Tuesday, February 26, 2008

Academia: Not Like Business

On his NY Times blog, Stanley Fish weighs in on the controversy over the appointment of a businessman who lacks an advanced degree as the new president of the University of Colorado. Fish explains why business acumen may not be so useful in running a university:
It is no doubt true that an experienced executive will quickly learn the ropes of an industry new to him. The product may be different, but the tasks will be basically the same: assess market share, learn the routes of distribution, fine-tune the relationship between inventory and demand, increase efficiency perhaps by downsizing the workforce.

But in the academy there is no product except knowledge, and that may take decades to develop, if it develops at all. The concept of market share is inapposite; efficiency is not a goal; and there is no inventory to put on the shelves. Instead the norms are endless deliberations, explorations that may go nowhere, problems that only five people in the world even understand, lifetime employment that is not taken away even when nothing is achieved, expensively labor-intensive practices and no bottom line. What is an outsider to make of that?

Monday, February 25, 2008

Candidates on the March

in the wrong direction....

In the Senate, John McCain opposed the 2001 and 2003 tax cuts, but now he is out to prove that he has imbibed the supply-side kool aid with a tax plan that shows the zeal of the converted. Len Burman of the Tax Policy Center looks at it and says "McCain calls Bush, and Raises Big Time" -
Some conservatives back huge tax cuts because they think the government would just waste the money that would otherwise pour into government coffers. While it's true that a growing economy (and the voracious AMT) would cause federal revenues to grow to over 20 percent of GDP by 2018 under current law, the Post reports (based on my estimates) that Mr. McCain's tax cuts would slash tax revenues to 16.6 percent of GDP in 2018. By comparison, the postwar average of tax revenues was over 18 percent of GDP, and the federal government will face enormous pressures as the baby boomers begin to retire.
According to the CBO, federal government spending amounted to 20% of GDP in fiscal year 2007, so that would leave a big gap (especially if we have more war). McCain likes to talk up his opposition to Congressional "earmarks" for projects back home, but even eliminating them entirely would not make much of a dent in the deficit (they totaled $18.3 billion - less than one percent of federal outlays).

Newsweek's Daniel Gross thinks McCain doesn't really mean it. One can hope.

And hopefully the Democratic candidates don't really mean some of the things they're saying either. As the campaign rolls into Ohio, Obama and Clinton are fighting over who hates international trade more. Although there are more nuances than economists sometimes care to acknowledge - I have some sympathy with Dani Rodrik's defense of Clinton (see this previous post) - the Lou Dobbsian rhetoric is taking us further away from a serious discussion of the challenges, and opportunities, of a global economy. Or, as Lawrence MacDonald puts it on the Center for Global Development's blog: "Earth to Dems: Enough with the Trade Bashing Already."

As if trashing NAFTA weren't enough, Obama also has floated a proposal to give to give tax breaks to "Patriot Employers." Last week, Clive Crook described it as "barking" (which I believe is British for "insane"). He went on to say: "It would take a lot to persuade me that Obama is the wrong choice for Democratic nominee, but if he keeps this up he might do it." Indeed. Count me as one Ohio Democratic primary voter who is unimpressed.

Neither Democratic nor Republican trends are encouraging, but McCain's silliness (if sincere) is likely of more practical import than Democrats'. The scheduled expiry of the 2001 and 2003 tax cuts means that the next President definitely will face some serious decisions about tax policy. It is not clear that there will any decisive moments on trade in the foreseeable future: the current round of WTO negotiations seems hopelessly stalled, leaving us with mostly symbolic tussles over various and sundry small potatoes regional trade agreements.

Update (2/26): Willem Buiter and Anne Sibert say the "Patriot Employer" proposal is "reactionary, populist, xenophobic and just plain silly," but The Economist's Free Exchange blog thinks their criticisms are overstated. For a more optimistic take, see this New Republic article on Obama's policy advisors (he actually cares what experts think - wow!) (Hat tip: Greg Mankiw).

Update #2 (2/26): The Washington Post fact-checker looked the argument between Clinton and Obama over NAFTA (the North American Free Trade Agreement between the US and Canada) and concluded: "
You would not think it from the way they have been attacking each other, but Clinton and Obama are not all that far apart on NAFTA. They both believe in free trade, but they both argue that the U.S. has got a bad deal from the way NAFTA and other trade deals have been enforced. Both candidates have used quotes selectively to slam the other."

Update #3 (2/28): The NY Times' David Leonhardt thinks they don't really mean it. Also, Economists' View has more here, and here.

Sunday, February 24, 2008

Steven Pearlstein Takes on Wall Street

In his Washington Post column last week, Steven Pearlstein offered a scathing multi-count indictment against Wall Street's purveyors of "financial innovation":
For starters, these innovations have helped to create a cycle of financial booms and busts that have a tendency to spill over into the real economy, contributing to a heightened sense of insecurity.

They have shortened the time horizons of investors and corporate executives, who have responded by under-investing in research and the development of human capital.

They have contributed significantly to massive misallocation of capital to real estate, unproven technologies and unproductive financial manipulation.

They have made it easy and seemingly painless for businesses, households and even countries to take on dangerous levels of debt.

They have given traders a greater ability to secretly manipulate markets.

They have given corporations clever new tools to hide risks, liabilities and losses from investors.

And by giving banks the tools to circumvent reserve requirements and make more loans with less capital, they have enormously increased the leverage in the financial system and with it the risk of a financial meltdown.

But far and away the greatest damage from all this financial wizardry is the obscene levels of compensation it has generated for a select group of Wall Street executives and money managers.

For when you look over the long term, at the good periods and the bad, it is obvious that the pay collected by these masters of the universe has been grossly excessive -- out of line with the personal financial risk they have taken, out of line with their skills relative to the next-best performers and certainly out of line with the returns earned by investors...

It would be bad enough if the consequences of this excessive pay were confined to Wall Street. Unfortunately, it has not worked out that way. For the prospect of earning untold wealth also has attracted an enormous amount of young talent that could have been more productively used in science, engineering, medicine, teaching, public service and businesses that generate genuine long-term value.

Is it not fair to ask whether the United States can remain the world's most prosperous and innovative economy when half of the seniors at the most prestigious colleges and universities now aspire to become "i-bankers" at Goldman Sachs?

So I hope you'll forgive me, dear readers, when I say that the best thing that could happen to our economy is for a dozen high-profile hedge funds to collapse; for investment banking to enter a long, deep freeze; for a major bank to fail; and for the price of a typical Park Avenue duplex to fall by 30 percent. For only then might we finally stop genuflecting before the altar of unregulated financial markets and insist that Wall Street serve the interest of Main Street, rather than the other way around.

So, what is to be done? Some of the implications came up in Pearlstein's "chat" with readers. One is better regulation:

Boston, Mass.: Citigroup, State Street, and myriad other US banks hid billions in contigent SIV liabilities off-balance sheet, often using off-shore tax havens. What does this say about the FED's competence as a regulator? Or do you think it's a matter that the FED is corrupt and turned a willful blind eye to all of these off-balance sheet transactions? Is it time to combine regulators so that there is one sole financial markets regulator? Thanks Steve!

Steven Pearlstein: The Fed is not corrupt but they have been blinded by the mindless regulatory philosophy of the Greenspan era and they do look on the big bans and the holding companies as their charges -- institutions to be protected, part of a financial system that needs to be protected -- so they never utter a bad word about them and try to handle things quietly and without penalty. The result is that they give up the deterrant aspect of regulation, which is to have a ritual hanging every couple of years and scare the bejezzus out of people so they behave better in between the hangings. The Fed doesn't believe in that. They also don't believe they should substitute their judgment for the markets, which is crazy, because in financial regulation, that is exactly the purpose of regulation. Otherwise, you'd just leave things to markets. It is a form of modesty that they have taken to gross excess. And frankly it is not going to change until someone like Barney Frank finally makes such an example of a Fed chairman of the head of the Fed's banking regulation department that they get fired for being a bad regulator. Greenspan got out before he could be fired, but there are others who should be held accountable so that their unpleasant dismissal will be a lesson that will be remembered by their successors.

(N.B. Barney Frank is Chairman of the House Financial Services Committee). Pearlstein isn't the only one calling for more effective regulation - Martin Feldstein, one of Ronald Reagan's economic advisors (i.e., not a lefty), recently did so. The economic market failures that necessitate regulation are primarily of the "imperfect information" variety - i.e. that when people (or institutions) buy a financial asset they have a limited knowledge of the underlying risks. This problem seems to get worse as the financial assets become more complicated.

Another, more profound, issue that deserves more thought than it gets is the type of behavior that receives approbation in our society:

Potomac, Md.: Steven, thank you for your comment on the status of America's financial system today. As a 24 year-old finance professional looking to apply to business school in the coming years, I hope to shift into a line of work that generates "genuine long-term value." I remember at graduation the air of superiority surrounding my classmates who landed jobs as analysts on Wall Street. For many of us at "elite" Northeast schools, they seem to be the only jobs out there, because everyone is gunning for them. How can the other industries appeal to the talented kids who are so easily swayed by the glamour of I-banking salaries and bonuses?

Steven Pearlstein: That's a simple question that probably doesn't have a simple answer. But one thing we could do is not to glamorize Wall Street so much in the press or in movies, and begin to show more appreciation for real enterpreneurs and public servants and scientists and engineers. I think a lot of this is as much cultural as economic.

The "credit crunch" resulting from some of these "financial innovations" turning out badly is one of the reasons the US economy may be headed into a slump. That is, if there is a recession, we have partly to blame our excessive zeal for "de-regulation," "free markets," and greed (er, "rational self-interest"). The age of Milton Friedman, indeed.

Friday, February 22, 2008

Stagflation Redux?

The latest inflation report from the BLS has generated some concern about "stagflation," an ugly artifact of the 1970's, making a comeback (can avocado appliances be far behind?). The word is a combination of "stagnation" (i.e. high unemployment and slow growth) and "inflation." We already knew that unemployment has been creeping up (4.9% in January, up from 4.4% last March). And now we learn that over the past 3 months, CPI inflation has been running at a 6.8% annual rate. Partly that reflects oil prices - just as 1970's inflation did - but the "core" CPI (i.e. with food and energy prices removed) has been increasing at a 3.1% annual rate. Ominous portents, but we have some distance to go before things look this bad:
(the red line is the unemployment rate, and the blue is CPI inflation)

One reason stagflation is so pernicious is that it puts the Fed in an awkward spot. High inflation requires the Fed to tighten monetary policy (i.e. raise the fed funds rate target), while the proper response to stagnation is to loosen. At Econbrowser, James Hamilton examines the numbers and the Fed's dilemma.

Paul Krugman believes the appropriate parallel is to early 1990's rather than the late 1970's. He writes:
...I don’t believe we’re really facing anything comparable to 1970s stagflation. For one thing, we’re less dependent on oil: America has more than twice the real G.D.P. it had in 1979, but consumes only slightly more oil. For another, there’s no sign of the wage-price spiral that once drove inflation into double digits — in fact, wage growth has been declining even as inflation rises.

What’s much more likely is that we’ll have an economy like that of the early 1990s, only worse.

The first President Bush presided over the 1990-1991 recession. But his real problem came during the alleged recovery, which was hobbled by financial problems at many banks, which had been badly damaged by the collapse of the late-1980s real estate bubble, and by sluggish consumer spending, held down by high levels of household debt.

As a result, the unemployment rate just kept rising, not reaching its peak of 7.8 percent until June 1992.

If all this sounds familiar, it should. Many economists have pointed out the parallels between the current situation and the early 1990s: another real estate bubble, subprime playing more or less the same role formerly played by bad loans by savings and loan institutions, financial trouble all around.

The difference is that the problems look a lot worse this time: a much bigger bubble, more financial distress, deeper consumer indebtedness — and sky-high oil prices added to the mix...
This Wall Street Journal article has some very informative background on stagflation, including:
British Parliamentarian Iain Macleod is credited with first using the word stagflation in 1965. "We now have the worst of both worlds -- not just inflation on the one side or stagnation on the other, but both of them together. We have a sort of 'stagflation' situation."

Wednesday, February 20, 2008

None More Black

This has nothing to do with economics, but I can't resist. The Washington Post reports:
Researchers in New York reported this month that they have created a paper-thin material that absorbs 99.955 percent of the light that hits it, making it by far the darkest substance ever made -- about 30 times as dark as the government's current standard for blackest black...

"It's very deep, like in a forest on the darkest night," said Shawn-Yu Lin, a scientist who helped create the material at Rensselaer Polytechnic Institute in Troy, N.Y. "Nothing comes back to you. It's very, very, very dark."

Or, in the immortal words of Nigel Tufnel: "It's like, 'how much more black could this be?' and the answer is none. None more black."

Monday, February 18, 2008

Helping Africa?

The NY Times reports that President Bush accentuated the positive on his trip to Africa:
“This is a large place with a lot of nations, and no question, everything is not perfect,” Mr. Bush said during a brief visit to Benin before arriving Saturday evening here in the capital of Tanzania. “On the other hand, there’s a lot of great success stories, and the United States is pleased to be involved with those success stories.”

Mr. Bush’s short stay in Benin — just three hours, enough time for an airport news conference with President Thomas Yayi Boni and for Air Force One to refuel — made him the first American president to visit that tiny West African nation. It was on Mr. Bush’s itinerary because it represents the kind of success he wants to highlight — how American aid has helped fight poverty and disease in some of the world’s poorest nations.

The administration considers its aid efforts to be one of its successes. In an interview with the Council on Foreign Relations, Steve Radelet of the Center for Global Development offers a mostly positive assessment of the administration's efforts. The centerpiece is the Millennium Challenge Corporation, a program Bush announced in 2002 - Radelet says:

The Millennium Challenge Corporation (MCC) has evolved into what I think is an imaginative and creative new way to think about foreign assistance. It has done many things well, in terms of how it is thinking about foreign assistance, but it has also been quite slow in getting off the ground and dispersing money. What it has done well is recognizing that not all countries are the same and that we should deliver assistance differently to different countries. It separates out those that are better governed, countries that have made choices toward democracy, toward better governance, and toward better health and education policies. It gives those countries the responsibility to set their priorities and design the programs. This is a huge change and a huge step forward in how we think about foreign assistance, to actually give the recipient countries much more responsibility....

They’ve been very slow to disperse the funds so there haven’t been huge benefits on the ground yet. The African countries that have qualified and have signed compacts include Benin, Cape Verde, Ghana, Lesotho, Madagascar, Mali, Morocco, Mozambique. Those are the African countries that have signed compacts for $3.8 billion, which are beginning to be implemented, but it’s still very early in the day. So far, the MCC has only dispersed $150 million worldwide. So, their disbursements have been slow. It still remains to be seen if the great promise of the MCC turns into reality in terms of real benefits for people on the ground.

The structure of the program represents the growing appreciation by economists (and others) of the importance of institutional factors like governance for development.

Since most people do not realize how small a fraction of our income is spent on foreign aid, it is useful to put it in context: According to the OECD, US "Official Development Assistance" was $23.5 billion in 2006. That's a large amount of money, but it is 0.18% of Gross National Income (aka GNP) and less than 0.9% of federal budget outlays - that is, less than one cent from each tax dollar. This chart breaks down American aid by region and category. Although the US is the largest giver by amount, most rich countries give a higher percentage of their incomes in development aid. In percentage terms, Sweden is the most generous (1.02%), followed by Luxembourg and Norway (both 0.89%). In dollar terms, Britain is #2 at $12.5 bn, followed by Japan at $11.2 bn.

But does it do any good? That is the subject of sometimes heated debate. A good starting point on this issue is Nicholas Kristof's review article in the New York Review of Books. Kristof, who is a NY Times columnist, will be speaking at Miami on Mar. 4.

Globalization and Divergence

The gap between the rich and poor nations has widened over the past two centuries, rather than narrowed as neoclassical growth theory (e.g. the Solow model) predicts. At Vox EU, Oded Galor and Andrew Mountford offer a hypothesis to explain this "great divergence":
[W]e suggest that international trade has played a significant role in the differential timing and pace of the demographic transitions across countries and has been a major determinant of the distribution of world population as well as the 'Great Divergence' in income per capita across countries. International trade has an asymmetrical effect on the evolution of industrial and non-industrial economies: While in the industrial nations the gains from trade have been directed primarily towards investment in education and growth in output per capita, a greater portion of the gains from trade in non-industrial nations has been channelled towards population growth...

The expansion of international trade has enhanced the specialisation of industrial economies in the production of industrial, skilled intensive, goods. The associated rise in the demand for skilled labour has induced a gradual investment in the quality of the population, expediting a demographic transition, stimulating technological progress and further enhancing the comparative advantage of these industrial economies in the production of skilled intensive goods. In non-industrial economies, in contrast, international trade has generated an incentive to specialise in the production of unskilled intensive, non-industrial, goods. The absence of significant demand for human capital has provided limited incentives to invest in the quality of the population and the gains from trade have been utilised primarily for a further increase in the size of the population, rather than the income of the existing population. The demographic transition in these non-industrial economies has been significantly delayed, increasing further their relative abundance of unskilled labour, enhancing their comparative disadvantage in the production of skilled intensive goods and delaying their process of development. This implies that international trade has persistently affected the distribution of population, skills, and technologies in the world economy, and has been a significant force behind the 'Great Divergence' in income per capita across countries...

The "demographic transition" they refer to is the reduction in fertility rates that tends to occur as countries develop. In contrast to neoclassical models, their hypothesis implies that investment in human capital and population growth be treated as endogenous variables - i.e. determined within the model, rather than taken as exogenously given.

Saturday, February 16, 2008

The Macroeconomic Situation

Paul Krugman offers an assessment of our current macroeconomic troubles. He says there are basically two problems. One is that the economy is "unbalanced," with unusually high consumption and a large trade deficit. That is, in terms of Output = Consumption + Investment + Government + Net Exports, the fact that net exports (i.e. the trade balance: exports - imports) is negative allows the other three components to add up to more than 100% of output, and for consumption to be unusually large relative to GDP. In the BEA's advance estimate of 2007 GDP, consumption was 70.3% of GDP, while net exports were -5.1%. Another imbalance Krugman notes is that, as a share of GDP, residential investment (new housing) has been unusually high, while nonresidential investment (new capital) has been lower than its average. The other problem, which has grabbed more headlines lately, are the troubles in the financial system, which may be creating a "credit crunch," making it harder for individuals and firms to borrow. Here's Krugman's take on what's ahead:
What we want, and will eventually get, is a rebalancing: smaller trade deficits, consumer spending more in line with income, more normal housing spending. The trouble is in getting there. At the moment it seems likely that consumption and housing investment will fall faster than net exports can rise — probably with additional downward pressure from at least some types of business investment, especially commercial real estate. The result will be a recession or at least something that feels like one.

The goal of monetary and fiscal policy should be to bridge the gap — to sustain spending until a falling trade deficit comes to the rescue, and to hasten the rise in net exports (remember, in the current context a weak dollar is good.)

Wednesday, February 13, 2008

The Trouble With Tweed

Brad deLong contempates the sartorial dilemmas of the professorate. He suggests that slovenly-dressed academics may be playing a mixed strategy:
  • The most important signal of expertise that a professor can send is that he or she is so monomaniacally focused and on intellectual task as to be completely outside the normal status hierarchies
  • Thus it is very important that their values and tastes appear visibly different from those of either the striving poor or the smug rich
  • And the best way to do this, from a sartorial point of view, is to make it appear that the professor had better and more important things to think about than mere appearance while getting dressed that morning
    • There is a faction that thinks that the best way to appear to have had better and more important things to think about is to never care at all about appearance--so that whatever one thinks of is automatically more important than how one looks
    • There is another faction that thinks that true unconcern is too risky, and that one must utilize great art in appearing artless in one's dress
      • But systematic artful artlessness is an impossibility
      • Pulling things at random from one's closet may, however, come close

Personally, I like tweed, but as deLong rightly notes:
[T]he traditional tweedy professor male academic clothes are, from a thermodynamic point of view, appropriate only for some British or New England campus without effective central heating.

Monday, February 11, 2008

Growth Accounting is Useful (and Fun)

Dani Rodrik asks a question that perhaps some of my intermediate macro students are asking - that is, if they've started the problem set (seriously, folks, don't wait until Thursday night) - "What Use is Sources of Growth Accounting?"
I am teaching this stuff this week, and while I enjoy doing it and think it is important for students to know--no World Bank country economic memorandum is apparently complete without a sources-of-growth exercise--I wonder what purpose it really serves....

Aside from all kind of measurement problems, these accounting exercises say nothing about causality, and so are very hard to interpret. Say you found it's 50% efficiency and 50% factor endowments. What conclusion do you draw from it? You could imagine a story where the underlying cause of growth is factor accumulation, with technological upgrading or enhanced allocative efficiency as the by-product. Or you could imagine a story whereby technological change is the driver behind increased accumulation. Both are compatible with the result from accounting decomposition. Indeed, I have yet to see a sources-of-growth decomposition which answers a useful and relevant economic or policy question....

What growth accounting allows us to do is to break down output growth into its component parts. For example, growth in "labor productivity" (output per unit of labor) can be decomposed into "total factor productivity" (technological progress) and contributions from "capital deepening" (increasing the amount of equipment per worker), and sometimes also "labor quality" (changes in the education and experience of the labor force).

One recent example that I found interesting is Jorgenson, Ho and Stiroh's paper "A Retrospective Look at the US Productivity Growth Resurgence" which further sub-divides capital deepening and total factor productivity into information technology (IT) and Non-IT components. Their results indicate that the US "productivity resurgence" since the mid-1990's has two distinct sub-periods:

Robert Solow once said "we see the computers everywhere but in the productivity statistics," (this is the "Solow paradox") but they seem to have finally showed up in a big way in the late 1990's. The decomposition suggests that productivity growth in the late 1990's was an Information Technology story, reflected in the boom in IT investment and in productivity growth in the IT sectors. The second phase of the resurgence appears to have been much more broadly based.

I stumbled on another interesting example writing a problem set for my principles students. I asked them to break the 1974-95 slowdown period into sub-periods:The late 1970's were terrible for TFP (perhaps due to oil shocks, or maybe because we were distracted by "CHiPs") but still saw a respectable contribution from capital deepening, while the later period had decent TFP growth, but didn't get much from capital deepening. That might lend some creedence to the notion that the federal budget deficts that ballooned during that period "crowded out" investment.

Rodrik is right that growth accounting doesn't really explain what causes growth, but it is very useful for telling us where to look. That is, it doesn't really answer questions so much as help us figure out what questions to ask.

Sunday, February 10, 2008

Consumption Inequality

is much lower than income inequality. The Dallas Fed's W. Michael Cox and Richard Alm explain in the New York Times, with the aid of a nifty chart. They write:
[I]f we compare the incomes of the top and bottom fifths, we see a ratio of 15 to 1. If we turn to consumption, the gap declines to around 4 to 1. A similar narrowing takes place throughout all levels of income distribution. The middle 20 percent of families had incomes more than four times the bottom fifth. Yet their edge in consumption fell to about 2 to 1.

Let’s take the adjustments one step further. Richer households are larger — an average of 3.1 people in the top fifth, compared with 2.5 people in the middle fifth and 1.7 in the bottom fifth. If we look at consumption per person, the difference between the richest and poorest households falls to just 2.1 to 1. The average person in the middle fifth consumes just 29 percent more than someone living in a bottom-fifth household.

Update: Paul Krugman is skeptical.

Update #2 (2/11): So are Mark Thoma, Dean Baker and Free Exchange.

Update #3 (2/12): And Barry Ritholtz.

Fiscal Policy in the Long and Short Runs

The Times' Edmund Andrews has a useful look (with nice charts) at the fiscal policy challenges that will confront the next administration. One major issue is that the tax cuts passed in 2001 and 2003 are scheduled to expire:
Extending them would reduce revenues by about $3 trillion over the next 10 years, according to the Congressional Budget Office. Those reductions would coincide with sharply rising costs for Social Security and Medicare as millions of baby boomers enter retirement.

Senator John McCain of Arizona, the front-runner for the Republican nomination for president, has flip-flopped on the issue. In 2001 and 2003, he alienated many Republicans by voting against the tax cuts, arguing that they were too heavily tilted toward the rich. But as a presidential candidate, Mr. McCain competed fiercely with his Republican rivals in vowing to not only make the tax cuts permanent but also to cut the corporate tax rate....

The Democratic contenders, Senator Barack Obama and Senator Hillary Rodham Clinton, would extend the tax cuts for most people but revoke them for families earning more than $250,000 a year. “I am not bashful about that,” Mr. Obama said at the Democratic candidates’ debate on Jan. 31. “What we have right now is a situation where we cut taxes for people who don’t need them.”

Clinton and Obama plan to use the additional revenue to finance their health care plans. Obama has also expressed a willingness to consider raising the social security payroll tax on earnings over the current cap of about $90,000 (see earlier post).

The steps discussed so far on the campaign trail are unlikely to close the gap between revenue and spending (and McCain, if he doesn't change his mind again, would widen it). None of the candidates (except Huckabee) has offered plans for fundamental changes to the tax system. Andrews puts it in context nicely:
Historically, federal taxes have averaged about 18.5 percent of the gross domestic product.

That percentage sank to 16.3 percent of the G.D.P. in 2004, largely because of Mr. Bush’s tax cuts, but it edged up to 18.8 percent last year as a result of booming corporate profits and investment income.

But government spending remains above 20 percent of G.D.P., and the gap between taxes and spending is likely to widen sharply as a result of the economic slowdown this year.

President Bush’s budget plan for 2009, which includes money for an economic stimulus package, calls for the federal deficit to more than double, to $410 billion, this year.

That is, in addition to the gap between revenue and spending expected over the long run, we can expect the deficit to increase in the short run, and that's not entirely a bad thing. The expected increase in the deficit this year is partly a reflection of the "automatic stabilizer" role of the federal budget - since most taxes are proportional to income, revenues automatically fall when incomes decrease, and spending on some government transfer programs like unemployment insurance rises in a downturn. On top of that, we are indeed going to get a "fiscal stimulus" - a one-off tax rebate intended to increase aggregate demand this year. The efficacy of this has been much-debated; I think Jared Bernstein has it about right:

It's both good news and a missed opportunity to craft a much more effective package.

On the plus side, those who said the political system was too clogged with partisanship to get this out the door quickly are proved wrong. The package is also much improved from the White House's first pass, which excluded low-income families and about 20 million elderly persons.

On the negative side, they could have crafted a package that would have had a lot more bang-for-the-buck....

By leaving out extended unemployment benefits and other more directly stimulative measures, like helping revenue-strapped states invest in infrastructure (roads, school repairs), the Congress and the White House missed the chance to get a significantly bigger return on our investment...

That said, and I know there's a fair bit of skepticism on this point, this package will surely help. It won't stave off recession, but it will mitigate the pain for many.

Saturday, February 9, 2008

Speaking (Bob) Frankly

Economists' proofs that markets lead to "efficient" outcomes hold only under a specific set of assumptions, including perfect competition, perfect information, and the absence of externalities. These assumptions, of course, never completely hold - the world we live in is one of "market failure." The benefits of markets are often hard to see and appreciate; understanding them is an important contribution of economics, but it is also important to understand market failures. One of the most acute observers of market failure is Cornell's Bob Frank, who Steven Pearlstein writes about in his Washington Post column:
Think of skyrocketing tuitions among elite colleges and universities that spend lavishly on winning sports teams, rock-climbing walls and scholarships for those who don't even need them, all to attract top students.

Or the runaway compensation for chief executives who would be willing to take the job for half of what they are being paid.

Or the ridiculous prices paid for "it" handbags, fancy watches or houses in the Hamptons.

How do we explain why cities are still tripping over themselves to offer subsidies for baseball stadiums and convention centers in the face of overwhelming evidence that these diminish economic efficiency and welfare rather than enhance them?

And how is it rational that first-year associates at top law firms are paid more than federal judges?

One thread that runs through all these "market failures" is that they involve a kind of competition in which "winning" is more a relative concept than an absolute one -- that the goal is not so much to maximize profits, income or welfare, as economic models assume, but to beat the competitors. In the process, perfectly rational investors, businesses or consumers wind up doing things that are irrational, leaving them no better off than before.

The intellectual roots of this economic theory of relativity go back to Adam Smith, Alfred Marshall and Thorstein Veblen. It got a big boost from game theorists, among them University of Maryland's Thomas C. Schelling, who won a Nobel Prize for his work on unproductive arms races, both economic and military. More recently, the hot new area of behavioral economics has focused considerable light on the seemingly irrational side of homo economus.

Perhaps nobody has done more to expand our understanding of relative competition than Robert H. Frank of Cornell University. Frank's particular focus has been on the importance of status in consumer choices. His point is that the desire for ever-bigger homes, ever-fancier gas grilles, ever-more powerful SUVs is based not on some absolute notion of what is good or sufficient, but rather on the relative basis of what everyone else has.

It is this compulsion to keep up with the Joneses, Frank argues, which leads us to over-spend on status goods that, in the end, make us no happier. Meanwhile, we wind up under-investing in leisure time or "public goods," such as better schools and parks, that would give us more satisfaction.

The latest example of Frank at work is his piece in today's New York Times. He looks at the puzzle of why people contribute to political campaigns, which seems to go against our assumption that people behave in a narrowly self-interested manner:

The problem, as described by Mancur Olson in his classic book, “The Logic of Collective Action,” is that even those who share a presidential candidate’s policy goals will reap no significant material advantage by donating their time or money. After all, with cash donations legally capped at $2,300, even donors who give the maximum have no realistic hope of influencing an election’s outcome. Nor can any individual volunteer — even one whose efforts resulted in hundreds of additional votes for his candidate — realistically hope to tip an election.

Although the logic of the free-rider problem may seem compelling, people’s behavior strikingly contradicts many of its predictions. Last month alone, for example, the presidential campaign of Senator Barack Obama raised over $32 million from more than 250,000 individual donors and sent huge numbers of volunteers into the field. (Disclosure: I’m an Obama contributor myself.) Other campaigns have benefited in similar, if less spectacular, ways from their supporters’ willingness to set narrow self-interest to one side.

Frank goes on to describe a theory from Albert O. Hirschman that posits alternating periods dominated by collective action and by selfishness. So, while Obama was criticized for saying positive things about Ronald Reagan, his "movement" may be a sign that the Reagan era is over...

One crucial thing sometimes students (and professors) misunderstand about the free rider problem - and the assumptions we make about behavior in general - is that economics does not exist to tell people how to act. Economists are social scientists, and our task is to explain human behavior. In Frank's example, what is problematic is not the behavior of the donors, but the fact that economic theory has a hard time explaining it.

Wednesday, February 6, 2008

Panda Bearishness

Double-digit annual GDP growth has become almost routine for China, but in the Financial Times, Kenneth Rogoff argues a slowdown may be in the offing:
China’s remarkable resilience to both the 2001 global recession and the 1997-98 Asian financial crisis has convinced almost everyone that another year of double-digit growth is all but inevitable. In fact, the odds of a significant growth recession in China – at least one year of sub-6 per cent growth – during the next couple of years are 50:50. With Chinese inflation spiking, notable backpedalling on market reforms and falling export demand, 2008 could be particularly challenging.
The bar is pretty high when 6% growth counts as a "growth recession" (a period of below average growth, but not a full-blown recession where output actually falls). In the "Economists' Forum" comments, Rogoff's former professor Jagdish Bhagwati reminds us of some institutional issues that could yet derail the China growth story:
I think that Rogoff's analysis needs to be supplemented by a fuller recognition of the problems that Chinese authoritarianism poses. Unless you have the institutions of a liberal democracy - a free press, NGOs, opposition parties and an independent judiciary - you run the danger of "social disruptions" that China has and you are unable to channel dissent and distress into creative political channels. This is why a big question mark hangs over China's future.
And William Easterly expects "regression to the mean":
Growth forecasters are curiously oblivious of the overwhelming evidence for regression to the mean. Of course, a small number of countries can defy gravity for a while, as China has already done with the length of its current rapid growth episode. Until recently, the East Asian tigers (Hong Kong, Korea, Singapore, Taiwan) also defied gravity for an unusually long period, but in the last ten years gravity reasserted itself - their growth has decelerated back down towards world average growth.
Or, to put it on a more solid theoretical footing - neoclassical growth models (e.g. the Solow model) imply that the rate of growth will slow as an economy gets closer to its steady state.

More Sino-pessimism is available from Michael Pettis, who considers the possibility of Chinese stagflation on his China financial markets blog.

Update (2/10): The Cleveland Fed's "Economic Trends" has a good explanation of the relationship between inflation and China's exchange rate policy.

Sunday, February 3, 2008

Aim Slightly Higher

The unusually aggressive reductions in the fed funds rate target in the last two weeks have been criticized for increasing the potential for future inflation. One defense of the Fed is that the risks it faces are asymmetric. In particular, the Fed wants to make sure to avoid falling into deflation and a "liquidity trap" where monetary policy becomes ineffective - when the price level is falling, even if nominal interest rates go to zero, real interest rates can still be high. This is the point made in the FT's Economists' Forum by Johns Hopkins' Christopher Carroll:
[T]he Fed's gamble seems well judged, not because the concerns of the inflation hawks are unwarranted but because they are balanced by a more dangerous possibility on the opposite side. Put it this way: if I'm hiking a narrow cliff-hugging mountain trail, I don't want to stroll right down the middle of the path. Instead I will edge to the to the side of the trail away from the precipice, even if this means an occasional scraped ankle or a bit of extra scrambling. This is the "precautionary principle" in mountain-climbing.

The cliff, for monetary policy, is the possibility of deflation, whose dangers were calamitously illustrated by the Japanese government during the 1990s. And the precautionary principle would say that it is worth risking a spell of extra inflation to avoid even a small risk of a deadly dose of deflation.

The uptick in long-term interest rates (noted previously) might suggest that the Fed's actions are denting its inflation-fighting credibility and that inflation expectations are rising. One way to enhance credibility and keep inflation expectations anchored would be for the Fed to adopt inflation targeting (i.e. announcing a goal for inflation and committing to adjusting monetary policy to meet it). As an academic, in addition to being a student of the depression, Ben Bernanke was an advocate of inflation targeting.

Most of the countries that have adopted inflation targeting (e.g. Britain) have set targets of 2% (or ranges centered on 2%). If the Fed is indeed strongly deflation-averse (as it should be), perhaps 2% would be cutting it too close. Setting a slightly higher target - say 3% - would give the benefits of inflation targeting without requiring it to walk so close to the edge of the cliff. For example, if we start from an equilibrium at an assumed "neutral" level of the real fed funds rate of 2.5% and an inflation target of 3%, the fed funds rate would be 5.5%, giving the Fed 550 basis points to work with in a downturn (as opposed to 450 bps with a 2% target).

The downside of that, of course, is higher inflation. But many of the problems with inflation come more from uncertainty and volatility rather than the rate itself. Its not clear that an economy with consistent, anticipated inflation of 3% is much worse than one with consistent, anticipated 2% inflation. Moreover, if nominal wages are sticky downwards, a little bit of inflation makes it easier to adjust real wages (as Akerlof, Dickens and Perry explained).

Saturday, February 2, 2008

The Mandate Debate

Part of the discussion in last week's Democratic debate was over an "individual mandate" for health insurance. Clinton is for it - her health care proposal would require all people to get insurance (like most states require all drivers to be insured) - and Obama is opposed, which is why Clinton can say he wouldn't provide "universal coverage" since some people would choose to go without insurance.

For more, Jonathan Cohn of The New Republic has an even-handed assessment of the issue (and Krugman continues to take Obama to task, as does Ezra Klein). The plan instituted by Governor Romney in Massachusetts also includes an individual mandate.

For a broader look at the candidates' economic policy views, see the series by NY Times' David Leonhardt. Here's his article about Obama, Hillary Clinton and John McCain.


Part of Barack Obama's appeal comes from the notion that he can bring people together. Last week he collected the endorsements of Hulk Hogan and former Federal Reserve chairman Paul Volcker. Both are known for laying down some smack in the 80's - Hogan on the Iron Sheik and Andre the Giant, and Volcker on inflation. The victory over inflation was not without its cost - Volcker's tight, quasi-monetarist policies led to the 1981-82 recession, the deepest US recession since the great depression.

Obama talks of working as a community organizer in the 1980's in south Chicago neighborhoods devastated by factory closings. The unemployment he saw is at least partly attributable to the Volcker Fed's actions.

The red line is the Fed Funds rate, the blue line is inflation (CPI) and the unemployment rate is in green.
It should be noted that the Fed's policies were a response to the inflation that had developed over the 1970's, and some economic "pain" was arguably necessary in those circumstances.

The Business End of the Stimulus Package

Most of the discussion (including mine) of the proposed fiscal stimulus package has focused on the tax rebates for individual households. I wasn't sure how to assess the roughly $50 billion in corporate tax breaks, but according to Howard Gleckman of the Tax Policy Center, the news isn't good. At Tax Vox (the TPC blog), he writes:
The bills moving through Congress would permit businesses to accelerate their tax write-offs for the purchase of equipment. This "bonus depreciation" was a favorite of Congress in 2002 and 2003 as well. The Senate Finance Committee version would also allow companies to use current losses to reduce their tax liability from as long as five years ago.

But this morning, at a TPC Forum on the stimulus effort, tax experts generally agreed that neither idea would do very much to accelerate investment.

Doug Elmendorf, a fellow at TPC and Brookings, says that he and former colleagues at the Fed struggled to find evidence that bonus depreciation enacted in response to the 2001 recession boosted capital spending. The Joint Committee on Taxation concludes that only 10% of businesses changed either the timing or amount of their investments as a result of the 2002-2004 tax breaks.

Plenty of other companies took the extra depreciation, all right, but they got it for investments they would have made anyway. Some call this "leakage," which is a polite way to say "boondoggle."

This time, we are creating the worst of all worlds. On one hand, the business breaks will increase the deficit by nearly $50 billion over the next two years. At the same time, they are too small to matter much to the real economy. If the 2002–04 changes, which were more than twice as generous as those on the table today, didn't do much, it is hard to see how the 2008 version will encourage investment. Besides, the Fed's huge cuts in interest rates will be far more important to a business' decision to invest than these tiny tax changes.

The stimulus, naturally, is cooling in that saucer of democracy known as the US Senate.