Sunday, September 30, 2007

A Primer on "Core" Inflation

When explaining its monetary policy decisions, the Fed often speaks of "core inflation" - that is, an inflation rate calculated without food and energy prices, which tend to be rather volatile. Of course, food and energy are major expenses for most people, so you wouldn't want to throw them out of a calculation of the "cost of living." For the most part recently, "core" inflation has been lower than overall inflation, or as Daniel Gross explained, "If You Don't Eat or Drive, Inflation's No Problem." On his blog, Berkeley's Brad De Long defends the Fed's practice of focusing on "core" inflation:
The Federal Reserve's mandate to maintain price stability requires that whenever significant inflation threatens it is supposed to hit the economy on the head with a brick: raise interest rates, and so discourage investment spending, lower capacity utilization, raise unemployment, and so create excess supply. The Federal Reserve would rather not do this unless it has no other option. If the rise in inflation is thought to be (a) transitory and thus (b) self-limiting, the Fed would prefer to let sleeping dogs lie rather than hit the economy on the head with a brick.

The Fed cannot, however, just say "we regard this rise in inflation as (a) transitory and thus (b) self-limiting, and so are going to let sleeping dogs lie." A Fed that does that quickly loses its credibility as an inflation-fighter, and a modern central bank with no inflation-fighting credibility is in a world of hurt.

However, when increases in inflation are confined to (i) energy and (ii) food prices, odds are that the increase is transitory and will be self-limiting. Hence the concept of "core inflation." If the Federal Reserve concludes that the current rise in inflation is transitory and self-limiting, it can point to the core inflation number as a principled excuse for not hitting the economy on the head with a brick.

The Fed's favorite measure is the "core" deflator for personal consumption expenditures (PCE) reported by the Bureau of Economic Analysis (in addition to the GDP deflator, the BEA calculates separate deflators for each component. Overall GDP statistics are quarterly, but the BEA provides monthly data on consumption). Here's how it looks (% changes from 1 year ago):

Clearly overall PCE inflation is more volatile than the "core" - taking out food and energy prices makes inflation appear more steady. Also, core inflation has mostly been lower than overall inflation - food and energy prices have been going up faster than the prices of consumption goods generally. That is, the inflation rate the Fed is responding to is less than the one we consumers are experiencing. (BEA data via FRED).

Marginal Utility of What?!

In 1930, Keynes predicted that economic growth would lead to a tremendous increase in leisure time. I recently had my principles students read a NY Times column by Bob Frank where he examined the failure of this prediction. Frank says "decisions to spend are also driven by perceptions of quality, the desire for which knows no bounds. But quality is an inherently relative concept." So, although productivity growth and capital accumulation mean that we could have had rising standards of living and more leisure, we find ourselves working to produce (and be able to afford) goods of ever-higher perceived quality. That came to mind when I read this in the Cincinnati Enquirer:
P&G Launches Smart Toothbrush

Oral-B, the toothbrush brand from the Procter & Gamble Co., announced on Friday it is launching Oral-B Triumph with SmartGuide, a wireless display that allows users to time their brushing....

The company says SmartGuide combines the brushhead, handle and visual display so users receive prompts from microchips. These prompts tell users when they are brushing too hard, when to move to the next quadrant of the mouth and when brushing has lasted two minutes. It also indicates when it is time to replace the brushhead.

One of the weaknesses of mainstream economic theory is the way that we think of preferences. In particular, we typically assume that preferences for particular goods or attributes are an intrinsic, or primitive, aspect of the individual. However, the example above reminds us of something that John Kenneth Galbraith pointed out: businesses are constantly working to create preferences for goods we never imagined we might want. (Here's Brad De Long's review of Richard Parker's fine biography of Galbraith, who passed away last year).

Wednesday, September 26, 2007

A Most Useful Corrective

One of the things I like most about economists is that, in general, we are good critical thinkers who eschew dogma and ideology. Unfortunately, we seem to fall into some bad habits when it comes to certain issues - trade, in particular. That's why I found this paper, "Deconstructing the Argument for Free Trade" by Robert Driskill of Vanderbilt such a useful corrective. From the introduction:
The claim we make here is that, in light of economists' apparent settled judgment on the issue of trade liberalization, the profession has stopped thinking critically on the question and, as a consequence, makes poor quality arguments justifying their consensus.
It came to my attention via Dani Rodrik's blog. Rodrik says "Once in a while you come across a paper that makes you nod in agreement and go "yes!" with every sentence you read."

Tuesday, September 25, 2007

Outsourcing in Circles

Some of India's outsourcing firms are setting up shop outside India. Anand Giridharadas reports in the NY Times "Outsourcing Works, So India Is Exporting Jobs." Among the locations mentioned are the Czech Republic, Mexico, and the United States:
In a poetic reflection of outsourcing’s new face, Wipro’s chairman, Azim Premji, told Wall Street analysts this year that he was considering hubs in Idaho and Virginia, in addition to Georgia, to take advantage of American “states which are less developed.”

Sunday, September 23, 2007

Don't Look Down!

The greenback has sunk to parity with the Canadian loonie, and hit its all-time low against the Euro. In part, this reflects the Fed's interest rate cuts, which made investing in dollars less attractive. But the dollar's slippage does raise a bigger worry - that we could be headed for a current account "reversal." The the flip side of the US trade deficit (5.2% of GDP last quarter) is a "capital inflow" - in exchange for the goods they send us in excess of the goods we send them, our trading partners receive financial assets. That is, the US economy has become heavily dependent on borrowing from abroad. If our foreign creditors anticipate further declines in the dollar, they have an incentive to sell their US financial assets now... which would cause the dollar to fall further, which gives more reasons to unload dollar-denominated assets before everyone else does....

Or, as Paul Krugman asks, "Is This the Wile E. Coyote Moment?" There is considerable academic debate on the "sustainability" of our current account deficit (I seriously doubt it). If there is a reversal, does it come gradually, or all at once in an emerging-market style crisis? The upside of a dollar rout would be that exporting and import-competing industries would gain a price advantage over their foreign rivals (though it takes a while for exchange rate changes to "pass through" to consumer prices). The downside for consumers would be higher prices for imported goods (which would show up as inflation in our price indexes, presenting the Fed with a dilemma). More importantly, if the inflow of foreign finance is curtailed, long-term real interest rates would rise significantly.

Recall that GDP is the sum of government purchases (G), consumption (C), investment (I) and net exports (NX). The fact that NX is a negative number allows C + I + G to add up to more than 100% of GDP. The decline in the dollar would help with NX (our exports become cheaper to foreigners and imports become more expensive). Higher interest rates would reduce C and I. If the current situation is unsustainable, some rebalancing is necessary over the long run, but if it happens quickly, it could be quite unpleasant....

Krugman's asking the right question... has our ACME capital inflow kit (undoubtedly made in China) allowed us to run off the edge of a cliff? Is it time to turn to the kids watching at home and hold up a sign that says "gulp!"? However, if I'm correct on the laws of cartoon physics, we won't fall unless we look down.

On a related note, Ben Bernanke revisited his "savings glut" hypothesis of the current account deficit in a recent speech. This deserves more attention, but I'm not sure I'll get to it (fortunately, Econbrowser's Menzie Chinn did).

NB: the "current account" and trade deficits are not exactly the same, but they are closely related. The current account includes the trade deficit and also net income on foreign assets, but the trade deficit accounts for most of it.

Update (9/25): Here's The Economist's take (they're not so worried), and an op-ed by Morgan Stanley's Stephen Roach (who is worried).

People are from Earth, Economists are from Vulcan

In today's NY Times Economic Scene column, Austan Goolsbee looks at the departure from economically rational behavior known as "loss aversion," which may interfere with home sales as prices slump. He writes:
Economists and other humans don’t always see eye to eye. “Economists tend to think people are crazy because they won’t sell their houses for less than they paid for them — and people think economists are crazy for thinking things exactly like that,” said Professor Christopher Mayer, director of the Paul Milstein Center for Real Estate at Columbia Business School and an authority on real estate economics....

Classical economics can’t explain this behavior. That’s because people who refuse to sell their houses for less than they paid for them are violating a cardinal rule of the market: stuff is worth what it’s worth. It doesn’t matter what you paid for it. But when Professor Mayer and his co-author, David Genesove, a professor of economics at the Hebrew University in Jerusalem, studied the Boston condominium market in the 1990s — scene of one of the biggest real estate busts in recent American memory — the actual patterns of human behavior did not seem to follow the standard rules at all...
As any thinking student of economics realizes, our traditional assumptions about human behavior are not realistic. The goal of economic models is not "realism," however. Even the most elaborate economic model is a vast simplification of an infinitely complex reality. A model which accurately predicts how people will behave is a useful one - Milton Friedman's famous example* is that one could use physics to analyze the shots of a professional billiard player. Even though the player is using instinct and senses, the rules of physics can be used to make accurate predictions of the player's shots. Similarly, utility maximization may make good predictions of human behavior, even though people aren't solving constrained optimization problems in the grocery store.

Goolsbee's column points us to a case where our lack of realism may get us into trouble. The good news - for economic methodology but not home sellers - is that the economics profession recognizes the problem, and some people are working on it. Meyer and Genesove's paper was published in the Quarterly Journal of Economics, one of the most prestigious journals in the field, and Goolsbee himself is a faculty member at Chicago, hardly a backwater of heterodoxy.

*Friedman's example is in a 1953 article titled "The Methodology of Positive Economics," which is a must-read for students of economics.

Wednesday, September 19, 2007

Bernanke Credibility Watch

The Federal Reserve lowered its target for the federal funds rate by 50 basis points (hundredths of a percent) to 4.75%. James Hamilton at Econbrowser examines the reactions of the bond, stock, currency, oil and gold markets. This is cause for concern:
But the really interesting thing is what happened at the longer end of the yield curve. The ten-year nominal yield actually increased, which is in contrast to the usual historical pattern for long yields to move, albeit less dramatically, in tandem with the short. Taken together with today's fall in the 10-year inflation-adjusted Treasury yield, the bond market seems to view the Fed as having surrendered some on its long-run inflation goals.
Expectations are important for monetary policy. Long-term interest rates reflect, in part, inflationary expectations. The increase suggests that markets are now anticipating looser monetary policy, which will lead to more inflation. That is, the Fed's credibility as guarantor of low inflation seems to have been dented, early in Ben Bernanke's tenure as chairman.

Tuesday, September 18, 2007

Bank Run!

Nervous depositors lined up down the street and around the block to get their money out of the bank. A scene from the US in the depression? From one of the "emerging market" financial crises in that occurred in Asia and Latin America in the 1990's?

Nope. Britain, September 2007. The NY Times has the story, as do The Guardian and Financial Times.

In the US, deposit insurance has made banking panics largely a thing in the past - people know that the FDIC will take care of them if their bank fails. Britain's deposit insurance is less generous, but the government has promised to make the depositors whole. But many still want their money out. Here's a comment from the FT on the UKs deposit insurance scheme, and a critique of the government's action from Willem Buiter of the LSE.

Monday, September 17, 2007

Clinton-care Redux

Health care reform is back, and so is Hillary Clinton. In 1993, she played a prominent role in developing the Clinton administration's plan to reform the health care system. At the time, change seemed inevitable due to rising costs and growing ranks of uninsured. Everyone was offering reform plans (I remember attending a presentation of a universal health insurance plan from the right-wing Heritage foundation!). However, the Clinton plan did not get through Congress, there was no "reform," and 14 years later costs are higher and even more Americans are uninsured.

The ill-fated reform attempt seems to have entered national mythology as follows: In 1993, a secret cabal led by the First Lady - Bill's "liberal" (gasp!) wife - concocted a complicated scheme to impose "socialized" (gasp gasp!) medicine on the United States. That's basically what many people seem to think, but its simply not true.

In The American Prospect, Paul Starr provides an extremely useful debunking of "The Hillarycare Mythology." He knocks down a number of misconceptions about the 1993 episode. Most importantly, the Clinton plan was not "socialized" medicine - it gave consumers choices among private insurers. Here's Starr's characterization of the way the plan would have worked:
The basic idea was not complicated. Consumers, not employers, would choose health plans. Firms would pay into a regional health insurance purchasing cooperative (later called an "alliance" in the Clinton plan), which would offer private plans of varying types to all residents under age 65 in an area (Medicare would remain separate). The alliances would be required to offer traditional, fee-for-service insurance as well as health maintenance organizations and preferred provider plans. Benefits, copays, and other features would be standardized so as to make it easier for consumers to compare prices and get the best value for money. Health plans would have to offer coverage to everyone without exclusions of preexisting conditions, and they would be paid according to the characteristics of the population they enrolled...
Once more into the breach, candidate Clinton has offered her plan. Here's the NY Times story, and an assesment by Ezra Klein.
Another useful thing to read on this topic is "The Health of Nations," a comparison of national health care systems in The American Prospect by Ezra Klein.

Saturday, September 15, 2007

Easy as MSB = MSC

There are some things that seem so obvious after intermediate microeconomics, but unfortunately much of the citizenry hasn't had that pleasure... One example is the use of Pigouvian taxes on externalities to equate marginal social costs and benefits. In the NY Times, Greg Mankiw makes the case for a carbon tax:
IN the debate over global climate change, there is a yawning gap that needs to be bridged. The gap is not between environmentalists and industrialists, or between Democrats and Republicans. It is between policy wonks and political consultants.

Among policy wonks like me, there is a broad consensus. The scientists tell us that world temperatures are rising because humans are emitting carbon into the atmosphere. Basic economics tells us that when you tax something, you normally get less of it. So if we want to reduce global emissions of carbon, we need a global carbon tax. Q.E.D.

Mankiw explains why a carbon tax is preferable to fuel economy regulations and cap-and-trade. Politically, its a tough sell. Mankiw offers an idea to make it go down easier:

Yet this natural aversion to carbon taxes can be overcome if the revenue from the tax is used to reduce other taxes. By itself, a carbon tax would raise the tax burden on anyone who drives a car or uses electricity produced with fossil fuels, which means just about everybody. Some might fear this would be particularly hard on the poor and middle class.

But Gilbert Metcalf, a professor of economics at Tufts, has shown how revenue from a carbon tax could be used to reduce payroll taxes in a way that would leave the distribution of total tax burden approximately unchanged. He proposes a tax of $15 per metric ton of carbon dioxide, together with a rebate of the federal payroll tax on the first $3,660 of earnings for each worker.

Eminently sensible, but I'm not holding my breath. Mankiw is advising Mitt Romney's campaign - if he can get Romney to come out for a payroll for carbon tax swap, I will be very impressed, with both of them.

Now He Tells Us

The Washington Post's Bob Woodward managed to get his hands on Alan Greenspan's memoir ahead of its release on Monday (maybe someone gave it to him in a parking garage!). He reports:
Alan Greenspan, who served as Federal Reserve chairman for 18 years and was the leading Republican economist for the past three decades, levels unusually harsh criticism at President Bush and the Republican Party in his new book, arguing that Bush abandoned the central conservative principle of fiscal restraint.

While condemning Democrats, too, for rampant federal spending, he offers Bill Clinton an exemption. The former president emerges as the political hero of "The Age of Turbulence: Adventures in a New World," Greenspan's 531-page memoir, which is being published Monday.

Greenspan, who had an eight-year alliance with Clinton and Democratic Treasury secretaries in the 1990s, praises Clinton's mind and his tough anti-deficit policies, calling the former president's 1993 economic plan "an act of political courage."

But he expresses deep disappointment with Bush. "My biggest frustration remained the president's unwillingness to wield his veto against out-of-control spending," Greenspan writes. "Not exercising the veto power became a hallmark of the Bush presidency. . . . To my mind, Bush's collaborate-don't-confront approach was a major mistake."

Greenspan accuses the Republicans who presided over the party's majority in the House until last year of being too eager to tolerate excessive federal spending in exchange for political opportunity. The Republicans, he says, deserved to lose control of the Senate and House in last year's elections. "The Republicans in Congress lost their way," Greenspan writes. "They swapped principle for power. They ended up with neither."

Of course, Greenspan played a key role in the shift from Federal budget surpluses in the late 1990's to deficits today. His January 2001 testimony to the Senate Budget Committee helped get President Bush's tax cuts - which led to the deficits - passed. His stated reason was concern that the budget surpluses would eventually lead to the government becoming a large owner of private assets - i.e., after repaying the existing Federal debt, the government would invest the surpluses in stock and bond markets. The key sentence from his testimony:

In general, as I have testified previously, if long-term fiscal stability is the criterion, it is far better, in my judgment, that the surpluses be lowered by tax reductions than by spending increases.
That is a reflection of Greenspan's political preferences (he calls himself a "libertarian Republican"), and completely unrelated monetary policy, which is the Fed's purview. In a NY Times column titled "Et Tu, Alan" Paul Krugman wrote:

...The headlines were all about Mr. Greenspan's endorsement of tax cuts -- something the Fed chairman must have known would happen. And when you look at the tortured logic by which Mr. Greenspan arrived at that endorsement, you have to wonder whether those headlines weren't exactly what he wanted...

...Mr. Greenspan was out of bounds. Since when is it the Fed's business to say that we should have a tax cut rather than, say, a new prescription drug benefit -- or for that matter a missile defense system?...

But the really strange thing about his argument was that he seemed to ignore the fact that the main reason the federal government will one day become an investor is the buildup of assets in the hands of the Social Security and Medicare systems -- and those funds must accumulate assets to prepare for the future demands of the baby-boom generation. Indeed, by all estimates even the huge projected surpluses of those trust funds will be inadequate to the task. ''Certainly,'' Mr. Greenspan declared, ''we should make sure that Social Security surpluses are large enough to meet our long-term needs.'' Well, I'm sorry, but you can't do that without allowing the federal government to become an investor.

So if that prospect was what was really worrying Mr. Greenspan, he should have focused on the problem of how to prevent the government's position as an investor from being abused. And there are many ways to do that -- including, by the way, realistic plans for partial privatization of Social Security, which (unlike the fantasy promises of the Bush campaign) would require the federal government to ante up trillions of dollars to pay off existing obligations, solving the ''problem'' of excessive surpluses quite easily.

But Mr. Greenspan seemed determined to arrive at tax cuts as an answer...

When a man who is usually a clear thinker ties himself in intellectual knots in order to find a way to say exactly what the new president wants to hear, it's not hard to guess what's going on. But it's not a pretty sight.

The criticisms Greenspan makes in his book of Republican policies might have made a difference if he'd offered them earlier - in 2004, perhaps. Would he have been overstepping the bounds of his role as chairman of the Federal Reserve to do so? Possibly. However, it is legitimate for the Fed chairperson to weigh in on the fiscal position of the government, but only insofar as it affects monetary policy. For example, the Reagan tax cuts and associated deficits in the early 1980's forced the Fed to raise interest rates even further. If the economy is a "car with two drivers" - monetary and fiscal - Reagan's stepping on the fiscal "gas" forced the Fed to hit the monetary "brakes" ferociously, resulting in the worst recession since the depression. In such a situation, it would have been appropriate for the Fed to point out that tax cuts caused interest rates to be higher than otherwise.

At the time of his testimony, the US was coming to the end of the longest economic expansion in its history. Stock tickers were ubiquitous. Greenspan was a celebrity and viewed as somewhat of an economic oracle - "Maestro," Woodward's book about him, was on the bestseller list. What he did in 2001 was to use his prestige to push his own - Ayn Rand-influenced (yikes!) - view of the role of government in society. Now that its too late, he tells us he regrets the consequences.

Update (9/18): Brad deLong has a favorable (and amusing) take on Greenspan and his book. Krugman is not amused. Current Bush admin. official and former House Budget chair Jim Nussle sees Monday morning quarterbacking.

Thursday, September 13, 2007

Central Bank Trash Talk

The NY Times reports:
In an unusual public display of discord, the British central bank criticized other central banks yesterday for injecting cash into the financial system to help stabilize credit markets, saying that such a policy amounted to a bailout of investors who made bad decisions.
The swipe came in this testimony submitted by Mervyn King, the Governor of the Bank of England (Britain's central bank - King's position is equivalent to Ben Bernanke's in the US) to a Parlimentary committee:
The main thrust of his written testimony to Parliament, however, was a sharp warning about “moral hazard” — a term used to describe the downside of policies that effectively rescue investors when their bets turn out wrong.

“The provision of such liquidity support undermines the efficient pricing of risk by providing ex-post insurance for risky behavior,” Mr. King wrote. “That encourages excessive risk-taking and sows the seeds of a future crisis.”

He didn't name names - the British do that understatement thing - but that could be taken as a strong implicit criticism of the Fed and European Central Bank, which have actively tried to inject funds to stabilize financial markets (earlier posts on the Fed's actions here and here).

Update (9/14): Perhaps he spoke too soon. The Bank of England is bailing out Northern Rock, a mortgage lender. Willem Buiter says: "I can only conclude that the Bank of England is a paper tiger. It talks the ‘no bail out’ talk, but it does not walk the talk."

Monday, September 10, 2007

Economic Development and Economic History

I really should have attended the Economic History Association conference in Austin this weekend. Brad DeLong has posted his talk "Marx, Rostow, Kuznets, Gerschenkron" from a session on "The role of economic history as a guide to economic development." The talk is full of interesting ideas, combining intellectual history with a strong case for the importance of economic history in understanding development.

The August Job Loss

The Bureau of Labor Statistics reported "nonfarm payroll employment was essentially unchanged," declining by 4,000 (out of 138 million) in August. That number came from the BLS survey of firms (the "establishment survey"). The most closely watched statistic about the labor market - the unemployment rate - comes from their survey of households; it was unchanged at 4.6%.

The household survey did have some bad news, though - it also reported declines in total employment, as well as in the labor force (the number of people working or looking for work). The number of unemployed persons also fell; the unemployment rate is the number of unemployed as a fraction of the labor force - in August both the numerator and denominator decreased, leaving the fraction the same. The decline in labor force participation may be a sign people are discouraged about job prospects.

The Wall Street Journal's Real Time Economics had reactions from Wall Street "economists", who were worried (hint, hint, Bernanke) and from politicians, who were - predictably - divided.

At Econbrowser, Menzie Chinn draws a parallel with the last recession.

As a caution on reading too much into one month's numbers, it should be noted that there are occasional bad months even during expansions - during the 1990's expansion, payroll employment declined in March 1993, May 1995, January 1996 and August 1997, and that the payroll employment figure is preliminary and subject to revision by the BLS.

Thursday, September 6, 2007

To Laff er to Cry

In the New Republic, Jon Chait explains "How Economic Crackpots Devoured American Politics." He writes:
American politics has been hijacked by a tiny coterie of right-wing economic extremists, some of them ideological zealots, others merely greedy, a few of them possibly insane. The scope of their triumph is breathtaking. Over the course of the last three decades, they have moved from the right-wing fringe to the commanding heights of the national agenda. Notions that would have been laughed at a generation ago--that cutting taxes for the very rich is the best response to any and every economic circumstance or that it is perfectly appropriate to turn the most rapacious and self-interested elements of the business lobby into essentially an arm of the federal government--are now so pervasive, they barely attract any notice.
The article details the influence of the "Laffer Curve" - the proposition that, since at 100% taxation, there is no incentive to work and therefore (theoretically) no output would be produced and no revenues would be collected, a cut in tax rates would increase tax revenues. Logical enough, but this idea has morphed into the idea expressed by some politicians - indeed, it seems to be Republican dogma nowadays - that tax cuts raise revenues in general. Which is simply not true. Real economists, who happen to be Republicans, like President Bush's former economic advisor Greg Mankiw, don't believe it. But the idea refuses to die... In an earlier post I suggested it was a good example of "Agnotology," the production of ignorance.

The problem is not whether a particular tax policy is good or bad, but the terms of the argument - as Matthew Yglesias explains well:
There's a systematic effort by the right to convince people that tax cuts are not merely beneficial in some ways or beneficial all things considered but that there are actually no tradeoffs whatsoever.
Its easy to see why such a politically convenient idea might take on a life of its own. But it does raise an interesting question of why the economics profession has not succeeded in discrediting it, and whether people like Mankiw - who supported President Bush's tax cuts even though he never believed one of the main arguments the President frequently offers - bear some responsibility. Ezra Klein says:
Jon Chait is right that the supply siders are maniacs, but they aren't marginalized maniacs, and that's in part because that economics profession hasn't seen fit to marginalize them. Mankiw may say, in his textbooks, that they're charlatans, but when push came to shove he joined their cause, disagreeing, he says, with some of their nuttier claims, but nevertheless lending them and their claims -- which included, in the Bush administration, such ideas as "returning to Clinton-era levels of taxation would wreck the economy, that retirement security can best be provided to all by expanding tax breaks for rich people, that health care can best be improved by expanding tax breaks for rich people," etc -- his name and credibility.
Megan McArdle defends Mankiw, and Matthew Yglesias responds. The Economist's Free Exchange weighs in (they, too, cannot resist bad "Laff" puns).

Chait's article is excerpted from his new book, "The Big Con: The True Story of How Washington Got Hoodwinked and Hijacked by Crackpot Economics," which might be a better way of spending my weekend than painting the guest bedroom...

Cone of Silence

I was shocked to learn that my international trade students were unfamiliar with the Cone of Silence (not to be confused with the Cone of Diversification). I can only conclude that children today aren't raised properly - in front of the TV watching reruns - as I was. Or perhaps they just watched different reruns?

For the sake of cultural literacy, via YouTube, a demonstration of the cone, and the classic opening of the show, "Get Smart." Here's more about the show. The movie, starring Steve Carrell and Anne Hathaway should raise awareness of the threat from KAOS when it comes out next year.

Monday, September 3, 2007

Foreign Aid

In his review of Paul Collier's The Bottom Billion (today's Econ 202 reading), Niall Ferguson alludes to the broader debate over the effectiveness of aid to low-income countries. The most visible academic protagonists are Jeffrey Sachs of Columbia, who believes that more aid could considerably boost living standards, and William Easterly of NYU, who is a critic of aid.

Here are opinion pieces (pdf) from the LA Times by Easterly, "The Handouts That Feed Poverty," and Sachs, "Foreign Aid Skeptics Thrive on Pessimism." For a less polemical consideration of the issue, see "Aid: Can It Work?" by Nicholas Kristof in the New York Review of Books.

Easterly titled his latest book "The White Man's Burden" after a poem by Rudyard Kipling, implying a parallel between modern aid efforts and 19th century colonialism (not very nice!).

Swapping Lemons with China

The US trade deficit with China is essentially an exchange of goods for financial assets; rather than getting an equal amount of goods in exchange for what they sell to the US, the Chinese are getting financial assets - stocks and bonds, etc. - in return. Or, in other words, the Chinese are purchasing US financial assets with their goods.

Lately, there has been much attention the fact that some of the goods we are importing from China have turned out to be unsafe - toys with lead paint, for example. As Dani Rodrik explains, the recent credit crisis has shown that many of the financial assets that we are selling to the Chinese (and other foreign investors) are also, arguably, unsafe.

Sunday, September 2, 2007

Misunderestimating Growth

The Economist's Free Exchange blog examines why the transformative power of economic growth is so little appreciated.
The now-well-documented historical record suggests that economic growth has done more for the welfare of humanity than any moral creed or non-economic initiative meant to improve the dignity and quality of human life. So why is there no treatise required of all undergraduates singing growth's praises and setting it out as a moral imperative for all decent peoples?
The post discusses several explanations: (i) people do not understand compounding growth, (ii) historically speaking, sustained growth is a relatively new phenomenon, and much of our religion and philosophy predates it and (iii) we find it easier to imagine future disasters than the positive effects of growth.

An illustration of the power of growth from principles class is that Japan and Mexico both had real per capita GDP of just over $1,000 (in 1990$) in 1890. Over the next 110 years, Mexico's per capita GDP increased sevenfold (!) to $7,249, and Japan's increased twenty-one times (!!) to $21,051. Mexico's average annual growth rate over the period was 1.8%, and Japan's was 2.8% - only 1% higher, but over 110 years that is the difference between being a "rich" and a "middle income" country. [data are from the best spreadsheet ever, Angus Maddison's Historical Statistics for the World Economy: 1-2003 AD]

One person who understood compound growth was John Maynard Keynes. In his famous essay "Economic Possibilities for our Grandchildren," he foresaw growth solving the "economic problem" of scarcity and making possible dramatic social changes and liberation from social values oriented towards capital accumulation:
When the accumula­tion of wealth is no longer of high social im­portance, there will be great changes in the code of morals. We shall be able to rid our­selves of many of the pseudo‑moral principles which have hag‑ridden us for two hundred years, by which we have exalted some of the most distasteful of human qualities into the position of the highest virtues. We shall be able to afford to dare to assess the money‑motive at its true value. The love of money as a possession ‑ as distinguished from the love of money as a means to the enjoyments and realities of life ‑ will be recognised for what it is, a some­what disgusting morbidity, one of those semi­criminal, semi‑pathological propensities which one hands over with a shudder to the specialists in mental disease.
With scarcity behind us,
for the first time since his creation man will be faced with his real, his permanent prob­lem ‑ how to use his freedom from pressing economic cares, how to occupy the leisure, which science and compound interest will have won for him, to live wisely and agreeably and well.
Although Keynes understood the power of growth, it seems he underestimated our ability to create new material wants, and perhaps overestimated how quickly our value systems could change.

As for why we still fail to appreciate economic growth, I would add a fourth reason: we don't really know how to improve it. Although there is quite a bit of fascinating research being done, the improvements of "total factor productivity" that are the main driving force of growth remain elusive. Moses Abramovitz once described the Solow residual (which is how total factor productivity is measured), as a "measure of our ignorance." That still holds some truth today.