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October 1, 2012

Latest Posts from Economist's View


Latest Posts from Economist's View


The 'World-Straddling Engine of Theft, Degradation, Manipulation and Social Control We Call the Welfare State'

Posted: 26 Sep 2012 12:33 AM PDT

John Kay is tired of hearing the same old same rants about the unaffordable welfare state that he's been hearing for decades:

The economy depends on the welfare state, by John Kay: It is more than 30 years since I first attended a conference on the global welfare crisis. Rarely have a few months passed without an invitation to another. Last week, Tom Palmer, the American libertarian, came to London to denounce the "world-straddling engine of theft, degradation, manipulation and social control we call the welfare state".
The content of these rants is familiar. Levels of welfare provision are unaffordable; government finance is a huge Ponzi scheme. A common conclusion is to provide an estimate of the discounted value of the cost of some hated item of expenditure if its current provision were continued into the indefinite future. Mr Palmer reported that the present value of unfunded liabilities of US medicine and social security is $137tn.
Social security is a means of inter-generational transfer..., but why ... should we look after old people, who can no longer do anything for us?
The obvious answer invokes Kant's categorical imperative: it would be good for everyone (including ourselves when we are old) if everyone acted in this way. We feed the generations of our parents and grandparents in the expectation future generations will come along and do the same for us. But the consequences of this arrangement do have the character of a Ponzi scheme. One day, the world will end and the last generation of workers will have been cheated of their expectation of a peaceful retirement. In the meantime it is possible to calculate enormous measures of unfunded obligations, and it doesn't matter. The value of these obligations is offset by the implied commitments of future generations. ...
Exaggeration can sometimes be forgiven when it is used to draw attention to a problem that has received insufficient attention. It is less easy to excuse when it threatens the fragile social arrangements on which economic security depends.

Are Oil Prices 'Determined Solely by Fundamentals'?

Posted: 26 Sep 2012 12:24 AM PDT

Jim Hamilton on what determines prices in oil markets:

...The Wall Street Journal carried this account last week:

Oil prices dropped more than $3 in less than a minute late in the trading day on Monday, just as trading volume spiked. The move also dragged down prices of gold, copper and even the euro.

"Traders were looking like deer in the headlights," said Peter Donovan, a floor trader... "I called four different desks, and they all said, 'we don't know.' " ...

The move sparked talk of an erroneous trade—called a "fat-finger" error in industry parlance—or a computer algorithm gone awry.

Fat finger or no, there was an even bigger drop on Wednesday...

Those who doubt that oil prices are determined solely by fundamentals would naturally ask, what aspect of the supply or demand for oil could have possibly changed in the course of less than a minute last Monday? The obvious and correct answer is, there was no change in either the supply or the demand for physical oil over the course of that minute. The minute-by-minute price of a NYMEX contract is determined by how many people are wanting to buy that financial contract and at what price, not by how much gasoline motorists burned in their cars that minute. But since changes in the price of crude oil are the key determinant of the price consumers pay for gasoline, doesn't that establish pretty clearly that the whims or fat fingers of financial traders are ultimately determining the price we all pay at the pump?
In one sense, the answer to that question is yes-- last week's decline in the price of crude oil will soon show up as a lower price Americans pay for gasoline. But here's the problem you run into if you try to carry that theory too far. There are at the end of this chain real people who burn real gasoline when they drive real cars. And how much gasoline they burn depends in part on the price they pay-- with a higher price, some people use a little bit less. Not a lot less-- the price of gasoline could change quite a lot and it would take some time before you could be sure you see a response in the data. That small (and often sluggish) response is why the price of oil can and does move quite a bit on a minute-by-minute basis, seemingly driven by forces having nothing to do with the final users of the product.
But if the price of oil that emerges from that process turns out to be one at which the quantity of the physical product that is consumed is a different amount from the physical quantity produced, something has to give. Indeed, the bigger price drops we saw on Wednesday followed news that U.S. inventories of crude were significantly higher than expected ...

Links for 09-26-2012

Posted: 26 Sep 2012 12:06 AM PDT

Fed Watch: Why I Agonize About The Zero Bound

Posted: 25 Sep 2012 05:49 PM PDT

Tim Duy:

Why I Agonize About The Zero Bound, by Tim Duy: I increasingly agonize about the zero lower bound. It's really no secret that I believe that the faster we normalize interest rates, the better. Such a goal should appeal to those who believe current monetary policy is reckless. To be sure, the Fed's forecast that the US economy will be stuck at the zero bound into 2015 does not leave me filled with confidence; the risks are all too high that the economy will experience a recession before then. But I very much doubt the Fed can simply raise interest rates to normalize the yield curve. That would simply invert the yield curve, and such inversion is a harbinger of recession. As long as the economy is operating at sub-optimal levels, monetary policy will be constrained by the zero bound. To lift the economy well clear of the lower bound, we need greater cooperation between fiscal and monetary authorities. I suspect this will require making explicit what is often viewed as crazy but many would argue is already implicit in recent policy, the monetization of some fiscal spending.

Japan serves as a role model for the zero bound problem. As Paul Krugman notes, fiscal policy has been effective in staving off the worst consequences of the Japanese financial crisis. But the associated fiscal deficits appear never ending; the Japanese economy never gained enough strength to eliminate the dependency on fiscal stimulus, leading to what looks like an excessive build-up of government debt that now exceeds 200% of GDP.

We frequently see concerns that a build-up of government debt will lead to a new Japanese financial crisis. Peter Boone and Simon Johnson are the latest addition to that long line of thought. On the surface, it might be easy to dismiss such concerns, as they have been regularly voiced over at least the past 12 years, so far proving to be incorrect. Japanese interest rates have not skyrocketed, the crisis has not arrived.

That said, I would not bet against that crisis over the decade, and I think that the longer the economy is stuck at the zero lower bound, the more likely it becomes. Boone and Simon note:

Japan's taxpayers are already rebelling against small tax increases needed to limit escalating deficits. This leaves little room for hope that future taxpayers will accept the larger tax increases needed to repay debts.

Japan's demographic decline will be hard to reverse...

...A crisis in Japan would most likely manifest as a collapse of confidence in the yen: At some point, Japanese citizens will decide that saving in any yen-­denominated asset is not worth the risk. Then interest rates will rise; the capital position of banks, insurance companies, and pension funds will worsen (because they all hold long-maturing bonds, which fall in value when rates rise); and fears of insolvency will surface.

The basic story is straightforward. Japan has a fiscal problem, but cannot find the political will to fix it via tax increases or spending cuts. I am not surprised. It is too easy to claim that this is simply the outcome of a broken political system. Fiscal austerity will be met with a recession, just as it has been elsewhere. And with the economy operating at the zero bound, the Bank of Japan will have relatively few tools to counteract the recession (actually, no, but more on that later). Fiscal austerity is easy to say, hard to do.

It is hard to believe, however, that the debt situation in Japan is sustainable indefinitely (see Noahpinion here). At some point the Japanese will not be able to finance their deficit without deep budget cuts, hard default, or soft default in the form of outright monetizing of debt.

Austerity will prove to be ineffective; I don't think it will be politically possible. Too many people starving in the streets. Eventually, the hit will be taken by bondholders. It is simply a question of whether they take that hit in the form of hard or soft default.

And herein lies the problem with the zero bound. Japan has long moved past the point where their citizens can worry only about the lost income from low interest payments. Now it is all about capital preservation, making it harder to implement either a hard or a soft debt default. In effect, the outcome of being at the zero bound is an every increasingly large political class that has a lot to lose by anything that increases interest rates, inflation or a drop in confidence.

Worse, that large political class makes it increasingly difficult to do what seems to be the best path, a gradual erosion of the real value of that debt through inflation. The failure of generate inflation over a period of decades actually makes it more difficult politically to create that inflation as the capital losses would be borne more intensely by an ever increasing part of the population. They are all taxpayers and bondholders. They take the hit in taxes, spending, or capital position. The longer they wait to take that hit, the bigger it will be.

What I expect to happen is this: The Bank of Japan will be forced into outright monetization at some point; a soft default in the form of higher inflation will occur. And dramatically higher inflation, I fear. Japan has not had inflation for two decades. I suspect they will experience all that pent-up inflation in the scope of a couple of years.

In other words, you can take your inflation medicine a little bit at a time, or a whole bunch at once. But a even a little bit at a time becomes increasingly more difficult politically as the debt load grows larger.

Now, how does this apply to the US? After all, the US does in fact have inflation, with prices projected to grow at something less than 2% annually. But this argument assumes that 2% is the "right" inflation rate. I would argue that it is not the right inflation rate if it is insufficient to lift the economy from the zero bound. The Fed's own forecasts, and the fear of the fiscal cliff and the subsequent recession, says we are not yet there.

I suspect the US needs higher inflation, just like Japan. The commitment to ultra-low inflation seems to be a pendulum that has swung too far. Policymakers need to take the danger of the zero-bound seriously. And I think the Fed's forecast imply they are not taking it seriously.

Think we can't create inflation? Think again. Federal Reserve Chairman Ben Bernanke gave the answer:

There is no unique solution to the problem of continuing declines in Japanese prices; a variety of policies are worth trying, alone or in combination. However, one fairly direct and practical approach is explicit (though temporary) cooperation between the monetary and the fiscal authorities. Let me try to explain why I think this direction is promising and may succeed where monetary and fiscal policies applied separately have not...

...My thesis here is that cooperation between the monetary and fiscal authorities in Japan could help solve the problems that each policymaker faces on its own. Consider for example a tax cut for households and businesses that is explicitly coupled with incremental BOJ purchases of government debt--so that the tax cut is in effect financed by money creation. Moreover, assume that the Bank of Japan has made a commitment, by announcing a price-level target, to reflate the economy, so that much or all of the increase in the money stock is viewed as permanent....

...The health of the banking sector is irrelevant to this means of transmitting the expansionary effect of monetary policy, addressing the concern of BOJ officials about "broken" channels of monetary transmission. This approach also responds to the reservation of BOJ officials that the Bank "lacks the tools" to reach a price-level or inflation target.

Isn't it irresponsible to recommend a tax cut, given the poor state of Japanese public finances? To the contrary, from a fiscal perspective, the policy would almost certainly be stabilizing, in the sense of reducing the debt-to-GDP ratio. The BOJ's purchases would leave the nominal quantity of debt in the hands of the public unchanged, while nominal GDP would rise owing to increased nominal spending. Indeed, nothing would help reduce Japan's fiscal woes more than healthy growth in nominal GDP and hence in tax revenues.

Potential roles for monetary-fiscal cooperation are not limited to BOJ support of tax cuts. BOJ purchases of government debt could also support spending programs, to facilitate industrial restructuring, for example....

Lifting off the zero bound probably requires a high degree of cooperation between the fiscal and monetary authorities that may, gasp, require some outright monetization of government debt. Such monetization is what Bernanke advocated for Japan, but this advice fell on deaf ears. Because such cooperation is feared, it is essentially off the table. For now. But what I think will be the case is that instead of small amounts of cooperation now, we are setting the stage for large amounts in the future. Debt reduction via inflation will come; the longer we wait, the more disruptive it will be.

Such thoughtful, careful, technocratic cooperation between monetary and fiscal authorities, however, is no where to be found. In the US, Europe, and Japan, at best we have is monetary authorities trying to offset real and expected fiscal austerity. That path, I fear, only leads us deeper into permanent zero bound territory.

Bottom Line: 2015 is too long to wait to emerge from the zero bound. Policymakers need to make efforts to normalize the economic environment a priority. That may require a level of fiscal and monetary cooperation that today seems to be unthinkable. But if gets to the point where central banks are pulled kicking and screaming into such cooperation (the European Central Bank may be the first to explicitly monetize government spending; I suspect it will be the only way to keep Greece in the Euro and live up to Draghi's pledge that the Euro is permanent), then I think we will all wish we had engaged in such cooperation sooner than later.

Sheila Bair on the Financial Crisis

Posted: 25 Sep 2012 10:59 AM PDT

From a Marketplace interview of Sheila Bair:

... Jeremy Hobson: Now you don't paint a very pretty picture of the relationship between the various regulators -- in particular, your relationship with the New York Fed, which was at the time headed by Timothy Geithner. What was the issue there with you and Geithner?
Bair: Well, I think Tim and I just had profoundly different ways of viewing the world. He, I think, viewed the large financial institutions as entities that needed to be supported, because he viewed them as central to the functioning economy. And I realized their importance to the economy, but I wanted them to have accountability.
In 2009, when the system was stabled, I wanted to launch programs that would have forced banks to cleanse their balance sheet; to sell off a lot of these bad assets. He was not particularly supportive of that approach. So there was little accountability, and also, I think our economy continues to suffer today because we just never dealt with a bloated, inefficient financial sector. We propped it up the way the Japanese did; we didn't have them take their medicine.
Hobson: Well do you think that looking back, then, that we are going to look back at the crisis and the government's response to the crisis, as a bunch of people acting honorably and selflessly and in the interest of the country; or that we will look back and see a rather pathetic picture of people acting in their own interest, or in the interest of these Wall Street firms?
Bair: I think we will look back and see a regulatory response and a Congressional response that was unwilling to show independence to these large financial institutions and that at the end of the day -- not withstanding the rhetoric -- implemented policies that were highly friendly to these institutions.
I don't think that's nefarious; I think it's a skewed perspective. I think Tim Geithner is an honorable person, and he did what he thought was right. But what he thought was right was saving institutions like Citigroup. He identified saving them with saving the country, and they are two very, very different things. ...

In a tweet, Zachary Goldfarb says:

Sheila Bair: "I don't think helping home owners was ever a priority for" Geithner and Summers.

And:

Beyond their policy disputes, it's clear Geithner and Bair just hated each other. Much have had an impact on quality of outcome.

To repeat a complaint I've made many times, we had a balance sheet recession. In response, one set of balance sheets -- those of financial institutions -- received plenty of attention and help. Not so for household balance sheets, and that is one of the reasons the recovery remains so lethargic.

Labor's Declining Share of Income and Rising Inequality

Posted: 25 Sep 2012 09:54 AM PDT

Labor's share of income has been declining, and inequality has been increasing. Will these trends continue?:

Labor's Declining Share of Income and Rising Inequality, by Margaret Jacobson and Filippo Occhino, FRB Cleveland: Labor income has declined as a share of total income earned in the United States. This decline was caused by several factors, including a change in the technology used to produce goods and services, increased globalization and trade openness, and developments in labor market institutions and policies.
One consequence of the labor share decline has raised concerns. Since labor income is more evenly distributed across U.S. households than capital income, the decline made total income less evenly distributed and more concentrated at the top of the distribution, and this contributed to increase income inequality. In this Commentary, we look at how the labor share decline has affected income inequality in the past, and we study the likely future path of the labor share and its implications for inequality.
The Decline in Labor's Share of Income
Household income comes in two types: labor income, which includes wages, salaries, and other work-related compensation (such as pension and insurance benefits and incentive-based compensation), and capital income, which includes interest, dividends, and other realized investment returns (such as capital gains). During the last three decades, labor's share of total income has declined in favor of capital income (see "Behind the Decline in Labor's Share of Income" for more detail).
There are a number of ways to measure the share of income that accrues to labor. We look at three different data sources, and each provides broad evidence of the decline. According to data from the Bureau of Economic Analysis, labor's share of gross national income fluctuated around 67 percent during the 1980s, 1990s, and early 2000s, but it has declined since then and now stands at 63.8 percent.1 (See figure 1.) According to the Bureau of Labor Statistics, the ratio of compensation to output for the nonfarm business sector fluctuated around 65 percent until the early 1980s and has declined steadily since, from 63 percent during the 1980s and 1990s to 58.2 percent most recently. Finally, a 2011 study of income tax returns and demographic data by the CBO (CBO 2011) finds that labor's share of income decreased from 75 percent in 1979 to 67 percent in 2007.

These three data sources measure slightly different labor share concepts, which is why their estimated levels are different. But they agree in indicating a significant drop of 3 to 8 percentage points in labor's share of income since the early 1980s, with the trend accelerating during the 2000s.
Such a decline had implications for the distribution of incomes. Labor income is more evenly distributed across U.S. households than capital income, while a disproportionately large share of capital income accrues to the top income households. As the share that is more evenly distributed declined and the share that is more concentrated at the top rose, total income became less evenly distributed and more concentrated at the top. As a result, total income inequality rose.
Income Inequality
Income inequality is the dispersion of annual incomes across households, relative to the average household income. Inequality affects a variety of other important economic variables, such as the composition of consumption and investment, tax revenue and government spending, government policies, economic mobility, human capital accumulation, and growth. Some economists—most prominently Raghuram Rajan in his book Fault Lines—have suggested that rising income inequality contributed to the debt accumulation and financial imbalances that led to the recent financial crisis. And of course income inequality is the focus of much attention as an indicator, albeit imperfect, of the inequality of lifetime income and welfare across households.
Several indicators suggest that inequality was declining up to the late 1970s, but it has since reversed course. It rose sharply during the 1980s and early 1990s and currently is at near record-high levels. ... [facts and figures on inequality, several measures presented] ...
This is a sizeable effect. More importantly, most of the effect occurred during the last decade, when the decline in the labor share was accelerating. Is this trend going to continue, and how will it affect income inequality going forward?
Future Paths
We use the model described in box 2 to learn about the future path of the labor share. The model decomposes the labor share into its long-run trend and its transitory components, and then it forecasts the future path of the overall labor share. We do all the calculations twice, once with the BEA data and once with the BLS data.
According to our model, the labor share trend has declined since 1980, with an accelerated drop in the 2000s, in both sets of data (figure 4). In the BEA data, the trend declined from levels as high as 69 percent before 1980 to 66.9 percent in 2000, to 64.9 percent today. In the BLS data, the trend declined from levels of approximately 64.5 percent before 1980 to 62.8 percent in 2000, to 59.8 percent today. According to these measures, the trend in the labor share declined 1.5 to 2 percentage points between 1980 and 2000, and then dropped an additional 2 to 3 percentage points, for a total of 4 to 4.5 percentage points.

Our model indicates that the labor share is currently 1 to 1.5 percentage points below its long-run trend level. Part of the decline in the labor share in the past five years was temporary, and it will be reversed as the recovery continues. Going forward, the labor share will pick up and converge to its long-run trend value. This will tend to decrease income inequality, lowering the Gini index by up to 0.5 (0.33 × 1.5) percentage points, as the decomposition in box 1 indicates.
Income inequality will not necessarily decrease though. As shown in box 1, inequality is affected not only by the relative shares of labor and capital income, but also by the concentrations of each. Concentration refers to the way each type of income is distributed across the households that earn it. In particular, concentration indexes measure how concentrated capital or labor income is at the top of the income distribution.
The future path of labor concentration is hard to predict, as it depends on the evolution of the returns to education and of the wage-skill premium. The concentration of capital income, however, is strongly procyclical, rising during recoveries (figure 5), and this suggests that capital income will become more concentrated at the top in the coming years of the recovery, helping to raise income inequality even further. This effect has dominated the dynamics of income inequality during the past two business cycles, so the future path of income inequality will likely be determined by the strength of the recovery and the associated pickup of the concentration of capital income.

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