Saturday, January 31, 2015

A Note from Irving Fisher

via twitter: from "The Debt-Deflation Theory of Great Depressions" (Econometrica, 1933). Note: the tweet was cropped a bit when I embedded it, but if you click on it you can see the entire quote.

Saturday, January 24, 2015

Deflategate

So, I guess we're sorta implicated, then...

Wednesday, January 21, 2015

Reminder: Your Major is Not Your Career

On twitter, Diana Farrell (Wes '87) points us to a fantastic interactive graphic from Williams math Professor Satyan Davadoss.
The varied paths from all the different majors is an excellent corrective to the widespread misperception that one's major determines one's career.

Franc Notes

Switzerland abruptly ended its ceiling on the euro-franc exchange rate last week, resulting in a 20% appreciation of the franc.

This highlights one fact of fixed exchange rates: no peg is forever.  This fact lends some drama to foreign exchange markets.  Normally pegs collapse in the other direction - a country which is trying to keep its currency over-valued spends down its reserves of foreign currency and faces speculative attacks from traders who believe it cannot sustain the policy, and the attacks make the policy even harder to sustain (e.g., Britain's 1992 ejection from the european exchange rate mechanism).  Since Switzerland's intervention involved keeping its currency under-valued relative to its market price, it was selling Swiss francs for euros.  In doing so, it accumulated reserves, so the possibility of running out which could have forced a crisis did not exist.

Normally, I'm not a fan of fixed exchange rates, but Switzerland's motivation for implementing the ceiling was understandable, as it faced huge financial inflows seeking a "safe haven" during some of the worst parts of the euro crisis.
On the graph, the exchange rate is the euro price of the franc, so an increase is a franc appreciation.  One can see the rapid appreciation in 2010-11 before the intervention, as well as the spike at the very end when the Swiss National Bank lifted the ceiling.

One of the problems of a fixed exchange rate is that it forces monetary policy to follow an external objective, rather than focusing on the state of the domestic economy.  In this case, Switzerland's policy had been forcing it to expand the supply of francs.  While this can be inflationary, in a world where deflation is the main worry, expansionary policy is appropriate (and Switzerland was not seeing any problems with inflation).  However, Switzerland does have low unemployment and a huge current account surplus.  Allowing its currency to appreciate will help its current account adjust.  It also means that the franc will not be locked into following the euro on its downward trend relative to the dollar and other currencies (the SNB's move also makes it easier for the ECB to exploit the exchange rate channel to stimulate the european economy).  Floating the franc does mean that the SNB once again faces the prospect of inflows seeking a safe haven - its trying to combat this with negative interest rates (the costs associated with holding large amounts of cash create a bit of space for negative returns on financial assets).

There has been quite a bit of commentary on this, which Brad DeLong nicely rounded up in one of his "socratic dialogues."  This guest post at The Economist's Free Exchange by Simon Cox of BNY Mellon seems to me like a sensible take.


An Interview

I did a short interview with Wesleyan student Jake Orlin for a class project of his.  He turned it into a nice video:
I definitely benefit quite a lot from editing.  A nice touch on his part working in Lee Iaccoca, my childhood hero.

Saturday, December 20, 2014

The Birth of Inflation Targeting

Inflation targeting, where monetary policy is directed to aim for a specific level or range for the inflation rate, has become a widespread practice.  The Times' Neil Irwin looks back at its first implementation by New Zealand; he writes:
Sometimes, decisions that shape the world’s economic future are made with great pomp and gain widespread attention. Other times, they are made through a quick, unanimous vote by members of the New Zealand Parliament who were eager to get home for Christmas.

That is what happened 25 years ago this Sunday, when New Zealand became the first country to set a formal target for how much prices should rise each year — zero to 2 percent in its initial action. The practice was so successful in making the high inflation of the 1970s and ’80s a thing of the past that all of the world’s most advanced nations have emulated it in one form or another. A 2 percent inflation target is now the norm across much of the world, having become virtually an economic religion.
Irwin goes on to provide a nice description of how and why New Zealand adopted this policy. Although it initially seemed quite successful in achieving the goal of avoiding a repeat of the high inflation if the 1970s (which continued well into the 80s in some countries) while maintaining reasonable growth rates, it has been tested by the experience of the past seven years.  One question is whether the level of 2 percent is the right one.  Irwin describes how Janet Yellen successfully argued against those at the Fed who wanted to go for zero inflation in the mid-1990s, but even 2 percent may be too low:
Starting in the late 1990s, Japan found itself stuck in a pattern of falling prices, or deflation, even after it cut interest rates all the way to zero. The United States suffered a mild recession in 2001, and the Fed cut interest rates to 1 percent to help spur a recovery. Then came the global financial crisis of 2007 to 2009, spurring a steep downturn across the planet and causing central banks to slash interest rates.

All of this has quite a few smart economists wondering whether the central bankers got the target number wrong. If they had set it a bit higher, perhaps at 3 or 4 percent, they might have been better able to combat the Great Recession because they could cut inflation-adjusted interest rates by more.
The apparent initial success as well the reasons for recent doubts can be seen in the UK's experience, which adopted inflation targeting in 1998:

(the chart data is from the OECD, via FRED.  The UK's target was initially 2.5%, but expressed in terms of a different price index measure, when it switched to using the CPI, it moved the target to 2% based on differences in the measures.)

While the UK generally has had low and (relatively) stable inflation since the early 1990s, it did miss its target considerably in 2007-2012, and it may be in danger of undershooting its target (as the Fed is) - inflation in November was 1% (this is not evident in the chart because it plots the percentage change in the price index from the year before).

Although I think the Bank of England deserves credit for not tightening in the face of inflation which ultimately proved transitory, this does call the inflation targeting framework into question.  Arguably, it may have helped keep inflation expectations "anchored" even as inflation deviated from target.  However, at some point, one would expect such deviations to undermine the credibility of the regime, and it was the idea of establishing credibility that made it attractive to academic economists in the first place (the underlying intuition for this was nicely described in this speech by Philadelphia Fed President Charles Plosser).

The other question, of whether a higher target, or a different one - such as a target price level (inflation is the rate of change of the price level) or nominal GDP - would be better is an interesting and important one.  The difficulty now is that, having established a monetary policy rule, the credibility of any new rule could be diminished by a change in rules.
 

Economics Navel-Gazing, Curricular Edition

A group of economics students in the UK have undertaken a movement to reform the economics curriculum.  I'm a little surprised that I haven't run into similar sentiments at Wesleyan - I can't decide if I'm disappointed or relieved by this.

The criticisms seem to me to be based on a somewhat unfair caricature of economics and economists, that we're head-in-the-sand apologists for "neoliberalism" who use mathematics as a form of obscurantism and have little useful to say about the "real world," particularly in the wake of the financial crisis.

Some of this may be rooted in the fact that the "economics" articulated by politicians, government officials and the press - what Simon Wren-Lewis has called "mediamacro" - does not reflect the views of most of mainstream academic economics.  In particular the obsession with government budget deficits is not based on textbook economics (I discussed an example of this misconception in a European context a couple of years ago).

Markets are at the heart of economics - this may be where the view that economists are "free market fundamentalists" comes from.  In introducing markets, though, there are really two main points to make:
  1. The gains from exchange and specialization possible from voluntary trade (i.e., Adam Smith's "Invisible Hand"), and the ability of markets make to adjustments based to dispersed information about what Hayek called "the particular circumstances of time and place" which would be un-knowable to any central planner.
  2. While economists need to make our students aware of the hidden and under-appreciated role markets play in organizing society and in lifting humanity out of subsistence-level poverty, we also devote a considerable amount of attention to how they fail.  In particular, problems of monopoly power, externalities, public goods and asymmetric information are standard subjects for introductory economics courses.  (2a., There are also reasons to be skeptical in practice of the ability of our political system to effectively correct market failures).
We do suffer from an excess of libertarians who mistakenly believe that economic theory validates their views - I usually think of these people as students who stopped listening after they learned about point #1 in first several weeks of their principles courses (or put too much weight on #2a).  But these folks are a minority in economics, though perhaps a vocal enough one that students and other outsiders might believe they are more representative than they really are.

We typically introduce markets with the model of "supply and demand," and the exercise of thinking in terms of models provides much of the lasting value of studying economics.  Working with economic models can sharpen students' logical and critical thinking skills immensely.  As John Cochrane nicely put it recently, "economic models are quantitative parables, not explicit and complete descriptions of reality." The criticism that models are "simplifications" is a cheap one - writing down a set of assumptions in mathematical form and working out the implications (and then testing them against data), is where the insight comes from.  The discipline of doing this cultivates an ability to think intelligently about tradeoffs and hidden costs, and to trace conclusions back to underlying assumptions and consider how changing assumptions lead to different conclusions.  Since models are, by necessity, very stylized descriptions of the world, students of economics must not only learn how to work with them, but also how to judge which simplifications are appropriate for a given circumstance or question.  As Keynes said, "Economics is the science of thinking in terms of models joined to the art of choosing models which are relevant to the contemporary world."

So I think the core of what we try to do in our introductory economics courses - introducing markets (both their successes and failures), and teaching students how to think in terms of models - is extremely worthwhile.  Of course, this does not cover everything that we possibly would like to do in a course (or in small set of courses).  Much of economics is concerned with the allocation of scarce resources, and the time that our students can spend on a course in a semester (both in and out of the classroom) is very limited, forcing some difficult choices on instructors.  Some of the criticisms made by the UK students seem to be about what we're leaving out, though I think what we're doing in our introductory courses is pretty important, and laying some groundwork in the economic way of thinking will help the students tackle issues like understanding the financial crisis, either in later classes or independently.  While many of the debates in the news are about macroeconomic policy (and as a macroeconomist, I'm happy to see the revival of interest in the topic, even if arises from unfortunate sources), the core microeconomic concepts are very important and not to be skipped.  While it can be exciting to be teaching a subject that is relevant to contemporary events, we should not be seduced into bringing "news" into the classroom in a way that interferes with developing an understanding of the fundamentals.

There is sometimes a bit of a muddle in these navel-gazing discussions, too, between what should be in our undergraduate curriculum and the separate, but not wholly unrelated, issue of our research agenda and graduate curriculum.  I'm not entirely unsympathetic to the calls for "methodological pluralism" though I wouldn't go as far as the UK students would like.  I have argued for graduate study of the history of economic thought, and I have emphasized it in my undergraduate teaching, using it as an organizing principle for my intermediate macroeconomics class (and also making my intro students read some Smith, Hayek, Friedman and Keynes).  As a field, I do think macroeconomics is at a point where we should be open to reconsiderations of some of the standard tools (though I don't think that is ever not the case), and I worry that the "publish or perish" incentives we all face mean that we do too little of that.

Karl Whelan of University College, Dublin has a written nice essay "Teaching Economics 'After the Crash'" with a more detailed response to the UK students' criticisms which is well worth reading.

Friday, November 28, 2014

Gray Matter and the US Current Account

After increasing steadily from the mid-1990s through the mid-2000s, the rate at which the US is borrowing from the rest of the world - our current account deficit - has come down considerably.
The current account deficit peaked at around 6% of GDP in 2006 and has hovered around 2.5-3% over the past several years.

During the period when it looked like the US current account deficit was growing inexorably, there was quite a bit of discussion of "global imbalances" and whether or not the US' borrowing was sustainable.

Despite years of borrowing, the US tends to earn a positive balance on income - i.e., the US receives more in payments on assets it owns abroad than it makes to foreign owners of US assets.  Ricardo Hausmann and Federico Sturzenegger argued that national accounts understate the true value of US foreign assets.  They called the gap between the accounting value and the true value "dark matter", which they largely attributed to the know-how exported (but not properly measured) with US FDI.  (I revisited this idea in a previous post).

Writing at Project Syndicate, Jeffrey Frankel offers another idea on why our balance of payments accounts may make the US deficit look worse than it really is:
Every year, US residents take some of what they earn in overseas investment income – interest on bonds, dividends on equities, and repatriated profits on direct investment – and reinvest it then and there. For example, corporations plow overseas profits back into their operations, often to avoid paying the high US corporate income tax implied by repatriating those earnings. Technically, this should be recorded as a bigger surplus on the investment-income account, matched by greater acquisition of assets overseas. Often it is counted correctly. But there is reason to think that this is not always the case...

...For example, US multinational corporations sometimes over-invoice import bills or under-report export earnings to reduce their tax obligations. Again, this would work to overstate the recorded current-account deficit.
While the efforts that US multinationals make to evade their tax obligations are probably technically legal in most cases, they go against the spirit of the US tax law, which taxes US corporations based on their global earnings (whether it should be this way is another matter).  Since it arises from a gray area in our tax code, perhaps the we should call the resulting gap between our measured and true foreign assets "gray matter."

Friday, November 7, 2014

October Employment

A good report today from the BLS on employment in October:  the unemployment rate fell to 5.8% (from 5.9%) and employers' payrolls rose by 218,000.
The payroll figure comes from a survey of firms, while the unemployment rate is based on a survey of households (which has a smaller sample than the employer survey).  The household survey figures look even better: the number of people employed rose by 683,000, and the number unemployed fell by 267,000.  The labor force (i.e., people who are working or looking for work) rose by 416,000, which put the labor force participation rate at 62.8%, an increase from last month's historic low of 62.7%. 

The decline in labor force participation (which was at 66% in late 2007) has been one of the worrying trends of the past several years.  It partly reflects demographics, though, as the population is becoming older and a larger portion of the population is of retirement age.  Looking at the employment-population ratio for 25-54 year olds gives a picture of the labor market that takes out some of the guesswork in interpreting participation:
This ratio increased from 76.7 to 76.9 in October.  Overall, it shows some recovery over the past three years, but also gives an indication of why many Americans remain unhappy with the state of the economy - it is still less than halfway back from its low point to its pre-recession level.

Moreover, while employment is improving, wages are still growing slowly - the BLS reports that average hourly wages have increased 2% over the past year.  This suggests that there is still plenty of "slack" in the labor market.

The BLS' broader measure of un- and under-employment, 'U-6', which includes the "marginally attached" and people working part-time who want to be full-time, is at 11.5%, down from 11.8% last month (it peaked at 17.2% in April 2010).

Wednesday, September 17, 2014

Information Overload

We've arrived at the point in Econ 302 this semester where we're reading Paul David's "The Dynamo and the Computer: An Historical Perspective on the Modern Productivity Paradox" which means that I find myself again marveling at the prescience of this:
That's a pretty amazing thing to have written in 1989! (the paper was published in the May '90 American Economic Review, which has papers presented at the meeting in early January 1990).

For a nice (and un-gated) summary of David's argument, see this Tim Harford piece in Slate.