Economics

Actually, Economics is No More Rigorous Than Political Philosophy

Thursday, June 27th, 2013

It’s no secret that economists have become very powerful in recent decades, especially within policy circles. As such, the influence of the political philosopher has been reduced.

This shift is probably due to the way we perceive the two disciplines. We tend to think there’s something scientific about economic arguments; whereas we see the philosophers as merely hand-waverers, who speak in vague terms about concepts like justice and morality. In my opinion, the disparity reflects a bias that we have for rigor: for some reason, when we see an argument presented in mathematical symbols or statistical charts, we immediately get excited.

The reality, though, to anyone who has studied both economics and philosophy, is that the former is no more rigorous than the latter. Modern economists often forget that all of their conclusions hold only under ceteris paribus assumptions. To be sure, all scientific conclusions hold only under ceteris paribus assumptions. But what makes economics different – or “inexact,” as Daniel Hausman likes to say – is that the disturbing causes that aren’t accounted for in ceteris-paribus analyses often end up being a little more than insignificant. Indeed, they often end up changing the entire conclusion in unpredictable ways.

The idea is that since the economy is a dynamic, non-linear system, small changes in unimportant variables can have large effects. You may think you have a model that controls for all of the relevant causal effects of some policy, and you probably do. But the effects of the uncontrolled variables, however small, may end up biasing your model’s results in a big way. In some cases, even very small events can have significant macro effects, thereby determining which particular path the entire system will take.[1]

All of this means that macroeconomics is really difficult. As such, we should not put too much faith in the conclusions drawn from economy-wide models, whether they are microfounded or not. Such models may help to ground our thinking, but we must always recognize that the real world is infinitely more complex.

The same holds true for philosophy. The luck-choice principle used by luck egalitarians – which says that people should be rewarded for their effort, but not for their luck – is also a tool that helps to ground our thinking. In most cases, the principle should not be taken literally; almost everywhere we look, luck and effort seem inseparable. Nevertheless, the tool helps us understand what distributive justice requires, in an ideal sense.

Why is it, then, that the tools of philosophers are viewed with skepticism, whereas those used by economists are worshipped? In the debate on tax policy, we hardly ever talk about the principles of justice anymore; the discussion is always about how to set taxes in such a way that maximizes the overall economic pie. Sure, President Obama will talk every now and then about “the rich not paying their fair share,” but the reality is that, behind closed doors, the conversation is mostly about social-welfare functions and leaky-bucket problems.

I don’t have a good solution to make policy debates more balanced. As I said, we all have a bias for things that look rigorous. We could try to educate the masses about the limitations of economic models; but it’s so hard when even the economists themselves who are creating the models don’t understand the limitations. How many of them have even read Mill’s writings on ceteris-paribus deductions? Or Kevin Hoover’s writings on micro-to-macro aggregation?

No matter how much we try to educate economists about the limitations of their work, there will still be armies of them making unequivocal assertions in the media or on blogs. To be sure, there may be many economists who do truly understand their profession’s limitations; but their voices will always be drowned out by the Paul Krugmans and Greg Mankiws of the world.

So maybe the solution is to fight fire with fire. The first person who figures out how to mathematize Rawls’ Theory of Justice may end up doing a lot of good in the world.


[1] James Buchanon and Viktor Vanberg. (1991). “The Market as a Creative Process.” Cambridge University Press. Economics and Philosophy. Volume 7. Page 167-86.

Capabilities Come Prior To Sweatshops, Always

Thursday, June 27th, 2013

I saw Justin Lin, former chief economist at the World Bank, speak the other day. He had some interesting things to say, but, like most economists, he was too one-dimensional.

Lin’s basic point was that the conventional story about China causing the global imbalances that led to the 2008 financial crisis is wrong. Lin argues that China wasn’t manipulating its exchange rate in the decade leading up to the crisis. The reason why China had so much money to invest in the US in the 2000s, Lin argues, is because the money first flowed from the US to China in the 1990s due to a shift in manufacturing.

This may be true, but let’s assume it is for the sake of argument. The question then arises: why did money first flow from the US to China? Lin didn’t really answer this question, but he mentioned that China became better at producing labor-intensive goods. So he presumably views the shift in production as something that is natural, perhaps related to technology.

The problem I have with this is that I think there were many unnatural factors at work. Even if we assume that China wasn’t manipulating its exchange rate, there are still many other potential reasons why US manufacturing companies chose to shift production to China. Perhaps labor standards are low in China? It’s much easier for companies to streamline production if they don’t have to deal with pesky unions. How about environmental regulations? There’s obviously more room to make money if a company doesn’t have to adhere to a list of rules set by the EPA.

Lin doesn’t mention any of these potential drivers of Chinese manufacturing, perhaps because they fall outside the scope of economics. If workers aren’t being treated appropriately by companies, well then that’s a humanitarian issue. And environmental ethics? Why should any economist get bogged down in discussing such mushy topics?

It’s okay for economists to be specified. But they should at least comment on philosophical issues. What has happened in China over the past 30 years has been impressive. More than 600 million people have been lifted out of extreme poverty. Nobody is denying the efficiency benefits of China’s development. I’m just saying that there are non-economic costs of development that shouldn’t be ignored.

At one point, Lin mentioned that what’s needed in Africa to lift the continent out of poverty is the same process that occurred in China. Maybe. Nobody is denying that capitalism and markets can do wonders. But capitalism and markets only operate through profit incentives, remaining are silent on whether the profits come from exploitation.

The fact is that while there are many people in Africa who are struggling, bringing them sweatshops isn’t necessarily the best way to improve their lives. A more fruitful strategy might be to bring them schools, public order, and health care. Once they are given the same basic capabilities that many in the Western world have, then it’s their choice whether they still want to work in sweatshops — maybe many of them will still choose to. But if the sweatshops come before the capabilities are satisfied, then there’s no choice for the African people.

My Anecdote on Social Mobility Doesn’t Even Count

Saturday, June 15th, 2013

Greg Mankiw writes:

[T]he educational and career opportunities available to children of the top 1 percent are, I believe, not very different from those available to the middle class. My view here is shaped by personal experience. I was raised in a middle-class family; neither of my parents were college graduates. My own children are being raised by parents with both more money and more education. Yet I do not see my children as having significantly better opportunities than I had at their age.

If anyone should hold this view, it should be me: my parents also did not go to college, I earned my associate’s degree at a community college, and now I’m getting ready to graduate from LSE with a master’s degree in economics (and philosophy). But even I know enough to never reason from an anecdote.

The fact is that social mobility has declined noticeably since when Mankiw went to college. There are perhaps many reasons for this decline, but it’s generally understood that more fruitful opportunities for those born into rich households is playing a role (Haskins and Sawhill 2009). In short, parents at the top of the income distribution in the United States are more likely to buy success for their children in the form of access to prestigious schools, safe neighborhoods, adequate nutrition, and good health care. For anyone who holds the moral view that each individual should have an equal opportunity for welfare – especially including welfare that is influenced by positional circumstances – these trends are indeed frightening.

Please Publish My Definition

Wednesday, May 29th, 2013

If I wrote an article saying that an odd number multiplied by an even number is always even, would it get published in Scientific American? Michael Heller apparently thinks it would. He tells us that the contribution Rogoff and Reinhart added to the discussion about debt is their finding that countries with debt over 90 percent of GDP tend to have slower growth than countries with debt below 90 percent of GDP – not whether there is some cliff at 90 percent, above which growth drops off sharply.

Which is kind of funny, because that there is a negative correlation between debt, measured as a percentage of GDP, and GDP growth is basically definitional. When GDP growth slows, this necessarily increases a country’s debt-to-GDP ratio – in the same way that reducing the denominator of any fraction increases the fraction.

In other words, without the claim that there is some debt threshold above which growth slows sharply, Rogoff and Reinhart aren’t saying anything at all; they’re just repeating the definition of a fraction. If that were their original finding, would their paper have gotten published in the American Economic Review?

Yes, The Assumptions Of Neoclassical Economics Are Unrealistic; And Yes, You Are Allowed To Criticize Them

Saturday, May 18th, 2013

According to popular rhetoric, there are ways to criticize neoclassical economics, and then there are ways not to criticize neoclassical economics. A big No-No, the experts say, is the argument that the profession is flawed because its assumptions are too unrealistic.

Economists recognize that their assumptions are unrealistic. Most, I hope, can see that a Walrasian general equilibrium is not something that actually exists in the real world. Nevertheless, they still think it is a useful simplification that can yield valuable insights, a perfectly reasonable position to be sure. After all, this is how science is supposed to work: simplifying assumptions need to be made in order to make models tractable. Physicists do this all the time. For example, they often need to assume “zero friction” in order to zoom in on other, perhaps more interesting, properties of motion. Anyone criticizing neoclassical economics for using simplifying assumptions is therefore usually seen as ignorant for not understanding the scientific method.

But allow me to argue the opposite in this post: namely, that one can – and indeed one should – criticize the simplifying assumptions that neoclassical economists make. Why? Well, because economics is different than physics of course!

The subjects studied in physics – e.g., atoms, planetary masses, etc. – do not change after physicists study them. The same is not true in economics. When economists model social phenomena, they’re not just describing “what is,” as they so often proclaim. On the contrary, by modeling social phenomena, economists actually end up changing what is.

This performative link is made because although economists recognize that their simplifying assumptions shouldn’t be interpreted literally, the general public does not often make the same recognition. For example, when economists arrive at a conclusion like the first fundamental theorem of welfare economics (FFTWE), which states that any Walrasian equilibrium is Pareto-efficient, they recognize that Pareto efficiency is an interesting theoretical result but not one that can be observed in reality. But people outside of the economics paradigm don’t usually proceed with the same level of caution. In particular, policymakers often see conclusions like the FFTWE as evidence that not only are Pareto improvements desirable, but also that the key to achieving them is to structure markets in such a way that mimics a Walrasian setting. Hence, we must cut taxes, deregulate, and encourage people to act more self-interestedly, the politicians argue.

Of course, after the neoliberal policies are enacted, the economist inevitably comes back defensively, saying that the FFTWE was misconstrued; that we shouldn’t blame the model, but rather that we should blame those who jumped to erroneous conclusions. The way I see it, though, that’s not a sufficient response to get the economist off the hook. Indeed, economists can’t just stand back after their models are published and claim innocence; they have a responsibility to make sure that their simplifying assumptions aren’t interpreted in the wrong way, so that politicians don’t use them to sway policy.

In my opinion, it seems that there’s a cost-benefit calculation that needs to be done here. On the one hand, there are benefits from making simple and tractable models. Although Walrasian equilibriums don’t exist, thinking about them still helps to clarify some things – perhaps making them a good “scratchpad,” as Paul Krugman would say. On the other hand, there are (potentially huge) costs if policymakers misinterpret economic models.

My guess is that most economists would be unhappy with this sort of cost-benefit analysis, as it would likely significantly restrict their modeling efforts. Fortunately, there is a way forward: economists could drop the questionable declaration that their work is positive and admit that their profession is a fundamentally normative endeavor.

In other words, economists could stop offering allegedly value-free statements, such as: “These are the conditions that will lead to Pareto efficiency.” They could, on the other hand, make it clear that Pareto efficiency is something that they find normatively attractive, and that they have a step-by-step blueprint for getting us there. If they make this admission, then there are no modeling restrictions; economists will be able to model whatever they want, whenever they want. And they won’t need to worry about their results being (mis)interpreted by policymakers, because that’s precisely the point of any normative endeavor.

But – and this is a big BUT – once economists step into the normative playing field their models are fair game for political philosophers to scrutinize. For example, if an economist normatively defends the FFTWE, the political philosopher can respond by saying, “That’s an interesting result, but are you aware that you’re measuring welfare by looking at revealed preferences? And are you aware of the problems of measuring welfare by looking at revealed preferences? Have you read Martha Nussbaum’s criticisms of subjective welfarism? What happens if preferences are adaptive? Is it really possible to “purify” preferences à la Dan Hausman?”

At this point, most economists will likely have no idea what the political philosopher is even talking about. In fact, many may see the political philosopher’s comments as merely sloppy thinking and hand-waving theorizing, without acknowledging the obvious reality that the world is too complex to be modeled by simply observing buying-and-selling decisions in the marketplace.

The political philosophers have been desperately awaiting the day when economists admit that they’re doing normative philosophy and not positive science – when they stop running from normative questions, and stop citing Milton Friedman ranting about leaves growing on a tree or something. If economists are unwilling to make this admission, then holding them responsible when their models are misinterpreted by the general public is fair game. And if their simplifying assumptions are the cause of the misinterpretation, then it is perfectly acceptable to criticize them.

Ur by Education

Friday, May 3rd, 2013

CEPR has a good chart: unemployment rates by education, indexed to just before the crisis. We can dig deeper into the data to see if skill mismatches are keeping the unemployment rate elevated – and some have! – but this chart shows that, on its face, the idea that the labor market is plagued by structural problems is absurd.

jobs-2013-05-ge

The United States Is Exceptional, Too

Friday, April 26th, 2013

Rogoff and Reinhart have a response to their critics in the NYT. They note that even after correcting for their infamous Excel error, there is still a negative historical relationship between public debt and economic growth.

They then go on to cite some statistics:

In 2012, the ratio of debt to gross domestic product was 106 percent in the United States, 82 percent in Germany and 90 percent in Britain — in Japan, the figure is 238 percent, but Japan is somewhat exceptional because its debt is held almost entirely by domestic residents and it is a creditor to the rest of the world.

RR should have mentioned here that the United States is somewhat exceptional, too, in that its currency is the world’s principle reserve currency. This gives the United States much more flexibility in terms of its ability to accumulate debt; because in a world that is awash in excess savings – which has been the state of the world since 2008 – investors will be more prone to hold dollar-denominated assets, such as US Treasury securities. In fact, this is an important reason why yields on Treasuries remain at ultra-depressed levels.

(And, no: Yields aren’t low because the Fed is keeping them low. This conspiracy theory was proved wrong in mid-2011, when yields continued to fall even after the Fed ended QE2.)

This matters enormously because it’s related to the problem of causation, which RR allude to. They say:

Our view has always been that causality runs in both directions, and that there is no rule that applies across all times and places.

The problem is that there’s really only one mechanism through which high debt could cause weaker economic growth: if the high debt crowds out private-sector investment by raising interest rates. However, so long as the world remains awash in excess savings, this risk is essentially a non-risk for the United States because of its reserve-currency status.

This point should have been mentioned in the article.

What’s Dismal Is the Lack of Political Philosophy

Tuesday, April 23rd, 2013

Dean Baker has a few comments about the BEA’s recent changes to its GDP calculations. Toward the end of the post, Dean comments generally on GDP and its usefulness. He writes:

GDP is not a comprehensive measure of well-being and no one should ever use it as such.

I left Dean a comment, which I’ve pasted here in full.

But most economists do. This is the whole notion of Kaldor-Hicks efficiency, which is central to the cost-benefit approaches employed in welfare economics. The idea is that if we pursue projects that yield net overall gains, then we will be roughly approximating utilitarianism, which means that well-being will be maximized. In fact, this is one of the key justifications that economists have put forward for pursuing KH efficiencies.

GDP is central in this story. When we pursue policies that yield net gains in GDP, we will be approximately maximizing social welfare, according to the economist. However, this says nothing about rights or about egalitarian considerations; or about non-anthropocentric things like intrinsic value. When economists talk about GDP per capita being the relevant measure for living standards, they’re implicitly ignoring many other moral factors that may be worthy of consideration. And importantly, there may be cases where people would actually be better off with a policy that leads to a lower level of GDP if the policy, say, yields better results in terms of rights and distributive justice.

Economists may respond by saying that they’re field is very specialized – that while non-utilitarian considerations may be important, they’re beyond the scope of economics and for the philosophers to ponder. But this ignores the performative aspects of what economists do. Economists see themselves as describers, putting forth theories about how individuals make choices. But economists are not just describers; they are also prescribers. Because of the influence of their research – Rogoff-Reinhart being just one obvious example – the ideas that economists come up with end up changing the way societies function, because social institutions are erected in line with the conclusions that economists derive from their models. This would all be fine and dandy if “approximate utilitarianism” were superior among the various schools of moral theory. But it’s not. Not even close.

What’s the solution? Economists need a better understanding of political philosophy. Some do – e.g., Amartya Sen – but nowhere near enough. The whole Rawlsian movement should have changed this. Rawls wrote his masterpiece in a language that most economists could understand, but they didn’t listen. They said, “We’re doing science here, and we can’t be bothered by this mushy philosophy stuff.” So they continued to maximize, and the world continues to change to better fit their implicit conception of the good. It’s appalling.

If it were up to me, I’d abolish all formal studies of economics in higher education. There would be no more stand-alone economics degrees – no more utility-maximizing drones funneled into central banks, governments, and development agencies. Every econ topic would be taught alongside rigorous criticisms from political philosophy. Students would always get both sides of every story. And the media would stop treating the modern-day economist as if he is some sort of god, who has all the answers.

The reality is that the modern-day economist is basically a wannabe mathematician, who isn’t even that good at math and who is utterly incapable of thinking outside of his preferred comfort zone.

Addendum: This comment was in no way meant to implicate Dean. He obviously cares a great deal about more than just maximizing the pie – which is why he writes repeatedly on things like climate change and workers’ rights. My comments are more general and are directed toward the economics profession as a whole, based on my experiences.

The R-R Ratio Mattered For Countries Unlike Greece

Thursday, April 18th, 2013

Annie Lowrey has a deeply misleading blogpost in the New York Times. She writes that the Rogoff-Reinhart ratio probably hasn’t had that much of an influence on budget policy in Europe. According to her commentary, “countries like Greece were boxed in.” In fact, she uses the phrasing “countries like Greece” several times in the blogpost.

This is misleading because Greece is perhaps the only country that was boxed in and had to implement austerity. (And maybe Portugal.) The reason countries like Spain, Italy, and Ireland faced funding problems in 2011 and 2012 is because the ECB refused to take its role of lender of last resort seriously, not because these countries had profligate governments. In fact, prior to the crisis, Spain and Ireland were posterchilds for fiscal responsibility, carrying debt-to-GDP ratios that were lower than that of Germany; and Italy was running only modest budget deficits that could have been sustained indefinitely had growth not collapsed.

Given these facts, policymakers could have recognized that Spain, Italy, and Ireland were not boxed in and that, rather than austerity, what they really needed was full funding support from the ECB and expansionary policies in northern Europe to help restore competitiveness. Instead, the eurocrats decided to implement harsh austerity in these countries, often times relying on fictitious measures like the Rogoff-Reinhart ratio.

Readers of the New York Times are unlikely to know the full story about the European crisis. They are more likely to see a phrase like “countries like Greece” and conclude that every country in Europe resembles Greece. To avoid this problem, New York Times reporters should become more knowledgable about macroeconomics and international trade.

Fiscal Policy 101: Trivial For Most, Difficult For Bankers

Tuesday, April 16th, 2013

Wells Fargo showed us again why it is known as, “The Fox News of Wall Street.” The company released a long report on US fiscal policy that managed to get just about everything wrong.

What is the problem with fiscal policy, according to Wells Fargo? The problem is that the government is not managing its budget like a responsible household would:

[T]he systematic tendency on the part of policymakers to produce excessive deficits over the long run, not the countercyclical fiscal policy that was the basis of Keynes’ proposals, suggests that counter to much of the rhetoric, it is not true that government currently or in the future will operate its budget in the same way as the average middle-income household in America.

There are at least three problems with this analogy. The first is that the government is expecting to be around in perpetuity, whereas a household will die off. This means that the government never has to pay off its debt; it just needs to be able to fund itself at reasonable interest rates.

The second problem is that the government prints dollars, whereas a household does not. This means that the government’s ability to fund itself is very flexible; if the government does run into funding problems, then it can always just print more money to pay off its debts. This sounds reckless, but what you need to understand is that just the mere ability of the government to print money actually lowers its borrowing rate in the credit markets. We’ve seen this over and over again. The reason why there were bond runs recently on Spanish, Italian, and Portuguese debt is because the Spanish, Italian, and Portuguese governments can’t print money to fund themselves. Since bond investors know this, they chose to sell Spanish, Italian, and Portuguese debt in hopes of earning a profit when yields rise; and they know that it’s a worthwhile strategy to pursue because they won’t be competing in their short-sale efforts against a central bank. (This is obviously no longer the case since the ECB finally decided to take its role as lender of last resort seriously. But the point still stands for illustration.)

The last reason why a government is different from a household is that a government is responsible for supporting the entire economy when times are bad, whereas a household is not. The government runs the social safety net. This means that it needs to spend more money when the economy falters, so that unemployed workers don’t die out on the street. Some may have the view that unemployed workers “should” die out on the street when times are bad; but if that’s the view, then anyone making the government-household comparison should make this assumption clear, so that readers can know where commentators stand ideologically. Such an extreme right-libertarian (non-Lockean-Proviso-adhering) view may not be very popular with most readers.

The point is, if you can’t tell the difference between a government’s budget and a household’s budget, then you probably shouldn’t be writing on fiscal-policy issues. Nevertheless, that hasn’t stopped Wells Fargo, which goes on to write:

Only in recent years have taxpayers learned the true state of fiscal deficits as the retirement and healthcare bills begin to accumulate.

Of course, those who follow the government’s budget position regularly know that the fiscal deficits we have seen in recent years are entirely due to the collapse of the housing bubble and subsequent recession, and not due to retirement and healthcare bills. This point is easy to show with the CBO’s projections. The deficit in 2007 was just 1.2 percent of GDP. A deficit of this size can be sustained forever, since it implies a falling debt-to-GDP ratio. That same year, the CBO predicted that deficits would continue to fall over the next five years and that the government’s budget position would actually turn into a surplus by 2012. However, instead of a surplus in 2012, we got a deficit of around 7 percent of GDP. What happened? The government didn’t implement any long-term spending increases or tax cuts over this period that would account for the swing in the budget. The answer is that the economy collapsed. As tax revenues shrunk and spending increased through temporary stimulus efforts, the deficit exploded. This is entirely a story of a collapsed economy and has nothing to do with retirement and healthcare bills.

Now, there is a problem of retirement and healthcare bills beginning in the 2020s, and then increasing thereafter. However, this is not a problem of retirement and healthcare bills in the way that Wells Fargo believes. Rather than a story about reckless spending in Washington, the story is overwhelmingly about soaring private-sector healthcare costs, which are specific to the United States due to its corrupt provider-payment and drug-patent system. If consumers in the US paid the same prices for healthcare that consumers in Canada, Germany, or France pay, then the longer-term budget projections would show surpluses rather than huge deficits.

But if you don’t know the story about soaring healthcare costs, you might tend to think that rising retirement bills are due to increasing life expectancies, as Well Fargo apparently believes:

[L]ife expectancies currently exceed the expectations that existed when the structure of these entitlement programs were established. These forces are large and persistent thereby suggesting a widening gap between spending and revenues in the future, which, in turn, will require investors and business decision makers to reevaluate their expectations on growth, inflation and interest rates in an environment where there is little likelihood that the federal budget will be balanced over the economic cycle.

It is a well-known fact to those who follow data that life expectancies have risen only for the top half of the income distribution. Since retirement programs like Social Security primarily serve to benefit those in the bottom half of the income distribution, claiming that we should cut Social-Security benefits because average life expectancies have risen is like claiming that we don’t need to worry about global warming because the past winter was colder than usual. Once you dig deeper into the data, both claims can be easily debunked.

The Wells-Fargo report then goes on to talk about rational consumers and investors, and about how high deficits can lead to lower economic activity if consumers and investors expect them to be financed by higher taxes in the future. This is evidently some sort of Ricardian-Equivalence argument. (Though traditional Ricardian Equivalence doesn’t say anything about whether agents will expect higher taxes from increased deficit spending; it only says that for a fixed level of government spending, the timing of taxes doesn’t matter.) But this logic doesn’t hold in a liquidity trap. As Summers and DeLong showed us last year, once you take into account problems like hysteresis, deficit spending in a liquidity trap can actually be self financing.

The most serious error from Wells Fargo, however, comes when it discusses the crisis in Europe. It writes:

The euro experience follows a long history of financial crises that illustrate that transitions from an unsustainable fiscal deficit position are rarely smooth, especially when the markets recognize that such a debt position is really unsustainable. For example, we have witnessed a default, sharply lower real exchange rates, increased inflation and recessions, such as the case in Mexico. These crises disrupt capital markets, lower real investment and reduce real economic growth.

This rhetoric is presumably used to make the point that, any day, the credit markets could turn on the US, sending Treasury yields through the roof. But if you don’t understand why government borrowing costs soared in Europe – they soared because of balance-of-payments problems and because of the gold-standard-like aspects of the euro currency – then you’re likely to misforecast the direction of Treasury yields, as Wells Fargo has done repeatedly for the past three years. For example, back in 2010, before Treasury yields fell through the floor, Wells Fargo was pushing the same story about rising deficits leading to higher interest rates:

The 2009 deficit broke the scales at $1.4 trillion and swelled to more than 10 percent of GDP in the fourth quarter. Another equally large deficit is expected for fiscal year 2010. Treasury securities are generally considered risk-free in terms of default risk, because the full faith and credit of the U.S. government supports their repayment. Still, if the flood of U.S. debt to the marketplace exceeds the market’s appetite for those securities, interest rates could ratchet up quickly … Higher Treasury rates and, consequently, higher private borrowing rates could have a chilling effect on the economic recovery if they come too soon or are too large.

Of course, we know what happened: Treasury yields fell to a 60-year low in 2011 and remain at ultra-depressed levels. The history of other advanced economies (e.g., Japan) suggests that Treasury yields could remain low for a very long time, and that they will probably only rise gradually as economic growth picks up. That’s not to say that there’s no risk of the sort of doomsday scenario that Wells Fargo has been warning about for years. There is. But the risk is so small that it doesn’t justify doing nothing in the way of fiscal policy to help the millions of Americans who saw their lives ruined from the collapse of the housing bubble – a bubble that, mind you, was driven in part by epic incompetence (and, in many cases, fraud) at banks like Wells Fargo.

Correcting Summers On The Financial/Austerity Crisis

Sunday, April 14th, 2013

Larry Summers has a book review in the FT of Mark Blyth’s new book, Austerity: The History of a Dangerous Idea. The review is generally good, and Summers does a fine job explaining why austerity policies when the economy is in a liquidity trap are self-defeating. Two corrections, however, need to be made.

The first is that Summers is seemingly confused about why the budget moved into surplus in the late-1990s. He uses that experience as an example of successful austerity, writing:

The possibilities of offsetting reduced government demand with growing exports crowded in investment, and greater confidence made fiscal consolidation an appropriate strategy.

Summers may have missed it, but the only reason why investment became “crowded in” in the late-1990s is because there was a $10 trillion bubble in the stock market. In fact, the growth this bubble provided is the sole reason why the budget moved into surplus toward the end of the decade. According to the CBO’s projections in 1996, there was expected to be a budget deficit in the year 2000 of around 2.7 percent of GDP. Instead, we saw a surplus of 2.4 percent of GDP that year. No massive tax increases or spending cuts were implemented after 1996 to account for this swing in the government’s budget balance. The sole reason for the swing was the extra tax revenues and economic activity that the stock-market bubble provided. That bubble was, of course, unsustainable, which is why it’s incredibly irresponsible of Summers to use its effects as evidence of fiscal responsibility.

The other point that Summers misses relates to the banking crisis. After citing how well Iceland has performed because it let its banking sector collapse, Summers notes that the Icelandic experience doesn’t provide any lessons for the United States, because the US is much more financially intertwined than Iceland. According to Summers:

It is entirely legitimate to question whether the Icelandic approach to financial crisis, in which banks were allowed to fail, provides a reasonable model for Cyprus. It is not reasonable to ask whether it would have been availing for the US in 2008 or for Spain today. Instead, as the aftermath of Lehman’s collapse should have demonstrated, cascading failures put at risk the functioning of not just the whole financial sector, but major non-financial companies and a huge range of small and medium-sized businesses.

It is important to note that even though the entire US financial system was at risk of failing in 2008, such a failure need not have led to catastrophe. The leading example here would be Argentina in the early 2000s. After Argentina defaulted on its debt in late-2001, its entire financial sector did, in fact, collapse. People were unable to withdraw money from ATMs, and the functioning of major non-financial companies and a huge range of small and medium-sized businesses was impaired. However, the result was not catastrophe. After about 6 months of pain, Argentina’s economy bounced back sharply, with real GDP growing at an average annual rate of 8.5 percent from 2003 to 2008.

In contrast with the terrible recovery in the US from the Great Recession, Argentina’s performance looks pretty good. One of the reasons why the US has done so poorly is because the waste in the financial sector has not been eliminated. Today’s megabanks are bigger than they were prior to the crisis. As such, they have played a major role in blocking all efforts to fill the demand that was lost from the collapse of the housing bubble. Whenever inflation runs slightly above the Fed’s 2-percent target, they whine about the harm that it will do to savers – when, in reality, we need an inflation rate that is much higher than 2 percent – and they played a key role in blocking all efforts from Congress to spend more money on things like infrastructure. To make their case, they’ve continually made up stories that have no basis in the data that most economists should be familiar with – stories like the horror that comes with a rising debt-to-GDP ratio (even though the government’s interest burden is near a post-war low) or like the idea that the labor market is so plagued with structural unemployment that it’s futile for policymakers to do anything.

If we had pulled an Argentina back in 2008, then it’s not unreasonable to suppose that we may have had a stronger recovery with the banking cartel out of the way. It’s understandable that Summers may not recognize this point, because he is a strict adherent to the economics textbook, which says that the government must always act as a lender of last resort during a financial crisis. But this is one area where the textbook could perhaps use some updating.

Addressing The Beveridge Curve: #3,435,921

Thursday, April 11th, 2013

Wells Fargo is still trying to use the Beveridge Curve to claim that structural unemployment is a serious problem:

While some have argued that the structural shift in labor markets, as evidenced by the Beveridge Curve, is temporary, we should note that after four years of economic expansion this shift is taking on the character of a more fundamental change than simply a temporary cyclical phenomenon. Even as the headline U-3 unemployment rate has improved in the typical, albeit slow, cyclical fashion, other indicators on the labor market continue to suggest that today’s labor market environment has changed. Job vacancies have become more plentiful as the economy has recovered. However, the unemployment rate remains high relative to the rate of job openings in previous cycles and suggests more frictions in matching the unemployed with available jobs.

It has been argued that the outward swing in the Beveridge curve is typical during the early stages of a labor market recovery. While some skills mismatch is to be expected as the economy undergoes significant periods of restructuring following a recession, more than four years into the recovery the Beveridge curve remains above its path during the last economic expansion. The depth of the previous recession posts a challenge to structural frictions beyond the typical pattern. The share of unemployed workers out of a job for more than 27 weeks remains historically high, and the longer these workers are out of a job, the higher the risk that the slow cyclical recovery results in longer-lasting structural mismatch as these workers’ skills become increasingly out of date.

Apparently, Wells Fargo missed the recent report from the Boston Fed, which breaks out the Beveridge Curve by unemployment duration. What that report showed is that the shift in the Beveridge Curve is entirely accounted for by those who have been out of work for 27 weeks or more:

This throws an important wrench into Wells Fargo’s hypothesis that structural unemployment is preventing the Fed from returning the labor market to full employment. At present, there are roughly 7.1 million workers who have been unemployed for less than 27 weeks. As the Boston Fed report indicates, there is no evidence that these workers are structurally unemployed. According to the JOLTS, there are currently 4 million aggregate job openings in the labor market. This means that there are roughly 1.8 non-structurally unemployed workers for every job opening.

This ratio is well above its level prior to the downturn. In 2006, there were an average of 1.3 workers who were unemployed for less than 27 weeks for every job opening. (Prior to the 2001 recession, the ratio was approximately one.)  So even if we consider all of the workers who have been out of work for 27 weeks or more to be completely unemployable – a questionable assumption to be sure – there is still a dearth of job openings available to the unemployed workers who we know are not structurally unemployed. This suggests that the overwhelming problem in the labor market is a demand problem, and that further monetary easing from the Fed is required to get the unemployment rate back down to a level that more closely resembles full employment.

If Wells Fargo has better evidence that further monetary easing is unwarranted due to the presence of structural unemployment, then the evidence should be presented. If not, then Wells Fargo should stop speculating.

Japan Takes The Lead On Monetary Policy

Friday, March 22nd, 2013

I wrote another article in Rationale Magazine, a student publication at LSE. This one’s on monetary policy in the US.

In 2004, a prominent economist at the Federal Reserve declared that improvements in monetary policy were an important source of the Great Moderation, the roughly 20-year period beginning in the mid-1980s that was characterized by low economic volatility. During the Great Moderation, prices were stable and unemployment rates were low, meaning that the Fed was successfully meeting its dual mandate from Congress. It was indeed a flourishing time to be a central banker.

The prominent economist who gave that 2004 speech was none other than Ben Bernanke, the Fed’s current chairman. Looking back, though, it seems as if Bernanke raised the victory flag too early, for if he had known back then what challenges were in store for him and the Fed, my hunch is that he would have been much more hesitant to praise the accomplishments of central bankers.

Indeed, nearly four years after the last US recession officially ended, the Fed is still trying to fix an unusually sluggish labor market and an economy that is operating at nearly $1 trillion worth of goods and services below potential output. Meanwhile, inflation rates remain low, as core economy-wide prices have increased at an average annual pace of just 1.5 percent since the recession ended, decisively below the Fed’s implicit 2-percent long-run inflation target.

To be fair, the Fed has been in an awfully difficult situation since late-2008.  In the wake of the collapse of Lehman Brothers, the Fed cut its short-term policy rate to zero percent. Normally, such low interest rates would spur enough borrowing, consumption, and investment activity to get the economy going again. But this time was different: even at a zero-percent federal funds rate, consumers still sought to pay down debts accumulated during the housing boom and businesses still sought to hoard cash.

A liquidity trap is defined as a situation in which the conventional tools of monetary policy lose their effectiveness. This is arguably the situation that the Fed has been in since the recession ended. The way in which the Fed normally stimulates growth is through open-market operations: by buying short-term Treasury securities from banks in the secondary market, the Fed can increase reserve balances in the banking system. As banks then seek to rid themselves of the excess reserve balances, they move to lower interbank lending rates. Since rates on bank deposits, business loans, and credit cards are effectively tied to interbank lending rates, the result is that open-market purchases tend to translate into lower borrowing costs for consumers and businesses, stimulating aggregate demand.

But when rates on short-term Treasury securities fall to zero percent, open-market purchases become futile. The reason is because agents start to perceive short-term Treasury securities and cash as equivalents – both are non-interest-bearing, store-of-value assets. Effectively, then, when the Fed engages in traditional open-market purchases at the zero-percent lower bound, it is just swapping cash for cash, leaving no effect on borrowing rates in the broader economy.

One way for a central bank to get around this problem would involve direct purchases of longer-dated Treasury securities, or so-called “quantitative easing.” Insofar as quantitative easing works to flatten the yield curve, the result will be lower mortgage and corporate-bond rates, since both rates are tied to longer-term Treasury yields. In addition, a flatter yield curve usually forces some investors to seek higher returns in riskier asset classes, leading to, for example, gains in the stock market. Each of these things, in theory, would help boost economic activity.

So it’s no surprise that the Fed has been heavily engaged in quantitative easing. Since 2008, the Fed has purchased $1.2 trillion worth of Treasury notes and bonds. In turn, the yield curve has flattened considerably, leading to historically low borrowing rates for homeowners and corporations and to strong gains in the stock market. Yet the effects on the broader economy have been relatively muted. So what gives?

The main problem with quantitative easing is that it just isn’t bold enough – as Keynes would say, it’s akin to “pushing on a string.” The relevant literature on monetary policy in a liquidity trap, after all, suggests that central bankers need to take drastic measures when short-term interests rates fall to their zero-percent lower bound.

That literature starts with a 1998 paper by Paul Krugman. In it, Krugman maintained that monetary policy in a liquidity trap is all about expectations: if a central bank can promise to keep policy loose far enough into the future, then there’s a chance that future consumption and investment decisions will be brought forward, helping to lift the economy out of the liquidity trap. In other words, a credible commitment to be transparent about future policy just might spur enough activity today.

This is indeed the direction that the Fed has moved in recent years. Beginning in August 2011, the Fed began to incorporate in its policy statement an explicit timeline for when it expects to start raising the federal funds rate. Such forward guidance was taken a step further this past December, when the Fed made a commitment to keep policy loose so long as the unemployment rate, which currently stands at close to 8.0 percent, remains above 6.5 percent and so long as market expectations for annual inflation one to two years forward do not exceed 2.5 percent. For a central bank that has historically prided itself on maintaining secrecy, such transparency about the direction of future policy has been nothing short of unprecedented.

But Krugman circa 1998 would undoubtedly be arguing for more. The whole point of his paper was to say that central bankers need to be “irresponsible” at the zero-percent lower bound. The best way to do that, Krugman insisted, is for them to temporarily abandon their commitment to price stability.

By targeting a higher inflation rate, Krugman argued, the central bank can move expectations in such a way that promotes economic recovery. In particular, a higher expected rate of inflation would disadvantage those hoping to sit on cash, which is exactly the sort of thing that a central bank should aim to discourage in a liquidity trap. Not to mention, higher inflation, if realized, would reduce real interest rates, making borrowing costs even cheaper for households and businesses. Finally, higher inflation would go a long way toward reducing the real burden of debt on the balance sheets of households, since most household debt is denominated in nominal terms. As previously mentioned, a big reason why cheaper borrowing costs haven’t spurred consumer spending all that much is because consumers are still paying down debts accumulated during the housing boom. Insofar as higher inflation erodes those debts more quickly, the implication is that consumers will have more money in their pockets to buy stuff.

It’s important to point out that while the abandonment of price stability sounds like a radical proposal for a central bank that has worked hard since the 1970s to rein in inflation expectations, it’s the exact same proposal that Ben Bernanke himself argued for with respect to the Japanese economy in the late-1990s. In fact, Bernanke encouraged the Bank of Japan to do “whatever necessary” to bring the Japanese economy out of the liquidity trap, including not only abandoning price stability temporarily, but also making an explicit commitment to weaken the value of the yen to boost export growth as well as coordinating with the Japanese fiscal authorities to literally drop printed money on households to get them to spend more. (Fun fact: This latter policy proposal is what eventually gave Bernanke the nickname, “Helicopter Ben.”)

Whether Bernanke still believes the things he argued for in the late-1990s is an interesting case study, perhaps reserved for psychologists to explore. But what Bernanke can’t do is claim that because prices aren’t actually falling in the US, the policy measures he advocated back then don’t apply today – which is, in fact, the argument that Bernanke has made in press conferences when questioned about his old research. Why? Because his argument back then was mainly about closing the output gap in Japan, not about stopping deflation. As a practical matter, the current US output gap is much larger than the output gap in Japan was during the 1990s. Furthermore, the US labor market continues to suffer from a devastating level of long-term joblessness not witnessed since the Great Depression, whereas as the Japanese labor market actually held up relatively well during Japan’s so-called “lost decade.” In short, just because prices aren’t falling in the US doesn’t mean that the case for radical monetary-policy measures isn’t strong.

The incredible irony of this whole story is that Japanese policymakers have finally started to adopt some of the policy measures that Bernanke pushed for in the late-1990s. The newly elected Prime Minister, Shinzo Abe, has called on the Bank of Japan to raise its inflation target. Furthermore, Abe recently unveiled a sizable fiscal-stimulus package, which he is encouraging the Bank of Japan to finance by printing money. The result of these policies thus far has been to weaken the value of the yen, an encouraging sign for a country for which large and persistent trade surpluses used to serve as an important source of demand.

Time will tell whether Abe’s bold measures translate into a full-fledged economic recovery for Japan. But if they do work as planned, then the pressure will be on the Fed to follow suit – in which case Bernanke may finally be in a position to unregretfully praise the accomplishments of central bankers.

Sorry Trichet, Europe Has Been Alone in the Crisis

Saturday, March 16th, 2013

Jean-Claude Trichet, former ECB president, has an op-ed in the NYT that says basically nothing. In fact, he starts off by telling us that he doesn’t even understand what a sovereign debt crisis is:

Why did the epicenter of the sovereign debt crisis of advanced economies move to Europe? … We learned the hard way that the financial crisis was global, even if its epicenter was in the United States.

I may have missed something, but I’m pretty sure there was never a sovereign debt crisis outside of Europe. Sure, debt-to-GDP ratios spiked in many advanced economies after the 2008 meltdown; but a soaring debt-to-GDP ratio is *not* a sovereign debt crisis.

A sovereign debt crisis is a situation where the market believes that a government will not be able to pay back its creditors. Under such a belief, market participants then sell their current holdings of the government’s outstanding debt as well as refuse to buy any newly issued debt. This then sends up borrowing rates for the government, making it even more insolvent. Where outside of Europe was this process taking place prior to 2010?

Nowhere, of course. The sovereign debt crisis has been unique to Europe. The reason is that the countries in Europe don’t have their own currencies. If you look across the advanced world, there’s not a single country with its own currency that is suffering from a sovereign debt crisis.

It may not be preferable to breakup a monetary union that took more than 60 years to create, but if the goal is to keep the union, then we need to figure out how the problem countries in Europe are going to regain competitiveness without devaluing in the foreign-exchange market. At the end of the day, the reason Spain, Italy, et al. are in trouble is because their domestic prices and wages got way out of whack with prices and wages in northern Europe. Since Europe as a whole is a relatively closed economy, the only way the problem countries are going to be able to compete again is through a price-wage adjustment. Specifically, we either need to see either a deflation adjustment in southern Europe or an inflation adjustment in northern Europe – or some combination of both adjustments.

So far, the entire adjustment has been in the form of deflation in the problem countries, which has crippled them. Not to mention, the adjustment is occurring only very slowly. Does anyone think that Spain, Italy, and Greece can endure five more years of mass unemployment? Considering the protests and political problems we have already seen in these countries, it’s more likely that unless the adjustment process is shifted to allow for more inflation in northern Europe, these countries aren’t going to make it.

Does Trichet understand this reality? Probably not, considering that he fails to mention it in his op-ed, which is filled with only vague declarations like the need to monitor “imbalances” and restore “competitiveness.”

Oh, and you gotta love the part about how “[c]onfidence is returning and paving the way for growth and job creation.” Is it? Really? Unemployment rates across Europe are sky high. Is that a sign of confidence?

Source: IMF

OK, I guess I should lay off Trichet a bit. I mean, at least he’s not talking about increasing interest rates in the middle of a financial crisis. That counts for progress, right?

Jeffery Sachs Thinks America Is Close To Anarchy

Monday, March 11th, 2013

Sachs’ recent HuffPo article is being torn up in the blogosphere. See Mark Thoma for a summary.

I don’t have a whole lot add except that I want to make an obvious point about debt: that for a country that owns a printing press, it’s extremely difficult for a debt crisis to emerge. Not impossible, but extremely difficult.

A crucial piece of Sachs’ argument lies in the belief that when interest rates rise, the government will need to pay more to fund itself, thereby crowding out other forms of public investment.

Here’s Sachs:

[I]nterest rates are likely to return to normal levels later this decade, and if and when that happens, debt service would then rise steeply, increasing by around 2 percent of GDP compared with 2012. Many people seem to believe that we can worry about rising interest rates when that happens, not now, but that is unsound advice. The build-up of debt will leave the budget and the economy highly vulnerable to the rise in interest rates when it occurs … As interest service costs rise, vital public investments and other programs are likely to be shed. That’s when we’ll suffer the most severe fiscal consequences of our debt buildup of debt.

Sachs is right that it’s the interest burden, not the debt, that matters for fiscal sustainability. But Sachs’ argument only holds if interest rates rise and the economy remains weak. After all, the interest burden, which needs to always be measured as a percentage of GDP, need not rise if interest rates rise and GDP growth picks up.

In fact, this has been Krugman’s stance all along: that we will see interest rates rise only when growth picks up — and when we are out of the liquidity trap and on the road to full employment.

Now, it’s very possible that interest rates could rise without growth ever picking up. But it’s important to understand what such a situation would actually look like. History tells us that for countries with a printing press to suffer from a debt crisis, there needs to be a complete breakdown of political trust. And by complete, I literally mean a situation close to anarchy. For example, if we look at Zimbabwe in the 2000s, countless citizens were being raped and murdered in the streets as the government continued to print money.

Do we think America is going to be in a state of near anarchy anytime soon? Do we think that citizens are going to be overthrowing the police and chucking Molotov cocktails at the White House next year? Or even in the next decade?

I may be exaggerating a bit. But the point is that I don’t think the people constantly fretting about debt and deficits actually understand how much America would have to change, both socially and politically, for a debt crisis to emerge.

Now, it’s seriously problematic that one of our political parties has shown a repeated willingness to do whatever it takes to dismantle the welfare state, even if it means pushing the government to the brink of default every time the silly debt-ceiling deadline comes up. But it seems to me that if we really care about ensuring fiscal sustainability, we should be directing our energy toward fixing that dynamic rather than reducing the debt.

A Not-So-Great Report For International Women’s Day

Friday, March 8th, 2013

Some quick points on this morning’s jobs report.

First, it was a relatively strong report. Job growth in February totaled 236K, well above January’s downwardly revised print of 119K. Over the past three months, the economy added an average of 191K jobs per month, a pace of growth that’s certainly fast enough to bring down the unemployment rate somewhat quickly. As such, the unemployment rate fell further to 7.7 percent.[1] But even if the current pace of job growth were to hold indefinitely, it would still take about another 30 months just to bring the unemployment rate down to 6.0 percent.

If we look at the working age employment-to-population ratio (EPOP), the story is less optimistic. The working age EPOP is probably the best measure to consider when trying to determine the health of the overall labor market, since it accounts both for workers dropping out of the labor force and for demographic changes. Since its trough in October 2011, this ratio has risen just 1.5 percent to 75.9.

However, a clear dichotomy is starting to emerge between the success of men and women in the labor market. The working age EPOP for men continues to show impressive gains, while the working age EPOP for women remains lackluster. Since the recession ended, the working age EPOP for men is up 2.1 percent, whereas, for women, it has fallen by roughly 1.9 percent. An indexed comparison of the two series makes this point rather starkly.

That said, it should be mentioned that men suffered much more than women did during the downturn. From peak to trough, the working age EPOP fell 8.6 percent for men, whereas, for women, the drop was only 5.6 percent. It is for this reason that many commentators have labeled the recent recession as primarily a “mancession.”

Finally, we saw some good news on the wages front. The growth in average hourly earnings is now on a clear upward trajectory. There is still a long way to go before we get to a pace of wage growth that is close to what the economy can produce at full employment, but the gains we have seen over the past year or so are definitely welcomed.


[1] Note: For this particular report, a decline in the labor force accounted for almost the entire drop in the unemployment rate. But more generally speaking, sustained job growth at the pace we have seen recently would be associated with a relatively quickly falling unemployment rate; since, according to the CBO’s projections on the growth of the labor force, it should only take monthly job growth of about 90K-110K to keep the unemployment rate steady.

Why The Rogoff-Reinhart Ratio Is So Destructive

Thursday, March 7th, 2013

Krugman recently wrote about the problems associated with the Rogoff-Reinhart ratio, which says that when a country’s debt-to-GDP ratio crosses above the 90-percent threshold, growth starts to slow. Krugman pointed out the obvious issue that correlation does not imply causation: does growth slow because of the high debt load, or is the debt load high because growth slowed?

In addition, Dean Baker notes that the debt-to-GDP ratio is probably not the best measure to even consider, because the ratio can be arbitrarily reduced or increased whenever interest rates rise or fall. If the yield on the 10-year rises over the next decade according to the CBO’s latest projections, then the Treasury will be able to reduce the debt-to-GDP ratio with just the click of a mouse by buying back debt issued today. (If rates rise as anticipated, then the debt issued today will come at a sharp discount.) According to Dean, the interest burden (as a percentage of GDP) is a better measure to consider, since it would not change in the event that the Treasury did decide to engage in such mouse-clicking shenanigans.

I think Krugman and Dean are basically right; but there is a broader philosophical point that needs to be made. That is, in a world in which the social scientist is not just a describer but also a prescriber, the Rogoff-Reinhart findings become not just wrong, but also destructive.

The issue of performativity is often underestimated by economists, who see themselves as objective scientists discovering all of the various relationships that exist in the macroeconomy. But what if it’s the case that by exposing such relationships, economists actually end up influencing the way in which policy is constructed?

This is, after all, exactly what happened when economists first introduced the Phillips curve in the 1950s, named after the late William Phillips. What the Phillips curve showed, in its original form, is that throughout history, there was always a tight negative correlation between inflation and unemployment. (The higher the inflation rate, the lower the unemployment rate, and vice versa.) However, once this correlation was exposed – once the social scientist made what he thought was an objective description – the world changed, as policymakers attempted to exploit the apparent trade-off between inflation and unemployment. Moreover, as policymakers sought to favor a higher inflation rate in order keep unemployment low, the original relationship that Phillips exposed actually broke down: once higher inflation expectations became ingrained into society — as they did in the late-1960s and 1970s — the trade-off between higher actual inflation and lower unemployment no longer held. The verdict among economists today is that there is only a trade-off between actual inflation and unemployment in the short run, before inflation expectations have the chance to become hardwired into society.

The point is, the same sort of interplay between the economist’s findings and the reactions of policymakers could easily occur with the Rogoff-Reinhart ratio. The risk is that even if the ratio is incorrect as an accurate threshold for fiscal sustainability, it may actually change the way in which policymakers perceive fiscal sustainability. The obvious danger is that it may cause governments to prematurely implement austerity policies at precisely the time when expansionary policies are needed. In fact, we may actually be seeing this in the US, as anyone who has followed the debate in Washington closely over these past few years knows that the Rogoff-Reinhart ratio has been used as a lever by the deficit scolds.

There are two ways forward. Either we need to make mainstream media more scientifically rigorous – why do reporters continue to cite the Rogoff-Reinhart ratio as important when it has such obvious flaws? – or we need more economists to understand the performative aspects of their research. On the latter point, it seems to me that if Rogoff and Reinhart truly understood the policy implications of their research, then they would have been much more careful in their analysis.

Story Telling At The Washington Post

Saturday, March 2nd, 2013

If I say 2 + 2 = 4, and another guy says 2 + 2 = 5, are we both telling stories? The Washington Post apparently thinks so.

After reporting on the views of Kevin Warsh, a former Fed governor who thinks that the economy’s potential to grow has weakened due to structural problems, the Post told readers:

You can tell an inverted version of Warsh’s story through the economic models of another famous economist, John Maynard Keynes. That story holds, like Warsh’s story, that policymakers fumbled the response to the recession — but in this telling, the problem is that they didn’t do enough. The depth of the recession was so great, the effects of the financial crisis so dire, that the economy needed a huge dose of fiscal and monetary stimulus to regain all the lost ground and return to historical growth trends.

Since the stimulus that policymakers supplied wasn’t big enough, the economy hasn’t grown as fast as it could have, the Keynesian story goes.

The argument that the 2009 stimulus package wasn’t big enough isn’t a “story.” In the same way that a 1st grader can show that 2 + 2 = 4, anyone with access to national-accounts data can show that the stimulus package was too small.

When the housing bubble popped, the economy lost more than $1 trillion in annual demand. About $500 billion was lost directly from the collapse in residential construction activity. (RI as a share of GDP fell nearly four percentage points from peak to trough.) About another $500 billion was lost indirectly from the inverse wealth effect that falling home prices had on consumer spending. (The personal saving rate also rose about four percentage points from peak to trough.) In addition, the collapse in commercial construction activity, which occurred a little later, subtracted about another $150 billion in demand.

By contrast, the 2009 stimulus package pumped about $300 billion into the economy in each of 2009 and 2010. In the same way that 2 + 2 != 5, $300 billion, under any plausible assumption about the multiplier, does not equal more than $1.1 trillion.

Importantly, the reason why the economy is still weak is because we still haven’t filled the demand gap that the housing collapse created. Sure, residential investment is slowly coming back, and investment in equipment and software has been surprisingly strong. But we are still a long ways away from potential GDP. It is also not helping that the government has been reducing its budget deficit for the past two years, despite the fact that the government’s interest burden is near a post-WWII low.

If the US were a small, open economy, then maybe things could have been different – that is, maybe we could have managed even with the woefully inadequate stimulus package. But if you thought for a minute that the trade deficit was going to swing into surplus overnight, you were dreaming. Not when the dollar is a global reserve currency and when much of the developing world manipulates its currencies for exporting purposes.

The implication is that we needed massive budget deficits to fill the demand gap in the short run. The logical consequence of not having those deficits is high unemployment. There is really no coherent way to get around this fact. At the end of the day, it all comes down to C + I + G + Nx.

Which is really ironic because at one point the Post article even mentions that Warsh likes to quote Milton Friedman, who said: “Everything we know in economics we teach in Econ 1, and everything else is made up.”

The Demographic Storm Has Already Passed

Friday, March 1st, 2013

Bloomberg TV decided to run an interview with hedge-fund honcho Stan Druckenmiller. On the issue of entitlement spending, Druckenmiller asserted that:

Transfer payments have gone up not because of demographics. They’ve gone up because seniors have a very powerful lobby … The demographic storm is just starting out.

It’s important to note that Druckenmiller is 100 percent wrong here. According to data from the Social Security Trustees Report, the worker-to-retiree ratio fell from above 5 percent in the 1960s to 2.9 percent in 2011. Over the next 20 years, the worker-to-retiree ratio is expected to fall further to 2.0 percent.

In other words, most of the “demographic storm” that Druckenmiller warns about has already passed. He may have missed it, but the near halving of the worker-to-retiree ratio didn’t dramatically reduce living standards for the current generation of workers.

The reason is because productivity continued to increase as the worker-to-retiree ratio fell, making the effects of the demographic shift insignificant. In fact, as Dean Baker explains, it takes only third-grade arithmetic to show that – provided productivity continues to grow at even a modest pace – further declines in the worker-to-retiree ratio will likely go unnoticed to today’s youth.

Now, many workers in the current generation have not seen their wages increase in decades. This is a serious problem. But it has nothing to do with demographics; it is an issue about who benefits from productivity growth. If productivity growth were more shared – if income inequality hadn’t risen enormously – then there would be nothing to complain about.

But when we do complain, we need to remember that the problem is the continued upward redistribution of wealth, not demographics. Now, will somebody please teach Druckenmiller some third-grade arithmetic?

If David Cameron Were a Forklift Driver, He Would Be Fired

Thursday, February 28th, 2013

Let’s say you’ve just landed a job as a forklift driver. In your training, you were warned about the consequences that come with taking sharp turns while carrying heavy loads, where high centrifugal forces often lead to accidents. Nevertheless, while carrying an unusually heavy load, you decide one day to cut a corner and take a turn very sharply – perhaps reckoning that by moving the load very quickly, you will be noticed by your bosses, who will be impressed. The obvious then happens: the centrifugal force associated with taking the turn too sharply causes the load to slip off the forklift, destroying the merchandise as it comes crashing to the ground. You are noticed by your bosses, but not in the way you intended to be. Shortly after the accident, you lose your job.

And yet, David Cameron is not only still employed, but he is also still taking turns too quickly, ignoring the basic instructions he was given at Oxford, where he studied economics.

According to Reuters, in reference to Moody’s downgrade of the UK government’s credit rating, Cameron said that:

[The] credit rating does matter, and it demonstrates that we have to go further and faster on reducing the deficit.

Under the assumption that Cameron took Econ 101 at Oxford, then he should lose his job as prime minister. After all, he was taught that austerity in a depressed economy only further weakens demand, yet he continues to ignore such advice. Remember, when the forklift driver ignores what he is taught during training, he gets fired.

It’s important to point out that all one needed to determine whether the recent turn to austerity in the UK would be counterproductive is an Econ 101 textbook. The textbook tells us that GDP = Consumption (C) + Investment (I) + Government Spending (G) + Net Exports (Nx). This means that for a decline in G to not cause GDP to fall, some combination of C + I + Nx needs to rise in an offsetting fashion.

It was very obvious that C wasn’t going to rise to offset a decline in G. UK households became extremely overleveraged in the previous cycle – in fact, much more so than even US households. And so it was pretty clear that they were going to maintain relatively high saving rates to pay down debt, regardless of whether the government decided to spend more or less money.

Source: IHS Global Insight

In terms of I, it’s very difficult to get more investment without consumption, as the two series are highly correlated. Intuitively, this makes sense: no business that wishes to stay in business chooses to ramp up investment spending precisely when its customer base is falling off a cliff. This fact is true regardless of how “confident” business managers become when they see the government reducing its budget deficit. Sure, a lower budget deficit may lead to lower borrowing costs for private firms during normal times, thereby stimulating investment. But we are so far from that reality today that it’s almost a laughable stance to take.

The only realistic chance, then, is for Nx to offset the drop in G. For a small, open economy, this can indeed happen. But history shows that it’s very unlikely that a large economy like the UK will be able to quickly devalue and swing its trade deficit into surplus overnight. Not to mention, the Euro crisis has made a quick trade adjustment even less likely, as the safe-haven status of gilts has made it relatively difficult for the pound to depreciate.

Thus, the predictable consequence of a drop in G beginning in 2010 is that it would weaken GDP. Again, anyone with a rudimentary understanding of economics would have come to this conclusion.

The moral of the story is that either Cameron needs to go or companies should stop firing forklift drivers when they cut corners. Take your pick.

The Long-Run Growth Rate Isn’t A Trump Card

Wednesday, February 27th, 2013

Wells Fargo has an interesting take on the determinants of long-run growth:

Should the Congress and the Administration decide to cancel the sequestration completely without replacing the cuts, the result would be a lower long-run rate of economic growth stemming from higher budget deficits today and higher federal interest outlays in the future. In addition, there is a significant likelihood that the United States would face another debt downgrade, and, in turn, raise the possibility of higher interest rates.

It is certainly true that too much government spending, if it crowds out private investment through higher taxes or increased borrowing, can weaken long-run growth. However, that’s not the end of the story.

The fact is that we will pass on an entire economy to the next generation, not just a debt/tax burden. If the government, for example, fails to invest adequately in roads and public schooling, then the result will also be a lower long-run growth rate. The real question is whether the benefits of spending more today on things like roads and public schooling outweigh the costs that could come in the form of higher interest outlays or taxes. Reasonable people can disagree about the conclusion drawn from such a cost-benefit analysis. But at the end of the day, we can’t disagree about data, which show that the government’s current interest burden is near a post-WWII low, and that there are few, if any, signs suggesting that more spending today would actually crowd out private investment in the future. If such data exists, then I would love to see it.

The other issue, which is more philosophical, is that boosting the long-run growth rate isn’t a trump card. There may be cases in which we might actually accept a lower long-run growth rate if it means a more just world. For example, we may want the government to spend more money on early childhood development to maintain the basic liberal-egalitarian ideal of equality of opportunity for all. Even if such spending comes with the cost of reducing the economy’s long-run growth rate, it still might be a cost worth bearing.

Confidence Won’t Help Unit Labor Costs Adjust

Sunday, February 24th, 2013

From Olli Rehn, the Eurozone’s Economic Affairs Commissioner:

The hard data is still very disappointing. [But] we must stay the course of reform and avoid any loss of momentum, which could undermine the turnaround in confidence that is underway. [The austerity programs] are paving the way for a return to recovery.

Meanwhile, the economic depression continues.

Source: IMF

How long can this continue? As Krugman notes, the adjustment in unit labor costs, which is at the root of the crisis, is progressing very slowly. In other words, it could take years before these economies start to recover.

If history is any guide, social unrest will threaten the system long before unit labor costs fully adjust. The only way out will be if the Germans accept higher inflation in the core to speed up the adjustment. For the sake of the tens of millions of people unnecessarily suffering in peripheral Europe, let’s hope the Germans come to their senses soon.

The Point of ZIRP is to Punish Savers

Thursday, February 21st, 2013

Wells Fargo published a report yesterday on the idea that the Fed’s ZIRP is distorting incentives by punishing savers. The report notes:

[M]onetary policy does impact households and businesses—big and small—differently, reflecting their debt/creditor position and their sensitivity to inflation and labor market developments … One surprising development for many households has been that even low, moderate inflation will negatively impact savers in a world of even lower interest rates. This is an era of financial repression. Moreover, policy that holds interest rates below the market-clearing equilibrium rate for an extended period provides little incentive for lenders to extend credit.

While the report obviously views the punishment of savers as a bad thing, it’s important to point out that such a development is, in fact, the goal of monetary policy in a liquidity trap. One of the many paradoxes we have in macro is the “paradox of thrift,” which is the idea that when everyone saves at the same time, growth weakens, incomes fall, and everyone is made worse off. My spending is your income, and your spending is my income. If nobody is spending, then nobody has any income.

This is an important paradox because it has been driving the Fed’s ZIRP. Right now, there is an excess demand for money in the economy – because aggregate demand is still depressed – such that even at a zero-percent interest rate, the demand for money is not able to be fully satisfied. Of course, if short-term interest rates could fall below zero percent, then the market would clear; but all sorts of contradictions arise when we start talking about negative nominal interest rates.

Which brings me to the final point regarding the Wells Fargo report: If the report’s authors believe that interest rates are currently below the market-clearing equilibrium rate, then such a belief needs to be qualified. In every intermediate macro course, students are taught about the Taylor rule, which gives a predicted value for where the federal funds target rate should be set. With a 7.9 percent unemployment rate, an output gap of nearly $1 trillion, and persistently low core inflation, it’s virtually impossible to construct a Taylor rule that predicts that the federal funds rate should be higher than where it is today. Even an overly simplified Taylor rule using only the unemployment rate and core CPI (with the parameters taken from this blogpost by Mankiw) shows that the current fed funds rate is about where it should be.

Of course, if you estimate the rule more carefully, the prediction will almost certainly be very negative, as this FT article explains.

In short, if Wells Fargo has a model showing that the market-clearing interest rate is actually higher than where rates are today, then it would do the world a huge favor by divulging the model’s information to policymakers, so that we can get people back to work. Otherwise, if no model exists, then it’s hard to see the conclusion of this report as anything more than an assertion.

The Financial Crisis Ended … Like Four Years Ago

Wednesday, February 20th, 2013

For those of you who were wondering whether Washington, DC is really insulated from the rest of the country, Neil Irwin provided confirmation in a blognote published yesterday. As the blognote shows, Irwin is evidently so far removed from the rest of the country that he doesn’t even have access to basic economic data. In a more alert world, this would be seen as a very serious problem, considering that the paper for which Irwin writes, The Washington Post, is highly influential.

Irwin starts his blognote off by mentioning that many professional economic forecasters have been wrong in recent years. The CBO, the Fed, and various private-sector forecasters have been consistently forecasting a quick return to full employment that never seems to materialize.

After speculating on many reasons why forecasters have been wrong, Irwin settles on the idea that the problem must be due to the financial crisis and the impact that the crisis had on banks, consumers, and businesses:

[T]here are things about a financial crisis that make it hard for the economy to regenerate. Breakdowns in the financial system mean that low-interest rate policies from the Fed don’t have their usual punch. An overhang of household debt means that consumers hold their wallets more than usual … [The crisis] may have sparked a permanent (or semi-permanent) shift in how consumers and businesses think about their desired levels of savings.

Look, the idea that the banking sector is still injured from a crisis that occurred more than four years ago is silly. Most banks are extremely well capitalized and have been loosening lending standards for years. And neither is household debt causing consumers to “hold their wallets more than usual”: in a historical context, the personal saving rate is still very much depressed.

If Irwin had access to some economic data, then he would recognize that the reason why the economy is operating at nearly $1 trillion below potential output is because aggregate demand remains depressed. This was the predictable consequence of the collapse of the housing bubble. At it’s peak, the bubble generated about $1.2 trillion in annual demand – $600 billion from construction activity, and $600 billion from consumer spending due to the wealth effect from rising home prices. When the bubble burst, the demand evaporated.

To understand how to get the missing demand back, we need to bring out our handy Econ 101 textbook, which tells us that GDP is the sum of consumption, investment, government spending, and net exports. If we start with consumption, the story is straightforward: the housing bubble drove the personal saving rate to nearly zero percent in the mid-2000s. Absent another bubble, there is absolutely no reason why we should expect consumers to save that little again going forward. As previously mentioned, it’s amazing how little consumers are already saving, considering that the personal saving rate used to average more than twice its current rate in the 1950s, 60s, and 70s. In short, the financial crisis didn’t spark a shift in the way consumers think about saving; they are behaving exactly as one would expect following the collapse of an $8 trillion bubble that decimated their wealth.

Next, the financial crisis didn’t permanently change how businesses think about investment either, because businesses are already investing a surprising amount. As a share of GDP, investment in equipment and software is nearly back to its prerecession level. Again, absent another bubble, there is no coherent story to tell in which investment in equipment and software gets much stronger than where it is today. Investment is highly correlated with consumer spending, which makes sense because no profitable business ramps up investment without a growing customer base.

You could say that there is room for more investment in commercial real estate. That’s definitely true, but two points need to be made. First, the CRE market is still recovering from overbuilding during the boom years. Vacancy rates for office and retail spaces are still high, and there’s no reason to expect them to fall overnight. Second, and more importantly, a recovery back to trend investment in CRE is nowhere near enough to get us back to full employment – at most, $150 billion in demand would be created.

It’s true that Irwin mentions that political gridlock has prevented the government from spending more money to address the aggregate demand gap. But this should be the main point of the blognote. The fact that the government has been reducing its budget deficit since 2010 is obviously very problematic. We’ll get to net exports in a minute, but the point I really want to make with this note is that most sectors were not going to recover overnight. With so many vacant properties, it was obviously going to take many years for investment in residential and commercial real estate to recover. In addition, a large economy like the US was not going to be able to swing its trade deficit into surplus very quickly. As most economists are starting to realize, it’s hard to get the dollar to depreciate even a little when it serves as a global reserve currency. Not only has the euro crisis put a bid into the dollar because of safe-haven reasons, but overall global financial and geopolitical volatility also hasn’t helped. Not to mention, Asia is still playing pegging games.

The point is that the government sector was, and has always been, the only sector from which we could have expected a rapid swing from surplus to deficit to fill the demand gap. Such a swing was not going to happen in any other sector. Had more forecasters noticed this very basic point, my guess is that their forecasts would have been more accurate.

But back to Irwin: We really need to stop making this ridiculous claim that all of our problems stem from the financial crisis. It’s obviously not true, and it takes two minutes to show that it’s not true by pulling up the relevant data. Irwin would do his city a lot of good by letting more data drive his analyses; for that way, DC outsiders wouldn’t feel as if the people living on the inside are from another country, where facts don’t matter.

The Dollar’s Decline in the 2000s Was Not “Big”

Monday, February 18th, 2013

Matthew O’Brien has a piece in The Atlantic, which Krugman has linked to, arguing against Joe Scarborough’s claim that deficit reduction should take priority over job creation. The piece is mostly correct – though proving Joe Scarborough wrong isn’t exactly rocket science. But I do take issue with something O’Brien and Krugman both wrote about: namely, the reduction in the value of the dollar during the Bush years.

Krugman writes:

“[T]his particular episode jogged me into doing something I’ve been meaning to do for a while: talk about the causes of the big decline in the dollar during the Bush years.”

If you look at an index of the trade-weighted dollar, it does indeed look like the dollar lost considerable value from 2002 to 2007. However, a glance at the trade deficit tells a different story: over the same period, the trade deficit as a percent of GDP grew by roughly 2.5 percentage points, or $350 billion.

This is important because many economists consider movements in the trade balance as being indicative of the underlying strength of a country’s currency. The fact is that while the dollar was technically falling during the Bush years, it remained heavily overvalued all throughout. In this context, it would be more appropriate if Krugman had referred to the dollar’s decline as “tiny” or “insignificant” rather than “big.” If the depreciation were “big,” then it would not have been associated with a widening trade deficit.

The Graduate Macro Curriculum Needs More Induction

Friday, February 15th, 2013

I thought the graduate macro curriculum would change in the wake of the 2008 meltdown. I thought, finally, macroeconomists would abandon their questionable deductive approach toward determining macroeconomic relationships and would adopt a more reliable inductive approach, in which relationships are determined by actual trends in real-world data. But I was wrong.

My macro course thus far has been nothing short of a disaster. We spend most of our time maximizing consumer, firm, and social-planner utility functions in a general-equilibrium setting, and almost no time fitting the results of those maximization problems to actual data.

What would an inductive approach look like? Well, for one, it would start with the data, which we would examine as far back as possible to see if any relationships have been persistent over time. We would then do our best to tease out causality using, if necessary, econometric techniques.

Of course, a big problem in macro is that we only have non-experimental data. This is a hurdle, for sure, but it is by no means insurmountable. We can, in fact, rigorously examine natural experiments to understand more about the impact of policy changes. For example, what happened when the US implemented austerity in 1937, and does that event provide any insights for policymakers today?

To make this as clear as possible, consider how different the world would be if Ben Bernanke had appealed to inductive reasoning in 2005. By now, everyone should be familiar with his remarks back then, when he maintained that a bubble did not exist in the housing market. What’s amazing about those remarks, though, is that if he had looked just once at the data, then he wouldn’t have asserted such nonsense.

In 2000, Robert Shiller released his book, Irrational Exuberance, which included a data series on real home prices going back to the late-19th Century. What Shiller’s data showed is that real home prices really don’t rise much, if at all, over long periods of time. That is, an analysis of Shiller’s data would have led one to conclude, through induction, that the long-run relationship between inflation and home prices is tight.

If Bernanke had examined Shiller’s data to arrive at this inductive conclusion, then he would have noticed in 2005 just how far out of whack home prices actually were. And he wouldn’t have even had to appeal to sophisticated econometrics; one look at Shiller’s dataset in chart form would have been enough to convince even a drunken bum on a street corner that the housing market was in a bubble.

I don’t want to blast the entire macro profession. There are many people out there, like Shiller, Dean Baker, and Bill McBride, who are doing wonderful applied work, carefully inductively teasing out long-run relationships. But we need more of these people. And for that to happen, I’m sorry to say, the graduate macro curriculum needs to be totally revamped. Instead of being forced to spend countless hours working through DSGE models, students should be taught how to examine actual data and how to inductively draw conclusions from the data.

Having worked in an applied setting, I like to think (shamelessly) that I have a pretty good handle on how to dig up and analyze relevant data for applied work. But many of my grad-school colleagues have not had similar work experience, which is downright frightening – especially if one of them one day makes it to the top of a central bank.

Same Old Storytelling

Friday, February 1st, 2013

Lot’s of data out this week. So let’s run through some of it to see if there’s a story worth telling – because, after all, macroeconomics is all about storytelling.

Real GDP fell by 0.1 percent (annualized) in the fourth quarter. The drop, however, was not driven by fundamentals; payback from strong inventory building in the third quarter plus a huge plunge in federal government spending (driven by a collapse in defense spending) subtracted 2.5 percentage points off headline growth. Real final sales rose a moderate 1.1 percent (annualized), driven by a decent gain in consumer spending and strong gains in residential investment and in equipment-and-software spending.

That last point is worth repeating once more: A strong gain in equipment-and-software spending helped support real final sales in the fourth quarter. In other words, all of the “fiscal cliff” rhetoric about how the economy was supposed to collapse in the fourth quarter because business managers were drowning in uncertainty turned out to be, well, rhetoric. And let’s not forget: business investment is the most volatile component of GDP. If the impact of fiscal-policy uncertainty were to show up anywhere, it would have shown up there.

Now, you could argue that some of the surge in business investment was due to the fact that the bonus-depreciation tax break was set to expire at the end of December, and that firms were pulling investment forward to take advantage of the tax break before it expired. (The tax break did get extended for another year as part of the year-end deal, but this information was not available to firms until the end of the month.) No worries: Another cyclically sensitive coincident indicator is employment growth, and employment growth in the fourth quarter was also relatively strong.

With the data revisions in this morning’s jobs report, we learned that the economy added an average of about 200K per month in the fourth quarter. The average monthly gain in the third quarter was about 150K. In other words, firms accelerated hiring as we approached the fiscal cliff. It’s true that the business and consumer confidence measures plummeted in the months leading up to the cliff; but as I’ve stressed relentlessly, stated-preference surveys often provide a misleading picture of the underlying fundamentals. It’s better, always, to look at hard data.

So where is the economy heading? Has the outlook improved? No. We are in the same situation that we were in six months ago; and six months ago, we were in the same situation we were in a year ago. The reason why we have an employment gap of about 9 million jobs from trend growth isn’t because of uncertainty or because of skill mismatches in the labor market. The issue is that there’s not enough demand.

We had a huge housing bubble, which, at its peak, generated about $1.2 trillion in annual demand. When that demand evaporated, there was nothing left to fully fill the gap. Sure, we tried some fiscal stimulus, and the trade deficit has narrowed somewhat; but neither of those developments provided enough demand to get the economy going again.

If somebody has a story about how a surge in business investment can close the demand gap, then I’d love to hear it. Equipment-and-software spending as a share of GDP is already back to prerecession levels. It doesn’t matter how much we shower business managers with tax cuts and compliments for assuming the role of “job creator”; they have no reason to boost investment spending above trend rates of growth when there is still so much excess capacity out there.

Nor should we expect consumer spending to lift the economy out of its funk. The personal saving rate jumped 1.1 percentage points to 4.7 percent in the fourth quarter. In contrast, the personal saving rate averaged around 10 percent in the 60s, 70s, and 80s – ya know, before the economy morphed into a bubble-creating machine. If anything, we should expect the personal saving rate to climb further in the coming years if we are to avoid another debt-driven bubble.

That leaves only government spending and reductions in the trade deficit as mechanisms to get back to full employment. For a large economy like the US, the trade deficit obviously isn’t going to swing into surplus overnight. That process could take years, and may not even happen unless the Fed and Treasury find the courage to drive down the value of the dollar.

And so in the short run, we need big federal budget deficits. (A recovery back to trend rates of residential and commercial-real-estate construction is not enough to fully close the demand gap.) Unfortunately, the recent fiscal-cliff deal will only further weaken demand. Tax increases, especially on high earners, are of course less problematic than cuts in government consumption and investment. Nevertheless, the automatic spending cuts set to begin in March still haven’t been averted. If they do indeed occur, then the outcome will likely be weaker job growth and a higher unemployment rate.

Anyway, that’s my story — and I’m sticking with it.

The Skills Gap Is About Technology, Wages, and Group-Level Irrationality

Friday, January 25th, 2013

UPenn has an excellent review of Peter Cappelli’s new book, Why Good People Can’t Get Jobs: The Skills Gap and What Companies Can Do About It. The book’s theme, which Dean Baker has written a lot about, is that there isn’t really a skills shortage in the labor market; the problem, rather, is that employers are reluctant to raise wages in order to attract talented workers.

As the book review notes, technology has enabled firms to employ choosier recruiting tactics. Keyword searches are routinely used to distinguish attractive resumes from non-attractive ones, and firms are increasingly using online assessment tests to weed out uncompetitive applicants.

Firms have chosen the technology-driven approach to attract skilled labor rather than the more traditional approach of raising wages. The idea is that, from an individual firm’s point of view, if skilled labor can be found without having to increase wages, then profits will be higher. It’s a very rational strategy.

But rationality at the individual level doesn’t always translate into rationality at the group level. In fact, if all firms simultaneously employ technology-driven approaches to attract skilled labor without raising wages, then the predictable outcome is that each firm will see a skills shortage in the overall pool of available labor. It’s not a real skills shortage, per se, because a real skills shortage is defined as a situation in which firms are unable to find suitable workers at market-clearing wages. If wages never rise to market-clearing levels, then the suitable workers, even if they exist, won’t ever show up.

An equivalent way of saying the same thing is that, in many ways, demand creates supply in the market for skilled labor. While employing new recruiting technology may be rational from an individual firm’s point of view, the risk is that the technology may contribute to a demand gap at the aggregate level; in which case, it might actually be in every firm’s best interest to raise wages.

But no firm is willing to raise wages individually. What all firms really need, then, is a coordinated agreement whereby they all raise wages for the types of positions that are in high demand. It’s obviously not the government’s role to force such an agreement, but one would think that unions, if they were still around in America, would be playing an important role.

Let The Chinese Students In

Saturday, January 19th, 2013

The NYT published an article last week on the explosive growth of Chinese college graduates in recent decades. Generally speaking, the article is well researched and provides a lot of useful information.

But one point needs to be corrected. On the issue of whether college graduates in China will be able to compete with their American counterparts for jobs, the article implies that the most important factor is skill accumulation:

“Giles Chance, a longtime consultant in China who is now a visiting professor at Peking University, said that many of the tens of millions of new Chinese college graduates might find jobs at manufacturers but did not have the skills to compete in big swaths of the American economy — particularly in services like health care, sales or consumer banking.”

It would have been useful to point out that an even bigger issue relates to government protectionism. As I mentioned in my previous post, there are many laws and norms that prevent highly skilled foreign workers from moving to the US for work. For example, the lack of standardization in medical education, as well as burdensome licensing requirements, prevents foreign doctors from treating US patients, while various public-sector hiring laws limit the number of non-US citizens allowed to work in civil service.

So long as these labor-mobility barriers remain in place, overall social welfare won’t be maximized.

Now, what may potentially happen is this: If these Chinese college graduates turn out to be the real deal and, as such, provide the Chinese economy with enough cheap, high quality services, then more American consumers may end up traveling to China to take advantage of the price differentials. It’s not an optimal outcome, but it just may be inevitable if the politics in our country remain dominated by protectionists who’ve never read an Econ 101 textbook.

On Inequality and Labor Mobility

Thursday, January 17th, 2013

I wrote an article for Rationale Magazine, a publication put out by the LSE Economics Society. The article is on inequality and labor mobility and is pasted here in full after the break. Hope you enjoy.

Inequality played a pivotal role in the recent US presidential election.  The slogan, “We Are The 99 Percent,” first proclaimed by the Occupy movement, seemed to resonate with many voters, who felt that President Obama would be in a better position to crack down on excessive disparities in income and wealth than would Mitt Romney, if elected.

And indeed, narrowing the enormous gap between the haves and the have-nots seems like a worthwhile goal. According to a report published last year by the International Monetary Fund, too high inequality can be destructive to growth, leading to more frequent financial crises and political instability. The only question, then, is: What can President Obama do in his second term to reduce inequality to more sustainable levels, thereby keeping his end of the election bargain?

The answer is simple: Adopt policies that increase labor mobility.

It should be abundantly clear by now that globalization has made capital more mobile. Not only have plummeting transportation costs made global trade easier, but declining communication costs have also made it easier for the owners of capital to coordinate production on a global scale.

The problem, though, is that the increase in capital mobility has not been matched by a corresponding increase in labor mobility. While manufacturing workers have become increasingly exposed to foreign competition in recent decades, highly skilled professionals working in the US have largely been protected. For example, the lack of standardization in medical education, as well as burdensome licensing requirements, prevents foreign-born doctors from treating US patients, while various public-sector hiring laws limit the number of non-US citizens allowed to work in civil service.[1] In addition, limitations on green-card issuance provide strong incentives for US employers, especially those in technical services and in law, to not hire foreign professionals.

Such restrictions on labor mobility have served to artificially inflate the wages of the workers protected from the forces of globalization. These artificial wage imbalances, moreover, are a key driver of growing inequality.

According to a paper by Jon Bakija of Williams College, Adam Cole of the US Treasury Department, and Bradley Heim of Indiana University, nearly 30 percent of the workers with incomes placing them in the top 1 percent of the earnings distribution work in industries that are protected from overseas competition.[2] Opening up these industries to globalization, and the wages within them to global market forces, would, therefore, go a long way toward reducing incomes for top earners.

Even beyond the immediate gains of a more-equal earnings distribution, the potential gains to American consumers from more labor mobility among foreign professionals could be enormous. According to a 2007 analysis by the Congressional Research Service, on a purchasing-power-parity basis, salaries for general practitioners in the US are nearly twice as high as the average GP salary in other OECD countries. Closing this salary gap by allowing more foreign-born doctors to undercut the pay of domestic doctors would result in significantly cheaper health-care costs for US consumers – an undeniably welcome outcome, especially considering that rising health-care costs have been eating up an increasing share of US household budgets for more than 50 years.

According to Dean Baker, co-director of the Center for Economic and Policy Research, a policy think tank in Washington, DC, the gains to American consumers from more labor mobility among foreign-born physicians would total nearly $100 billion per year. In contrast, the gains to consumers from, for example, removing the steel tariffs put in place by the Bush Administration in 2002 only ranged from $3 billion to $5 billion per year. In short, if the removal of trade tariffs was previously put on high priority in Washington for the purpose of boosting economic efficiency, then an even stronger form of the same argument applies to the removal of laws restricting labor mobility.

It is worth pointing out at this point that pushing for more labor mobility means pushing for more free trade. There is no economic difference between a tariff that raises the price of an imported good and a law that raises the relative wages of a certain segment of the labor force. In each case, removing the barrier obstructing a market-determined price or wage would result in efficiency gains.

This point is important because it provides a political lever that President Obama can use in his second term to push for policies aimed at increasing labor mobility for foreign professionals. American politicians typically love packages that come wrapped with the ribbon of free trade. By making the case that more labor mobility is needed for free-market purposes, President Obama should be able appeal to House Republicans, who claim to support market-oriented policy solutions. On the other side of the aisle, Senate Democrats should be on board, too, because, again, more labor mobility means less inequality.

Finally, the issue of labor mobility is not just about election mandates. What’s also at stake is America’s image in the world. By opening up its doors to more highly skilled foreign workers, America would take a giant step toward becoming a more inclusive society, in which the gains from productivity growth are distributed more equitably.

Think of it this way: When the Soviet Union tore down the Berlin Wall, the global community cheered in support of market liberalization. While the wall inhibiting labor mobility in the US is, to be sure, much more subtle than the Berlin Wall was, tearing down the former is still likely to elicit a similar response, if for no other reason than because it’s the morally right thing to do to foster greater freedom and openness.

In his symbolic 2008 presidential campaign, President Obama ran on the theme of “change.” Well, if you seek change for America, Mr. Obama, then tear down this wall and let in the brightest minds from the developing world. They’ve been waiting on the sidelines for far too long.


[1] For example, see Executive Order 11935.

[2] These industries include medical services, law, computer and technical services, and government.

The Economist Flunks The Innovation Test

Friday, January 11th, 2013

The lead article in The Economist this week is on innovation, the pace of which appears to have slowed in recent decades. The article draws on Robert Gordon’s work and is insightful up until about the last few paragraphs, where the article takes a sharp turn toward finger pointing, effectively blaming government for stifling innovation.

Specifically, the article notes that:

“The biggest danger is government … When government was smaller, innovation was easier. Industrialists could introduce new processes or change a product’s design without a man from the ministry claiming some regulation had been broken. It is a good thing that these days pharmaceuticals are stringently tested and factory emissions controlled. But officialdom tends to write far more rules than are necessary for the public good; and thickets of red tape strangle innovation.”

The article then goes on the assert that governments should “get out of the way of entrepreneurs, reform their public sectors and invest wisely.”

This is the sort of editorializing that only an unserious magazine would engage in. After all, fans of history will recall that the last time the government “got out of the way” of the private sector and deregulated financial markets, the end result was economic ruin.

Now, that’s not to say that too much government isn’t currently a problem. The article correctly notes that “[t]he West’s intellectual-property system … is a mess”; however, this is a point that the article could have elaborated on with several paragraphs, rather than with just one sentence.

Americans currently pay an extra $270 billion per year on prescription drugs due to patent monopolies in the pharmaceutical sector. In addition, the public spends an extra $100 billion per year due to copyright protection on creative work, such as recorded music, books, and software. (Both figures come from Dean Baker’s book, “The End of Loser Liberalism: Making Markets Progressive.”) Without these giveaways to the corporate sector, you can bet your butt that there would be more money to go around for entrepreneurs to use to innovate.

The article also stresses the need for more innovation from government in the healthcare sector. Yet, amazingly, the article never once mentions the possibility of invoking more free trade. On average, Americans spend more than twice as much on health care as do citizens of other wealthy nations, with little to show for in the way of health outcomes – life expectancies in the US are no better than in most other OECD countries. This suggests that huge gains could be had from more international trade. For example, if Medicare recipients were permitted to purchase foreign medical care, the gains could be enormous. In addition, if our trade policies were redesigned in such a way that allowed more foreign doctors to enter the country, then the salaries of US doctors would be brought down from their artificially inflated levels – after all, on a purchasing-power-parity basis, salaries for general practitioners in the US are nearly twice as high as the average GP salary in other OECD countries. Such an effort would inevitably place more money into the pockets of American consumers, meaning, again, more money to go around for entrepreneurs to use to innovate.

The final issue, which the article fails to mention, is that the inability of government to effectively limit intergenerational wealth transfers has undoubtedly led to less innovation. When children are given multimillion-dollar estates, they will clearly have less of an incentive to produce than if they had to work for those estates themselves. (This is, after all, the exact same argument that was used to decry “welfare queens” in the late-1970s.) The prime example here would be Paris Hilton, who would probably be living on the streets right now if her great grandfather didn’t found a multibillion-dollar hotel chain.

The point is that we need much higher estate and gift taxes, perhaps approaching 100 percent for very large bequests. The recent budget deal, which raised the estate tax to 40 percent for bequests over $5 million, is basically a joke. Innovation will pick up only when handouts are rightly taxed at extreme levels and when the associated revenue raised is rightly used to improve the terrible educational opportunities for the millions of unfortunate children who are born into poor neighborhoods each year. Maybe then will we start to see the data on social mobility make a turnaround.

In short, The Economist needs to take off its ideological blinders to see why the pace of innovation has slowed. If anything, less government in the way that the magazine envisions would almost inevitably lead to less innovation and more economic injustice.

Appoint a Treasury Secretary Who Will Weaken the Dollar

Sunday, January 6th, 2013

Serious analysts understand the need for a weaker dollar. The unprecedented asset bubbles that we have seen in recent decades are a direct consequence of the trade deficit, which a weaker dollar would reverse.

This is especially so because the United States is a developed nation. Neoclassical trade theory posits that developed economies should be capital exporters to the developing world, because rates of return are typically higher in the developing world. When capital flows from the developing world to the developed world – which is the situation today – the predictable outcome is an asset bubble in the developed world, as capital that is forced to seek higher rates of return in a low-return economy will ultimately make its way into risky investments, such as subprime mortgage-backed securities.

It’s imperative that our next Treasury Secretary understands this story. Despite the rhetoric about the dollar being a floating currency whose value is determined by the market, the fact is that the dollar’s value is heavily influenced by the Treasury Department. History buffs will remember that it was Treasury Secretary Robert Rubin who, in the 1990s, first promoted the high-dollar policy. No Treasury Secretary has since had the courage to reverse Rubin’s chosen path.

Many are encouraging President Obama to appoint Paul Krugman as the next Treasury Secretary, and I think that would be a fine choice. Krugman obviously understands the need for a weaker dollar; his recent analysis showing that an attack by the bond vigilantes would actually be a welcomed occurrence if it led to an exchange-rate depreciation was spot on.

Conservative economists, for their part, will no doubt try to block the effort to nominate Krugman. It’s important to point out, though, that their disapproval will be contradictory in two ways.

First, conservative economists love to decry budget deficits, but they never want to talk about the trade deficit. This position is, of course, nonsensical because the two deficits are linked through an accounting identity.

The other point is that a smaller trade deficit would also arguably shrink the social safety net, an outcome that conservative economists claim to want to see. The logic is simple. The high-dollar policy of the past few decades decimated our manufacturing sector, destroying job opportunities for millions of blue-collar workers. Because these workers presumably want to live, they voted for income support to get by. And so if we close the trade deficit, then we effectively bring paychecks back to millions of workers who have become more dependent on government to survive. In right-wing circles, this is usually called “promoting personal responsibility.”

The only people who have a legitimate reason to block President Obama from appointing Krugman as the next Treasury Secretary are those in the Wall Street crowd. This crowd benefits tremendously from asset bubbles, which, as previously mentioned, an overvalued currency promotes. In addition, a weaker dollar would almost certainly result in much higher inflation, hurting creditors. Around 90 percent of individually held bonds are held by those in the top 5 percent of the income distribution. These people, many of whom work in the financial sector, obviously have a stake in seeing inflation stay low in the years ahead.

I say we take a vote on it. Let’s put all the people who want to see manufacturing make a real comeback and who actually want to see a serious path toward budget balance put forward on one side of the debate, and those who want to see more asset bubbles and continued low inflation on the other. My hunch is that Krugman would get the job if the debate were appropriately framed this way.

December Job Growth: A Muzzle For The Uncertainty Pushers

Friday, January 4th, 2013

Remember when every mainstream newspaper was warning about the uncertainty created by the fiscal cliff? I certainly do. Such scare stories ran almost every single day over the past six months in newspapers like The Washington Post, The New York Times, and The Wall Street Journal.

We were told that the negotiations on Capitol Hill over tax-and-spending policy were frightening businesses, leading to slower business investment and inevitably weaker job growth. As we learned today, however, those claims had almost no basis in reality, as job growth during the second half of the year was actually slightly stronger than job growth during the first half of the year.

Nonfarm payrolls increased by 155K in December, about in line with market expectations. In the first half of the year, the economy added an average of 146K jobs per month; in the second half, average monthly job growth totaled 160K.

155K jobs added per month is a pace of growth that is obviously not strong enough to put a dent in our country’s unemployment problems. If December’s pace of job growth continued indefinitely, it would take roughly another four years just to bring the unemployment rate down to six percent.

Job growth will pick up only when the experts running this country start to realize why job growth is so weak in the first place. Since the recovery began, there have basically been two opposing views: one that has attributed sluggish growth to emotional factors – our consumers aren’t confident enough, and our business managers are too uncertain! – and one that has attributed sluggish growth to the demand gap created by the housing collapse. In an objective world, today’s jobs report would put a muzzle on those who hold the former view. In reality, they will probably continue to make their case in the months leading up to the debt-ceiling deadline.

It is important that we do our best to strive for accountability. Those who have been pushing the emotional explanation for our economic ills have been wrong on almost everything in recent years. If their reputations weren’t tarnished for missing the housing bubble, which wrecked the economy and which remains the source of all our problems, then the least we can do is make sure that they receive the blame they deserve for ignorantly distracting everyone over the past six months with fairytales about uncertainty. Maybe then will we finally be in a position to create the demand needed to get people back to work.

Austrian Theory Is Not An Economic Theory

Wednesday, January 2nd, 2013

So the old Keynesian-vs-Austrian debate has flared back up in the blogosphere. Economic Policy Journal has the full story, but the short version is that Robert Murphy, a famed Austrian economist, made an incorrect inflation forecast, which Paul Krugman and Brad DeLong have jumped on to argue that the Austrian explanation for what ails the US economy is misguided.

Getting a forecast wrong is, of course, OK. But Krugman and DeLong’s main gripe is that the incorrect predictions coming from the Austrian school in recent years have not forced the school’s practitioners to retool their theory.

Here’s Krugman:

Basically the whole [Austrian/Austerian] movement has been wrong about everything for two and a half years — wrong about interest rates, wrong about the effects of austerity on GDP in Europe. Yet where is the reconsideration?

I thought it might be useful to take a step back and talk briefly about methodology; because, while I think Krugman and DeLong are more or less right, they do seem to be slightly misrepresenting the Austrian view. In particular, Austrian theory doesn’t make specific predictions about economic phenomena; the theory simply serves as a blueprint for thinking about relationships between economic variables.

Major_Freedom, a commenter on Robert Murphy’s blog, has the full story:

Krugman writes:

“On the other hand, the unfortunate Romer-Bernstein prediction of a fairly rapid bounceback from recession reflected judgements about future private spending that had nothing much to do with Keynesian fundamentals, and therefore sheds no light on whether those fundamentals are correct.”

And

“The fact is that while Keynesians predicting a fast recovery weren’t really relying on their models.”

The same exact principle applies to the Austrian model. The Austrian model DOES NOT “predict” that price inflation will be X% when the money supply increases by Y%. Krugman is being unfair. While he claims that Keynesians are immune from bad predictions, he doesn’t grant that same immunity to Austrian theory. To him, Austrian theory says that price inflation goes up Y% when the money supply goes up X%. But that is not correct. Austrian theory does not contain that argument at all. In fact, it holds the exact opposite.

Rothbard explains:

“Mises agreed with the classical “quantity theory” that an increase in the supply of dollars or gold ounces will lead to a fall in its value or “price” (i.e., a rise in the prices of other goods and services); but he enormously refined this crude approach and integrated it with general economic analysis. For one thing, he showed that this movement is scarcely proportional; an increase in the supply of money will tend to lower its value, but how much it does, or even if it does at all, depends on what happens to the marginal utility of money and hence the demand of the public to keep its money in cash balances.”

Krugman is not correctly describing the Austrian theory. He wants his readers to believe that Austrian theory predicts hyperinflation whenever the Fed prints a lot of money, and that’s that. If it doesn’t occur, then Austrian theory is wrong. Krugman is repeating this lie over and over again, almost as if he doesn’t want his readers to look closely into Austrian theory lest they “convert”. So he keeps “reassuring” his readers that Austrian theory is wrong because we haven’t had hyperinflation yet, so don’t bother with it.

Bob Murphy for his part made a bet with Henderson about price inflation, yes. But this bet was NOT a consequence of any Austrian models. It was Bob Murphy’s model. Austrian theory does not make predictions of the form

Price inflation = a + b * (Money supply growth)

What Bob Murphy did was what Krugman claimed Romer and Bernstein did. They, like Murphy, made a prediction that did not turn out correct, but they were not Keynesian or Austrian models.”

I think this comment is accurate, but I also think that it exposes an even bigger flaw with Austrian theory: namely, that the theory isn’t really an economic theory.

Economics, after all, is a positive science, whose purpose is to make accurate predictions about the world in which we live, so that consumers, businesses, and policymakers can make better choices. This is how John Stuart Mill described the science’s purpose nearly 200 years ago; and how Milton Friedman did the same in the 1950s. In short, if the purpose of Austrian theory isn’t to make predictions about economic phenomena, then the theory is not an economic theory – at least not in the behavioral sense.

Which is obviously fine: normative, non-behavioral endeavors in the social sciences are clearly useful endeavors, which warrant considerable attention.

What’s NOT fine, though, is when normative, non-behavioral social scientists try to influence public policy. Austrians claim to not make explicit predictions about economic phenomena, but the fact is that they’ve been trying to influence policy in meaningful ways – whether by arguing that we need to cut government spending now now now, or by arguing that all unions and regulations need to be abolished, so that the “free market” can operate more efficiently.

The point is, if you’re unwilling to make predictions (using empirical tools like statistics), then you’re not allowed to have a say in economic policy matters. And, to be clear, I’m not arguing that normative matters aren’t important in policy debates; we should obviously always care about things like distributive justice and moral rights. But we don’t call the people arguing for normative goals “economists” – we call them philosophers.

In this context, the whole Krugman/DeLong-Murphy debate is somewhat pointless because you essentially have the aged-old debate between economists and philosophers, and each group is speaking past one another on fundamentally different playing fields.

The AP’s Ignorance Helps To Foster A Last-Minute Deal

Friday, December 28th, 2012

The Associated Press (AP) is a very powerful news organization, which syndicates articles to thousands of local newspapers all across the country. Given this responsibility, one would hope that AP staff writers have at least a basic understanding of economics. Unfortunately, that appears to not be the case, as evidenced by an AP-syndicated article on yesterday’s consumer confidence numbers.

The article notes:

“U.S. consumers peering over the ‘fiscal cliff’ don’t like what they see. Fears of sharp tax increases and government spending cuts set to take effect next week sent consumer confidence tumbling in December to its lowest level since August.”

While the overall consumer confidence index did fall, the drop was driven entirely by the expectations component, which has a horrible track record of predicting future consumption spending. The present-situation component, which correlates much more strongly with current consumption spending, actually increased on the month to its highest level since the housing collapse tanked the economy. If consumers are truly worried about the upcoming austerity bomb, which begins on January 1, those worries are not showing up in the data.

It’s important that we understand what’s at stake here. Since the recovery began, there have been two opposing views on the economy: one that has attributed sluggish growth to emotional factors – Our consumers aren’t confident enough! And our business managers are too uncertain! – and one that has attributed sluggish growth to the demand gap created by the housing collapse.

The recent fiscal-cliff scare story, which media companies all across the country are doing their best to propagate, has been yet another attempt by those holding the former view to influence public policy. The story, we’re told, is that if we don’t get a deal on the fiscal cliff before January 1, the economy will collapse. This narrative is, of course, false – whether we get a deal in the next few days or by the end of January, the effect on the economy will be almost indiscernible – but that hasn’t stopped the confidence-uncertainty pundits from making their case. Their thinking has been that if they can scare enough of the public into believing that a deal needs to be made before January 1, then they may be able to push one through that preserves tax cuts for the ultra rich and that slashes income security benefits for millions of retirees.

By failing to understand the importance of yesterday’s consumer-confidence report, the AP has helped the confidence-uncertainty pundits make their case. And if we get a deal in the next few days in accordance with their demands, news organizations like the AP will be partly responsible.

The Wall Street “Geniuses” Are At It Again – This Time In Chart Form

Friday, December 21st, 2012

Business Insider ran a piece yesterday, motivated by a number of charts submitted by analysts on Wall Street. The piece refers to the analysts as “geniuses.”

Call me stupid, but I’m having a hard time seeing the ingenuity. In fact, I’m seeing nothing but a bunch of errors in the associated chart commentary. And so, being the faithful public servant that I am, I decided to devote a post to correcting some of those errors.

Here goes:

For this chart, it would have been worth noting that the US is still in a liquidity trap. The definition of a liquidity trap is a situation in which conventional monetary policy has lost its effectiveness – i.e., when increases in the money supply do little boost economic activity. The reason why the US is in a liquidity trap is because the market-clearing interest rate is currently below zero percent, which is as low as short-term nominal interests rates can go.

The research on liquidity-trap economics suggests that there are two ways to get the economy going again: through more fiscal stimulus or through more explicit central-bank communication. (The latter would involve more credible commitments from the Fed, such as a commitment to let inflation overshoot – and no, 2.5 percent inflation isn’t bold enough – or a commitment to weaken the value of the dollar.) Neither of these channels has been pushed seriously. To that end, Wien’s commentary is misleading: we will only have to rely on more monetary expansion/M2 in the years ahead if policymakers at the Fed and in Congress keep failing on the job.

Shilling is mostly correct here, except for the last line. There is nothing “massive” about stimulus spending in recent years. When the housing bubble burst, the economy lost roughly $1.2 trillion in annual demand – about $600 billion from spending directly related to construction activity, and another $600 billion from consumption spending, which had been driven by soaring home prices. The American Recovery and Reinvestment Act pumped about $300 billion per annum into the economy in each of 2009 and 2010. And guess what: $300 billion is not $1.2 trillion. In this context, it would have been more appropriate to call the stimulus effort “minuscule” rather than “massive.”

I don’t know whether the debt series in this chart refers to overall debt or to just public debt. Nevertheless, it would have been worth noting that a key difference between the 1947-1985 period and the 1985-present period relates to the trade deficit.

By definition, a trade deficit implies debt accumulation, which must occur in either the public sector, the private sector, or in some combination of both sectors. A trade deficit, moreover, also serves as a drag on growth – there is, after all, a variable in national income accounting called “net exports.” Given this, it would make sense that the period after which the trade deficit exploded would be associated with slower real GDP growth per additional dollar increases in debt.

So, in short, Certo’s chart doesn’t warrant an elaborate discussion about “the real economy, policy considerations, and investment prescriptions”; it simply warrants a serious discussion about reducing the trade deficit.

For this chart, it would have been worth noting that ECRI’s track record in recent years has been horrible. In fact, ECRI was one of the key players propagating the double-dip scare story in mid-2011. Anyone familiar with the data knew that the economy was not on the verge of another recession – housing starts and car sales, two key cyclical indicators to watch, were steadily improving amid the double-dip rhetoric.

Given this track record, BI should have perhaps put a big asterisk next to Achuthan’s commentary – either that, or just drop the chart and commentary altogether.

Juckes could have mentioned here that not all economists agree that money was too loose in the years leading up to the housing collapse. As I’ve mentioned before, adjusting the Taylor rule for the trade balance would have almost certainly predicted that money was actually too tight back then. Considering that the US is still running a large trade deficit of more than 5 percent of GDP (that is, if the economy were at full employment), a case can be made that money is probably still too tight today. If Juckes were serious about calling attention to potential future asset bubbles, then a better strategy would be to examine trade imbalances rather than the fed funds rate – especially since the latter is a poor indicator of easy money when an economy is, as previously mentioned, stuck in a liquidity trap.

It would have been worth noting here that the trend shown in Cui’s chart is the exact outcome that neoclassical growth theory would predict. Investment spending should be strong in fast-growing emerging economies, as the convergence effect in a simple Solow-Swan growth model is driven almost entirely by factor accumulation. We can debate whether it’s time for China to move away from an investment-driven growth model toward a consumption-driven one, but we can’t debate the data on living standards. So long as GDP per capita in China remains a fraction of that in developed economies, Chinese investment spending will likely remain strong.

Remember when I said that monetary policy at the lower bound is all about expectations? Ducrozet’s chart shows exactly what I’m talking about.

Ever since Draghi made the decision to actually do his job – that is, to act as a lender of last resort to peripheral Europe – capital flight has reversed. The irony here is that Draghi really didn’t have to do anything except make a forceful statement about the ECB’s willingness to maintain fiscal solvency in Spain.

For this chart, it would have been worth noting to readers that Boone has trouble with arithmetic. As Dean Baker has pointed out, tirelessly, the demographic scare story is a fraud. The gains from relatively stable productivity growth always swamp the losses from poor demographics. In this sense, there is nothing that suggests that the euro area’s aging population will lead to “tough times ahead.”

Now, it’s undoubtedly true that the pointless austerity and unnecessary suffering in some countries in Europe will ensure that tough times remain ahead for the foreseeable future. But this is a matter of economic ignorance – not of an aging demographic profile.

For this chart, it would have been worth pointing out that the reason why there hasn’t been a material reduction in debt relative to GDP in the developed world is because there hasn’t been a material reduction in the trade deficits that various developed countries continue to run. The path of least resistance, after all, is a path toward balanced trade in the developed world.

Neoclassical trade theory states that rich, developed economies should be capital exporters to the developing world; because rates of return are typically higher in the developing world. When capital flows from the developing world to the developed world, the predictable outcome is an asset bubble in the developed world, as capital that is forced to seek higher rates of return in a low-return economy will ultimately make its way into risky investments, such as subprime mortgage-backed securities. So if you’re worried about debt and asset bubbles, by definition, you should also be worried about trade imbalances.

Cullen Roche gets it. This is perhaps the most important chart of our times, as it shows very clearly that the large public deficits of the past few years were a necessary outcome of the collapse of the housing bubble.

In the 2000s, the private sector was a huge net borrower; the household saving rate fell to nearly 0 percent, and capital investment by businesses was very strong. Then, when the real estate bubble burst in 2006, the private sector moved from a large net borrowing position to a large net saving position. Since the current account deficit was still kicking at this time, the implication was that large budget deficits in the public sector had to emerge. Again, this is an accounting identity: the public sector necessarily had to move to a huge net borrowing position in order to finance the current account deficit, because the private sector was no longer in a position to finance it. This is where we are today, with the public sector still running large budget deficits and with the private sector still deleveraging.

In fact, we should all be praising the government’s large deficits, as they are helping to support the demand that the private sector won’t provide. In other words, if you want lower deficits right now, you also want higher unemployment and weaker GDP growth. End of story.

Darby should have also noted here that a recovery back to trend construction and structures spending is not enough to get the economy back to full employment. A recovery back to trend residential investment implies a roughly $270 billion swing in demand, while a recovery back to trend structures spending implies a roughly $150 billion swing in demand. The economy is still grappling with a nearly $900 billion annual output gap. In addition, consumer spending is high relative to historical levels.

Therefore, in order to get back to full employment without inflating another bubble in housing or commercial real estate, the trade deficit will need to narrow.

Trennert wants to blame the liquidity trap caused by the collapse of the largest real estate bubble the world has ever seen on increased financial regulation. Nuff said.

It would have been useful for Juckes to point out that the reason why some economies in Europe are addicted to ECB funding is because of the anti-inflation cult that dominates governance at the ECB. As any serious analyst knows, the European crisis is, at its roots, all about wage-price imbalances.

During the boom years, wages and prices in the core of Europe became way out of whack with wages and prices in the periphery – with the latter growing much faster than the former, due to the enormous housing bubbles that the private sector recklessly bid up in some peripheral economies. The only way to restore competitiveness between the core and the periphery, therefore, is for wages and prices in the periphery to fall or for wages and prices to rise at a much faster pace in the core. Since the elites in the core have chosen to restore competiveness through deflation in the periphery, the predicted result of this policy has been to throw much of the periphery into an economic depression – which mandates that the economies suffering from depression will be addicted to ECB funding for some time.

All of this would have been useful information for Juckes to add – assuming that he even knows this story.

I actually looked at this issue very closely back in early 2012 and found that there hasn’t really been a bias toward low-wage hiring in recent years. And I know Brusuelas is familiar with my research, because I sent it to him in the past.

I don’t mean to talk up my own book, but any serious analyst should trust my research over Brusuelas’ chart. While Brusuelas aggregates employment growth into just four broader sectors, I looked at employment growth on a subsectoral basis, covering more than 80 different subsectors. It was a lot of work, but it was the proper way to do this sort of analysis.

It would have also been worth noting here that Fleckenstein has the same credibility problem that ECRI has. He, along with other notable investors such as Bill Gross, predicted that Treasury yields would rise right before the bond market went on an unprecedented tear in 2011, taking yields down to levels not seen in more than 60 years.

I have no idea what Juckes is even talking about here. The ECB wasn’t “hamstrung”; it purposefully chose higher unemployment and weaker real GDP growth by pushing deflation on the peripheral economies rather than inflation on the core economies.

Also, the comment about the US losing the “currency war” is frankly bizarre. For one, the US doesn’t even trade much with Europe, so there’s very little currency tension between the two economies. Second, as I’ve mentioned repeatedly, the US needs to close its massive trade deficit. Insofar as losing a currency war is associated with balanced trade, we should all be cheering whenever the dollar loses value.

It would have been helpful for Boone to note here that growth in Germany has come at the expense of poor growth in Spain and Italy. Germany doesn’t have some magic formula for resilience that Spain and Italy lack; rather, Germany has more political power – fullstop.

Pento is another analyst who should have zero credibility and who should not be allowed to publish anything in any major media outlet. After all, this is the same guy who predicted an “inflationary death spiral” in 2010. That BI would even let him talk about inflation despite being wrong on the subject every year for the past four years baffles the mind.

***

In sum, there are many things that are wrong with this piece by Business Insider – which shouldn’t be all that surprising, considering that the whole thing is motivated by the views of the “geniuses” on Wall Street, who, for some odd reason, can’t stop being wrong about everything.

Bernanke Still Isn’t Partying Like It’s 1999

Saturday, December 15th, 2012

I should probably say something about the Fed’s recent policy move, which is more or less a derivation of the Evans recommendation. Explicitly, the Fed will now keep policy loose provided that annual inflation is at or below 2.5 percent and the unemployment rate is above 6.5 percent. In addition, the Fed will also start buying more Treasury securities, to the tune of $45 billion per month of longer-dated bonds.

All of this is a step in the right direction, for sure. But I just don’t know if it’s irresponsible enough.

Per Krugman (1998), monetary policy at the lower bound is all about expectations. If a central bank can promise to keep policy loose far enough into the future, while allowing inflation to overshoot a bit, then, through the expectations channel, there’s a chance that future consumption and investment decisions will be brought forward, helping lift the economy off the lower bound. In other words, if a central bank can make a credible commitment to be irresponsible far enough into the future, it just might spur enough activity today.

The problem with all of this, though, is that the US economy doesn’t really need more consumption and investment spending; the personal saving rate is still very much depressed in a historical context, and equipment-and-software spending by businesses is already back to prerecession levels. What the economy does need, rather, is a reduction in the trade deficit via a currency depreciation. To that end, a truly irresponsible – and thus more attractive – policy move at the Fed would have involved making a commitment to weaker the value of the dollar.

And you don’t need to take my word for it; just listen to Bernanke himself in 1999, when he encouraged the Bank of Japan to make a commitment to devalue the yen:

“Franklin D. Roosevelt was elected President of the United States in 1932 with the mandate to get the country out of the Depression. In the end, the most effective actions he took were the same that Japan needs to take – namely, rehabilitation of the banking system and devaluation of the currency to promote monetary easing.”

It’s also important to point out that the case for reducing the value of the dollar is much stronger than was the case for a yen depreciation in the late-1990s. At more than 5 percent of GDP (that is, if the economy were at full employment), the US trade deficit is simply far too large to be offset responsibly by other sectors. This is why we needed a $10 trillion stock-market bubble in the late-1990s to achieve full employment, and why we needed the largest real-estate bubble the world had ever seen in the mid-2000s to bring the unemployment rate down to just below 5 percent.

So like I said, the Fed’s move this week was a step in the right direction. But it’s not enough to lift the economy off the lower bound and to get us back on a sustainable growth path, not characterized by multitrillion-dollar asset bubbles. For insights on the latter, Bernanke will need to reread some of his research from the 1990s. And let’s hope he gets to that soon before it’s too late.

Public Service Reminder: Business Managers Say and Do Different Things

Wednesday, December 12th, 2012

Wells Fargo published a report yesterday that highlights a theme I’ve talked much about: namely, the irrelevance of stated-preference surveys.

From the report:

“The NFIB Small Business Optimism Index declined 5.6 points in November, marking one of the largest declines in the survey’s history… Small businesses are concerned about the future course of public policy, particularly as it relates to taxes and regulation.”

The problem with this story is that it’s completely at odds with the data, which show that businesses are in fact hiring new workers as well as investing a surprising amount in equipment and software. If businesses were truly “concerned about the future course of public policy,” then they would be sitting tight. Remember, in economics, actions speak louds than words.

The reason why economists should care about revealed preferences and not stated preferences is because, at its core, economics is a positive science. In The Methodology of Positive Economics (1953), Milton Friedman viewed the goal of economics as purely behavioral; that is, to make accurate predictions about economic phenomena. On this reading, economists should not give a hoot about how business managers are “feeling” about public policy, because feeling is a mushy, normative thing that falls outside the scope of economics. What’s important, rather, is what business managers are actually doing, which can be determined only by analyzing hard data.

(It’s also worth mentioning that the econometric verdict on whether the rise of sentiment surveys, or “soft” data, has led to better macro forecasting is still very much mixed.)

First and foremost, I blame the media. The relentless effort to appeal to sensationalism has spawned a whole industry that thrives off statements like, ‘Survey data show the largest drop in confidence since the Great Recession.’ And as a result, the broader public is incredibly ignorant of the important issues, like the fact that the large budget deficits of the past few years are a necessary result of the collapse of the housing bubble or the fact that the US can’t possibly end up like Greece or Italy, because the US owns a printing press.

The point is, there are a lot of pointless surveys out there that do nothing but add confusion to the national debate. And so economists/reporters would do themselves a lot of good by ignoring them.

Releveraging Does Not Equal Clear Skies

Tuesday, December 11th, 2012

Tim Duy, via Hatzius at Goldman Sachs, thinks that the consumer will be ready to releverage by the end of next year:

“I think fiscal policy should refrain from deleveraging until the private sector is ready to relever. When will that be? Jan Hatzius of Goldman Sachs expects that releveraging to begin in the second half of 2013 – see his interview with Joe Weisenthal. If so, then the first half of 2013 will be stormy, but the sky will clear toward the end of the year and into 2014.”

Duy’s forecast may end up being right, but it’s hard to see how a releveraging cycle would be an indication of clear skies. After all, we just went through an epic credit binge, during which the personal saving rate fell to nearly zero percent, as consumers bid up a colossal bubble in the real estate market.

In fact, consumers are already saving too little. At only 3.4 percent, the personal saving rate is still way below levels witnessed in the 1950s, 60s, and 70s, when American consumers saved close to 10 percent of their income.

The difference between then and now? Well, the trade deficit, obviously:

Source: BEA

Look, the next few years are going to be crucial. We can either get back to full employment through a reduction in the trade deficit (via an increase in foreign demand), or we can inflate another asset bubble. At more than 5 percent of GDP (that is, if the economy were at full employment), the trade deficit is simply far too large to be offset responsibly by other sectors in the economy. This is why we needed a $10 trillion stock-market bubble as well as massive amounts of equipment-and-software spending in the late-1990s to achieve full employment, and why we needed the largest real-estate bubble the world had ever seen in the mid-2000s to bring the unemployment rate down to just below 5 percent.

The trade deficit obviously isn’t going to normalize overnight. Economic theory would predict that the ultra-low interests rates of the past few years should have led to a gradual reduction in the value of the dollar, eventually closing the deficit – this story, however, gets complicated when half of the developing world pegs its currencies to the dollar at low rates. But that’s a prolonged process.

In the near term, we should look to support demand through higher public deficits. Since the markets are currently willing to lend to the US government for almost nothing in return, we should be taking advantage of the opportunity by spending more money on things like infrastructure, education, and research. Then later, when the dollar falls enough and when the trade deficit closes, we can worry about reducing budget deficits.

Uncertain Business Managers, Who Won’t Stop Hiring

Saturday, December 8th, 2012

A very good article by Fortune, taking down the uncertainty myth:

“The best piece of evidence yet that the fiscal cliff has had little or no impact, at least when it comes to hiring, came from the November jobs report … it’s clear the fiscal cliff has been more of a talking point than an actual economic catastrophe.”

I made a similar point a few days ago with regard to business investment.

The only way the fiscal cliff will end up doing serious damage is if we actually go over and never come back. If a deal isn’t reached by, say, late-February, then I’ll start to worry. All of the sensationalism until then, however, is nothing more than theatre.

It Should Actually Be: “The Campaign To Weaken The Dollar”

Saturday, December 8th, 2012

Some interesting data out this week from the Fed’s flow-of-funds survey.

First, there was a huge reversal in households’ purchases of US Treasuries in the third quarter, with the sector moving from a large net-buying position to a modest net-selling position. The last time the household sector was a net seller of Treasuries was in Q2 2011, just before the Fed ended its second round of quantitative easing.

Treasury yields rose a bit during the third quarter, but other sectors did step up to offset the selling that occurred in the household sector. Specifically, foreign buying of Treasuries increased noticeably, with the foreign sector purchasing more than $600 billion worth, totaling roughly 4 percent of GDP.

Which brings me to an important point: If you’re a fiscal hawk who gets infuriated every time the government runs a deficit, then you should be equally infuriated whenever the Treasury finances the deficit by selling massive amounts of bonds to foreigners.

The two outcomes, after all, are closely related:

What I never hear the fiscal hawks also complain about, however, is the fact that the US runs a large trade deficit. This is strange because the reason why the Treasury often finances the federal deficit by selling bonds to foreigners is because of the trade deficit. It is, after all, an accounting identity that links the two deficits together.

If the fiscal hawks were consistent, then they would actually be rooting for a weaker dollar, which is the primary mechanism through which trade deficits are supposed to normalize. In fact, according to most of the literature on intertemporal current-account smoothing, the large trade deficits of the past decade or so actually imply future exchange-rate depreciations. And so the sooner we get those depreciations, the sooner we get back to a sustainable growth trajectory; that is, if you believe (as you should) that high net-external debt flows contribute to asset bubbles and financial crises.

It is for all of these reasons that private-equity billionaire Peter Peterson’s recent pet project, “The Campaign To Fix The Debt,” is a serious misnomer. If the Campaign’s funders knew anything about economics, then the initative would actually be called: “The Campaign To Weaken The Dollar.”

Uncertain Business Managers, Who Won’t Stop Investing

Wednesday, December 5th, 2012

I don’t normally put too much weight on monthly data swings; it’s best, always, to look at the broader picture. But I’m going to take some cheap points today by directing everyone’s attention to this morning’s factory orders report.

From Salon:

“Factory orders edged up 0.8 percent in October, the Commerce Department said Wednesday. That compared to September when orders had jumped 4.5 percent.

Orders for core capital goods, a category viewed as a good proxy for business investment plans, increased 2.9 percent in October, the biggest increase in eight months.”

Why is this important? Well, in case you haven’t heard, there’s this thing coming up on January 1st called the “fiscal cliff,” which, according to nearly every mainstream economist and newspaper, is frightening business managers. The problem with this story, however, is that it is at odds with the data, which show that businesses are actually investing quite a lot, especially given how much slack is still out there in the economy.

And I’m not just talking about this morning’s factory orders report. If we take a step back and look at overall equipment-and-software spending by businesses, the story is quite telling.[1]

The above chart plots equipment-and-software spending as a share of real GDP. As can be seen, the series is basically back to prerecession levels. And so the whole notion that the economy is being held back by a lack of investment spending because business managers are uncertain is absurd on its face. Any more investment spending than what we currently have would put us into bubble territory, which should not be welcomed by anyone.

Now, it’s undoubtedly true that many business managers are claiming to be uncertain because of fiscal policy. But there’s a difference between “claiming” to be uncertain and “being” uncertain. As I’ve mentioned, repeatedly, serious economists look at revealed preferences rather than stated preferences. It would be great if we didn’t have so many pointless surveys asking business managers about how they’re feeling or about what mood they’re in or whatever, but such is the world we live in.

Nevertheless, one would think that competent analysts would be able to sift through the madness and focus on what’s important. Unfortunately, as the fiscal-cliff debate demonstrates, that’s apparently too much to ask.

[1] It’s important to look at just equipment-and-software spending rather than total private investment because the structures component of investment spending is still being held back by an excess supply of properties in the commercial real estate market.

The NYT: No Pain, No Gain

Saturday, December 1st, 2012

Epic nonsense from the NYT:

“In the short term, policy experts expect that the combination of increased tax revenue and reduced government spending would put a drag on the economy. Both Democrats and Republicans have warned that too-steep tax increases or too-deep spending cuts might create a recession.

Nevertheless, a short-term ‘down payment’ on a broader tax and entitlement reform process might sap growth in the next year or two. That so-called fiscal drag might be offset by increased business investment because of the removal of uncertainty, or a ‘relief rally’ in the stock markets.”

Translation: In order to please the confidence fairy, we need to throw the economy back into recession!

C’mon, people. This is really getting silly. As a percentage of GDP, equipment and software spending by businesses is near prerecession levels. So it’s hard to argue that businesses are “uncertain” when they’re investing so much already. And, no: anecdotes don’t count. If you know a business manager who claims to be uncertain about the future, that doesn’t prove anything; serious economists listen to revealed preferences rather than stated preferences.

Also, in terms of making a “down payment” to please markets, one really has to wonder what the NYT is smoking. If markets were really worried about fiscal policy, then we would be seeing those worries percolating in the bond market (not the stock market). If the NYT has any evidence of this, then it should be presented – because when I look at the bond market, all I see are historically low yields.

In short, the idea that we need to suffer in the short run in order to be rewarded in the long run is incredibly irresponsible. And you don’t need to read Keynes to see this; just ask any worker in Spain, Italy, or Ireland.

Bargain Hunting For Affordable Care

Monday, November 26th, 2012

Dean Baker makes an important point regarding health-care costs:

“The CBO projections imply an ever-growing disparity between the per-person cost of health care in the United States and the cost in other countries, a gap that might prove difficult to sustain given the ability of people to travel across national borders.”

Indeed, the fact is that Americans spend an enormous amount on health care with little to show for in the way of health outcomes. Considering just North America, data from the World Bank show that, on a per capita basis, health-care spending in the US is 1.6 times that in Canada and nearly 14 times that in Mexico. But in terms of life expectancy, Americans, on average, live about as long as Mexicans and slightly shorter than Canadians.

Source: World Bank (2010)

This gap cannot persist indefinitely. As the NYT reported back in June, thousands of Americans are already making the trip across Mexico’s boarder in search of affordable care. And if we are to believe the CBO’s horror projections on the trajectory of future health-care costs, then the flood of consumers across the boarder is only going to intensify.

We could, therefore, save Americans a lot of hassle by reforming healthcare in a way that actually lowers costs. Specifically, we could allow more foreign doctors to train up to US medical standards, thereby undercutting the pay of domestic doctors. (Salaries for general practitioners in the US are nearly twice as high as the average GP salary in other OECD countries.) And we could end the corrupt patent monopoly scheme that allows pharmaceutical companies to sell certain drugs as high as a thousand percent above free-market prices.

Or how bout this: Why don’t we just nationalize the entire sector, like many other developed nations have successfully done?

The plus side, I guess, is that if we don’t reform healthcare in a way that lowers costs, then the shoe industry is likely to boom – because Americans are going to be doing plenty of walking in the decades ahead.

Listen To The Behaviourists

Thursday, November 22nd, 2012

Here’s a short paper I recently wrote on methodology. Comments and criticism are welcome. The trailer:

“Since the 2008 global financial crisis, the economics profession has come under fire. In particular, the models that economists have been using to make sense of the world have been criticized for their lack of predictive power. The Queen of England perhaps best summarized the public’s frustration toward the economics profession when, in late-2008, she asked a simple question: Why did so many economists fail to foresee the financial crisis?

The answer, I argue, lies at the root of rational choice theory (RCT), the human-decision-making framework governing the models that most economists use. While there are many different readings of RCT, I argue in this paper that there is really only one reading that economists should be concerned with; namely, the behavioural reading. Psychological, biological, and normative readings of RCT, while certainly interesting, have only served to distract economists from making progress in their field, which, on a foundational level, is inherently linked to practical politics.”

Conservatives Are Not Interested In The Market

Wednesday, November 21st, 2012

I have to call Mike Konczal out on an otherwise informative blognote on the impact of the Great Recession on married households. At one point, Konczal speculates on the philosophy of modern-day conservatives:

“Another important conservative focus is running everything the government does through private hands. The conservative movement is not about small government, it is about privatized government. From Bush and Ryan’s attempts to privatize Social Security, to turning Medicare into a Groupon, to bringing private industry into the military, every step involves introducing market agents into government processes and pushing market risk to individuals. This continued under Mitt Romney’s big policy ideas.”

This is not true. On the major issues, conservatives are not interested in using the market to solve economic problems. In fact, conservatives are as big of a fan of big government as liberals.

For example, conservatives have put forth no plan to end the implicit insurance subsidy that our government provides to the nation’s biggest banks. This subsidy totals tens of billions of dollars each year. Any true believer in the virtues of free markets would not support such a subsidy.

In the same vein, conservatives are protectionists when it comes to globalization. If globalization were done in a free-market way, then all classes of workers would be exposed to foreign competition. This means that, along with the jobs of manufacturing workers, the jobs of doctors and lawyers working in the US would be up for grabs to workers in the developing world. There are plenty of smart, eager people in, for example, China and India who would love to train up to US medical and legal standards and, in turn, undercut the wages of domestic doctors and lawyers. In addition, the savings to consumers from a free-market approach to globalization would be enormous. Doctors in the US are paid more than twice as much as the average pay of doctors in other developed countries. Letting workers from the developing world undercut the wages of domestic doctors means cheaper health-care costs for American consumers.

Finally, conservatives support free riding in the same way that big-welfare-state liberals do. Evidence: The relentless support of conservatives to abolish inheritance taxes. Without inheritance taxes, the children born into wealthy families will have the same incentive to not produce that the so-called “welfare queens” had when Reagan ran on reforming the welfare state in the late-1970s. This is why classical liberals like John Stuart Mill – from whom the modern-day libertarian party arguably spawned – supported heavy inheritance taxes.

In other words, the whole idea that conservatives are somehow believers in the market is absurd on its face. The first step toward better policymaking is recognizing this fact.

Greenspan’s Confused View On Fiscal Policy

Monday, November 19th, 2012

Alan “No Housing Bubble” Greenspan is back, spreading a whole bunch of nonsense. Here’s what he had to say regarding fiscal policy:

“I think the markets are getting very shaky. And they are getting shaky because I think fiscal policy is out of control.”

Yes, fiscal policy is so out of control that the government’s interest burden as a share of GDP is near a post-war low.

Also, what markets are shaky? The Treasury bond market, where the yield on the 10-year is near an all-time low? Admittedly, stock markets have been shaky; but that’s because continental Europe has been unnecessarily pushed back into recession by fiscal hawks like Greenspan.

At one point, Greenspan also pulled the usual trick of lumping Social Security together with Medicare in citing an “extraordinary rise in spending on social benefits.” Any fiscal-policy wonk knows that this is complete nonsense. According to the CBO’s most recent projections, Social Security will be fully funded from its dedicated stream of tax revenues through 2038, with no changes whatsoever. Medicare’s finances are expected to rapidly deteriorate, but that’s because the underlying growth trend of health-care costs is unsustainable – it is, however, worth pointing out that healthcare costs have actually slowed dramatically in recent years. In fact, Medicare handles costs better than most forms of private insurance. The way to ensure long-term fiscal solvency involves fixing our broken healthcare system. Period.

Greenspan also referred to the “Simpson-Bowles plan” as if the plan were some sort of bipartisan compromise that both parties should embrace. It isn’t. In fact, the president’s deficit-reduction commission, for which Simpson and Bowles served as co-chairs, failed to put forth a plan. (There was never a report that received the required approval of 14 of the 18 commission members.) The plan that was put forth was simply a plan from the co-chairs, having little to do with the commission on which they served.

Finally, Greenspan noted that markets will “crater” in another year or so if the US doesn’t get its fiscal house in order. Presumably, this is meant to imply that the US is on the same path that Greece and Portugal were on just a few years ago. The problem with this story is that the US both issues debt in and prints dollars. The same dynamic is not true for the problem countries in Europe. Countries that issue all of their debt in the currency for which they own a printing press have a high degree of flexibility. This is why Denmark, which has higher public spending levels than each of Greece, Ireland, Portugal, Italy, and Spain, has not seen its borrowing costs soar. (The Danes never surrendered their monetary sovereignty, even though the Danish krone is effectively pegged to the euro.) Or another example is Japan, which runs a debt-to-GDP ratio above 200 percent but which can still borrow very cheaply.

In short, Greenspan should have retired after his epic missed call on the housing market. He’s still failing to see things that are right in front of his eyes.

Loser Liberalism: The Rich Are Paying Their Fair Share

Friday, November 16th, 2012

Brad DeLong has a good chart, which shows how the share of taxes paid by the rich compares to that in other developed countries.

As Brad notes, as a percentage of their total income, the rich pay about what we would expect them to pay. By this measure, then, the rich are paying their fair share. The problem, of course, is that inequality has soared, leading to a situation in which the share of overall taxes paid by the rich has gone parabolic.

All of this exposes the “loser liberalism” stance on tax-and-spending policy. Liberals spend all of their time pushing for a more progressive tax system – we must end the Bush tax cuts for the rich! – when, in reality, the tax system is probably progressive enough. A more winning strategy for liberals would be to focus on lessening the disparities in before-tax incomes.

For example, pushing for a heavy speculations tax on Wall Street would go a long way toward reducing incomes for those who make a living by extracting rents in financial markets. In the same vein, ending the patent monopolies that allow pharmaceutical companies to sell drugs priced as high as a thousand percent above marginal cost would put a significant damper on the salaries of managers within pharmaceutical companies.

Think of it this way: Allowing the rich to rig the market and then focusing narrowly on taxing away their gains through higher income taxes is a lot like arguing about a bad pass-interference call after the game has already ended. One would think that a bad call should be protested the moment it’s made, not hours later when the game is already in the books.

In short, if liberals really want to make a difference in the fight for a more-equal world, then they should focus on undoing the rigging, not on redistributing the gains after the game has already ended.

RCT Exposed

Monday, November 12th, 2012

How is rational-choice theory holding up? Well, here’s an interesting paragraph in a paper I’m reading:

“[R]esearch by psychologists and economists over the past three decades has raised questions about the rationality of many of our judgments and decisions. People fail to make forecasts that are consistent with Bayes’s rule (Grether, 1980); use heuristics that can lead them to make systematic blunders (Kahneman & Frederick, 2002, p. 53; Tversky & Kahneman, 1973; Tversky & Kahneman, 1974); exhibit preference reversals (that is, they prefer A to B and B to A) (Thaler, 1992, pp. 79–91; Sunstein, Kahneman, Schkade, & Ritov, 2002); suffer from problems of self-control (Frederick, Loewenstein, & O’Donoghue, 2002, pp. 367–368); and make different choices depending on the framing of the problem (Camerer, 2000, pp. 294–295; Johnson, Hershey, Meszaros, & Kunreuther, 2000, pp. 224, 238). It is possible to raise questions about some of these findings and to think that people may do a better job of choosing in the real world than they do in the laboratory. But studies of actual choices reveal many of the same problems, even when the stakes are high (De Bondt & Thaler, 1990; Shiller, 2000, pp. 135–147; Camerer & Hogarth, 1999).”

I’d say not very well.

A Note On Substance

Monday, November 12th, 2012

I’ve been wanting to put some econometrics into this blog. (I am, after all, studying econometrics at a place that’s pretty good in that subject area.) But here’s the thing: Everything – and I really do mean everything – I’ve learned so far in my graduate metrics course is abstract. It’s good to know how to prove, for example, that OLS is BLUE under GM-i.i.d. assumptions regarding the variance-covariance matrix of epsilon given X but not under omega assumptions (in the latter case, IGLS is BLUE), but presenting such a proof here would likely bore my readers to death.

I’ve been told that the material in the spring term will be much more applied – or at least that’s what I hope.