Bernanke Isn't Neutral on the Long-Run

When I first started teaching intermediate macroeconomics ten years ago, I decided to consider economic growth in the first part of the class.  Partly my reasoning was tactical - its the most mathematically challenging part of the class for many students, so I thought it was good to get them in the habit of working hard and taking it seriously at the start (and the competing claims on students' time tend to be less severe earlier in the semester).  The more important rationale was motivation - at the time we were in the midst of the "great moderation" and it was hard to get students who had never seen a serious recession in their lives excited about learning about things like how the Fed sets interest rates.  That, of course, has changed, and I think starting in with business cycles would be a good way to get the students "hooked" now - its tempting to change, but I've stuck with my strategy of emphasizing growth at the beginning of the semester.

As I noted in a recent post, long-run economic growth is the most important determinant of how living standards change from generation to generation, and why they vary so much from country to country.  The rise in incomes over decades is much bigger than the disruptions due to any business cycle downturn, even relatively large ones like the slump following the 2007-08 financial crisis.  Economic theory says that the main determinant of growth in the long run is technological progress, though we're still a little iffy on explaining how that technological change occurs.

Robert Lucas famously said: "Once you start thinking about economic growth, its hard to think about anything else."  Actually, that's pretty wrong - its very easy to be focused on short-run fluctuations and policy responses to them (and this is really important, and the negative consequences of recessions are understated by representative agent type models that Lucas tends to favor).

Ben Bernanke used his commencement address at Bard College at Simon's Rock as an opportunity to step back from his usual focus on managing short-run fluctuations and talk about economic growth.   His speech acts as a rebuttal of sorts to Robert Gordon and others who are worrying that the benefits of the information technology "revolution" for productivity growth are already petering out.  The core of his response is:

First, innovation, almost by definition, involves ideas that no one has yet had, which means that forecasts of future technological change can be, and often are, wildly wrong. A safe prediction, I think, is that human innovation and creativity will continue; it is part of our very nature. Another prediction, just as safe, is that people will nevertheless continue to forecast the end of innovation. The famous British economist John Maynard Keynes observed as much in the midst of the Great Depression more than 80 years ago. He wrote then, "We are suffering just now from a bad attack of economic pessimism. It is common to hear people say that the epoch of enormous economic progress which characterised the 19th century is over; that the rapid improvement in the standard of life is now going to slow down." Sound familiar? By the way, Keynes argued at that time that such a view was shortsighted and, in characterizing what he called "the economic possibilities for our grandchildren," he predicted that income per person, adjusted for inflation, could rise as much as four to eight times by 2030. His guess looks pretty good; income per person in the United States today is roughly six times what it was in 1930.

Second, not only are scientific and technical innovation themselves inherently hard to predict, so are the long-run practical consequences of innovation for our economy and our daily lives. Indeed, some would say that we are still in the early days of the IT revolution; after all, computing speeds and memory have increased many times over in the 30-plus years since the first personal computers came on the market, and fields like biotechnology are also advancing rapidly. Moreover, even as the basic technologies improve, the commercial applications of these technologies have arguably thus far only scratched the surface. Consider, for example, the potential for IT and biotechnology to improve health care, one of the largest and most important sectors of our economy. A strong case can be made that the modernization of health-care IT systems would lead to better-coordinated, more effective, and less costly patient care than we have today, including greater responsiveness of medical practice to the latest research findings.  Robots, lasers, and other advanced technologies are improving surgical outcomes, and artificial intelligence systems are being used to improve diagnoses and chart courses of treatment. Perhaps even more revolutionary is the trend toward so-called personalized medicine, which would tailor medical treatments for each patient based on information drawn from that individual's genetic code. Taken together, such advances could lead to another jump in life expectancy and improved health at older ages.

Other promising areas for the application of new technologies include the development of cleaner energy--for example, the harnessing of wind, wave, and solar power and the development of electric and hybrid vehicles--as well as potential further advances in communications and robotics. I'm sure that I can't imagine all of the possibilities, but historians of science have commented on our collective tendency to overestimate the short-term effects of new technologies while underestimating their longer-term potential.

Finally, pessimists may be paying too little attention to the strength of the underlying economic and social forces that generate innovation in the modern world. Invention was once the province of the isolated scientist or tinkerer. The transmission of new ideas and the adaptation of the best new insights to commercial uses were slow and erratic. But all of that is changing radically. We live on a planet that is becoming richer and more populous, and in which not only the most advanced economies but also large emerging market nations like China and India increasingly see their economic futures as tied to technological innovation. In that context, the number of trained scientists and engineers is increasing rapidly, as are the resources for research being provided by universities, governments, and the private sector. Moreover, because of the Internet and other advances in communications, collaboration and the exchange of ideas take place at high speed and with little regard for geographic distance. For example, research papers are now disseminated and critiqued almost instantaneously rather than after publication in a journal several years after they are written. And, importantly, as trade and globalization increase the size of the potential market for new products, the possible economic rewards for being first with an innovative product or process are growing rapidly.  In short, both humanity's capacity to innovate and the incentives to innovate are greater today than at any other time in history. 

In typical Bernanke fashion, the whole speech is very nicely done (he must be a fantastic professor).  Another thing I liked about it is that Bernanke also makes a case for liberal arts education:

Well, what does all this have to do with creativity and critical thinking, which is where I started? The history of technological innovation and economic development teaches us that change is the only constant. During your working lives, you will have to reinvent yourselves many times. Success and satisfaction will not come from mastering a fixed body of knowledge but from constant adaptation and creativity in a rapidly changing world. Engaging with and applying new technologies will be a crucial part of that adaptation. Your work here at Simon's Rock, and the intellectual skills, creativity, and imagination that that work has fostered, are the best possible preparation for these challenges. And while I have emphasized technological and scientific advances today, it is important to remember that the arts and humanities facilitate new and creative thinking as well, while helping us to draw meaning that goes beyond the purely material aspects of our lives. 

I'd been thinking of adding Robert Gordon's paper on the "headwinds" facing economic growth to the reading list for next year.  Bernanke's speech will be a nice counterpoint to go with it.

The speech is also discussed by the NYT's Binyamin Appelbaum and Washington Post's Neil Irwin.

China to Switch Sides (of the Trilemma)?

At Wonkblog, Neil Irwin rightly points out that China's announced intention to liberalize financial flows by making it easier to convert renminbi into foreign currency is a big deal.  He writes:

China is essentially weighing a trade-off.  A transition to a freer, more market-based financial system could pack many advantages, including a more efficient system of funneling savings into productive investment, more reliable savings vehicles available for its citizens, and advantages for Chinese companies as they do business across Asia and beyond.

But getting those advantages will come at a price. It means pivoting away from an export-led growth strategy that has been wildly successful over the last generation and has benefited from an artificially low yuan. It leaves China with greater risk of volatile capital flows that have created booms and busts, and bursts of inflation, in many other emerging economies over the years.  And most importantly, from the vantage point of the ruling Communist party, it will mean ceding some of the power now held by top party officials to the hard-to-corral whims of markets.

As Greg Mankiw explains, the international finance "trilemma" (or "impossible trinity" for those who think "trilemma" sounds too silly) implies that a country cannot simultaneously have (i) free capital mobility (financial flows) (ii) a fixed exchange rate and (iii) monetary policy autonomy.  That is, on this diagram, all countries must choose a side:

China's current policy puts it on the right-hand side; while the yuan is no longer pegged to the dollar, its value is heavily managed.  The capital controls come in by preventing foreigners from buying yuan when interest rates in China rise (which would otherwise cause the yuan to appreciate).  Allowing relatively free financial flows and letting the yuan float would put it on the left-hand side, which is where the US is.

There is likely a significant pent-up demand demand for yuan- denominated assets and the rest of the world would soon take advantage of the opportunity to diversify portfolios by investing in China.  Furthermore, free capital flows would help the yuan to gain status as a "reserve currency" held by governments (it isn't one now because nobody wants to hold reserves in a currency they can't freely exchange).  Purchases of Chinese assets by investors and governments would cause the yuan to appreciate (which would be partly offset by outflows as Chinese buy more foreign assets).  This would hurt Chinese exports but raise its wealth and increase its consumption, helping to "rebalance" its economy toward a more consumer-oriented model (currently, consumption is about 35% of China's GDP, versus roughly 70% in the US).

China's policy of intervening to keep the yuan undervalued (relative to what it would be under a free float) means that its been buying alot of dollar-denominated assets.  A reduction in this buying, as well as possibly lower demand for dollars from other countries if the yuan takes market share as a reserve currency, would mean a dollar depreciation.  This would boost US exports, while lowering the purchasing power of consumers, thus rebalancing the US economy in the opposite direction of China's.  In general, the financial inflows associated with the dollar's unique role have meant lower interest rates for the US - while this has been called our "exorbitant privilege", it is, at best, a mixed blessing, as it has distorted the US economy away from tradable goods production and helped fuel the previous decade's housing bubble.  Ceteris paribus, the changes discussed above imply higher interest rates for the US, but for the immediate future, one would expect the Fed to try to make offsetting adjustments.

Allowing the yuan to appreciate would also make exports from other developing countries more competitive, and reduce the pressure on them to keep their currencies undervalued.  That is, the biggest beneficiary of a shift by China might be Mexico.

Econ PhD Musings

Holder of a more recent vintage economics PhD than me, Noah Smith says "If you get a PhD, get an economics PhD".  His foremost reason is that job market conditions are much better for economics PhDs than in most other fields.  It's definitely worth a read if you're considering grad school, though I have some friendly amendments to offer:

On the positive side:
The benefits of having a stronger labor market than most other academic disciplines persist beyond the initial job placement.  If you end up in a place that isn't a "good fit", you have a reasonable chance of being able to move.  This is in contrast to some fields where anyone with an academic job must cling desperately to it knowing they have slim chances of finding another one, which makes them vulnerable to jerky administrators etc (fortunately my current institution generally seems to treat people well, even when they don't have to).  Moreover, this means that the tenure process is slightly less terrifying - the economists I know who've been denied tenure have generally landed on their feet.

On the negative side:
Noah neglects to mention that, while the job market for economists is relatively robust, its still a fairly thin one (at least compared to most 'normal' jobs), so, while PhDs generally get jobs, they don't usually have alot of choices.  This means is a problem to have strong preferences about exactly what type of job you want, or where you want to live.

I think he also understates the risk of failure.  Its true that, once you're through the preliminary exams, you're not likely to experience "failure" as a single, discrete event. However, dissertations are a real struggle - even in the best case - and its not uncommon for people to drift away without finishing.

I like Noah's enthusiasm about the potential for "intellectual fulfillment" - and he's right, its pretty great - and rare - to have a job where you have freedom to pursue different ideas and topics with nobody telling you what conclusions to come to.  And its neat to be around people who are are sharp thinkers and/or doing interesting research.  But, that said, academics don't just get to think - they have to have their work validated by publishing, and the process of getting papers published is a real grind, and, on a bad day, can feel like a bit of a game.

Also, he says, "as an econ grad student, you'll have a life. Or a chance at having a life, anyway."  Hmm... depends on what you mean by "life", and certainly not the first year (or really the second, either).

I think the big qualifier is "If you get a PhD" - while conditions for economists are much better than in many other fields, getting a PhD in economics still has a high cost.  Not only does it entail giving up income - both during the grad school years, but also by forgoing more lucrative career options - it also means narrowing the set of career choices (there really is such a thing as being "overqualified," so having a PhD is limiting).  I agree with Noah that the careers available to econ PhDs are generally desirable, but my advice to college juniors and seniors who aren't sure would be to try out working in the "real world" first - it may give you some perspective.

I've posted some general advice about economics grad school here.

The Trend of Things

Amid all our concern about financial crises, zero lower bounds, stimulus packages and the euro, its worth remembering that they are related to a short-term fluctuation (albeit a relatively large one) around a long-run trend, and it is the trend that ultimately determines how well-off people will be in the future.  Or,

The prevailing world depression, the enormous anomaly of unemployment in a world full of wants, the disastrous mistakes we have made, blind us to what is going on under the surface to the true interpretation of the trend of things. For I predict that both of the two opposed errors of pessimism which now make so much noise in the world will be proved wrong in our own time-the pessimism of the revolutionaries who think that things are so bad that nothing can save us but violent change, and the pessimism of the reactionaries who consider the balance of our economic and social life so precarious that we must risk no experiments. 

as J.M. Keynes wrote in "Economic Possibilities for Our Grandchildren" (1931).*

The rise in living standards over time - the long-run growth rate - depends on labor productivity (i.e., output per hour of work).  That, in turn, depends on capital per worker and technological progress (broadly defined as our ability to wring more output from a given amount of capital and labor).  Since capital has diminishing returns, it is really technological progress that ultimately matters.

At his Conversable Economist blog, Tim Taylor notes that growth in per capita real GDP over the past two centuries in the US has been remarkably consistent in the long run.  Using Measuring Worth's series, it looks like this:

[Note: plotting the logarithm means that the slope of the line is proportional to the percentage growth rate; the gridlines at 7.5, 9 and 10.5 correspond to $1800, $8100 and $36300, respectively]**

Technological progress essentially determines the slope, and a seemingly small rate of change, compounded over a few decades, is a big deal - a much bigger deal, measured in output, than the "great recession" (whether output is the right thing to count is another, more complicated, matter). So it may be cause for concern that productivity growth, after picking up in from the mid-1990's through the early 2000's, appears to have slowed again.

Average TFP growth rates, US Private Sector (source: BLS)

1948-73:      1.9%

1973-95:      0.4%

1995-2007:  1.4%

2007-11:      0.4%

The New Yorker's John Cassidy has some interesting musings on why that might be.  The alarming possibility is that the productivity resurgence associated with the internet is petering out already.  However, in the short-run, productivity measurements can be volatile and affected by business cycles, so its we may want to hold off on worrying that the trend has turned down.

*I'd actually started writing this and forgotten to finish it put it aside some time before Niall Ferguson's repellent remarks (that he quickly apologized for) about Keynes not caring about the future because he was childless; "Economic Possibilities" is not only evidence that Keynes cared about the long-run, but that he had considerable insight into the process of long-run growth which anticipated some of the implications of Robert Solow's work in the 1950's.  Though it should be admitted that  Keynes' essay also shows that he wasn't entirely above invoking offensive stereotypes himself.

**If anyone knows of a graphing program that easily does a nice job with log scales, I'd love to hear about it (the ones Excel makes don't come out very well and I'm repeatedly aggravated by trying).