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September 23, 2012

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Posted: 23 Sep 2012 12:06 AM PDT

Is Japan Doomed?

Posted: 22 Sep 2012 11:24 AM PDT

Noah Smith:

Time to Japanic?, by Noah Smith: The Atlantic has a big story on the impending Japanese crash; one of the authors is the brilliant Simon Johnson. ...
This prophecy is hardly unique; I have beaten this drum myself. If Japan doesn't change course, it will have a major crisis within the next decade.
If. But what people need to understand is, the Japanese government does have the power to avert a crisis. It is not inevitable.
There is one way that the crisis can definitely be averted: Raise taxes. Japan's fiscal woes can be boiled down to one sentence: Japan has European levels social spending and European levels of aging with American levels of taxation. But this could change; if Japan raised taxes to European levels, crisis would be instantly averted. According to analyses I've seen, this would require raising Japan's taxes from their current level of 32.5% of GDP to somewhere between 40% and 50% of GDP. That's comparable to France or Sweden. Painful, but not impossible.
Now for the rumor (rumor always being a large component in Western analyses of Japan). My sources at the Bank of Japan and Ministry of Finance tell me that domestic Japanese investors are betting that, after all the grumbling and fighting and ending of political careers, Japan's government will suck it up and raise taxes. This, my shadowy sources say, is why pension funds are still willing to put the Japanese people's money into JGBs.
But this story is not really outlandish. It's similar to what we're observing in America right now. U.S. borrowing is at all-time highs, but demand for Treasuries shows no sign of flagging, and most of that demand - more than in the past - is from domestic U.S. investors. Yes, we have shown a reluctance to raise taxes - witness the apocalyptic debt ceiling fight from last year. But if the public really thought the U.S. government was willing to default, domestic Treasury buyers would be heading for the exits. That they are not heading for the exits probably indicates that they believe that when push comes to shove, the U.S. government will suck it up and raise taxes. There are signs that the Republicans are quietly recognizing the necessity of this. At this point, it's just a fight between Democrats and Republicans to see who takes the fall for raising taxes - that's what the "fiscal cliff" is really all about.
Japan seems to be in a similar situation. It is not really unusual or outlandish at all. Everyone in the country still seems to believe that the government will continue to function. The day that that that belief falters - or is proven wrong by main force, when interest payments swamp the primary budget - is the day that Japan collapses (the same goes for the U.S.). But if Japan's government is less dysfunctional than the often skittish Western press believes, that day will never come.
(Anyway...oh yeah, I did mention that there might be two ways out of Japan's fiscal trap, didn't I? The other way is to use monetary policy to create negative interest rates. If that can be done in a stable way (without accelerating inflation) and if stable growth persists, then Japan can use an "inflation tax" to erode the value of its government debt instead of an actual tax. Econ bloggers (and commenters), who tend to believe that central banks can hit any NGDP target they want, will probably advocate this "solution"...)

One Rule to Ring Them All?

Posted: 22 Sep 2012 09:25 AM PDT

In macroeconomic models, if everything works perfectly -- if all markets clear at all points in time, prices are fully and instantaneously flexible, people have the information they need, and so on -- then monetary policy will have no affect on real variables such as output and employment. Only nominal variables such as the price level will change. This is known as monetary neutrality.

In order to get non-neutrality, i.e. in order to make it so that changes in the money supply can change real output and employment in a theoretical model, there must be a friction of some sort. One popular friction is price/wage rigidity, but it is not the only type of friction that can generate non-neutralities. Any friction that prevents optimal and instantaneous response to a shock will overcome neutrality and restore the ability of the Fed to affect the course of the real economy.

The point I want to emphasize is that the optimal monetary policy rule depends upon the underlying friction that is being used to generate non-neutralities in the theoretical model. For example, Calvo type price rigidity combined with some sort of social objective function such as maximizing the welfare of the representative household often gives you something that resembles the standard Taylor rule (though whether the level and/or the growth rates of price and output belong on the right-hand side of the Taylor rule depends upon the nature of the friction, i.e. even in this case the standard Taylor rule may not be the optimal rule).

I am willing to believe that during the Great Moderation the standard Taylor rule may have at least been close to the optimal rule. If you believe price frictions were the source of the mild fluctuations we had during that time, then theory tells us that's possible. What puzzles me is why people think the same rule should work now. I don't think that Calvo type price rigidities are the reason for the problems we are having right now, and hence this does not give us much insight and explanatory power for the Great Recession. Mild price sluggishness is plainly and simply not the dominant friction at work right now, and if that is the case, why would we think the same monetary policy rule should be optimal? If, in fact, there has been a switch in the dominant type of friction affecting the economy -- and I would argue there has been -- it would be quite remarkable for the same monetary policy rule to be optimal in both situations.

So, I have to agree with Paul Krugman:

Self-contradictory Fed Bashing: David Glasner continues to be unhappy with the Bernanke/QE bashers, this time going after claims that the Fed's monetary policy was too easy before the crisis.
Much of this discussion is couched in terms of the Taylor Rule, which John Taylor originally suggested — a rule that sets the Fed funds rate based on inflation and either unemployment or some measure of the output gap. This was a clever idea, and has proved useful as a rule of thumb for both description and prediction. But a funny thing happened on the way to the crisis: Taylor and others have elevated this rule to sacred status — and not only that: they have insisted that the original coefficients Taylor suggested, which he basically pulled out of, um, thin air, are sacrosanct.
Surely this is silly. ...

Krugman is not making the argument that the nature of the friction has changed and therefore the optimal rule should change as well. That's my argument so blame me, not him. But the idea that the Taylor rule should have "sacred status" is "silly," and I don't understand why Taylor and others insist that the coefficients of the rule -- let alone the rule itself -- are optimal always and everywhere (there may be a robustness argument -- this is the best possible rule in the face of model uncertainty -- but that's not the argument being made).

September 22, 2012

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Paul Krugman: Disdain for Workers

Posted: 21 Sep 2012 12:33 AM PDT

Today's GOP doesn't have much respect for workers:

Disdain for Workers, by Paul Krugman, Commentary, NY Times: By now everyone knows how Mitt Romney, speaking to donors in Boca Raton, washed his hands of almost half the country — the 47 percent who don't pay income taxes... By now, also, many people are aware that the great bulk of the 47 percent are hardly moochers; most are working families who pay payroll taxes, and elderly or disabled Americans make up a majority of the rest.
But here's the question: Should we imagine that Mr. Romney and his party would think better of the 47 percent on learning that the great majority of them actually are or were hard workers, who very much have taken personal responsibility for their lives? And the answer is no.
For ... the modern Republican Party just doesn't have much respect for people who work for other people... All the party's affection is reserved for "job creators," a k a employers and investors. ...
Am I exaggerating? Consider the Twitter message sent out by Eric Cantor, the Republican House majority leader, on Labor Day...: "Today, we celebrate those who have taken a risk, worked hard, built a business and earned their own success." Yes, on a day set aside to honor workers, all Mr. Cantor could bring himself to do was praise their bosses.
Lest you think that this was just a personal slip, consider Mr. Romney's acceptance speech at the Republican National Convention. What did he have to say about American workers? Actually, nothing...
Where does this disdain for workers come from? Some of it, obviously, reflects the influence of money in politics... But it also reflects the extent to which the G.O.P. has been taken over by an Ayn Rand-type vision of society, in which a handful of heroic businessmen are responsible for all economic good, while the rest of us are just along for the ride.
In the eyes of those who share this vision, the wealthy deserve special treatment, and not just in the form of low taxes. They must also receive respect, indeed deference, at all times. That's why even the slightest hint from the president that the rich might not be all that — that, say, some bankers may have behaved badly, or that even "job creators" depend on government-built infrastructure — elicits frantic cries that Mr. Obama is a socialist. ...
The point is that ... the Boca Moment wasn't some trivial gaffe. It was a window into the true attitudes of what has become a party of the wealthy, by the wealthy, and for the wealthy, a party that considers the rest of us unworthy of even a pretense of respect.

Links for 09-21-2012

Posted: 21 Sep 2012 12:06 AM PDT

Is Europe Saved?

Posted: 20 Sep 2012 07:14 PM PDT

Acemoglu and Robinson argue Europe's troubles aren't over yet:

Is Europe Saved?, by Daron Acemoglu and James Robinson: September has been a good month for the euro-zone. ... So is Europe saved?
We think not. The problems underlying the European crisis were institutional. What we are seeing now are mostly short-term fixes, not true solutions to these institutional problems.
The roots of the crisis lie in the difficulty of operating a currency union without centralized fiscal authority. ... For the euro to survive and contribute to European economic prosperity in the medium term, Europe needs to follow the example of the United States as it transitioned from the Articles of Confederation of 1781 to the U.S. Constitution, which entailed strengthening the currency union with debt renegotiation (with the federal government assuming state liabilities) and more importantly, meaningful fiscal centralization.
And yet, there is no realistic plan for true fiscal centralization in Europe..., [which] means a European organization with the power to set taxes and harmonize labor, product and credit market institutions. But this is not possible without some centralization of political and military power. It was crucial that with the U.S. Constitution, political and military power shifted to the federal government.
This is not on the cards for Europe... So for the time being, we have to make do with short-term fixes, and in all likelihood, Europe isn't saved just yet.

Fed Watch: Getting Lonely to be a Hawk

Posted: 20 Sep 2012 05:24 PM PDT

Tim Duy:

Getting Lonely to be a Hawk, by Tim Duy: Minneapolis Federal Reserve President Narayana Kocherlakota today gave a speech that was something of a shocker. But a little background first. Kocherlakota has generally be viewed as a hawk, more so than his colleague St. Louis Federal Reserve President James Bullard. See, for example, the Credit Suisse mapping of Fed policymakers. I referred to Kocherlakota as one of the "Three Stooges" among the voting members of the 2011 FOMC meetings in regards to his dissents. So it came as something of a surprise today when he said:

The substance of this liftoff plan is that, as long as longer-term inflation expectations remain stable, the Committee will not raise the fed funds rate unless the medium-term outlook for the inflation rate exceeds a threshold value of 2 1/4 percent or the unemployment rate falls below a threshold value of 5.5 percent. Note that neither of these thresholds should be viewed as triggers—that is, once the relevant cutoffs are crossed, the Committee retains the option of either keeping the fed funds rate extraordinarily low or raising the fed funds rate.

At first blush, this sounds like a light version of Chicago Federal Reserve President Charles Evans' policy approach in which Evans would explicitly allow for an inflation rate as high as 3% as long as unemployment was above 7%. With this sentence, Kocherlakota appears to have decisively moved from the hawkish column to the dovish. Credit Suisse needs to update their charts, and the remaining hawks become even more marginalized.

Mark Thoma, however, argues that there is less here than meets the eye, noting that Kocherlakota shows no willingness to accept that inflation greater than 2% may be helpful. Indeed, Kocherlakota seems focused on the Fed's 2% target, with the 2.25% simply allowing for some uncertainty of plus or minus 25bp around that target. A true dove, in the classic definition (as I explain here), is a policymaker that seeks relatively higher inflation than his/her colleagues. But by that definition, Evans is the only true dove. The rest of the FOMC worships at the altar of their newly enshrined 2% target. The hawks/doves divide is now about how one views the upside or downside inflation risks to the target rather than the target itself.

A further distinction can be made. Hawks tend to view high upside risks to inflation because they believe structural factors limit the pace of growth. Thus, more monetary policy can only show up in higher inflation. Doves tend to view current challenges as largely cyclical. With the economy operating well below trend, further monetary policy can be applied without stoking inflation.

Now let's go back to our friend from Minneapolis. Recall that last year, Kocherlakota believed that the Fed funds rate would need to rise in 2011:

These two elements—the increase in core PCE inflation and decline in labor market slack—imply that the target fed funds rate should be raised by at least a percentage point. However, there is a third effect that partially offsets the first two effects. The level of accommodation provided by the Fed's holdings of long-term securities depends on how long people expect those holdings to last...By putting these three elements together, I arrive at my conclusion: If PCE core inflation rises to 1.5 percent over the course of 2011, the FOMC should raise the fed funds rate by around 50 basis points.

Last year, Kocherlakota was citing 1.5% (core) inflation as a trigger for immediate action; now he sees 2.25% as a threshold that may call for tighter policy. Thus, he exhibits a higher tolerance for inflation, which in and of itself makes him less hawkish in the classic sense than we saw last year.

In addition, last year Kocherlakota argued that monetary policy is incapable of achieving full employment in the near term. In this presentation, he modifies an IS-LM model to define an output level "FEDMAX" that is below the full employment level of output. That Kocherlakota would not have believed that the unemployment rate could be pushed to 5.5%, even in the context of price stability, before the Fed needed to tighten policy. See also Robin Harding on this point.

So by my read, Kocherlakota has definitely come off the hawkish side of the FOMC. He appears to be both more tolerant of inflation and putting less weight on concerns that structural factors could be limiting growth.

Bottom Line: The ranks of Fed hawks grows even thinner, down to just four clear hawks (plus or minus Bullard) out of nineteen policymakers. Barring an "sustainable and substantial" shift in the tone of the data, expect this Fed to keep their foot on the pedal for the foreseeable future.

Kocherlakota: Planning for Liftoff

Posted: 20 Sep 2012 01:08 PM PDT

[This is a pretend interview with Narayana Kocherlakota based on his speech today, Planning for Liftoff, laying out an exit strategy for the Fed.]

Hi. Good to see you again. What are you going to say in your speech?

In my remarks today, I'll briefly discuss the objectives of the Federal Open Market Committee, or FOMC, which is the monetary policymaking arm of the Federal Reserve. Next, I'll present a pictorial review of the evolution of macroeconomic data over the past five years.
With that background, I will then turn to a discussion of monetary policy. My jumping-off point is a phrase in the FOMC statement issued last Thursday. In that statement, the Committee said that it "expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens." My main message today is that the FOMC can provide additional monetary stimulus by making this sentence more precise in the form of what I'm going to call a liftoff plan: a description of the economic conditions that would lead the Committee to contemplate the initial increase in the fed funds rate above its currently extraordinarily low level.2

So if I understand correctly, now that the Fed has eased further -- something I would not have expected you to support given your past remarks -- your main goal is to be clear about how soon the Fed can begin reversing policy? Your goal is to clarify the exit strategy?

I will suggest the following specific contingency plan for liftoff:

As long as the FOMC satisfies its price stability mandate, it should keep the fed funds rate extraordinarily low until the unemployment rate has fallen below 5.5 percent.

The price stability part seems to be a bit of a catch. This appears to say that the Fed will only continue with stimulative policy so long as it is not worried about inflation. That doesn't seem much different from current policy, except it's dressed up with a few numbers and some bolded text. What's new here?
I'll be much more precise later about the meaning of the phrase "satisfies its price stability mandate." Briefly, though, I mean that longer-term inflation expectations are stable and that the Committee's medium-term outlook for the annual inflation rate is within a quarter of a percentage point of its target of 2 percent. The substance of this liftoff plan is that, as long as longer-term inflation expectations remain stable, the Committee will not raise the fed funds rate unless the medium-term outlook for the inflation rate exceeds a threshold value of 2 1/4 percent or the unemployment rate falls below a threshold value of 5.5 percent.

Wait a minute. I asked you very specifically last spring why the Fed had an asymmetric aversion to inflation -- there seems to be much more tolerance of inflation below target than inflation above target. In fact, 2 percent inflation looks more like a hard ceiling for than a central value. At that time, you insisted that the Fed had a symmetric tolerance -- it was just as willing to tolerate inflation above target as below. Now you're telling us a hard ceiling of 2.25 percent is needed? How is that consistent with the symmetry you claimed in the past? 

Note that neither of these thresholds should be viewed as triggers—that is, once the relevant cutoffs are crossed, the Committee retains the option of either keeping the fed funds rate extraordinarily low or raising the fed funds rate.
Thus, my proposed liftoff plan contains a specific definition of the phrase "a considerable time after the economic recovery strengthens." In my talk, I will argue that this specificity—about an event that may not take place for four or more years—will provide needed current stimulus to the economy.
I'll listen closely when you get to that part. But can you explain a bit more now?
A key question is: How much leeway around 2 percent is appropriate?
The Committee has made no formal decision about this issue, and my own thinking continues to evolve. But I currently believe that allowing the medium-term outlook for inflation to deviate from 2 percent by a quarter of a percentage point in either direction would provide sufficient flexibility to the Committee, while posing no threat to the credibility of the long-run target. I'll provide more details on my thinking about this issue later in the talk.
To sum up, the FOMC defines its price stability mandate as a 2 percent inflation target over the longer run. When operationalizing this definition, though, it is necessary to take into account the lags associated with monetary policy and to allow for some medium-term flexibility around the long-run target. Given these considerations, in my view, the FOMC can be said to be satisfying its price stability mandate as long as its medium-term outlook for inflation is between 1 3/4 percent and 2 1/4 percent, and longer-term inflation expectations remain stable.

So you basically have a hard 2 percent target, and only allow tolerance around that due to technical constraints that prevent tighter bounds? I suspect some people are going to think you have increased your tolerance for inflation, but you really haven't, have you?

Let's talk a bit more about your "liftoff" plan. Can you summarize how it works?

I think that it is safe to say that, relative to historical norms, the current stance of monetary policy is quite unusual. In June 2011, the FOMC released a statement describing its exit strategy—that is, the sequence of steps involved in returning monetary policy to a more normal stance. However, that 2011 statement said nothing about the conditions that would trigger the initiation of this exit strategy. This omission is problematic. The current economic impact of both forms of accommodation—low interest rates and asset purchases—depends on when the public believes that accommodation will be removed.
To understand this critical point, consider two possible scenarios. In the first, the public believes that the FOMC will initiate liftoff once the unemployment rate hits 7 percent. In the second, the public believes that the FOMC will defer initiation of liftoff until the unemployment rate hits 6 percent. The higher unemployment rate in the first scenario means that monetary policy will be tightened sooner, which, in turn, will lead to the unemployment rate being higher for longer. Foreseeing that, people will save more in the first scenario than in the second, to protect themselves against these higher unemployment risks. Because they save more, they spend less, and there is less economic activity. In other words, the FOMC can provide more current stimulus if people believe that liftoff will be triggered by a lower unemployment rate.

So what is the specific plan?

The proposed plan is the following:
As long as the FOMC is continuing to satisfy its price stability mandate, it should keep the fed funds rate extraordinarily low until the unemployment rate has fallen below 5.5 percent.
As discussed earlier, by "satisfy its price stability mandate," I mean that longer-term inflation expectations are stable, and the Committee's outlook is that the annual inflation rate in two years will be within a quarter of a percentage point of the target inflation rate of 2 percent.

Why so much sensitivity to inflation? Why not, say, a 3 percent threshold instead?

Why is this liftoff plan an appropriate one? I argued earlier that the FOMC can provide more current stimulus by using a lower unemployment rate threshold for liftoff. Of course, additional monetary stimulus will give rise to more inflationary pressures, and those pressures are problematic because they could lead the FOMC to violate its price stability mandate. However, in my view, the Committee should choose the lowest unemployment rate threshold that it sees as unlikely to generate a violation of the price stability mandate.

This seems far too sensitive to inflation to me. Why such a low tolerance?

The proposed liftoff plan does allow the FOMC to contemplate raising the fed funds rate if the Committee's medium-term inflation outlook rises above 2 1/4 percent. However, the following chart shows that recent historical evidence suggests that this possibility is unlikely to occur. It documents that the medium-term inflation outlook has not risen above 2 1/4 percent in the last 15 years.6 Thus, this historical evidence suggests that, as long as the unemployment rate remains above 5.5 percent, it seems unlikely that the price stability mandate would be violated.

I'm not asking about the likelihood of inflation rising above 2.25 percent, I'm asking why you have such intolerant bonds on the inflation rate.

The liftoff plan does not say that the Committee will raise the fed funds rate when the medium-term inflation outlook exceeds 2 1/4 percent—only that it could. The Committee's decision in this context would hinge on a delicate cost-benefit calculation that would weigh the inflation increases against the employment gains. That policy conversation would, I conjecture, be a challenging one. Among other issues, it could well involve a reassessment of the long-run unemployment rate that is consistent with 2 percent inflation.7
So your policy, in a nutshell, is that the Fed should be accommodative, but if inflation rises above 2.25 percent, or threatens to do so, the Fed should have a serious talk?
In the same vein, the unemployment rate of 5.5 percent should be viewed as only a threshold to initiate a policy conversation, not as a trigger for action. For example, it is possible that macroeconomic shocks could lead the Committee's medium-term outlook for inflation to be below 2 percent when the unemployment rate falls below 5.5 percent. At that point, the Committee might want to defer initiating exit, and the liftoff plan allows the Committee to consider doing so.

One thing I don't understand, how is this supposed to work if you won't allow inflation to rise above 2.25 percent -- basically the minimum technical tolerance associated with a hard 2 percent medium run target?

I want to be clear about the economic mechanism by which the proposed liftoff plan generates stimulus. First, it does not generate stimulus by having the FOMC tolerate higher rates of inflation, as has been espoused by many observers. I am doubtful about the efficacy of the inflation-based approach. I suspect that many households would believe that their wage increases would not keep up with the higher anticipated inflation rates. Those households would save more and spend less—exactly the opposite of the policy's aim. In any event, I think that this approach is a risky one for central banks to use, because it requires them to raise inflation expectations—but not too much.
Thus, the liftoff plan that I've discussed only applies when the FOMC satisfies its price stability mandate. How then does the proposed liftoff plan generate stimulus? The plan recommends that the FOMC clearly communicate its intention to pursue policies that are fully supportive of much higher levels of economic activity. Thus, the plan commits to keeping the fed funds rate extraordinarily low until the unemployment rate is much nearer historical norms, as long as inflation remains under control. With that commitment, households can anticipate a lower path for unemployment, and they can save less to guard against the risk of job loss. People will spend more today, and that will drive up economic activity.8

So because it might end up as too much inflation, your answer is none at all? You're saying that some inflation would, in fact be useful, but one is too many and a hundred not enough? One taste of inflation, and it rips out of control? I have more faith in you and your colleagues than that. The Fed can allow inflation to, say, go to three percent without risking that it spirals out of control, I think, but you don't seem to have much faith in your colleagues.

You are likely to get a lot of credit for dropping your inflation hawkery, but I don't see it. The target is still 2% + min possible error of .25 percent, so I don't see that you've loosened much at all relative to the past (and even if the "min possible error" interpretation is incorrect, plus or minus .25 percent is hardly the definition of tolerant). You certainly have not embraced a transmission mechanism for policy that runs through elevated inflation expectations, the way most economists think these policies work. How would you respond to that?

I've spent much of my time describing what I see as an appropriate liftoff plan. I've proposed that, given current Committee thinking about the economy's productive capacity, the Committee should plan on deferring exit until the unemployment rate falls below 5.5 percent. Critically, there are important inflation safeguards embedded in the plan: The Committee could consider initiating liftoff if its medium-term inflation outlook ever exceeds 2 1/4 percent. The evidence from the past 15 years suggests that this event is unlikely to occur.
President Charles Evans of the Federal Reserve Bank of Chicago has also proposed what I'm calling a liftoff plan. As I said last year in answer to a media query, I very much liked his approach to thinking about the problem. Those familiar with his plan will see that my thinking has been greatly influenced by his. This is perhaps hardly surprising, since he sits next to me at every FOMC meeting!
My building on President Evans' creative proposal in this fashion is, I think, indicative of how the Federal Open Market Committee operates. The making of monetary policy under Chairman Ben Bernanke's leadership is a distinctly collaborative process. Obviously, we don't always agree with one another. It would be surprising if we did in such unusual economic conditions. But we learn continually from each other's points of view. In that way, I believe that we can start to make progress on the challenging economic problems we face.

I hope you continue to sit by Evans, I sat by him not too long ago at a conference and I learned from him as well. You are still a ways from him -- you remain far more hawkish than he is, at least in my assessment -- but maybe, just maybe your views will continue to evolve towards his. One last thing. I know Jim Bullard respects you a lot, can you bring him along as well?

Perhaps not, but in any case, thanks for allowing me pretend I'm interviewing you.

Update: After posting this, I tweeted:

Pushback on previous post: Significance of Kockerlakota's speech is his changed view of structural vs. cyclical unemployment, not inflation.

Couldn't ask about that in pretend interview since he didn't say much about it in his speech.

But not so sure he's changed his mind, though he has allowed for the chance he's wrong. If it is structural, inflation will rise above 2.25 ... as QE proceeds, and he'll favor tightening even if unemployment > 5.5%. Only difference I see is that he isn't insisting it's structural ... as he was before. Perhaps the paper by Lazear at Jackson Hole raised some doubt.

'Mitt and the Moochers'

Posted: 20 Sep 2012 08:21 AM PDT

A quick one as I run off to a meeting. This is Simon Johnson taking on big banks once again:

Mitt and the Moochers, by Simon Johnson, Project Syndicate: The Republican Party has some potentially winning themes for America's presidential and congressional elections in November. Americans have long been skeptical of government...
But Republican presidential candidate Mitt Romney and other leading members of his party have played these cards completely wrong in this election cycle. Romney is apparently taken with the idea that many Americans, the so-called 47%, do not pay federal income tax. He believes that they view themselves as "victims" and have become "dependent" on the government.
But this misses two obvious points. First, most of the 47% pay a great deal of tax on their earnings, property, and goods purchased. They also work hard to make a living in a country where median household income has declined to a level last seen in the mid-1990's.
Second, the really big subsidies in modern America flow to a part of its financial elite – the privileged few who are in charge of the biggest firms on Wall Street. ...
Former Utah Governor and Republican presidential candidate Jon Huntsman addressed this issue clearly and repeatedly as he sought – unsuccessfully – to win his party's nomination to challenge President Barack Obama. Force the banks to break up, he argued, in order to cut off their subsidies. Make these financial institutions small enough and simple enough to fail – then let the market decide which of them should sink or swim.
That is an argument around which all conservatives should be able to rally. After all, the emergence of global megabanks was not a market outcome; these banks are government-sponsored and subsidized enterprises, propped up by taxpayers. (This is as true in Europe today as it is in the US.)
Romney is right to raise the issue of subsidies, but he badly misstates what has happened in the US during the last four years. The big, nontransparent, and dangerous subsidies are off-budget, contingent liabilities generated by government support for too-big-to-fail financial institutions.  These subsidies do not appear in any annual appropriation, and they are not well measured by the government – which is part of what makes them so appealing to the big banks and so damaging to everyone else.
If only Romney had turned popular disdain for subsidies against the global megabanks, he would now be coasting into the White House. Instead, by going after the hard-pressed 47% of America – the very people who have been hurt the most by reckless bank behavior – his prospect of victory in November has been severely damaged.

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On the 'Austrian' Hatred of Fractional Reserve Banking

Posted: 20 Sep 2012 12:10 AM PDT

Brad Delong on Ludwig von Mises:

...whenever I see something like:

Ludwig von Mises: Attempts to carry out economic reforms from the monetary side can never amount to anything but an artificial stimulation of economic activity by an expansion of the circulation, and this, as must constantly be emphasized, must necessarily lead to crisis and depression. Recurring economic crises are nothing but the consequence of attempts, despite all the teachings of experience and all the warnings of the economists, to stimulate economic activity by means of additional credit...

I find myself under a mysterious but inexorable and irresistible compulsion to waste what would otherwise be productive work time trying to make some kind of sense of it--to at least understand wherein lies the error, and how somebody trying very hard to understand the economy (never mind that he is a big fan of the political leadership of Benito Mussolini) can go so pathetically wrong.

It is, of course, not the case that every expansion of the circulation is an "artificial" (and unnatural) "stimulation of economic activity" that must "necessarily lead to crisis an depression". So why does Ludwig von Mises think that it must?

Here is my current guess as to where von Mises is coming from:

Let us start out with a world of publicly-known technology and constant returns to scale in everything. People happily make things and trade them. And everything sells at its resource cost.

One of the things people make is little disks of gold, usually decorated with pictures of bearded men on one side and allegorical female figures on the other, with lettering saying things like: "Fecund Augustae" or "Concordia Militum" or "Fides Exercituum" on them. These little gold disks trade--like everything else--at their cost of production: the cost of digging the ore out of the ground, extracting the metal from the ore, and stamping the disk into the right shape.

Then somebody has a bright idea: Because these little metal disks are valuable and easy to carry, they are subject to theft. I will offer to perform a service: I will keep everybody's little metal disks in my stronghouse, and let's write out signed, notarized declarations that people have little metal disks in my stronghouse and they can trade those rather than the disks directly. And--as long as 100% of the circulating medium is backed by gold--everything goes on as before, with everything selling for its cost of production.

Then somebody else has a bright idea: They write out a whole bunch of signed declarations that they have little metal disks in the stronghouse, even though they actually do not have any such. They then buy things with these pieces of the circulating medium that they have written out.

These people, Ludwig von Mises says, are thieves: thieves pure and simple:

They have bought useful things.

They have claimed that they have done so by trading (claims to) valuable little metal disks (in the warehouse) for useful commodities.

But they have lied.

They did not have any valuable little metal disks for trade.

And, Ludwig von Mises would say, these lying thieves come in three forms:

  • governments that print dollar bills without having 100% gold bullion backing for them in Fort Knox.
  • banks that issue bank notes.
  • banks that allow depositors to write checks in amounts that exceed the specie reserves they the banks have in their vaults.

The problem, I think Ludwig von Mises would say, is that the wealth of society is the amount of work has gone into creating the commodities in the economy: the food, the clothing, the houses, the little gold disks. The sum of past work crystalized in commodities is society's wealth. The food is wealth, the housing is wealth, the clothing is wealth, and the little gold disks are wealth. Then add unbacked fiat money and bank credit--either public or private, it doesn't matter--to the mix. The fiat money and the bank credit are counted as wealth, as if they were claims to little gold disks that took sweat and tears to create, but they are not wealth at all. They are fictions: false promises that there is somewhere some valuable gold that you have title to.

And, Ludwig von Mises would say, the larger the unbacked circulating medium the bigger the lie and the theft. It is all guaranteed to end in tears. Whenever society thinks that it is richer than it is, plans will be inconsistent and unattainable. When that unattainability becomes manifest, that will trigger the crash and the depression.

That is, I think, where von Mises is coming from.

And, of course, this is wrong--so so so so so so so so so unbelievably wrong.

It is simply not the case that we can cheaply and easily buy things with money because it is valuable. It is, instead, the case that money is valuable because we can cheaply and easily buy things with it.

One way into the tangle of understanding why it is wrong is to ask each of us: Why are you happy accepting money in exchange when we sell useful commodities?

Hint: It's not because we are looking forward to going down to the bank, exchanging our bank notes for the little disks of gold usually decorated with pictures of bearded men on one side and allegorical female figures on the other with lettering saying things like "Fecund Augustae" or "Concordia Militum" or "Fides Exercituum" on them, taking our little disks home, and feeling happy looking at them.

That's not why we accept money.

We accept money because if we don't have any money we have to buy commodities with other commodities, and when we do so we are unlikely to receive the cost of production for what we sell. Have you ever tried to buy a latte at Peets with a copy of Ludwig von Mises's Money and Credit? It does not go well.

The fact is that your wealth is only worth its cost of production if you are liquid--if you can wait to sell until somebody willing to pay full cost of production comes along, which is not every minute. The use-value of money is that it allows you to time your other transactions so that you can realize the full exchange value of what you sell, rather than having to sell it at a discount.

Thus there is no paradox: no sense in which the existence of fiat money creates a situation in which society must necessarily think that it is richer than it is, with claims to total wealth valued at more than the value of total wealth itself. You think--correctly--that your fiat money has value, and that value is just equal to the discount from its cost of production that your other wealth incurs because it is illiquid. But what if the government prints more fiat money than the illiquidity gap in your other wealth? Well, then people will say: "I don't need to hold all this extra money. I would be liquid enough with less." Everybody will try to run down their money balances, and so the price level will rise until the real money stock is just what people think covers the illiquidity gap between their other wealth and its cost of production.

What von Mises misses completely is that the size of this illiquidity gap can and does change suddenly and drastically--and it is the business of the central bank and of the government to alter the quantity of money to keep such changes from disrupting the real economy. ...

Links for 09-20-2012

Posted: 20 Sep 2012 12:06 AM PDT

Fed Watch: Fisher Turns to Fear Mongering

Posted: 19 Sep 2012 05:17 PM PDT

Another one from Tim Duy:

Fisher Turns to Fear Mongering, by Tim Duy: Dallas Federal Reserve President Richard Fisher is quick to continue his fear mongering about inflation. Via Bloomberg:

"I do not see an overall argument for letting inflation rise to levels where we might scare the market," Fisher said on Bloomberg Radio's "The Hays Advantage" with Kathleen Hays and Vonnie Quinn. "We have seen a sharp rise in inflation expectations. If you let this get out of hand, then I think we will have a market reaction."

Let's go to the chart:


You really can't say that inflation expectations are surging beyond anything we have seen in the past six years. Moreover, supporting inflation expectations was an expected outcome of Fed easing. And financial markets seem to like it.

Also, it is not clear that TIPS-derived expectations are the best measure (a point I don't make enough). The Cleveland Federal Reserve works on teasing out inflation expectations, and on September 14th reported:

The Federal Reserve Bank of Cleveland reports that its latest estimate of 10-year expected inflation is 1.32 percent. In other words, the public currently expects the inflation rate to be less than 2 percent on average over the next decade.


Yes, near term expectations have gained but from a too-low 1.2% to 1.8%. Moreover, this would be expected not just from anticipation of QE3, but from the rise in gas prices (and note that oil prices are now falling again). By this measure, the more important longer term expectations remain mired well below the Fed's 2% inflation target. Let's at least agree to stop worrying about inflation until we get expectations back up to the Fed's target.

Bottom Line: Fisher stays true to form, clutching to his fears of inflation like a drowning man grabs onto a life preserver. My guess is that he doesn't need to be marginalized by the doves; he does a fine job marginalizing himself.

Fed Watch: Hawks Are Marginalized

Posted: 19 Sep 2012 10:39 AM PDT

Tim Duy:

Hawks Are Marginalized, by Tim Duy: There has been a lot of Fedspeak over the last few days as policymakers expand upon the shift to open-ended QE. See Cardiff Garcia at FT Alphaville for an overview of some of the dovish talk, and see Pedro Da Costa at Reuters for some thoughts on the hawkish talk, described as a "vocal minority." See also Reuters for an interview with St. Louis Federal Reserve President James Bullard, who claims that he would have voted against QE3:

"I would have voted against it based on the timing. I didn't feel like we had a good enough case to make a major move at this juncture," said Bullard, who has been viewed as a centrist on the spectrum of Fed officials, though in recent months he has sounded opinions that have sounded more hawkish as he has expressed doubts about the need for further stimulus.

Bullard does acknowledge his preference for open-ended QE, had he believed it was needed:

Even so, Bullard said some of the contours of the plan, which has no set end date, were in keeping with how he thinks monetary policy should be conducted with interest rates already near zero. Leaving end dates off a bond buying program can make the policy "more effective," he said.

Bullard is also reported to have expressed support for dropping the dual mandate, although I am not seeing a direct quote. Same for concerns about commodity prices:

He also voiced concern that QE3 could spill over into higher commodity prices, as happened with the previous rounds of Fed bond-buying, although he said the soft tone of the world economy would help curb price rises.

The reporter reaches the conclusion:

In discussing his views on more monetary stimulus, Bullard said, "We should take a little bit more (of a) wait-and-see posture." His comments, in an interview with Reuters Insider, highlight potential dissent on the Fed's policy committee next year when he will be a voting member.

Should we be concerned about this warning? I would say no. I think it is easy for Bullard to say that he would have dissented, but a lot harder to actually dissent if he was seated in the meeting. Indeed, he gets the best of both worlds - he gets to display his hawkish credentials by saying he would voted against QE without the pressure of the actual vote. Might he get more vocal next year? Maybe. I suspect his comments will be a function of which way the political winds are blowing. All of his comments to Reuters - anti-QE, concerns about commodity prices, desire to dump the employment mandate - sound like attempts to position himself for a role in a Republican Administration. The more he needs to position himself in that direction, the more hawkish he will appear.

And note that fundamentally, whatever Bullard (or other hawks) say is for the time largely irrelevant. As a group, they were small to begin with, and by now have been intellectually marginalized. Via Cardiff Garcia, Credit Suisse provides a summary chart of policymakers:


The hawks are all bark, no bite. They are more than overwhelmed by dovish-leaning policymakers, even if Bullard joins Kansas City Federal Reserve President Esther George in hawkish dissent. What remains important heading into 2013 (aside from the data, of course), is Federal Reserve Chairman Ben Bernanke. He can pull the moderates where he wants to go. And it obviously is not in a hawkish direction.

Bottom Line: Fed hawks are largely marginalized. Their views have not and will not have a significant impact on policy making. They will only appear to have an impact on policy if the data signals that a policy shift is needed. Given the current set of policymakers on the Fed, the hawks will only have a voice if Bernanke is replaced with one of their own. And that is when it would get interesting, as I am not sure that the moderates would follow a hawkish Chairman.

Latest Posts from Economist's View

Latest Posts from Economist's View

Links for 09-22-2012

Posted: 22 Sep 2012 12:06 AM PDT

'Primetime Fox News And WSJ Editorial Climate Coverage Mostly Wrong'

Posted: 21 Sep 2012 05:27 PM PDT

Climate scientists document News Corporation's distortions on climate change:

Brenda Ekwurzel is a climate scientist with the Union of Concerned Scientists. She announced in New York City on September 21st the results of an analysis of climate change coverage at two major properties of the News Corporation, the Fox News Channel and the Wall Street Journal.
"What we found in our analysis was that a staggering 93 percent of all occurrences in the last six months in the prime time news of Fox News were misleading occurrences of climate science. Okay, for the Wall Street Journal opinion section in the last year, we found a surprising 81 percent of the occurrences were misleading. And of the accurate ones, these were all letters to the editor that were submitted in response to misrepresentations in editorials or other letters. So, a broad swath of News Corporation viewers and readership are being misled about the science."

'This Dynamic All But Guarantees a Permanent Underclass'

Posted: 21 Sep 2012 12:06 PM PDT

Laura Tyson:

The United States is caught in a vicious cycle largely of its own making. Rising income inequality is breeding more inequality in educational opportunity, which results in greater inequality in educational attainment. That, in turn, undermines the intergenerational mobility upon which Americans have always prided themselves and perpetuates income inequality from generation to generation.

This dynamic all but guarantees a permanent underclass.


Posted: 21 Sep 2012 10:08 AM PDT

Via Jared Bernstein, who says of the first graph, "All told, clearly some redistribution here but not anything that would lead to stark divisions between 'makers and takers'":

But tax expenditures go mostly to -- surprise! -- the top of the income distribution:

More here.

Latest Posts from Economist's View

Latest Posts from Economist's View

Frankel: Mitt Romney Rejects His Natural Voters

Posted: 19 Sep 2012 12:33 AM PDT

Jeff Frankel:

Mitt Romney Rejects His Natural Voters, by Jeff Frankel, Commentary, Project Syndicate: ...Mitt Romney's characterization of 47% of the American electorate as "victims" who are "dependent on government" and refuse to take "personal responsibility" for their lives ... appears to have categorized a large segment of his party's own voters as supporters of President Barack Obama. ...
The unspoken truth is that, compared to "blue-staters," those who live in red states exhibit less responsibility, on average, in their personal behavior: they are less physically fit, less careful in their sexual behavior, more prone to inflict harm on themselves and others through smoking and drinking, and more likely to receive federal subsidies.
Statistical analysis shows that ... the ... average score of the five "reddest" states ... is worse on each of six measures of irresponsibility than the average score of the five "bluest"...: more obesity, smoking, chlamydia, teenage pregnancy, drunk-driving fatalities, and firearms assaults. In the latter three measures, the "reckless" share of the population is almost twice as high among the reddest states as it is among the bluest.
The states that score worst on these measures are also the states whose congressional representatives voted against Obama's Affordable Care Act (Obamacare) in 2010, though many of these unhealthy people free-ride on their fellow citizens...
Policy wonks have long known that one gets similar results when looking at which states receive more federal subsidies: Despite all the rhetoric about "getting the government off our backs," the red states receive the most federal transfers... Democratic-leaning states ... are net contributors to the federal budget, and thus subsidize everyone else. Those who claim to be most fiscally conservative in fact tend to feed most voraciously at the public trough.
Blue-state residents, who tend to be more educated and have higher incomes than residents of red states, have refrained from suggesting that their red-states compatriots exhibit behavior that falls short of the conservative rhetoric of personal responsibility. It would be unseemly and perhaps "elitist" to point fingers at fellow Americans and imply that they are promiscuous, fat, gluttonous, lazy, uneducated, or that they are more prone to divorce, drunkeness, and gun-related deaths. ...
 What about the millions of red-state Americans who have been preaching hard work, family values, self-reliance, and small government, while practicing the opposite? Surely this is the more objectionable stance. Yet, for red-state politicians, this hypocrisy has been a winning electoral strategy for three decades.

Alan Greenspan's 'Gold and Economic Freedom'

Posted: 19 Sep 2012 12:24 AM PDT

Stephen Williamson discovers Alan Greespan's Randian roots:

Alan Greenspan and the Gold Standard, by Stephen Williamson: Speaking of weird monetary economics. Maybe everyone knows this, but a commenter on the last post led me to some details about Alan Greenspan's past that I did not know about.

First, Greenspan puts Paul Ryan to shame in the Ayn Rand department. Greenspan was not just a casual reader of Rand, but was in her inner circle while she was writing Atlas Shrugged. Greenspan was, or is, a committed Objectivist and wrote an essay, "Gold and Economic Freedom," for Rand's book Capitalism, the Unknown Ideal. That essay is described in the link as being influenced by the ideas of Murray Rothbard, whose ideas also have a bearing on what Ron Paul thinks. Like Rothbard, Greenspan thinks ... that the "golden" age of monetary arrangements existed prior to the existence of the Federal Reserve System. Most monetary historians think of the National Banking era (1863-1913) as a period when the financial system of the United States was fatally flawed, as it produced repeated banking panics. Not Greenspan apparently.

Here's an excerpt from "Gold and Economic Freedom":

In the absence of the gold standard, there is no way to protect savings from confiscation through inflation There is no safe store of value. If there were, the government would have to make its holding illegal, as was done in the case of gold. If everyone decided, for example, to convert all his bank deposits to silver or copper or any other good, and thereafter declined to accept checks as payment for goods, bank deposits would lose their purchasing power and government-created bank credit would be worthless as a claim on goods. The financial policy of the welfare state requires that there be no way for the owners of wealth to protect themselves.

This is the shabby secret of the welfare statists' tirades against gold. Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists' antagonism toward the gold standard.

You could put those two paragraphs in Ron Paul's "End the Fed," and no one would notice. The use of "insidious" is interesting. That's the same word that Paul Ryan used to describe QE3.

The amazing part of this story is that Greenspan served as Chair of the Fed for a long time, and didn't seem to screw up (though some people lay some of the blame for the financial crisis at his doorstep, I'm inclined not to). If I had read "Gold and Economic Freedom" before his appointment I would have been in a panic. Maybe this means we could appoint Ron Paul to replace Bernanke, and everything would be fine. No, never mind.

For your entertainment, here's a 2007 interview with Greenspan on the gold standard. Apparently his views have not changed much.

The Case for More Monetary Accommodation

Posted: 19 Sep 2012 12:15 AM PDT

Charles Evans, president of the Chicago Fed, explains the Fed's recent decision to provide more accommodative monetary policy at the end of a speech he gave on Monday:

... The Case for More Accommodation ... Given the slow and fragile recovery, the large resource gaps that still exist, and the large risks we face, it remains clear that we needed a more resilient economy that can withstand the headwinds that might come its way. Last week the FOMC provided a more accommodative monetary policy that can help us achieve such resilience. I strongly supported the Committee's policy actions. These actions, along with Chairman Bernanke's powerful commentary that the employment situation remained a "grave concern," moved quite a ways toward my preference for providing more explicit forward guidance with respect to monetary policy reactions to changes in labor market conditions.
In many venues over the past couple years I have laid out my preferred way to provide additional accommodation.[8] Specifically, I believe we should adopt an explicit state-contingent policy rule that commits the Fed to providing accommodation at least as long as the unemployment rate remains above 7 percent and the outlook for inflation over the medium term is under 3 percent. If our progress toward this unemployment marker falters, then we should expand our balance sheet to increase the degree of monetary support. Indeed, we took such an action last week. Note the importance of the inflation trigger — it is a safeguard against unacceptable outcomes with regard to price stability. I also believe we should be more explicit about what it means for the inflation target to be symmetric... Namely, symmetry means that the costs of an inflation rate above our 2 percent goal are the same as the costs of equal-sized miss in inflation below 2 percent. Its implication is that we should not be resistant to policies that could move the unemployment rate closer its longer-run level, but run the risk of inflation running only a few tenths above our 2 percent goal. Such accommodative polices could further improve the employment picture, even beyond our recent highly beneficial actions.
While our policy actions last week don't exactly match my preferred policy structure, I support them wholeheartedly. Tying the period of time over which we will purchase assets to the achievement of significant improvement in the labor market is a strong step towards economic conditionality — that is, it conditions our actions to the economy's performance instead of a calendar date. And stating that we expect to keep a highly accommodative stance for policy for a considerable time after the recovery strengthens is an important reassurance to households and businesses that Fed policy will not tighten prematurely. A large body of economic research says that committing to such a delay is a key feature of optimal policies during periods when policy rates are constrained to be zero, such as we have experienced in the U.S. since late 2008.
Let me be clear. This was the time to act. With the problems we face and the potential dangers lying ahead, it is essential to do as much as we can now to bolster the resiliency and vibrancy of the economy. We cannot be complacent and assume that the economy is not being damaged if no action is taken. I am optimistic that we can achieve better outcomes through more monetary policy accommodation.
Some have argued that the circumstances we find ourselves in today are so different from the way in which monetary policy normally operates that we must tread cautiously. They argue that more monetary policy accommodation may lead to unintended consequences. Yet, being timid and unduly passive can also lead to unintended consequences. If we continue to take only modest, cautious, safe policy actions, we risk suffering a lost decade similar to that which Japan experienced in the 1990s. Underestimating the enormity of our problems and the negative forces holding back growth itself exposes the economy to other potentially more serious unintended consequences. That type of passivity is a gamble that is not worth taking. Thank you.

Links for 09-19-2012

Posted: 19 Sep 2012 12:06 AM PDT

Who Receives 'the Disproportionate Share of Government Spending'?

Posted: 18 Sep 2012 04:34 PM PDT

David Brooks:

The people who receive the disproportionate share of government spending are not big-government lovers. They are Republicans. They are senior citizens. They are white men with high school degrees.

But ask them if they deserve the benefits they receive, even those who pay no taxes. They'll say they do, especially the elderly who paid taxes their entire working lives. Many of them will not recognize that they are, in fact, among the 47 percent (or nearly so), or that if they pay taxes, they still receive more than they ever gave. It's those other people, the ones who voted for Obama, they're the problem.

The worry, based upon a misunderstanding of who the beneficiaries of government spending actually are, is that Obama supporters will use their voting power to divert their hard-earned taxes to other people -- the moochers -- denying them of what they deserve. This group won't find Romney's remarks frightening at all, at least not until they begin to feel a Romney presidency puts their benefits in danger. It's the (false) fear of not getting what they deserve that drives this group -- they paid their dues and want into the club with the benefits they were promised. Romney's problem, I think, or one of them anyway, is that many of them thought they were in Romney's secret club, that Romney would protect them from "the others" no matter what he might actually say on the campaign trail. In doing so -- by Romney denying the moochers -- they'd be protected. But they are starting to realize that they may not be in the club -- the one with $50,000 plates -- after all.

'How to Cut the US Deficit'

Posted: 18 Sep 2012 08:01 AM PDT

I really do need to get to jury duty, but one more quick one. Curious to hear what you think about this idea:

How to cut the US deficit by fixing taxes, by Laura Tyson, Commentary, Financial Times: One of the few issues on which Barack Obama and Mitt Romney agree is the need for tax reform. ... But tax reform should not come at the expense of progressivity. Income inequality is greater in the US than in the other developed countries of the OECD. ...
Proponents of greater progressivity often call for an increase in corporate taxes but this would lead to slower growth and fewer jobs. The US ... effective marginal corporate tax rate is one of the highest in the world. ... Of all taxes, corporate income taxes do the most harm to economic growth.
Both Mr Obama and Mr Romney advocate corporate tax reform that lowers the rate and broadens the base. The economic benefits could be significant. ...
A lower rate would stimulate investment, narrow the tax preference for debt over equity financing and weaken the incentives for international companies to move production to lower-tax locations. But lowering the corporate tax rate is expensive – each percentage point reduction would cut revenues by about $120bn over 10 years. ...
A more efficient and progressive way to pay for a lower corporate tax rate would be to increase taxes on dividends and capital gains. This would shift more of the burden towards capital owners and away from labor, which bears the burden in the form of fewer jobs and lower wages. ...
The US economy needs efficient and progressive tax reform and it needs more revenues for deficit reduction. Revenue increases have been a significant component of all major deficit-reduction packages enacted over the past 30 years. ...

FRBSF Economic Letter: Uncertainty, Unemployment, and Inflation

Posted: 18 Sep 2012 07:47 AM PDT

Sylvain Leduc and Zheng Liu of the San Francisco Fed examine how changes in uncertainty impact the economy (As I rush off to jury duty -- can hardly wait -- I'll just note that I wish we knew more about what is driving the changes in uncertainty they use in their empirical work.)

Uncertainty, Unemployment, and Inflation, by Sylvain Leduc and Zheng Liu, Economic Letter, FRBSF: Heightened uncertainty acts like a decline in aggregate demand because it depresses economic activity and holds down inflation. Policymakers typically try to counter uncertainty's economic effects by easing the stance of monetary policy. But, in the recent recession and recovery, nominal interest rates have been near zero and couldn't be lowered further. Consequently, uncertainty has reduced economic activity more than in previous recessions. Higher uncertainty is estimated to have lifted the U.S. unemployment rate by at least one percentage point since early 2008.

The U.S. economy has slowed substantially in recent months. Many commentators argue that uncertainty about future economic conditions has been an important factor behind the tepid recovery. According to a recent New York Times article, "A rising number of manufacturers are canceling new investments and putting off new hires because they fear paralysis in Washington will force hundreds of billions in tax increases and budget cuts in January, undermining economic growth." However, evidence supporting this view is scant. In a 2011 Wall Street Journal interview, University of Chicago economist Robert E. Lucas, Jr., said he had "plenty of suspicion, but little evidence" that uncertainty was holding back the recovery.

In this Economic Letter, we examine the economic effects of uncertainty using a statistical approach. We provide evidence that uncertainty harms economic activity, with effects similar to a decline in aggregate demand. The private sector responds to rising uncertainty by cutting back spending, leading to a rise in unemployment and reductions in both output and inflation. We also show that monetary policymakers typically try to mitigate uncertainty's adverse effects the same way they respond to a fall in aggregate demand, by lowering nominal short-term interest rates.

Our statistical model suggests that uncertainty has pushed the unemployment rate up at least one percentage point in the past three years. By contrast, uncertainty was not an important factor in the unemployment surge during the deep downturn of 1981–82. One possible reason why uncertainty has weighed more heavily on the economy in the recent recession and recovery is that monetary policy has been limited by the zero lower bound on nominal interest rates. Because nominal rates cannot go significantly lower than their current near-zero level, policy is less able to counteract uncertainty's negative economic effects.

The demand effects of uncertainty

We use data from the Thomson Reuters/University of Michigan Surveys of Consumers in the United States and the Confederation of British Industry (CBI) Industrial Trends Survey in the United Kingdom to measure the perceived uncertainty of consumers and businesses. Since 1978, the Michigan survey has polled respondents each month on whether they expect an "uncertain future" to affect their spending on durable goods, such as motor vehicles, over the coming year. Figure 1 plots the percentage of consumers who say they expect uncertainty to affect their spending. The figure also tracks the VIX index, a measure of the volatility of the Standard & Poor's 500 Index. The VIX index is a standard gauge of uncertainty in the economics literature (see Bloom 2009). The consumer uncertainty sample goes from January 1978 to November 2011, the latest month for which we have data. The VIX sample begins in January 1990 and ends in June 2012.

Figure 1
Consumers' perceived uncertainty and the VIX index

Consumers' perceived uncertainty and the VIX index

Sources: Thomson Reuters/University of Michigan Surveys of Consumers and Bloomberg.

Figure 1 shows that both the VIX index and consumer uncertainty are countercyclical, rising in recessions and falling in expansions. For example, both measures of uncertainty surged in 2008 and 2009 at the height of the global financial crisis. However, they do not always track each other. The 1997 East Asian financial crisis and the 1998 Russian debt crisis led to large spikes in the VIX, but did not have much impact on consumers' perceived uncertainty. It is possible that U.S. consumers paid less attention to financial developments in emerging markets during that period.

To study the macroeconomic effects of changes in uncertainty, we use a statistical model that includes consumers' perceived uncertainty, the unemployment rate, the inflation rate, and the three-month Treasury bill rate. We measure inflation as the 12-month percentage change in the consumer price index. All macroeconomic data are seasonally adjusted. The sample goes from January 1978 to November 2011, matching the Michigan survey sample.

Isolating the effects of uncertainty on the economy is difficult. As Figure 1 shows, uncertainty fluctuates with the business cycle, typically falling in expansions and rising in recessions. To identify the effects of uncertainty, we take advantage of the timing of the survey interviews relative to the timing of macroeconomic data releases (see Leduc and Sill 2010 and Leduc, Sill, and Stark 2007). For example, in the Michigan survey, telephone interviews in a given month are typically conducted before that month's macroeconomic data are released. Survey respondents do not have information about current macroeconomic conditions when they participate in the interviews. Therefore, movements in perceived uncertainty are probably not driven by concurrent economic conditions (see Leduc and Liu 2012).

We use the timing difference between the survey and data releases to build what might be thought of as a small statistical laboratory. This allows us to measure how, all else equal, an unexpected increase in uncertainty would affect unemployment, inflation, and the nominal interest rate. We compare the result with the situation in which there is no disturbance to uncertainty. As the effects of the unexpected increase in uncertainty propagate over time, we can measure how the three macroeconomic variables fare relative to the situation with no disturbance.

The three panels of Figure 2 show how an unexpected increase in the percentage of Michigan survey respondents reporting they expect uncertainty to alter their spending on durable goods affects the unemployment rate, the inflation rate, and the nominal interest rate. The solid lines represent the median responses of these variables to the increase in uncertainty. The shaded area in each panel represents a 90% probability range for the variable in question. The horizontal axes indicate the number of months after the initial increase in uncertainty. The vertical axes indicate percentage-point changes in the three variables compared with the situation with no disturbance.

Figure 2
Responses to a rise in uncertainty

A. Unemployment

A. Unemployment

B. Inflation

B. Inflation

C. Interest rate

C. Interest rate

Note: Effects to a one-standard-deviation unanticipated change in uncertainty, as measured from the Michigan survey.

Figure 2 reveals that an unexpected increase in consumers' perceived uncertainty raises the unemployment rate and pushes down the inflation rate. The unemployment rate reaches a peak in about 15 months and returns to its trend very slowly. It remains above the level with no disturbance for at least three years. Similarly, inflation reaches a trough in about 12 months. However, the effects on inflation appear to be less persistent. Meanwhile, the bottom panel of Figure 2 shows that the nominal Treasury bill rate falls persistently.

Overall, our statistical model suggests that an increase in uncertainty has effects similar to a fall in aggregate demand. The economy slows and inflation falls. Moreover, the decline in short-term interest rates is consistent with the easing of the stance of monetary policy that would prevail if policymakers try to mitigate the negative economic effects of increased uncertainty.

These effects of uncertainty are not unique to the United States. A similar dynamic is evident in the United Kingdom. In Britain, each quarter the CBI surveys roughly 1,000 businesses on whether uncertainty about demand for their products is limiting their capital expenditures. We measure the perceived uncertainty of these businesses by the fraction of survey respondents reporting that uncertainty is a limiting factor. The sample ranges from the fourth quarter of 1979 to the second quarter of 2011.

Although our U.S. measure of uncertainty is based on a consumer survey and our British measure on a business survey, the results are similar. In both cases, perceptions of uncertainty tend to rise in recessions and fall in expansions. Applying our statistical analysis to the CBI data, we see a similar pattern to that observed in the United States: higher perceived uncertainty is associated with higher unemployment, falling inflation, and lower short-term interest rates (see Leduc and Liu 2012 for details).

The finding that an unexpected increase in uncertainty acts like a decline in aggregate demand rather than a decline in aggregate supply has important policy implications. A fall in aggregate supply depresses economic activity and puts upward pressure on inflation. If the effects of an increase in uncertainty were similar to a fall in aggregate supply, policymakers would face a tradeoff between the goals of maximum employment and price stability. By contrast, if uncertainty acts like a fall in aggregate demand, policymakers face no such tradeoff. Easier monetary policy would mitigate the decline in output and restore price stability. Our findings suggest that monetary authorities in both the United States and Britain do in fact accommodate increased uncertainty by lowering nominal interest rates.

Uncertainty during the Great Recession and recovery

Major economic downturns usually involve important economic disruptions and generate far-reaching proposals for economic policy changes, which can increase uncertainty (see Baker, Bloom, and Davis 2012). The shifts in unemployment, inflation, and interest rates shown in Figure 2 are the consequences of a modest increase in consumers' perceived uncertainty. During the Great Recession, the increase in uncertainty appears to have been much greater in magnitude. To examine how much the increase in unemployment during the recession and recovery has been due to increased uncertainty, we extend our statistical approach. We calculate what would have happened to the unemployment rate if the economy had been buffeted by higher uncertainty alone, with no other disturbances. Our model estimates that uncertainty has pushed up the U.S. unemployment rate by between one and two percentage points since the start of the financial crisis in 2008. To put this in perspective, had there been no increase in uncertainty in the past four years, the unemployment rate would have been closer to 6% or 7% than to the 8% to 9% actually registered.

While uncertainty tends to rise in recessions, it's not the case that it always plays a major role in economic downturns. For instance, our statistical model suggests that uncertainty played essentially no role during the deep U.S. recession of 1981–82 and its following recovery. This is consistent with the view that monetary policy tightening played a more important role in that recession. By contrast, uncertainty may have deepened the recent recession and slowed the recovery because monetary policy has been constrained by the Fed's inability to lower nominal interest rates below zero (see Basu and Bundick 2011).


Heightened uncertainty lowers economic activity and inflation, and thus operates like a fall in aggregate demand. During the Great Recession and recovery, we estimate that higher uncertainty has boosted the unemployment rate by at least one percentage point. Policymakers typically try to mitigate uncertainty's adverse economic effects by lowering nominal interest rates. However, in the recession and recovery, nominal interest rates have been near zero and couldn't be lowered further. As a consequence, high uncertainty has been a greater drag on economic activity in the Great Recession and recovery than in previous recessions.


Baker, Scott. R., Nicholas Bloom, and Steven J. Davis. 2012. "Measuring Economic Policy Uncertainty." Stanford University working paper.

Basu,Susanto, and Brent Bundick. 2011. "Uncertainty Shocks in a Model of Effective Demand." Boston College working paper.

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Competition Will Not Reduce The Price Of Medicare

Posted: 18 Sep 2012 06:30 AM PDT

It wouldn't hurt to emphasize this point once again. Competition "won't give us cheap healthcare":

Why Competition Will Not Reduce The Price Of Medicare, Cheap Talk: Mitt Romney and Paul Ryan have proposed a plan to allow private firms to compete with Medicare to provide healthcare to retirees. Beginning in 2023, all retirees would get a payment from the federal government to choose either Medicare or a private plan. The contribution would be set at the second lowest bid made by any approved plan.
Competition has brought us cheap high definition TVs, personal computers and other electronic goods but it won't give us cheap healthcare. The healthcare market is complex because some individuals are more likely to require healthcare than others. The first point is that as firms target their plans to the healthy, competition is more likely to increase costs than lower them. David Cutler and Peter Orzag have made this argument. But there is a second point: the same factors that lead to higher healthcare costs also work against competition between Medicare and private plans. Unlike producers of HDTVs, private plans will not cut prices to attract more consumers so competition will not reduce the price of Medicare. A simple example exposes the logic of these two arguments. ...[gives example]...
But there is an additional effect. Traditional competitive analysis would predict that one private plan or another will undercut the other plans to get more sales and make more profits. This is the process that gives us cheap HDTVs. The hope is that similar price competition should reduce the costs of healthcare. Unfortunately, competition will not work in this way in the healthcare market because of adverse selection. ...[continues example]...
So, adverse selection prevents the kind of competition that lowers prices. The invisible hand of the market cannot reduce costs of provision by replacing the visible hand of the government.