Political Economy of Financial Reform

From Ryan Grim and Arthur Delaney of the Huffington Post, a muckraking investigation of the House Financial Services Committee:

In the fall of 2008, Democrats took the White House and expanded their Congressional majorities as America struggled through a financial collapse wrought by years of deregulation. The public was furious. It seemed as if the banks and institutions that dragged the economy to the brink of disaster -- and were subsequently rescued by taxpayer funds -- would finally be forced to change their ways.

But it's not happening. Financial regulation's long slog through Congress has left it riddled with loopholes, carved out at the request of the same industries that caused the mess in the first place. An outraged American public is proving no match for the mix of corporate money and influence that has been marshaled on behalf of the financial sector.

The banking committee is the second-largest in Congress -- the Transportation and Infrastructure Committee has three more members -- and is known as a "money committee" because joining it makes fundraising, especially from donors with financial interests litigated by the panel, significantly easier.

The Democratic leadership chose to embrace this concept, setting up the committee as an ATM for vulnerable rookies. Eleven freshman representatives from conservative-leaning districts, designated as "frontline" members, have been given precious spots on the committee. They have individually raised an average of $1.09 million for their 2010 campaigns, according to the Center for Responsive Politics; by contrast, the average House member has raised less than half of that amount.

That makes achieving meaningful reform all the more challenging for the committee chair, Barney Frank:

Ultimately, though, Democrats are essentially relying on a "great man" strategy, figuring they can dump as many bank-friendly Democrats on the committee as they want and Frank will generally keep them in line. "We have a lot of faith in Barney. He can handle it," says a senior Democratic aide when asked about the phenomenon. Frank's senior staffers, say several current and former committee aides, similarly outmatch their counterparts. The chairman, they say, is able to use the knowledge gap at both the member and the staff level to his advantage.

"The good news is that we have, in my opinion, the most extraordinarily competent chair of that committee in place. He knows his subject, he's one terrifically smart pol, and he has a lot of self-confidence, to say the least," says Majority Leader Steny Hoyer (D-Md.).

All Quiet on the Banana Front

In the Times, Eduardo Porter looks back at the long running trade dispute over the EU's preferential treatment of banana imports from former colonies, which has finally come to an end. He writes:

When this started, trade was trumpeted as the single most important tool for development. Europe insisted that its special treatment of its former colonies was central to its post-imperial responsibilities. The United States and Latin American countries vowed to hold the line for free trade — over bananas at least — to make it a tool of development for all.

Today nobody talks about bananas. Stalled global trade talks (remember Doha?) barely get mentioned. There are a lot of problems out there, including the collapse of world trade in the wake of the global recession and the looming threat of protectionism. Yet there has also been a rethinking about trade’s supposed silver bullet role in economic development.

Bridges Weekly Trade News Digest has more on the case, and Paul Krugman laments, for a rather selfish reason.

Yo, PBS raps

Oh, dear...

Keynes vs. Hayek, with hip-hop:


What Bruce Bartlett said.

Update (1/25/10): Now there's a video, too.

Yo NAMA

The Times reports from Copenhagen:

The focus on reducing emissions from land use change is an important shift from the Kyoto Protocol, the first attempt by the nations of the world to develop a global plan to limit climate change. Current drafts circulating here would allow land-use activities that reduce emissions to be included in the United Nations Nationally Appropriate Mitigation Activities program, or NAMA, so countries could use that to achieve emissions reduction goals or targets.

But at the WTO in Geneva, NAMA is Non-Agricultural Market Access. Not only is the Doha round sputtering, it appears they are also losing control of their acronyms...

Our Ballooning Government

Is the Value-Added Tax (VAT) an idea whose time has come to the United States? In the midst of an article about this interesting question in the Times, I come upon this:

Introducing such a tax would probably require an overhaul of the entire federal tax code, no small order, and something the government last did in 1986. At the time the goal was to simplify the tax system, to raise money more efficiently and with fewer headaches for taxpayers.

Since then, federal spending has ballooned, while the government’s ability to raise taxes has become increasingly inefficient.

Ballooned? I don't see any ballooning here: Yes, there is a bit of a jump at the end due to automatic stabilizers and appropriate (though not big enough) countercyclical fiscal policy, but there's clearly no upward trend in federal spending since the mid-1980s. Moreover, federal government purchases - i.e., the stuff that's in the G component of GDP - accounted for 7.5% of GDP in 2008, down from 9.8% in 1986.

Update: Actually, since the graph goes through 2008, the main countercyclical fiscal policy (i.e., the stimulus bill) isn't in there.

The Liberty of Insignificance

China no longer enjoys it, Martin Wolf writes:

A country’s exchange rate cannot be a concern for it alone, since it must also affect its trading partners. But this is particularly true for big economies. So, whether China likes it or not, its heavily managed exchange rate regime is a legitimate concern of its trading partners. Its exports are now larger than those of any other country. The liberty of insignificance has vanished.

Anti-Dumping in My Backyard

Southwest Ohio's friendly neighborhood steelmaker, AK Steel, is among those being hit with antidumping tariffs by China, the Oxford Press reports:

The head of locally-based AK Steel said the company will “vigorously appeal” a decision by China, the world’s biggest steel consumer, to impose anti-dumping import taxes of up to 25 percent on specialized steel imports from Russia and the United States.China’s Ministry of Commerce said today, Dec. 10, that U.S. and Russian companies are selling flat-rolled electrical steel, a product used in the power industry for items such as transformers, at unfairly low prices in China. Starting Friday, Dec. 11, importers will need to pay anti-dumping deposits ranging from 10.7 percent to 25 percent to import the product from U.S. companies such as AK Steel.

Historically, the US steel industry has been a leading user of antidumping actions, so one naturally wonders if this is another example of the retaliation dynamic studied by Feinberg and Reynolds.

The College Tour

In the Times, high school senior Lauren Edelson writes of a new cliche on the campus tour:

I was surprised when many top colleges delivered the same pitch. It turns out, they’re all a little bit like Hogwarts — the school for witches and wizards in the “Harry Potter” books and movies. Or at least, that’s what the tour guides kept telling me.

During a Harvard information session, the admissions officer compared the intramural sports competitions there to the Hogwarts House Cup. The tour guide told me that I wouldn’t be able to see the university’s huge freshman dining hall as it was closed for the day, but to just imagine Hogwarts’s Great Hall in its place.

At Dartmouth, a tour guide ushered my group past a large, wood-paneled room filled with comfortable chairs and mentioned the Hogwarts feel it was known for. At another liberal arts college, I heard that students had voted to name four buildings on campus after the four houses in Hogwarts: Gryffindor, Ravenclaw, Hufflepuff and Slytherin. Several colleges let it be known that Emma Watson, the actress who plays Hermione Granger in the movies, had looked into them. I read, in Cornell’s fall 2009 quarterly magazine, that a college admissions counseling Web site had counted Cornell among the five American colleges that have the most in common with Hogwarts.

Hmm... for something different, she should visit Carleton College in Northfield Minnesota, where the tour guide would no doubt highlight the fact that a scene from "Mighty Ducks 3" was filmed in Carleton's Great Hall.

Economics PhDs

From the NSF report on the Survey of Earned Doctorates, which covers PhDs awarded in the US, for the 2007-08 academic year:

• Number of econ PhD recipients: 1091
• Percent female: 34.3%
• Percent US citizen/permanent resident: 34.9%
• Percent with bachelor's degree in econ: 56.1%
• Median age at doctorate: 31
• Median time to doctorate (from grad school start): 6.9 years

Of the 954 who responded to the question on their postgraduation status, 81 had definite plans for postgraduate study, 680 had definite employment and 168 were seeking employment or study (and 25 were 'other').

Of those reporting definite employment, 59.3% were headed to academe, 12.5% to government, 18.1% to business, 5.7% to nonprofits and 4.4% to other. Most (74.3%) of the jobs were in the US.

That's all in table 38, "Statistical profile of doctorate recipients in science fields, by sex and field of study: 2008." Nice to know the NSF considers us scientists!

The report came to my attention via Bruce Bartlett, who has some of the overall numbers.

Meanwhile, the next crop of soon-to-be Econ PhDs are in the midst of job market season, staring at their phones, waiting for calls for interviews at the meetings in Atlanta in January. They should read Brad DeLong's summary of what those interviews will be like.

BLS Brings Some Holiday Cheer

Relatively good news from the BLS this morning: in November, the unemployment rate fell from 10.2% to 10%.The unemployment rate is calculated from the household survey, which reports 227,000 more people were employed and 325,000 fewer were unemployed - the difference is largely attributable to people leaving the labor force, possibly because they have given up on finding a new job (to be counted in the labor force, you must either be working or looking for work). Accordingly, the labor force participation rate ticked down again, to 65%.If the labor market is truly turning around (and it does seem to be) we may soon see people re-entering the labor force, which would actually cause the measured unemployment rate to rise in the short term.

The establishment survey - which has a larger sample - reported a decline of 11,000 jobs (red line in the first graph). Less dramatic than the household survey, but a much smaller decline than recent months, and much better than expected. Moreover, a revision to the October and November figures reduced the jobs lost in those months by 159,000.

Floyd Norris is optimistic about the speed of the recovery:

One reason is the sheer abruptness of the decline in employment during the recent recession. (Yes, I think it is over.) After Lehman Brothers failed, the unemployment rate rose at a faster clip than at any time since 1975. There was something approaching panic among employers. They feared sales would collapse and that credit would be unavailable. In that spirit, they cut every cost they could. Imports plunged because no one wanted to add inventory. Ad spending collapsed. And people were fired.

That has left many companies in a position where they may need to add workers quickly for even a small increase in business.

Not surprisingly, Paul Krugman plays the grinch:

Today’s unemployment report was good news. But in a real sense good news is bad news, because this month’s not-too-bad number deflates the sense of urgency.

The fact remains that realistic projections show unemployment staying disastrously high for many years.

More on the employment report from David Leonhardt, Justin Fox.

Note: The charts were created using the St. Louis Fed's wonderful FRED tool. They have provisionally removed the shading for the recession at July, 2009, but the NBER business cycle dating committee has not yet officially a declared a date for the trough of the recession that began after the Dec. 2007 peak.

Pigou!

In the Journal, John Cassidy profiles A.C. Pigou, the Cambridge (UK) economist who pioneered the concept of externalities.

Keynes' Bad Grandchildren

At project syndicate, Keynes' biographer Robert Skidelsky revisits "Economic Possibilities for Our Grandchildren." While we have achieved economic growth even slightly better what Keynes hoped for, our attitudes towards work and wealth have not changed in the ways he predicted. In particular, the fact that we can now afford what would be a very high material standard of living in Keynes' day with much less work should have freed us to "live wisely, agreeably and well."

Skidelsky offers a very gloomy interpretation:

Moreover, Keynes did not really confront the problem of what most people would do when they no longer needed to work. He writes: “It is a fearful problem for the ordinary person, with no special talents, to occupy himself, especially if he no longer has roots in the soil or in custom or in the beloved conventions of a traditional economy.” But, since most of the rich – “those who have an independent income but no associations or duties or ties” have “failed disastrously” to live the “good life,” why should those who are currently poor do any better?

Here I think Keynes comes closest to answering the question of why his “enough” will not, in fact, be enough. The accumulation of wealth, which should be a means to the “good life,” becomes an end in itself because it destroys many of the things that make life worth living. Beyond a certain point – which most of the world is still far from having reached – the accumulation of wealth offers only substitute pleasures for the real losses to human relations that it exacts.

Hmmm... My favorite hypothesis on this remains Robert Frank's.

Don't Like International Capital Mobility?

Blame French socialists, says Dani Rodrik (in the context of a Project Syndicate column in favor of Brazil's tax on short term capital flows):

It may seem curious that [IMF Managing Director] Strauss-Kahn’s instincts are so off the mark on the matter of capital controls. One might have thought that a socialist, and a French Socialist at that, would be more inclined toward finance skepticism.

But the paradox is more apparent than real. Financial markets in fact owe French Socialists a great debt. Received wisdom holds the United States Treasury and Wall Street responsible for the push to free up global finance. But far more influential may have been the change of heart that took place among French Socialists following the collapse of their experiment in Keynesian reflation in the early 1980’s. When capital flight forced François Mitterrand to abort his program in 1983, France’s Socialists performed an abrupt volte-face and embraced financial liberalization on a global scale.

According to Harvard Business School’s Rawi Abdelal, this was the key event that set in motion the developments that would ultimately enshrine freedom of capital movement as a global norm. The first stop was the European Union in the late 1980’s, where two French Socialists – Jacques Delors and Pascal Lamy (the president of the European Commission and his assistant, respectively) – led the way. Then it was the turn of the Organization of Economic Cooperation and Development (OECD). Eventually, the IMF joined the bandwagon under Michel Camdessus, another Frenchmen who had served as Governor of the Bank of France under Mitterrand.

Unrealism is Not the Problem

At Vox, Paul DeGrawe describes contemporary macro models as "top down" because agents are assumed to know the structure of the world they live in. He writes:

There is a general perception today that the financial crisis came about as a result of inefficiencies in the financial markets and economic actors’ poor understanding of the nature of risks. Yet mainstream macroeconomic models, as exemplified by the dynamic stochastic general equilibrium (DSGE) models, are populated by agents who are maximising their utilities in an intertemporal framework using all available information including the structure of the model – see Smets and Wouters (2003), Woodford (2003), Christiano et al. (2005), and Adjemian, et al. (2007), for example. In other words, agents in these models have incredible cognitive abilities. They are able to understand the complexities of the world, and they can figure out the probability distributions of all the shocks that can hit the economy. These are extraordinary assumptions that leave the outside world perplexed about what macroeconomists have been doing during the last decades.

In its place, he advocates the modeling the economy as a "bottom up" system:

Bottom-up systems are very different in nature. These are systems in which no individual understands the whole picture. Each individual understands only a very small part of the whole. These systems function as a result of the application of simple rules by the individuals populating the system.

While I do think this is worth exploring (his paper will be on my holiday break reading list), his description of contemporary macroeconomics is not quite fair. The models do not imply that macroeconomists believe people really have all this knowledge (we most of us know better than that). Rather, we believe it makes sense to model them as if they do. Milton Friedman famously made this point by noting that it makes sense to model the shots of a champion billiard player as if he has a sophisticated understanding of physics.

It is worth recalling that macroeconomics adopted the paradigm of rational expectations and dynamic optimization because simple and apparently realistic assumptions like adaptive expectations led to situations where people could systematically and repeatedly be fooled, and this tendency could be exploited by policymakers. While rational expectations may be unrealistic, in a world where people are learning and updating their beliefs, one would expect tendencies that lead to significantly suboptimal outcomes to be driven out (and in the context of markets, with the help of competition). So, while real people are groping around in the fog trying to figure out a rough idea of how the world works, we would expect them to arrive at behaviors consistent with those of rational forward looking agents just as a billiard player, by trial-and-error, learns to make shots consistent with the laws of physics.

So the "unrealism" of the assumptions is not, by itself, a problem. The trouble arises if that unrealism leads us to incorrect predictions. Macroeconomics may indeed have gone astray in some ways, and the lack of realism in models may indeed vex non-economists, but the assumption of "incredible cognitive abilities" is not inherently a problem.

Update (11/22): I had a chance to a look at DeGrawe's paper (pdf). Although I disagree with his characterization of modern macroeconomics, I do think his paper is interesting, though I suspect it may be vulnerable to some of the same criticisms as adaptive expectations models. (via Mark Thoma's link to the "Whats Wrong with Modern Macroeconomics" conference papers).

Bart and Marge on Grad School

A grad school friend calls this to my attention:

One part of the transition from being a grad student to a professor that I found somewhat disorienting was the change from being treated with such disrespect - though our undergrad students were too polite to make comments like Bart's and Marge's, we knew what they were thinking - to receiving such deferential treatment as a professor. This big change in status felt particularly strange because it came in spite of the fact that there was little change in what I actually did every day - teaching and research - when I went from grad student to professor.

Double-Digits, Yikes!

I had hoped we wouldn't get here...

Not a nice headline number from the BLS today - the unemployment rate hit 10.2% in October. Payroll employment also fell by 190,000. The apparent discrepancy between the relatively modest decline in payrolls and the big jump in the unemployment rate is explained by the fact that the numbers come from two different sources. The unemployment rate is measured using a survey of households, while the payroll figure comes from a survey of firms. In this case, the divergence between the two was wide - according to the household survey, 589,000 jobs were lost. And there is no consolation from labor force participation, which ticked downward slightly.

Nonetheless, I see the folks at FRED have moved us out of the shaded area... presumably on the strength of the recent preliminary estimate of 3.5% GDP growth in the third quarter. Of course if output is growing, and employment is falling, productivity is rising. The BLS indeed reported a stunning 9.5% rate of increase in labor productivity for the third quarter. The accompanying decline in labor costs ought to be a pretty big inducement to hire more workers, but it is not clear that firms are confident that the demand will be there if they increase output.

Meanwhile, Paul Krugman reports the President is pinned down on the beachhead...

Update (11/9): Floyd Norris points out that the non-seasonally adjusted unemployment rate is 9.5%, unchanged from last month (and down from a peak of 9.7% in June-July).

Unemployment Rate, Not Seasonally Adjusted

Now that looks better! Hmm...

A New Cop on the Imbalances Beat?

The President's trip to China next week induces a bit of nostalgia for those famous "summit" meetings of the Cold War, when the "leader of the free world" would go "toe-to-toe with the Russkies."

Of course its far better, though perhaps less dramatic, that the meetings will deal with the "balance of financial terror" instead of nuclear terror. One element of reducing that terror will be convincing China to relax its de facto Dollar peg (but not too abruptly, please). Simon Johnson suggests an approach to deal with this issue:

Talking in public about big sticks never goes down well in Asia, and the administration should deny any inclination in this direction. But the mainstream consensus is starting to shift toward the idea that the World Trade Organization (W.T.O.), not the I.M.F., should have jurisdiction over exchange rates. The W.T.O. has much more legitimacy, primarily because smaller and poorer countries can bring and win cases against the United States and Western Europe in that forum. It also has agreed upon and proven tools for dealing with violations of acceptable trade practices; tailored trade sanctions are permitted.

No one wants to take precipitate action in this direction, but extending the W.T.O.’s mandate in the direction of exchange rates would take time — and presumably warrant discussion at the G-20 level. The United States has great influence over the G-20 agenda, and Mr. Obama’s staff members should hint, ever so gently, that this is where they see the process going.

Hmmm... living in Middletown Connecticut and Oxford Ohio, I'd missed the shift in the "mainstream consensus." Very interesting...

The Darkest Hour

is just before the dawn?

Perhaps, says David Leonhardt, who looks back at at the pessimism that prevailed in 1982:

In the fall of 1982, with a long recession ending but the unemployment rate heading toward 10 percent, The New York Times ran an article titled “The Recovery That Won’t Start.”

It quoted prominent economists who worried that “the recovery may amount to nothing more than a few quarters of paltry growth — and possibly not even that.” The economists, the article noted, had “growing doubts about whether the mechanisms of economic recovery will — or can — operate as they have in other postwar business cycles.”

Or as a classic song of the time put it:

And now you find yourself in '82
The disco hot spots hold no charm for you
You can concern yourself with bigger things
You catch a pearl and ride the dragon's wings

Of course, now we know that what came next were two years of very strong growth and soon it was "Morning in America:"



Perhaps the pessimists were just caught up in the heat of the moment, as Leonhardt suggests:

People tend to become overly pessimistic at the end of a recession, partly because they can see that the forces behind the last boom — housing and mortgage lending, in this case — won’t be around for the next one. If anything, the excesses from the last boom seem likely to hold back the economy for years to come. People are left to wonder where future growth will come from.

He has hope that we may indeed ride the dragon's wings to recovery:

For years, economists have been saying that China needs to consume more and the United States needs to consume less. Now it’s starting to happen.

The Chinese government has increased spending in the country’s impoverished countryside and made it easier for households to borrow money. Meanwhile, the global recession has caused China’s export sector to shrink.

However, Calculated Risk argues (seconded by Krugman) that today's situation compares unfavorably to that of 1982 because financial-crisis recessions generally tend to be longer, and because the Fed is out of room to lower interest rates.

Hmmm... only time will tell.

Out of the Shade?

The BEA's preliminary estimate is that real GDP grew at a 3.5% annual rate in the third quarter (July - Sept.). At some point in the future, the NBER will call the business cycle trough retrospectively, but it looks like, once they do, we will say that we emerged from the shaded area in mid-2009: However, the red line indicates continuing violation of "Okun's law," the rule of thumb which implies that 3.5% growth should give us rising employment (the unemployment rate increased from 9.5% in June to 9.8% in September).

The BEA's release suggests that we can attribute the growth largely to

• "Cash for Clunkers":

  Motor vehicle output added 1.66 percentage points to the third-quarter change in real GDP

  and
  

  Real personal consumption expenditures increased 3.4 percent in the third quarter, in contrast to a decrease of 0.9 percent in the second. Durable goods increased 22.3 percent, in contrast to a decrease of 5.6 percent. The third-quarter increase largely reflected motor vehicle purchases under the Consumer Assistance to Recycle and Save Act of 2009

• Federal Government:

  Real federal government consumption expenditures and gross investment increased 7.9 percent in the third quarter, compared with an increase of 11.4 percent in the second. National defense increased 8.4 percent, compared with an increase of 14.0 percent. Nondefense increased 6.8 percent, compared with an increase of 6.1 percent.

• Inventory Re-stocking:

  The change in real private inventories added 0.94 percentage point to the third-quarter change in real GDP after subtracting 1.42 percentage points from the second-quarter change... Real final sales of domestic product -- GDP less change in private inventories -- increased 2.5 percent in the third quarter, compared with an increase of 0.7 percent in the second.

• Housing (!):

  Real residential fixed investment increased 23.4 percent

  (which may have something to do with the first-time homebuyer tax credit, not to mention the Fed's efforts to keep mortgage rates low)
  

A hopeful sign is that investment in equipment and software increased, but ever so slightly (1.1%). A decrease in investment in nonresidential structures led to an overall negative number for nonresidential fixed investment.

The "rebalancing" of the economy took a pause: exports grew (14.7%), but imports grew still faster (16.2%).

Also, state and local government expenditures fell 1.1%; a further indication that states' inability to run deficits is acting as a counter-stimulus (Washington: send more money).

Overall, while the headline number suggests we're moving out of the shade, it is hard to say we've really emerged into the light until we see businesses confident enough to invest more robustly and hire workers as well as less reliance on federal efforts to prop up demand.

For more, see the Times story, and the roundup of "economist" reactions at Economix.

Update: Oops. I misinterpreted what was going on with inventories. Inventories continued to decline, but at a decreasing rate, hence the positive contribution to GDP growth (inventories declined by $130.8 bn in Q3, vs. $160.2 bn in Q2). That actually makes the picture look a bit better for the future as it means firms are not piling up inventories, which might lead them to cut back production.

Free Exchange has thoughts from Robert Gordon and Real Time Economics has more "economist" reaction.

Melissa on Health Care

NPR asks:

If you want to understand how to fix today's health insurance system, you'd be smart to look first at how it was born. How did Americans end up with a system in which employers pay for our health insurance?

My Miami colleague Melissa Thomasson answers.

Euro-hurt

After allowing a limited appreciation of the yuan from mid-2005 to mid-2008, China has tied its currency tightly to the dollar over the past year.

(note: the figure is the yuan price of $ so the fall represents a yuan appreciation)

In his Times column, Paul Krugman says China's policy of intervening to prevent the Yuan from appreciating is "outrageous" -

Although there has been a lot of doomsaying about the falling dollar, that decline is actually both natural and desirable. America needs a weaker dollar to help reduce its trade deficit, and it’s getting that weaker dollar as nervous investors, who flocked into the presumed safety of U.S. debt at the peak of the crisis, have started putting their money to work elsewhere.

But China has been keeping its currency pegged to the dollar — which means that a country with a huge trade surplus and a rapidly recovering economy, a country whose currency should be rising in value, is in effect engineering a large devaluation instead.

And that’s a particularly bad thing to do at a time when the world economy remains deeply depressed due to inadequate overall demand. By pursuing a weak-currency policy, China is siphoning some of that inadequate demand away from other nations, which is hurting growth almost everywhere. The biggest victims, by the way, are probably workers in other poor countries. In normal times, I’d be among the first to reject claims that China is stealing other peoples’ jobs, but right now it’s the simple truth.

After a spike during the financial crisis, when it was (ironically) seen as a safe-haven, the dollar has resumed its decline:

(note: the figure is the $ price of euro, so a rise denotes a dollar depreciation)

Because the dollar is declining relative to the euro and other currencies, the yuan is following it downwards. As Dan Drezner points out, the real losers are other countries with "strong" currencies:

[T]he United States is not the country that's hurt the most by this tactic. It's the rest of the world -- articularly Europe and the Pacific Rim -- that are getting royally screwed by China's policy. These countries are seeing their currencies appreciating against both the dollar and the renminbi, which means they're products are less competitive in the U.S. market compared to domestic production and Chinese exports.

Ambrose Evans-Pritchard also sees signs of tension:

What concerns European policymakers most is the lockstep rise against China's yuan. Beijing has clamped the yuan firmly to the weak dollar for over a year, quietly benefiting from the export advantages. It accumulated $68bn (£41bn) in reserves in September alone as a side-effect of holding down the currency. Fresh reserves are mostly being invested in eurozone bonds, pushing the euro higher.

French finance minister Christine Lagarde said it was intolerable that Europe should "pay the price" for a dysfunctional link between the US and China. "We want a strong dollar, and we have reiterated it again in the strongest manner," she said after this week's Eurogroup meeting. China's trade surplus with the EU reached €169bn (£154bn) last year.

Indeed, as the Times reported last week, China's share of world trade has grown - while its exports have fallen in the recession, most other countries have seen bigger declines:
A recent Times story on the benefit to US exporters from the falling dollar also notes the pain in Europe, and Willem Buiter blames the ECB for overly-restrictive policies.

Also, Krugman explains the "yuan" / "renminbi" thing.

Income and the Propensity to Consume

Capital Gains and Games points out a report from the BLS, which added some questions about the spring 2008 tax rebate stimulus checks to the consumer expenditure survey. According to the BLS:

Nearly half (49 percent) of recipients reported using the rebate mostly to pay off debt. Most other recipients reported either mostly spending the rebate (30 percent), or mostly saving the rebate (18 percent)... Although there is some variation, this pattern also generally holds true across income groups.

That last part surprised me. Like many other stimulus proponents, I expected that lower income households would spend more of the money, and, therefore, funds targeted at them would be more effective stimulus. That is, in the language of the textbook Keynesian model, the marginal propensity to consume would be higher at lower incomes. The survey results suggest otherwise. However, because the benefit phased out at with income, we don't know whether the truly rich would have behaved differently (the top category in the data is households with incomes over $70,000).

Incentives and Unknown Marginal Tax Rates

One effect of income taxes is to alter the incentives to work and save. Because income taxes change people's behavior - in theory, at least - they are said to "distortionary." What matters here is not the amount of taxation, but rather the marginal tax rate - e.g., a worker facing a 30% marginal tax rate will take home $70 for each additional $100 earned, so the tax reduces the benefit of working more (and decreases the cost of working less) by 30%. One of the central premises of the "supply side economics" that motivated the Reagan administration is that lower marginal tax rates would lead to an increase in work and investment (i.e., more "aggregate supply").

However, with our byzantine tax system it is difficult to calculate exactly what one's marginal rate is. An interesting post at TaxVox makes the point that effective marginal rates are altered by provisions tie benefits and tax breaks to income:

Many tax preferences are phased in or out according to income, and as a result, those who earn extra income may face either a hidden tax or a subsidy as their tax benefits change in value. For example, for those in the phase-in range of the earned income credit earning an extra dollar increases the credit and reduces their tax liability, driving their actual rate below their statutory rate. But once they make enough so the EITC begins to phase out, the opposite happens and the rate they actually pay climbs.

Altogether, half of taxpayers in 2009 face actual tax rates on additional earnings that differ substantially from their statutory rates. The tax on that last dollar – what economists call the effective marginal tax rate – is higher than the statutory rate for 32 percent of taxpayers and lower for almost 18 percent. Moreover, the difference between the two rates can be huge. For taxpayers whose effective rate is higher, the average discrepancy is almost 6 percentage points. For those with lower effective rates, the difference averages 11 percentage points....

Yet many don’t even know it. Statutory and effective rates differ so haphazardly that most taxpayers probably have no idea how much tax they owe on an additional dollar of income. What does this say about our current tax system? First, the phase-in and phase-outs of provisions really do bite. Second, in case you needed more proof that our current system is complex, here you have it. Finally, it suggests that many individuals are making decisions based on incorrect notions about the tax consequences of their behavior.

Not only does this remind us what a mess the tax code is, it also raises the question of how much we can depend on assuming that the incentive effects of taxes significantly alter behavior, if people cannot even determine what those incentives are.

All the Sugar and Twice the Caffeine

Social security payments rise automatically with inflation through a mechanism known as the cost of living adjustment (COLA). The adjustment is asymmetric - social security payments adjust upward for inflation, but not downward with deflation. This year, the index that the COLA is based on - the CPI for urban wage earners and clerical workers in the 3rd quarter - was 2.1% lower than a year ago, which implies that there should be a COLA of zero.

CPI-W (CPI for Urban Wage Earners and Clerical Workers)

Although deflation is generally bad news for the economy as a whole, one group that benefits are those who have fixed nominal incomes. Since prices have fallen over all, a given dollar income has greater purchasing power. That is, the real value of social security payments would rise, even if the nominal level (i.e., the dollar amount) stayed constant.

But that's apparently not good enough: through some confluence of money illusion, pandering and self-interest, the zero COLA has come to be viewed as unfair to seniors. The administration is proposing to add an artificial sweetener in the form of a $250 extra payment to social security recipients.

Normally, that's not very good policy - EconomistMom, for one, is not happy - but as Ezra Klein points out: "The economy needs more stimulus and this is good stimulus."

Potentially, a bad precedent. But hopefully we won't see deflation again.

From Dutch to Ike

In the Times last week, David Leonhardt writes about Bruce Bartlett, who was a staffer to Jack Kemp back when he was writing the legislation that eventually became Reagan's signature 1981 tax cut. According to Leonhardt:

[P]erhaps the most persistent — and thought-provoking — conservative critic of the party has been Bruce Bartlett. Mr. Bartlett has worked for Jack Kemp and Presidents Reagan and George H. W. Bush. He has been a fellow at the Cato Institute and the Heritage Foundation. He wants the estate tax to be reduced, and he thinks that President Obama should not have taken on health reform or climate change this year.

Above all, however, he thinks that the Republican Party no longer has a credible economic policy. It continues to advocate tax cuts even though the recent Bush tax cuts led to only mediocre economic growth and huge deficits. (Numbers from the Congressional Budget Office show that Mr. Bush’s policies are responsible for far more of the projected deficits than Mr. Obama’s.)

On the spending side, Republican leaders criticize Mr. Obama, yet offer no serious spending cuts of their own. Indeed, when the White House has proposed cuts — to parts of Medicare, to an outdated fighter jet program and to subsidies for banks and agribusiness — most Republicans have opposed them.

How, Mr. Bartlett asks, is this conservative? How is it in keeping with a party that once prided itself on fiscal responsibility — the party of President Dwight Eisenhower (who refused to cut taxes because the budget wasn’t balanced) or of the first President Bush (whose tax increase helped create the 1990s surpluses)?

“So much of what passes for conservatism today is just pure partisan opposition,” Mr. Bartlett says. “It’s not conservative at all.”

So Bartlett is now an advocate of "fiscal responsibility," and he is intellectually honest enough to say that this means higher taxes. In a recent Forbes column he wrote:

Everyone knows that fiscal discipline must be restored eventually, or we will face truly horrifying consequences--defaulting on the debt, nonpayment of Social Security benefits, a collapsing dollar, and double-digit inflation and interest rates. Everyone also knows that this will involve a combination of higher revenues and lower spending. The idea that we can restore fiscal health only with spending cuts is childish, as I tried to explain last week.

While there is some truth in his argument that the contemporary Republican anti-tax reflex is pretty far removed from the "supply side" principles of the Kemp-Roth bill (see, e.g., this post at Capital Gains and Games), it is a bit ironic to see an original Reagan revolutionary sounding like such an Eisenhower Republican (or Clinton/Rubin Democrat). EconomistMom likes what he's saying.

Update (10/16): Bartlett explains his thinking further in a blog post "Supply Side Economics, RIP."

Too Soon to Tell

Marginal Revolution picks up my favorite quotation.

September Employment Report

The latest report from the Bureau of Labor Statistics is a bummer:

Total nonfarm payroll employment declined by 263,000 in September. From May through September, job losses averaged 307,000 per month, compared with losses averaging 645,000 per month from November 2008 to April. Since the start of the recession in December 2007, payroll employment has fallen by 7.2 million.

The unemployment rate also ticked up, from 9.7% to 9.8%, and that somewhat understates the badness of the situation, because labor force participation fell, suggesting that people were giving up on finding a job. While the NBER may later tell us we are indeed technically out of the recession, the time has not come let up on efforts to stimulate demand, Paul Krugman writes in his Times column:

[T]he administration’s own economic projection — a projection that takes into account the extra jobs the administration says its policies will create — is that the unemployment rate, which was below 5 percent just two years ago, will average 9.8 percent in 2010, 8.6 percent in 2011, and 7.7 percent in 2012.

This should not be considered an acceptable outlook. For one thing, it implies an enormous amount of suffering over the next few years. Moreover, unemployment that remains that high, that long, will cast long shadows over America’s future.

See also Brad DeLong.

Van Customs

The US imposed a 25% tariff on imported trucks and commercial vans ("motor vehicles for the transport of goods," in the words of the Harmonized Tariff Schedule) in 1963 as retaliation for European tariffs on chicken. However, "motor vehicles principally designed for the transport of persons" face a much lower (2.5%) tariff rate. Via Autoblog, we learn of some cleverness on the part of the folks at Ford. They manufacture Transit Connect vans in Turkey and then:

They actually ship the Transit Connects here with the vans classified as wagons. Then, once they reach a processing facility in Baltimore, they are transformed into cargo vans, totally side-stepping the Chicken Tax. Smart, huh?

The process of transforming a passenger "wagon" into a cargo van works like this. The rear windows are removed and replaced by a sheet of metal that's quick cured in place. The rear seats and seat belts are then removed and a new floorboard is screwed into place. Voila – five minutes after they start as five-passenger wagons, Ford has a bunch of two-seater panel vans. The seats are then shredded and the material is used as land fill cover. No word on what happens to the glass.

Hmmm... I never expected that my reading of Autoblog would yield an example for my international trade class. All that time I was working, after all.

The Wall Street Journal has more.

Global Warming: Easy Economics but Hard Politics

The Times reports:

While virtually all of the largest developed and developing nations have made domestic commitments toward creating more efficient, renewable sources of energy to cut emissions, none want to take the lead in fighting for significant international emissions reduction targets, lest they be accused at home of selling out future jobs and economic growth.

The negotiations for a new climate change agreement to be signed in Copenhagen in December are badly stalled. With the agreement running more than 200 pages — including what negotiators estimate are a couple of thousand brackets denoting points of differences — diplomats and negotiators fear that the document is too unwieldy to garner a consensus in the coming months.

Sigh. The darn thing is, the costs of dealing with this are likely to be quite low. Further evidence of this comes from estimates by the CBO:

For example, CBO concludes that the cap-and-trade provisions of H.R. 2454, the American Clean Energy and Security Act of 2009, would reduce GDP below what it would otherwise have been—by roughly ¼ to ¾ percent in 2020 and by between 1 and 3½ percent in 2050. By way of comparison, CBO projects that real (that is, inflation-adjusted) GDP will be roughly two and a half times as large in 2050 as it is today, so those changes would be comparatively modest. In the models that CBO reviewed, the long-run cost to households would be smaller than the changes in GDP because consumption falls by less than GDP and because households benefit from more time spent in nonmarket activities. Moreover, these measures of potential costs do not include any benefits of averting climate change.

EconomistMom notes their reluctance to quantify the benefits, which makes the whole "cost benefit" thing a little hard:

What I see as the trouble with CBO–known as the official “scorekeeper” for legislation being considered by Congress–doing a quantitative analysis of the “economic effects” of climate change policy, is that all their qualifying statements about their inability to quantify (in dollar terms) the main point of climate change policy (avoiding environmental damage and what that means for the broader well-being of our society) will be lost on the policymakers, and hence on the public as well. People look for the numbers in a CBO report and will surely use the numbers about what’s bad about climate change policy as a reason not to enact that policy, as long as there are no concrete numbers to support the merits of the policy. In other words, it’s hard for CBO to be the unbiased arbiter on policy evaluation if they’re only “tooled up” on one side of the debate.

Indeed, the expected value is calculated as the probability weighted sum of the various outcomes. If we assign a value of infinity to "avoid complete destruction of human civilization" then, even if the probability is small, the expected benefit is infinite.

Also on the subject of global warming, Mark Thoma points us to this WSJ column by Robert Stavins of Harvard.

China's Cares for our (Fiscal) Health

The New Republic's Noam Scheiber reports that our largest creditor is, understandably, taking an interest in issues that affect the US government's future fiscal position:

To his surprise, when [Budget Director Peter] Orszag arrived at the site of the annual U.S.-China Strategic and Economic Dialogue (S&ED), the Chinese didn't dwell on the Wall Street meltdown or the global recession. The bureaucrats at his table mostly wanted to know about health care reform, which Orszag has helped shepherd. "They were intrigued by the most recent legislative developments," Orszag says. "It was like, 'You're fresh from the field, what can you tell us?' "

As it happens, health care is much on the minds of the Chinese these days. Over the last few years, as China has become the world's largest purchaser of Treasury bonds, the government has grown increasingly sophisticated in its understanding of U.S. budget deficits. The issue has become all the more pressing in recent months, as the financial crisis and recession pushed the deficit to record levels. With nearly half of their $2 trillion in foreign currency reserves invested in U.S. bonds alone, the Chinese are understandably concerned about our creditworthiness. And this concern has brought them ineluctably to the issue of health care.

The United States' dependence on foreign purchases of Treasury bonds means that no issue that affects the deficit is solely "domestic." The US has an interest in China's health care system, too, as it contributes to the high savings rate that fuels China's side of the current account imbalance. Scheiber writes:

The Chinese save such freakish amounts because consumer credit is scarce, insurance is rudimentary, and their social infrastructure is threadbare. They must often pay for houses in cash, and for medical procedures out of pocket.

Update (8/20): Ilian Mihov suggests (with evidence) that healthcare and education costs played a key role in the rise of US consumption.

Some Freshwater Saltiness

The navel-gazing turns nasty....

Paul Krugman's NY Times Magazine article "How Did Economists Get it So Wrong?" (see this earlier post) has generated quite a volume of reaction, usefully rounded up by Mark Thoma. Representing the "freshwater" school, John Cochrane is not happy. He asks "How Did Paul Krugman Get it So Wrong [.doc] ?" and part of his answer is:

So what is Krugman up to? Why become a denier, a skeptic, an apologist for 70 year old ideas, replete with well-known logical fallacies, a pariah? Why publish an essentially personal attack on an ever-growing enemies list that now includes practically every professional economist? Why publish an incoherent vision for the future of economics?

The only explanation that makes sense to me is that Krugman isn’t trying to be an economist, he is trying to be a partisan, political opinion writer. This is not an insult. I read George Will, Charles Krauthnammer and Frank Rich with equal pleasure even when I disagree with them. Krugman wants to be Rush Limbaugh of the Left.

Yikes. On his blog, a semi-response from Krugman.

A Tiresome Tariff?

President Obama has imposed "safeguard" tariffs for three years on Chinese tires, but at a lower level than the ITC recommended, the Times reports:

The International Trade Commission, an independent federal agency, ruled in late June that Chinese tire imports had indeed disrupted the domestic industry.

The panel recommended that the president impose tariffs for three years, starting at 55 percent and then declining. Mr. Obama, who was required by law to decide on the recommendation by Sept. 17, announced slightly lower tariffs that will start at 35 percent and drop to 25 percent in the third year.

Economists are mostly nonplussed... Brad DeLong says "really stupid." But not unusual, notes Douglas Irwin:

Regardless of party, every president, at some point, and often for political reasons, has imposed restrictions on imports. George Bush did, Bill Clinton did, Ronald Reagan did (a lot), Jimmy Carter did, and so forth...you get the drift. With some exceptions, most of these restrictions were not too costly or too important: they usually involved small industries, and the restrictions eventually expired. So on the broad canvas of presidential trade policy, Obama’s decision is unexceptional. Of course, the timing of the administration’s action, coming off the economic crisis and increasing fears of protectionism, makes it a bit riskier than most. And China’s response could make a bad situation worse; let us hope that it is posturing for its domestic audience. Still, the disruption to world trade is significantly less than Bush’s steel safeguard action early in his term.

Also, Dean Baker notes:

When China was admitted to the WTO it agreed to allow the United States to impose tariffs to temporarily counteract the disruptive effects of an import surge. The agreement did not require the United States to show that China had in any way acted unfairly, simply that the growth of imports had seriously disrupted the domestic market.

This clause was an important factor in selling China's entry to the WTO to interest groups in the United States. Therefore, it should not be surprising that the government would occasionally take advantage of a clause that it had demanded.

Real Time Economics rounds up more reaction.

Inflation (Just This Once...)

Or, "you shall not crucify mankind on the cross of an informal 2% inflation target"

Christopher Hayes of the New America Foundation argues for more inflation as a way of reducing the real burden of Americans' debts, which has become quite massive. He writes:

While accessible credit fuels growth, too much debt kills it. The entire institution of bankruptcy exists because we recognize that otherwise functional economic entities can be paralyzed by debt, and that it ultimately benefits economic growth to allow some means of wiping out debt and starting fresh.

But even short of default, a vicious cycle can take hold. At a certain point households, firms, and even governments are forced to spend money on meeting short-term debt servicing obligations rather than on making long-term investments. What results is a form of debt serfdom. Farmers don't invest in new crops and land; businesses don't add needed productive capacity because every spare cent goes towards interest payments. Governments can't afford to provide basic services because they have to pay off onerous debts. Households can't send their children to college because credit card payments have eaten up their savings.

Avoiding the deadening effect of too much debt on the economy is the kernel of wisdom found in numerous ancient traditions and scriptural injunctions that require formalized periodic debt cancellation. Deuteronomy commands that every seven years (that is, during the sabbatical year) debts will be forgiven "because the Lord's time for cancelling debts has been proclaimed" (Deut. 15: 1-2). In the Judeo-Christian tradition, it is called Jubilee.

We don't have Jubilee in modern financial capitalism and for good reason: the understanding of moral hazard then wasn't quite what it is today. But if we are to emerge from the current crisis into an economic future of sustained growth and widespread prosperity, we are going to have to do something to lessen the burden that past debts now impose on investors, innovators, consumers, and the federal government. Failure to do so would likely lead to a Japanese-like lost decade of low or non-existent growth, or worse.

The surest way to avoid such a fate is to jettison a central, indeed the central axiom of post-1970s neoliberal global capitalism, and that is to embrace a period of moderate, sustained inflation.

That is, in essence, a modern version of the argument made by late 19th century populists who campaigned for monetizing silver, which would have caused an inflationary increase in the money supply. At the time, grinding deflation had raised the real value of debts, effectively redistributing wealth from midwestern farmers to eastern bankers (i.e., a farmer's mortgage payments, fixed in dollar terms, increased relative to his income from selling crops, which had fallen in price).

Hayes is correct that high levels of household debt could be a serious drag on the recovery, as people seek to improve their balance sheets by holding back on spending. A little extra inflation could help in that regard, but it would potentially create new problems.

Expectations matter. When firms and individuals make plans and enter into contracts, they do so based on their expectations of future inflation rates. From a lender's perspective, higher inflation means that interest rates must be higher to make up for the erosion in the real value (purchasing power) of the payments over time. In high-inflation environments, borrowers are willing to pay higher interest rates because they expect their nominal incomes to be rising. One reason that interest rates have been lower over the past two decades is that people have come to expect moderate inflation. An unexpected increase in inflation would reduce ex post real interest rates and redistribute wealth from creditors to debtors. That would be a short-term boost to the economy, but it would also change people's expectations of the future. An increase in expected future inflation would mean higher nominal interest rates now.

Hayes' solution to the problem of spiraling inflation expectations is to use inflation targeting - i.e., for the Fed to announce a target level of inflation (some argue that its long-term forecasts of 1.5-2.1% inflation act as de facto targets now) - but at a higher level. He says:

Historically, this approach has been favored by inflation hawks, who feel that it would serve as a control on the temptation for the Fed to cut rates to spur economic growth, or to allow recovery to go on too long raising prices too much. In the context of promoting inflation, it would be used as a kind of check against the fears of spiraling inflation that a sustained rise in the price level might bring about. If global investors come to credibly believe the target, even if the target is 5 percent, then it will reduce speculation in commodities and gold and avoid a rush away from bonds. For investors can price a predictable rate of inflation into the futures markets now, creating stable prices, rather than rushing to place bets that inflation will go to 10 or 12 percent. (Some of those bets are likely to be placed regardless.)

This would work fine if the target were credible - if people believed that the increase was really just a one-time only event. But is a Fed which shifts its target around going to have much credibility? I doubt it. Interest rates would likely incorporate a premium for the risk that, next downturn, the Fed would ratchet up its target again. The effect of that premium would be to redistribute wealth to creditors, and to inhibit investment by making it more costly to business to finance projects.

Furthermore, the inflation would be painful to reverse: disinflation can be very costly, as the experience of the early 1980's "Volcker recession" showed.

Hayes is right that some of the inflation fears resulting from the Fed's unconventional policies are misplaced; the Bernanke Fed is rightly trying very hard to avoid deflation. To that end, it may make sense for central banks to target a slightly higher rate, as this would give them more room to ease monetary policy before hitting the dread zero lower bound (Real Time Economics reports John Williams has similar thoughts; see also this earlier post). But that is very different from a policy of deliberately inflating away debt.

While the overall argument is interesting, I think Hayes oversells it a bit, offering a somewhat mono-causal view of the postwar economy:

The annual real growth rate from 1948-1980, the bad old days of high inflation, was 3.7 percent. From 1980-2009, the brave new era of low inflation, it was a mere 2.9 percent.

We are, in many ways, now reaping what decades of historically low inflation have sown: a massive upwards redistribution of wealth, an oversized financial sector, an eviscerated tradable goods sector, and a grotesquely large trade deficit. In other words, the imbalances and structural weaknesses of the post-Volcker economy, the ones that built up to create the crisis, were partly produced by the Great Disinflation that Volcker ushered in. Recovery will involve a fundamental restructuring of our economic engine, shifting from the supply-side nostrums of the past two decades that paradoxically led to an unhealthy pattern of asset bubbles and debt-financed consumption to policies that bolster global demand by investing in quality-of-life improvements and by raising incomes and wages worldwide. That means the seeding of a global middle class and recalibrating the share of profits captured by labor as opposed to capital. Such an economy will almost certainly be an economy with higher inflation than has been the case over the past two decades.

While the stabilization of inflation at low levels may have contributed to some bouts of irrational exuberance, it is a bit of a stretch to attribute so much of the economic pathology of the last 30 years to it. Though the beginning of the rise in inequality roughly coincides with the Volcker disinflation, it likely has more to do with Reagan-era policies (lest we forget, Volcker was a Carter appointee) which discouraged unionization and lowered tax rates on high incomes. The trade deficits of the 1980's had something to do with the strong dollar resulting form Fed policy, but other factors, like China's massive intervention in foreign exchange markets, are more important for the imbalances of the past decade.

Also, while 1980 is an important breakpoint in both monetary and other policies, comparing averages over 1948-80 with 1980-2009 obscures the fact that much of the growth came in the 1960's, while the inflation was (mostly) in the 1970's.

(red: output growth, blue: inflation)

While I believe Hayes' proposal would have more serious costs than he does, we are in times that call for rethinking some of our views. If the current slump turns out not only to be deep, but also persistent (along the lines of Japan's "lost decade"), it may be that a policy that creates some long term problems is nonetheless worthwhile. After all, "in the long run, we're all dead."

(Hayes' article came to my attention via Matt Yglesias' blog).

Stagnation

At Economix, David Leonhardt writes:

The typical American household made less money last year than the typical household made a full decade ago.

To me, that’s the big news from the Census Bureau’s annual report on income, poverty and health insurance, which was released this morning. Median household fell to $50,303 last year, from $52,163 in 2007. In 1998, median income was $51,295. All these numbers are adjusted for inflation.

In the four decades that the Census Bureau has been tracking household income, there has never before been a full decade in which median income failed to rise. (The previous record was seven years, ending in 1985.) Other Census data suggest that it also never happened between the late 1940s and the late 1960s. So it doesn’t seem to have happened since at least the 1930s.

Oh, and the poverty rate is up, too. Mark Thoma points us to the Center on Budget and Policy Priorties, which produced this chart: And that's as of 2008. Next year's report likely won't be pretty. See also Ezra Klein, Catherine Rampell.

Trade Notes

A couple of interesting items on the trade front...

The Chinese tire safeguard tariff case moves forward. President Obama has until Sept. 17 to act on the International Trade Commission recommendation, and the Washington Post has the view from Albany, GA, home of a Cooper Tire plant. (See also this earlier post).

Meanwhile, regional trade agreements continue to proliferate. The Economist makes the case that such "free trade" agreements do not promote free trade:

Some regional trade deals in the right circumstances have indeed added to economic well-being. But the sorts of deals that are now being signed in Asia, just when multilateral trade desperately needs supporting, are likely to do less for their countries’ economies than for the egos of the politicians who sponsor them. Taken as a trend, they amount to a dangerous erosion of the system of multilateral trade on which global prosperity depends.

A Return to Arms?

More navel gazing....

Several years ago, in his brief intellectual history, "The Macroeconomist as Scientist and Engineer" [JSTOR] Greg Mankiw suggested that, after the vicious internecine strife of the 1970s and 80s, the field had arrived at an uneasy peace:

Like the neoclassical-Keynesian synthesis of an earlier generation, the new synthesis attempts to merge the strengths of the competing approaches that preceded it. From the new classical models, it takes the tools of dynamic stochastic general equilibrium theory. Preferences, constraints, and optimization are the starting point, and the analysis builds up from these microeconomic foundations. From the new Keynesian models, it takes nominal rigidities and uses them to explain why monetary policy has real effects in the short run. The most common approach is to assume monopolistically competitive firms that change prices only intermittently, resulting in price dynamics sometimes called the new Keynesian Phillips curve. The heart of the synthesis is the view that the economy is a dynamic general equilibrium system that deviates from a Pareto optimum because of sticky prices (and perhaps a variety of other market imperfections).

It is tempting to describe the emergence of this consensus as great progress. In some ways, it is. But there is also a less sanguine way to view the current state of play. Perhaps what has occurred is not so much a synthesis as a truce between intellectual combatants, followed by a face-saving retreat on both sides. Both new classicals and new Keynesians can look to this new synthesis and claim a degree of victory, while ignoring the more profound defeat that lies beneath the surface.

Much has happened in the short time since, and the implications for the field are not yet clear. Paul Krugman's essay in this week's NY Times Magazine, "How Did Economists Get it So Wrong?" continues the story. The truce is over, he says:

Between 1985 and 2007 a false peace settled over the field of macroeconomics. There hadn’t been any real convergence of views between the saltwater and freshwater factions. But these were the years of the Great Moderation — an extended period during which inflation was subdued and recessions were relatively mild. Saltwater [New Keynesian] economists believed that the Federal Reserve had everything under control. Fresh­water [New Classical] economists didn’t think the Fed’s actions were actually beneficial, but they were willing to let matters lie.

But the crisis ended the phony peace. Suddenly the narrow, technocratic policies both sides were willing to accept were no longer sufficient — and the need for a broader policy response brought the old conflicts out into the open, fiercer than ever.

This became most apparent in the intellectual debate over the fiscal stimulus:

Freshwater economists who inveighed against the stimulus didn’t sound like scholars who had weighed Keynesian arguments and found them wanting. Rather, they sounded like people who had no idea what Keynesian economics was about, who were resurrecting pre-1930 fallacies in the belief that they were saying something new and profound.

Krugman may be right. However, I think it may be premature to declare that combat has resumed. Krugman and Brad DeLong have found a number of examples of alarmingly pre-Keynesian thinking from some very big names in the field, but it is not clear they have a broad following. The recession presents a real challenge - and opportunity - for macroeconomists. While it would be natural for Minnesota and Chicago types to use more "freshwater" style tools to try to explain it, I am optimistic that most of the profession will be interested in convincing hypotheses of any degree of salinity.

Justin Fox has similar sentiments, but Brad DeLong is less optimistic.

Update (9/6): EconomistMom responds, with a Washington "engineering" perspective; she says "as I've gotten older, my elasticities have shrunk." On his blog, Krugman offers additional notes.

August Employment Report

The news from the August BLS report was not good (but less bad than earlier this year). According to the household survey, the unemployment rate increased from 9.4% to 9.7%. When I saw the headline, I was hoping the rise might be the artifact of increased labor force participation (recall the unemployment rate is measured as a percentage of those working or looking for work, so if improved prospects motivate people to re-enter the labor force, the unempolyment rate can rise), but it was steady at 65.5%. The establishment survey found a decrease in payrolls of 217,000. While rapidly rising productivity is good news in the long run, it implies a larger increase in output would be necessary to generate an increase in employment.

Overall, the picture is consistent with an agonizingly slow turn in the business cycle; if this economy was a car, one would say that it has poor cornering and sluggish acceleration (but good brakes).

For more, see the Times story, and roundups of reactions at Economix and Real Time Economics.

Hysteresis and the WTO

The US won its WTO dispute over auto parts with China, the Times reports, but the victory may be meaningless, in practice:

After four years of negotiations and W.T.O. reviews, the Chinese government announced late Friday that it would comply with the organization’s ruling that China must reduce its steep tax on imported auto parts for cars that do not meet certain local standards.

But the delay in changing its trade policies served to limit imports. During the lengthy negotiations, foreign automakers moved production to China on a large scale. The automakers with assembly plants in China have largely stopped using imported auto parts, partly to avoid paying the steep taxes on these parts and partly because international auto parts manufacturers moved production to China.

Because there are fixed costs and comparative advantage is not static, the time involved in resolving disputes at the WTO matters. Since the case would almost certainly take a long time and the outcome was uncertain, it was worthwhile for manufacturers to pay the fixed cost of setting up in China. China was, in effect, able to protect an "infant industry," and induce investment in auto parts manufacturing (i.e., in terms of neoclassical trade theory, change its factor "endowment"). Therefore, by the time China "lost" the case, it had a globally competitive auto parts industry.

Such "path dependence" is sometimes referred to as "hysteresis" after the property of metals that retain a magnetic effect after coming into contact with a magnet.

More information about the case from the WTO website.

Our Imperial Benevolence

Keynes' biographer, Lord Skidelsky, had lunch with the FT's Lionel Barber last week. We learn that Skidelsky himself has had quite an interesting life (his planned book about his family may be an interesting read) and also:

Skidelsky does not appear to like economists very much, I say. “Not true. But there is an imperial benevolence about them; they are not interested in people, they are very impersonal. I cannot imagine having a bosom friend who is an economist.”

I like that - "imperial benevolence" - but, really, we're not so bad as people think. Sigh.

$253K per Second, But Don't Panic

The Times visits Van Zeck, the Treasury official who manages the government's borrowing:

Last year alone, Mr. Zeck auctioned off $5.5 trillion of Treasury securities, to replace maturing debt and to meet new borrowing needs. Wall Street dealers expect the figure to exceed $8 trillion this year — an average of more than $253,000 every second.

In the first eight months of the current fiscal year, the government issued more Treasury bills, notes and bonds than in all of last year. Mr. Zeck expects to conduct more than 280 auctions this year, up from 263 last year and about 220 a year from 2004 to 2007.

Of course, that scary number is gross borrowing, not net (i.e., it includes refinancing), but the net picture isn't pretty either. The CBO and OMB will release updated estimates of the federal deficit tomorrow - the OMB's estimate for this year's deficit will be $1.58 trillion, and $9 trillion over the next decade. Stan Collender says not to panic:

[T]his is not the time for the administration to propose deficit reductions. Assuming that the current economic forecasts are as correct as they increasingly seem to be, that should happen when the president sends his fiscal 2011 budget to Congress next January or February. Proposing them now would unnecessarily complicate the politics of every issue being dealt with currently and that is likely the primary motivation for those who call for a deficit reduction effort between now and the end of the the year.

And Paul Krugman notes that the projected debt to GDP ratio is not historically unprecedented:

[T]he debt outlook is bad. But we’re not looking at something inconceivable, impossible to deal with; we’re looking at debt levels that a number of advanced countries, the US included, have had in the past, and dealt with.