.  That's simple, intuitive and wrong.  The basic principle of countercyclical fiscal policy - that when households are cutting back, government needs to step in and make up for it with offsetting spending increases or tax cuts - also seems simple and intuitive.  But apparently not enough so.  President Obama is a very good speech-maker, but has proven not to be enough of a great communicator to get the public thinking correctly about this.
It looks like we'll get some "cuts" and "freezes."  These may manage to be a drag on the recovery and damage some important government functions without making much of a dent in the real long run problem because domestic discretionary spending is a fairly small part of the overall budget (as Howard Gleckman says: "that makes Obama the anti-Willie Sutton. He is going whether the money isn't").  It seems that we're done with counter-cyclical fiscal policy and its all up to the Fed now.  With 14.5 million still unemployed, that is a mistake, and a real shame.  While I hope (and believe) the President is correct in presuming the recovery will continue, it still could benefit from a fiscal push.
See also: Paul Krugman, ... and Ezra Klein.

*There are number of possible caveats on that, including that while a country as a whole benefits, some within it are hurt (Stolper-Samuelson theorem) and that a trade deficit can reduce aggregate demand which is bad for employment in the short-run.

The FOMC Keeps the Federal Funds Rate and QEII Unchanged

Posted: 26 Jan 2011 11:53 AM PST

A quick reaction to the FOMC's decision to maintain current policy objectives. There wasn't much to say -- the Fed did just as expected -- but I said it anyway:

The FOMC Keeps the Federal Funds Rate and QEII Unchanged

Update: From Tim Duy:

Quick FOMC Response, by Tim Duy: The FOMC statement was largely as expected – sticking to the current policy path. That means maintaining the current asset purchase program while holding interest rates low for an extended period. Some specifics:

No Dissents: Kansas City Fed President Thomas Hoenig is no longer a voting member, and none of the new voting members took up his dissent. Completely unsurprising. While some policymakers such as Philadelphia Fed President Charles Plosser believe that QE2 was a mistake, they see the costs –market disruption and loss of credibility – of undoing that mistake as greater than the benefits.

Additional Flexibility: Note the change in the first sentence. From:

Information received since the Federal Open Market Committee met in November confirms that the economic recovery is continuing, though at a rate that has been insufficient to bring down unemployment.
To:
Information received since the Federal Open Market Committee met in December confirms that the economic recovery is continuing, though at a rate that has been insufficient to bring about a significant improvement in labor market conditions.

A focus on a specific data point – unemployment – was replaced with the more general "labor market conditions." This could signal a willingness to roll back the balance sheet expansion if nonfarm payrolls were growing rapidly but, as workers return to the labor force, unemployment rates remain persistently high. I have difficulty seeing the Fed raise rates as long as unemployment is high, but a return to allowing the balance sheet to contract naturally or directly would not be out of the question.

Commodity Prices: As expected, the FOMC is not poised to follow the path of ECB Head Jean-Claude Trichet and fret about headline inflation. In contrast, the FOMC will focus on the pass-through to core inflation, if any, and the path of longer term inflation expectations.

Bottom Line: No real surprises in this FOMC statement, with the exception of a slight change in language on labor markets that suggests an effort to create additional flexibility.

The Unbridgeable Moral Divide

Posted: 26 Jan 2011 09:44 AM PST

When Paul Krugman talks about a great and unbridgeable moral divide, this is the kind of thing he's talking about. There's no middle ground here, and no room for compromise (I left the highlighted passage out in the excerpt from Glaeser in the post below this one). This is Robert Higgs from the Independent Institute:

Freedom Is Not Compatible with Government's Initiation of Force against Innocent People, by Robert Higgs: In yesterday's New York Times appears an op-ed article by Edward L. Glaeser... Glaeser's article is remarkable because arguments in favor of freedom, insisting that economic analysis implicitly rests on a moral presumption that individual freedom has fundamental value, do not appear every day — or every month — in "the newspaper of record." So, I am glad to give two cheers to Glaeser, one for his theme and another for his courage in placing the argument in such a hostile outlet.

I cannot give Glaeser a third cheer, however, because toward the end of the article he inserts a concession that I find wholly inconsistent with the rest of the argument. He writes:

Economists' fondness for freedom rarely implies any particular policy program. A fondness for freedom is perfectly compatible with favoring redistribution, which can be seen as increasing one person's choices at the expense of the choices of another, or with Keynesianism and its emphasis on anticyclical public spending.

Many regulations can even be seen as force for freedom, like financial rules that help give all investors the freedom to invest in stocks by trying to level the playing field.

To be sure, many mainstream economists do think about policy just as Glaeser says they do. But in doing so, they are mistaken. I find it difficult to believe that a man of Glaeser's intelligence has really given much thought to what he is saying in these passages.

In fact, a presumption in favor of freedom rules out virtually everything that modern governments do, certainly nearly everything they do in interfering in economic affairs. Redistribution of income, for example, requires that the government rob Peter in order to benefit Paul (and its own functionaries, who serve as middlemen in this transfer). This action is not freedom; it is a crime against Peter, a raw violation of his right to his own legitimate property. Keynesian countercyclical spending requires the government to spend borrowed money whose acquisition is premised on future taxation (that is, robbery) of taxpayers in order to service the debt and repay the principal. Again, innocent persons have their rights violated. How can anyone fail to see that robbery is incompatible with freedom? Finally, the financial rules that Glaeser finds compatible with freedom entail threats of violence against financial transactors who do not follow arbitrary government rules — often extremely foolish and even destructive rules — in making their transactions, notwithstanding the fact that the parties to the transaction may be perfectly willing to proceed without such regulatory compliance. Such regulation is the very opposite of freedom; it is instead the sheer imposition of outside force, intruding on willing transactors, and thereby discouraging them to some extent, if not entirely, with consequent loss of the wealth that such transactions would have created, in addition to the loss of liberty...

Glaeser quotes Milton Friedman to good effect in his article... Friedman's arguments were good as far as they went, but they did not go nearly far enough. Like Glaser, Friedman was prepared to make many concessions to state power, and his focus on utilitarian arguments, as opposed to moral principles, diminished the intellectual force of his laudable efforts to enlarge the scope of liberty in economic affairs.

Taxation is robbery, regulation is a threat of violence -- it's not hard to understand why so many people who hold these beliefs do not accept the legitimacy or the authority of the democratic process as a means to resolve disputes about the proper role of government.