Twenty-Cent Paradigms

What is the Fed Doing?

2012-01-30T00:52:00.001-05:00

Last week, the statement following the Federal Open Market Committee meeting was accompanied by a summary of projections by the participants, which included for the first time projections on future interest rates. The FOMC also released a statement clarifying its policy goals, and Bernanke held a press conference.

The statement on the policy objectives included the following:

The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate.

That appears to somewhat formalize what we've known for a while, that the Fed is shooting for 2 percent inflation. Their interpretation of the employment part of their mandate was somewhat squishier:

The maximum level of employment is largely determined by nonmonetary factors that affect the structure and dynamics of the labor market. These factors may change over time and may not be directly measurable. Consequently, it would not be appropriate to specify a fixed goal for employment; rather, the Committee's policy decisions must be informed by assessments of the maximum level of employment, recognizing that such assessments are necessarily uncertain and subject to revision.

That sounds like a statement about the "natural rate" or NAIRU, which changes over time, and which economists can disagree about. In this context, "maximum level of employment" isn't a very good phrase - it sounds like something Stalin would try to achieve in industrializing the Soviet Union - but "maximum" is the word in the Federal Reserve Act, so they probably wanted to stick with it.

The FOMC participants' projections of the federal funds target rate were summarized in this chart:

This indicates that most of them expect the federal funds rate to be above its current range of 0-0.25% in 2014, their projections that inflation in 2014 will be 1.6-2.0% and unemployment will be 6.7-7.6% notwithstanding. Now that they've made their interpretation of their mandate more explicit, we can say the Fed is projecting inflation will be below their "mandate consistent" level and unemployment will be above it, but they will be raising rates anyway...

The language in their regular meeting statement was:

In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.

To be fair, though most of the participants are projecting a rate increase by 2014, all of the projected rates are still quite low relative to their "longer run" projection.

Many people seem to be interpreting the language about keeping rates "exceptionally low" through "late 2014" as an expansionary "open mouth operation" where the Fed tries to stimulate the economy by influencing expectations (and since the December statement said "mid-2013" they have opened the mouth wider). If people believe short term rates will be lower for longer, long term rates will also fall. Bernanke explained how this would work in his 2002 speech about deflation:

So what then might the Fed do if its target interest rate, the overnight federal funds rate, fell to zero? One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure--that is, rates on government bonds of longer maturities. There are at least two ways of bringing down longer-term rates, which are complementary and could be employed separately or in combination. One approach, similar to an action taken in the past couple of years by the Bank of Japan, would be for the Fed to commit to holding the overnight rate at zero for some specified period. Because long-term interest rates represent averages of current and expected future short-term rates, plus a term premium, a commitment to keep short-term rates at zero for some time--if it were credible--would induce a decline in longer-term rates.

Credibility is indeed one major problem with such a strategy, as Gavyn Davies noted in a blog post previewing the FOMC release:

The problem for practitioners, however, is the time inconsistency of these proposals. It is one thing to promise now to hold interest rates at zero if inflation starts to rise in several years time, and quite another actually to do that in the circumstances of the time.

The temptation to renege on a long forgotten commitment, possibly made by an earlier Fed chairman under a previous administration, would surely be overwhelming once the economy is recovering. Since the private sector knows in advance that this would be the case, it would be extremely hard to persuade people today that such a policy would in fact be pursued in the future. And that would defeat its purpose.

However, while many knowledgeable observers are interpreting it that way (e.g., Stephen Williamson and Ryan Avent) it seems to me that the Fed is being careful to say that it is not promising to keep rates low, only that it believes the economy in 2014 will still be lousy enough that rates should still be low then.

During the press conference, Bernanke seemed to place quite a bit of emphasis on the dual nature of the Fed's mandate, and even said "the Committee always treats its primary objectives on price stability and maximum employment symmetrically." Really? In the past, I've thought he's seemed to give higher priority to inflation, so that sounded unexpectedly dovish to me. One interpretation might be that he's listening to Chicago Fed President Charles Evans, who has argued the Fed needs to be more aggressive to try to reduce unemployment. Scott Sumner also found dovish signs in the press conference.

An alternate interpretation is Bernanke felt the need to be extra careful to sound like he is being faithful to the dual mandate because the statement making the 2% inflation goal explicit sounds like another step towards "inflation targeting," which Bernanke advocated during his academic days. Indeed, one of the reporters said: "Congrats on the inflation target or goal. That's a big achievement for you, I'm sure."

So, what is the Fed doing? I'm really not sure, but I hope it works.

Middletown - DC - Davos

2012-01-28T13:23:00.000-05:00

The New York Times profiles Lael Brainard, Wesleyan class of 1983, who has the difficult charge of prodding Europe towards a solution to the euro crisis:

Lael Brainard, America’s top financial diplomat, landed Thursday in Switzerland to help coax the European negotiations along. As the Treasury under secretary for international affairs, she has the urgent task of helping to persuade the Europeans to head off a financial crisis by building a firewall to quiet the markets once and for all — and doing so without any formal role in their negotiations. It is at times an awkward role, but the stakes are enormous, not just for the United States but for preservation of the euro zone and its currency.

Ms. Brainard, 49, operates mostly behind the scenes, in private phone calls and discreet visits — 17 trips to Europe alone in the last two years.

“They trust her, they reach out to her, they talk to her for ideas and to get us to engage,” said Timothy F. Geithner, the Treasury secretary, who is also in Davos this week.

Q4 GDP: Back to Average

2012-01-27T11:23:00.000-05:00

GDP grew at a 2.8% annual rate in the last quarter of 2011, according to the "advance" estimate the BEA released today. That can be taken as good news as it represents improvement over the first part of the year (growth rates of 0.4%, 1.3% and 1.8% in the first three quarters). But 2.8% is just the average growth rate over the past 40 years, so its not fast enough to significantly close the gaps in output and employment left by the recession.

The advance estimate puts growth for the full year at 1.7%. We'll get the revised "second" estimate on Feb. 29.

For more, see Wonkbook's Brad Plumer, Calculated Risk, NYT's Catherine Rampell.

UK: Worse than the Depression?

2012-01-26T14:08:00.001-05:00

On their blogs, Paul Krugman and Brad DeLong have both reproduced this graph (from here):

and cited it as evidence that the UK economy is now worse than the Great Depression. I haven't been following the UK situation closely, but I'm instinctively inclined to agree with their criticisms of the Cameron government's austerity policies.

Having said that, I think the graph (and implied interpretation) is a little unfair because of how Britain's experience during the interwar period differed significantly from that of the US.

While the US economy went pretty suddenly from the "roaring 20's" to the depression, the UK economy was already in bad shape throughout the 1920's, which I believe can be primarily attributed to the attempt to resume the gold standard at the pre-war parity (the infamous "Norman [Montagu] Conquest of $4.86"/ "Economic Consequences of Mr. Churchill") and the 1930's was just a further deterioration of an already dismal situation.

So, while it may be the case that the deterioration from 2008 in Britain has been comparable in magnitude and will be worse in terms of persistence than the decline starting from 1930, saying that its worse than the depression that ignores that Britain in 1930 already had an unemployment rate of 16%.

For comparison, here's the US (red) and UK (blue) unemployment rates over the past several years:

Yes, things look like they're getting worse in Britain, but they're not exactly in "Road to Wigan Pier" territory yet...

*Since this is just a quick blog post, I haven't dug into the technical differences between various unemployment data series, but I'm pretty sure they would all show similar trends, if not exact levels.

Update (1/30): In his column today, Krugman writes:

O.K., about those caveats: On one side, British unemployment was much higher in the 1930s than it is now, because the British economy was depressed — mainly thanks to an ill-advised return to the gold standard — even before the Depression struck. On the other side, Britain had a notably mild Depression compared with the United States.

Steve "Jobs" versus Barack "US" Jobs

2012-01-25T00:42:00.003-05:00

Indiana Governor Mitch Daniels, Republican response to the State of the Union:

Contrary to the President's constant disparagement of people in business, it's one of the noblest of human pursuits. The late Steve Jobs - what a fitting name he had - created more of them than all those stimulus dollars the President borrowed and blew.

Perhaps he missed this, in a fascinating story about Apple in Sunday's New York Times magazine:

[A]s Steven P. Jobs of Apple spoke, President Obama interrupted with an inquiry of his own: what would it take to make iPhones in the United States?

Not long ago, Apple boasted that its products were made in America. Today, few are. Almost all of the 70 million iPhones, 30 million iPads and 59 million other products Apple sold last year were manufactured overseas.

Why can’t that work come home? Mr. Obama asked.

Mr. Jobs’s reply was unambiguous. “Those jobs aren’t coming back,” he said, according to another dinner guest.

Apple employs 43,000 people in the United States and 20,000 overseas, a small fraction of the over 400,000 American workers at General Motors in the 1950s, or the hundreds of thousands at General Electric in the 1980s. Many more people work for Apple’s contractors: an additional 700,000 people engineer, build and assemble iPads, iPhones and Apple’s other products. But almost none of them work in the United States. Instead, they work for foreign companies in Asia, Europe and elsewhere, at factories that almost all electronics designers rely upon to build their wares.

As for those dollars we "borrowed and blew," according to the Congressional Budget Office:

CBO estimates that ARRA’s policies had the following effects in the third quarter of calendar year 2011 compared with what would have occurred otherwise:
They raised real (inflation-adjusted) gross domestic product (GDP) by between 0.3 percent and 1.9 percent,
They lowered the unemployment rate by between 0.2 percentage points and 1.3 percentage points,
They increased the number of people employed by between 0.4 million and 2.4 million,

(According to the CBO's estimates, the impact of the stimulus peaked in the third quarter of 2010 at 0.7-3.6 million).

To summarize, US jobs:

Steve Jobs' "noble pursuit": 43,000*
Barack Obama "borrowed and blown": 400,000-2,400,000

Maybe it would be fitting to call the President Barack "US" Jobs.

*Don't get me wrong - I'm a fan of his computers. There's alot to think about in the Times article - see Paul Krugman and Ryan Avent. However, many of the issues raised by it, and by the President's speech, about trade, education and "industrial policy," are really about the composition of employment. The total number of jobs at any time depends mainly on aggregate demand - and when there is a slump (particularly one the Fed can't handle), the appropriate fiscal policy response is indeed for the government to borrow some money and "blow" it.

Update (1/27): Paul Krugman noticed the same thing, and wrote a column about it.

An Inconvenient Mankiw

2012-01-22T14:44:00.000-05:00

Food for thought for all the would-be Romney administration Kremlinologists out there:

The National Journal's Jim Tankersley has an interesting article about Mitt Romney and his economic advisors. The gist of the article is that Greg Mankiw and Glenn Hubbard are well-respected economists, but Romney's statements on the campaign trail suggest he's not listening to them much. Tankersley writes:

This, then, is the Romney Conundrum—for conservatives, liberals, and everyone else. Even on the economy, Romney’s signature issue, it’s hard to know where his heart lies—and how he would govern in the White House. Would the former Massachusetts governor listen to his best and brightest? Or to his party base?

“Romney’s got Glenn and Greg advising him, and they’re both top-notch economists,” said Keith Hennessey, who ran the National Economic Council for President George W. Bush. “But there’s more to economic policy than just economics.”

Of course this isn't entirely unique to Romney - politicians often fail to follow through on politically inconvenient suggestions from economists (though the universe of what is inconvenient for a Republican primary candidate to say is pretty scary these days).

The article comes to my attention from Greg Mankiw, who linked to it on his blog, without comment. Hmmmmm...

As if to illustrate... Mankiw has a column in today's Times about tax reform. Among his suggestions:

Consider the tax on gasoline. Driving your car is associated with various adverse side effects, which economists call externalities. These include traffic congestion, accidents, local pollution and global climate change. If the tax on gasoline were higher, people would alter their behavior to drive less. They would be more likely to take public transportation, use car pools or live closer to work. The incentives they face when deciding how much to drive would more closely match the true social costs and benefits.

Economists who have added up all the externalities associated with driving conclude that a tax exceeding $2 a gallon makes sense. That would provide substantial revenue that could be used to reduce other taxes. By taxing bad things more, we could tax good things less.

Well, if Romney proposed that, it would probably take the attention off his tax returns!

Me and the "Mussa Puzzle"

2012-01-20T16:33:00.001-05:00

The international economist, and former chief economist of the IMF, Michael Mussa, died earlier this week. I never met the man, and reading these remembrances from the Peterson Institute makes me sorry I didn't. But we have done some work in the same area: one of my own favorite papers confirms one of Mussa's most well-known findings, that the behavior of real exchange rates depends on whether nominal exchange rates are fixed or floating. Paul Krugman explains:

Probably his most influential paper — certainly the one that had the biggest impact on me — was his 1986 paper (pdf) on currency regimes and the behavior of real exchange rates. This bore on the question of whether exchange rate changes make adjustments in relative costs and prices easier; it bore more broadly on the question of whether prices are flexible, as fresh-water economists like to assume, or instead sticky in nominal terms.

Mussa had a simple but powerful insight: if prices were flexible, then all relative prices should be determined by “real” factors, and their behavior shouldn’t change if, say, a country goes from a fixed exchange rate to a flexible rate or vice versa. As he pointed out, this proposition could be tested using a natural experiment, the breakdown of Bretton Woods and the move to floating rates. Did the behavior of real exchange rates — relative price levels expressed in a common currency — change?

I've seen the large increase in real exchange rate volatility under floats referred to as "the Mussa puzzle", though, as Krugman points out, "sticky" prices are a straightforward explanation.

I was able to address one significant limitation of Mussa's analysis. His paper relied heavily on a comparison of the periods immediately before and after exchange rates began to float in the early 1970's. That left open the possibility that some other changes at around the same time led to the difference in real exchange rate behavior. Vittorio Grilli and Graciela Kaminsky made that argument in a 1991 Journal of Monetary Economics paper:

In particular, the high volatility of the real exchange rate since the breakdown of the Bretton Woods system in the early 1970s may have arisen as a consequence of factors unrelated to the nominal exchange rate regime - such as the two oil price shocks of the 1970s or the wide fluctuations in interest rates during the late 1970s and early 1980s.

However, in "Across Time and Regimes: 212 Years of the US-UK Real Exchange Rate" (Economic Inquiry 48:4 [October 2010]), I exploited the fact that the exchange rate between the US and Britain has alternated a number of times between fixed and floating. One of the tables in the paper shows the average monthly change in the real exchange rate during different regimes.

Jan. 1794-Apr. 1821 (floating): 2.66%
May 1821-Dec. 1861 (fixed): 2.02%
Jan. 1862-Dec. 1878 (floating): 2.52%
Jan. 1879-June 1914 (fixed): 1.17%
July 1914-Mar. 1919 (wartime controls): 1.75%
Apr. 1919-Apr. 1925 (floating): 2.03%
May 1925-Aug. 1931 (fixed): 0.98%
Sept. 1931-Aug. 1939 (floating): 1.77%
Sept. 1939-Sept. 1949 (wartime controls): 1.52%
Oct. 1949-July 1971 (fixed): 0.49%
Aug. 1971-Dec. 2005 (floating): 1.97%

The pattern of higher volatility in floating periods is a robust one (and there is more statistical evidence in the paper). However, the differences between fixed and floating are smaller in earlier periods, which suggests that perhaps price stickiness has become more important over time.

City of Yesterday, Today

2011-12-23T00:41:00.000-05:00

Extremists who mistakenly believe they are defending liberty have the Detroit suburb where I grew up in their vise, the New York Times reports:

In what could be a new high water mark of anti-Washington sentiment, the city of Troy, Mich., is rejecting a long-planned transportation center whose construction would have been fully financed with federal stimulus money.

The terminal, which would help Troy become a transportation node on an upgraded Detroit-to-Chicago Amtrak line, was hailed by supporters as a way to create jobs and to spur economic development. But federal money is federal money, so with the urging of the new mayor, who helped found the local Tea Party chapter, the City Council cast a 4-to-3 vote this week against granting a crucial contract, sending the project into limbo.

“There’s nothing free about government money,” Mayor Janice Daniels said in an interview. “It’s never free, and it’s crippling our way of life.”

The street signs at the city's entrances say "City of Tomorrow, Today!" but it sounds like Mayor Daniels is leading Troy backwards, with great conviction.

A Professorial Dilemma (RIP, Saab)

2011-12-21T17:33:00.000-05:00

Sad news from Trollhättan, the NY Times reports:

The owner of Saab Automobile finally threw in the towel Monday, filing for bankruptcy after hopes of a life-saving investment from Chinese investors collapsed in the face of opposition from General Motors.

This creates a dilemma for those of us who feel a professional obligation to uphold the stereotype of the Swedish-car driving college professor, but believe we are too cool for Volvos.

The Economist's "Schumpeter" column gave a the brand a nice (though slightly premautre) obituary in September. It is still possible someone will buy the company whole in bankruptcy and restart it, but most reports suggest liquidation is more likely.

No "Buts" About It

2011-12-14T15:12:00.000-05:00

From the NPR website:

The story itself is fine, though the "but" in the headline suggests that the editor who wrote it expected austerity to lead to (short-term) growth. Most of us economists don't find the coincidence of fiscal tightening and slumping growth so surprising (see e.g., Krugman).

Last week's summit agreement to tighten enforcement of the budget rules in the "stability and growth pact" doesn't help matters. One is reminded of the old joke that the Holy Roman Empire was "neither Holy, nor Roman, nor an Empire." I suppose actually enforcing the rules would make it more of a "pact," but forcing procyclical fiscal policies won't be good for stability or growth (see this post by Antonio Fatas).

So its not surprising that the Washington Post reports "In Europe, summit optimism fades." The half-life of "summit optimism" seems to be declining, which means that Europe must either (a) really fix things or (b) hold summits more frequently. I think they're converging towards continuous summit.

November Employment: The Good, the Meh, and the Bleh

2011-12-02T11:15:00.000-05:00

From the BLS November employment report:

Good news: Significant drop in the unemployment rate, to 8.6% (from 9%)

Less good: Mediocre employment growth of 120,000 jobs (a "treading water" pace)

Not good: Labor force participation falls by 0.2 percentage points to 64%

The employment growth number comes from a survey of businesses (the "establishment survey") while the unemployment rate is calculated from a household survey (which has a smaller sample). Continuing a recent pattern, employment growth looks better in the household survey: 278,000 more people said they were employed. Also continuing the pattern of recent reports, the previous establishment survey numbers were revised upwards; September's job gain is now 58,000 higher and October's is up by 20,000. Over the past several months, the revisions have been bringing the establishment report figures up closer to the better household survey numbers (which aren't subject to revisions).

By itself, 278,000 more people employed doesn't get the unemployment rate down by 0.4 percentage points. The labor force fell by 315,000 (thus bringing the participation rate down). The unemployment rate is measured as a percentage of the labor force, and to be counted in the labor force, someone must either be working or looking for work. Another way of looking at it is that the number of people who were unemployed fell by 594,000 - roughly half of them got jobs, while the other half quit looking.

On a non-seasonally adjusted basis, the unemployment rate in November was 8.2% (down from 8.5% in October, mainly due to a big drop in participation) and payrolls rose by 339,000. That is, November is a month when the seasonal adjustment makes things look worse... it will be the opposite in January when all the extra holiday employees lose their jobs.

A Goolsbee is Haunting Europe

2011-11-30T23:37:00.000-05:00

In a WSJ op-ed, further elaborated in an interview with Ezra Klein, Austan Goolsbee lays out some of the fundamental problems of the Euro, which go deeper than the immediate financial crisis. In particular, the common currency closes off the avenue of exchange rate adjustment. That is, without the Euro, the DM would be rising and the Lira and Peseta falling, improving Italian and Spanish current account balances. He concludes:

[E]ven if Europe addresses the banking-capitalization crisis of the moment, and even if it struggles its way through the near-term fiscal crises of Greece and Italy, then what? With little prospect for growth in its South, Europe remains on the romantic road to nowhere—a road that merely runs in a circle. Without growth there will always be another fiscal crisis ahead for yet another country unable to balance its budget but prevented from devaluing and exporting its way forward.

On this path, Europeans will forever need to fight off financial and fiscal panics while trying to build their castle on a hill.

What really matters is the real exchange rate - i.e., the price of one country's goods in terms of another's. The real exchange rate between two countries is the nominal exchange rate times the ratio of the countries' price levels. Even if both countries have the same currency, the real exchange rate changes if they have different inflation rates. This means that Greece, Italy and Spain can have a real depreciation vis a vis Germany by having lower inflation, which would, over time, make their goods relatively cheaper. Of course, to get very far with this, if German inflation is low, then the peripheral countries' price levels actually need to fall. This is sometimes called "internal devaluation", and because it entails deflation, is quite painful. This what Goolsbee is talking about when he says: "In the short run, that would mean directly and significantly grinding down wages to make them competitive—a grisly option, prone to causing mass unrest."

I think this would be significantly less painful if it didn't involve price levels actually falling and, in principle, it doesn't have to. For simplicity, say the Eurozone consists of a "core" and "periphery" of equal size. If Eurozone inflation is 4%, it could be 7% in the core and 1% in the periphery, which means the periphery experiences real depreciation at a 6% rate. However, the ECB is quite firm about sticking to its mandate - which reflects German preferences - for inflation at or below 2%.

In a way, this is analogous to the Akerlof-Dickens-Perry case that slightly positive inflation facilitates real wage adjustment because it allows some real wages to fall without forcing very difficult nominal wage cuts.

Death, Taxes and Trade Disputes

2011-11-21T19:08:00.000-05:00

Douglas Irwin, Free Trade Under Fire (3rd ed., 2009):

The tuna dispute was resolved in 1992 when the United States, Mexico, and eight other tuna-fishing nations signed an international agreement to regulate the conditions of tuna fishing.

Bridges Trade News Digest, Nov. 16, 2011:

At its last meeting on 11 November, the WTO Dispute Settlement Body (DSB) decided to extend the deadline for submitting an appeal on the latest Tuna-Dolphin (DS381) ruling issued in September (see Bridges Weekly, 21 September 2011).

In light of the Appellate Body’s substantial workload, the US and Mexico had jointly requested an extension of the normally sixty-day period, which otherwise would have expired on 15 November. In accordance with the agreed extension, an appeal will have to be submitted no later than 20 January.

Lesson: never use the word "resolved" when writing about trade disputes....

To be fair to Irwin, whose book I recommend (and assign to students), one could consider "Tuna-Dolphin" to be a series of disputes, one of which was resolved in 1992.

Is the ECB Determined to Go Down with the Ship?

2011-11-15T01:20:00.001-05:00

With the risk premium on Italian government debt growing, the best hope for a resolution to the Euro crisis would seem to be for the European Central Bank to announce an unlimited intervention to cap the yield on sovereign bonds. However, it steadfastly refuses to do so - presumably because it feels that such an action might risk a violation its prime directive of "inflation rates of below, but close to, 2% over the medium term."

In a recent Project Syndicate column, Brad DeLong argued that the ECB is failing to step up to the plate as the lender of last resort:

The ECB continues to believe that financial stability is not part of its core business. As its outgoing president, Jean-Claude Trichet, put it, the ECB has “only one needle on [its] compass, and that is inflation.” The ECB’s refusal to be a lender of last resort forced the creation of a surrogate institution, the European Financial Stability Facility. But everyone in the financial markets knows that the EFSF has insufficient firepower to undertake that task – and that it has an unworkable governance structure to boot.

Perhaps the most astonishing thing about the ECB’s monochromatic price-stability mission and utter disregard for financial stability – much less for the welfare of the workers and businesses that make up the economy – is its radical departure from the central-banking tradition. Modern central banking got its start in the collapse of the British canal boom of the early 1820’s. During the financial crisis and recession of 1825-1826, a central bank – the Bank of England – intervened in the interest of financial stability as the irrational exuberance of the boom turned into the remorseful pessimism of the bust.

Similarly, Barry Eichengreen writes:

Here’s where the political cover comes into play. Merkel and Sarkozy need to make the case that if the euro is to become a normal currency, Europe needs a normal central bank – one that does not merely target inflation like an automaton, but that also understands its responsibilities as a lender of last resort.

More on this from The Economist, Antonio Fatas, Gavyn Davies and Martin Wolf as well as a nice "news analysis" from the NY Times.

If Italy is fundamentally solvent and merely facing a self-fulfilling "liquidity" panic (as investors sell bonds, yields rise, making it more costly to service its debts, which lowers the chances it will avoid default leading to investors selling bonds...), then it may not require much more than an announcement of a willingness to intervene to quell the crisis. By restoring confidence, the ECB could bring yields down without having to do much actual bond-buying (i.e., Super Mario* can be Chuck Norris).

The crisis potentially spells the end of the Euro - so the ECB is putting its mandate ahead of its own self-preservation. That is, it appears willing to risk its very existence for the sake of what it sees as its duty. As a matter of economic policy, it looks disastrously foolish, and yet, there's something oddly noble-seeming about it.

*Admittedly, referring to Italian policymakers named Mario as "Super Mario" is getting stale quickly (and I can't imagine how much they must despise it); and the press needs to decide whether it is ECB President Mario Draghi or new Prime Minister Mario Monti who is called "Super Mario" (or perhaps not... a quick search of "Super Mario" on the FT reveals a potentially confusing solution: "Super Mario Brothers"). The Guardian compares two of the "Super Marios" and this FT profile argues Draghi earned his "super."

October Employment: Not Bad

2011-11-04T18:07:00.000-04:00

Not really good, either... The BLS reports that the unemployment rate ticked down to 9.0% (from 9.1%) in October. Payroll employment increased (weakly) by 80,000; the private sector added 104,000 jobs but the public sector subtracted 24,000. The numbers from the survey of households (which is used to calculate the unemployment rate) were a bit stronger - the number of people employed rose by 277,000.

Also, the payroll employment growth (from the survey of establishments) figures were revised upwards for August and September, by 57,000 and 55,000, respectively.

On a non-seasonally adjusted basis, the unemployment rate fell to 8.5% and payroll employment rose by 883,000. That is, October is a month where a regular "seasonal" gain is removed to make the seasonally adjusted number.

Sigh.

2011-11-02T21:04:00.000-04:00

NYTimes.com headline:

The Fed's forecasts are here. Their projection for 2012 real GDP growth is 2.5-2.9%, down from the June estimate of 3.3-3.7%.

Romer: Bernanke's Volcker Moment?

2011-11-02T13:34:00.000-04:00

In the Times last weekend, Christina Romer suggested a precedent for a switch in our monetary policy regime. The Volcker Fed tightened money growth (thereby letting interest rates rise severely - the Fed funds rate was briefly above 19% at a couple of points in 1981) - the point was to bring the hammer down on inflation. As Romer notes, this very unpleasant policy was justified by a shift to a "monetarist" regime of targeting money growth. As I've discussed before, I have mixed feelings about the lionization of Paul Volcker, but I think Romer has a good point that it may be time for another regime shift, this time to nominal GDP level targeting:

Mr. Bernanke needs to steal a page from the Volcker playbook. To forcefully tackle the unemployment problem, he needs to set a new policy framework — in this case, to begin targeting the path of nominal gross domestic product.
Nominal G.D.P. is just a technical term for the dollar value of everything we produce. It is total output (real G.D.P.) times the current prices we pay. Adopting this target would mean that the Fed is making a commitment to keep nominal G.D.P. on a sensible path.

Just as Volcker's regime shift provided cover for a controversial action the Fed felt it needed to undertake (extreme tightening) and facilitated a shift in inflation expectations, a shift to a nominal GDP target would make possible (indeed, require) more aggressive expansion and thereby raise inflation expectations (which means lower real interest rates, ceteris paribus).

See also Paul Krugman, who agrees and Binyamin Appelbaum, who reports that the Fed is unmoved. Free Exchange's Greg Ip makes a contrary case and his colleague Ryan Avent responds.

GDP: The Video

2011-10-28T12:30:00.000-04:00

Its not exactly "Thriller," but this video from Slate and NPR, starring Simon Johnson, is a relatively zippy exposition of what "Gross Domestic Product" means:

Its the first in a series.

3Q GDP: Is the Recovery Recovering?

2011-10-27T16:19:00.000-04:00

The BEA's advance estimate of real GDP growth for the third quarter was 2.5% (annual rate). That's in the same ballpark as the long-run trend rate of growth - i.e., its a pretty normal growth rate, consistent with maintaining a stable unemployment rate as the labor force and productivity rise over time, but not fast enough to dig the economy out of the hole (14 million unemployed) that its in. It is, however, a significant improvement over the first two quarters of 2011, which saw growth rates of 0.4% and 1.3%.

Also, this puts real GDP back above its pre-recession (4Q 2007) peak; a milestone we previously thought had been attained at the end of 2010 until the estimates were revised downwards last summer.

More reaction: The Economist's "Free Exchange" blog, NYT's Catherine Rampell, Calculated Risk, James Hamilton, Mark Thoma, RTE's round up of Wall Street "economists."

The Structure of Macroeconomic Revolutions?

2011-10-16T11:08:00.001-04:00

Macroeconomics sometimes appears to be a somewhat confusing swirl of models and "schools of thought." This can be a somewhat off-putting feature to students (though for some of us it is also part of what makes macroeconomics more interesting than microeconomics). When I introduce it to my students, I make a nod to Thomas Kuhn's "Structure of Scientific Revolutions" framework, which provides a way of putting some structure on the development of macroeconomics that is more sophisticated than framing it as a series of "debates" between "sides" (i.e., "classical" vs. "Keynesian", "saltwater" vs. "freshwater", etc.).

So I liked this post by Matthew Yglesias, where he invokes Kuhn and draws an analogy between macroeconomics and the Copernican revolution in astronomy. He recounts how Copernican (Earth revolves around the sun) astronomy eventually supplanted Ptolemaic (Earth is center of universe), but initially the Ptolemaic system made much better predictions, and concludes:

My view, with both all due respect and all due derision, is that the Robert Lucas types are like the early Copernicans here. There’s something admirable in their insistence that it ought to all work out to an easily modeled system grounded in compelling theoretically considerations. The New Keynesian model is a mess, like late-Ptolemaic astronomy, thrown together to account for observed reality. But you don’t fly to a moon with an elegant model that delivers mistaken predictions about where the moon’s going to be. And what we actually need is a Kepler to give us an elegant model that actually predicts the phenomena, and then a Newton who can explain what that model means.

Hmmm... I'm more inclined to place the users of old Keynesian models, including the IS-LM-based macroeconometric models used by policymakers, in the "late-Ptolemaic" role, but, in any case, the Kuhninan approach helps explain why I simultaneously agree with Brad DeLong, Paul Krugman and Greg Mankiw that the IS-LM model remains a very useful tool, while being a little more optimistic than Krugman about the state of macroeconomics.

Also, I'm not sure that Lucas and others (including new Nobel laureate Tom Sargent) who have pushed macroeconomics towards "structural" or "micro-founded" models are leading us to an "easily modeled system." What counts for "elegance" in modern macro is consistency between the macroeconomic model and micro-economically optimal behavior on the part of consumers and firms (I suppose the obvious retort to that is to invoke Emerson: "A foolish consistency is the hobgoblin of little minds").

Eurosnark

2011-10-07T13:29:00.001-04:00

A nice column from Floyd Norris on the parallels between Argentina's exit from its dollar peg, and Greece's potential exit from the euro. It would be messy, in part because there is no legal mechanism in place to do that; or as Norris puts it:

The euro was designed to be the Roach Motel of currencies. Once you enter, you can never leave. There is no provision for departure.

Hmm... Norris' column might be a good reading for Econ 270, but will Greece still be in the euro by spring semester??

Norris is referencing this vintage TV ad.

September Employment: Partly Cloudy

2011-10-07T12:39:00.000-04:00

The BLS reported today that employers added 103,000 people to their payrolls in September, of which 45,000 were workers returning from the Verizon strike. That's not a great number - due to natural growth in the labor force and productivity improvements, the economy needs to add roughly 130,000 jobs per month just to keep the unemployment rate from rising. But in light of fears that the economy could be sliding into recession due to the hits on confidence from the debt ceiling fiasco and Europe's woes, a continuation of the pattern of sluggish employment growth may be somewhat of a relief. Also, July employment growth was revised up from 85,000 to 127,000 and August was revised from 0 to 57,000.

The numbers from the household survey (which has a smaller sample, so is considered less reliable) were more encouraging. The unemployment rate held steady at 9.1%. The number of people employed rose by 398,000, but the reason that didn't bring the unemployment rate down is that the labor force grew by 423,000 and the labor force participation rate ticked up to from 64.0% to 64.2%. The unemployment rate is measured as a percentage of the labor force, and to be counted as in the labor force, someone must report that they are working or looking for work, so this is a sign that people are re-entering the labor force, which may mean that they are more encouraged about prospects of finding a job.

Overall, the economy remains in a deep hole, with nearly 14 million people unemployed, 6.2 million of whom have been out of work for 27 weeks or longer. Government continues to be a drag on employment (i.e., the exact opposite of what it should be doing); government payrolls fell by 34,000 in September. The BLS noted that local government employment has fallen by 535,000 since September 2008 (more on this from Floyd Norris).

On a non-seasonally adjusted basis, the unemployment rate fell to 8.8% in September and payroll employment rose by 519,000. That is, September is a month that normally sees an improvement in the employment picture, which is removed by the seasonal adjustment factor.

More reaction: Calculated Risk, Mark Thoma, RTE's round up of Wall St. "economists".

Keynes and His Rivals

2011-10-06T00:44:00.001-04:00

The New Republic has a very nice review essay by Robert Solow (the founding father of modern growth theory) on Sylvia Nasar's new book "Grand Pursuit: The Story of Economic Genius." I particularly liked these three sentences:

SCHUMPETER thought of Keynes as his natural rival for the title of “greatest economist.” They were born in the same year, 1883. Keynes probably did not believe that he had a natural rival.

Zing!

Keynes on YouTube!

2011-10-03T16:31:00.000-04:00

Changing the Rules?

2011-09-15T01:58:00.001-04:00

In a recent speech, Chicago Fed President Charles Evans argued that the Fed has been neglecting the "maximum employment" part of its mandate "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." Evans explains:

Suppose we faced a very different economic environment: Imagine that inflation was running at 5% against our inflation objective of 2%. Is there a doubt that any central banker worth their salt would be reacting strongly to fight this high inflation rate? No, there isn’t any doubt. They would be acting as if their hair was on fire. We should be similarly energized about improving conditions in the labor market.

In the United States, the Federal Reserve Act charges us with maintaining monetary and financial conditions that support maximum employment and price stability. This is referred to as the Fed’s dual mandate and it has the force of law behind it.

The most reasonable interpretation of our maximum employment objective is an unemployment rate near its natural rate, and a fairly conservative estimate of that natural rate is 6%. So, when unemployment stands at 9%, we’re missing on our employment mandate by 3 full percentage points. That’s just as bad as 5% inflation versus a 2% target. So, if 5% inflation would have our hair on fire, so should 9% unemployment.

At his blog, Stephen Williamson offers a critique of the speech. Among his arguments:

Evans is forgetting the lessons of the 1970s. What Evans is proposing is a change in the policy rule - a change in how the state of the economy maps into actions by the Fed. What economists understand today that they did not in 1975, is that commitment by the Fed to a policy rule is critical for its success in fulfilling its mandate. Once the public understands that the Fed intends to exploit a short-run Phillips curve relationship (and the problem is worse if the short-run inflation/unemployment tradeoff in fact does not exist), then all bets are off. High inflation can become well-entrenched and we have to go through an episode like the policy-induced "Volcker recession," followed by a long period where the Fed re-establishes its credibility.

Although the wording of the Federal Reserve Act requires the Fed to care about both inflation and unemployment, as Williamson notes, its practice has evolved towards a de facto inflation targeting rule with an objective similar to the European Central Bank's "below, but close to 2%". This is evinced by all the mentions of the Fed's "comfort zone" as well as the "longer run" projections of 1.5-2% inflation from Fed board members and regional bank presidents. In terms of economic theory, it can be justified by the result, in some models, of "divine coincidence" - that policies which stabilize inflation also stabilize output.

If the Fed heeded Evans' argument, it would be more willing to risk breaking its inflation target rule to reduce unemployment. In economic theory, one of the main points benefits of having a rule is that it lends "credibility" to monetary policy and "anchors" expectations (this speech by Charles Plosser is a nice intuitive exposition of the "time consistency" logic underlying this argument). But that only works if the central bank actually follows its rule. Hence Williamson's concern.

Inflation targeting is relatively new - New Zealand was the first to adopt the practice in 1989, and it has since been implemented by the UK, Canada, and the European Central Bank, among others. Most of the countries that have adopted inflation targets have set them in the vicinity of 2%.

While there are good reasons in economic theory for having monetary policy rules, the past few years have raised questions over whether a 2% inflation target is the right rule. There are several alternative rules that might have performed better in the wake of the financial crisis:

Inflation targeting with a higher target would reduce the risk of hitting the "zero lower bound" on short-term interest rates.
Price level targeting would require higher inflation to make up for periods of too-low inflation.
Nominal GDP targeting is a re-incarnation of Milton Friedman's stable money growth rule, focusing on the right hand side of the identity MV = PY, which avoids the problem of unstable velocity (V), which doomed the early 1980's experiments with money growth rules.

All three alternatives have been discussed over the past several years in commentary about policy and are good subjects for academic research, which may ultimately show that many of the world's central banks have adopted the wrong rule.

However, that raises a conundrum: if the Fed breaks its (implicit) rule, even for the sake of adopting a better rule, it risks denting its credibility....

Of course, the real problem with Evans' speech is that Ben Bernanke has no hair, so there is no reason for him to act like his hair is on fire. That may be why bald guys are so cool.

Europe (Still) on the Brink

2011-09-11T23:40:00.001-04:00

Europe has done a remarkable job of kicking the can down the road so far on the Euro-debt crisis. But it sure looks like they won't be able to do that much longer. Things are looking bad... really bad....

Ambrose Evans-Pritchard writes:

[T]he chief reason why Greece cannot meet its deficit targets is because the EU has imposed the most violent fiscal deflation ever inflicted on a modern developed economy - 16pc of GDP of net tightening in three years - without offsetting monetary stimulus, debt relief, or devaluation.

This has sent the economy into a self-feeding downward spiral, crushing tax revenues. The policy is obscurantist, a replay of the Gold Standard in 1931. It has self-evidently failed. As the Greek parliament said, the debt dynamic is "out of control".

Gavyn Davies:

Last week, several events conspired to make the crisis more alarming. In Greece, the government faced lower GDP growth and higher budget deficits, making the task of hitting deficit targets appear more improbable than ever. Even though the Papandreou government has refused to throw in the towel and intends to close the latest budget gap by raising E2bn from a new property tax, there seems to be no conceivable escape from the familiar downward spiral – more budgetary tightening, low growth, higher budget deficits, higher bond yields.

That leaves Germany with a clear choice, which is either to rescue Greece with a huge fiscal transfer or prepare to deal with the consequences of a Greek default, with a possible departure from the euro. To judge from today’s German newspapers, it is increasingly likely that they will choose to jettison Greece.

Barry Eichengreen:

Europe doesn’t have months, much less years, to resolve its crisis. At this point, it has only days to avert the worst.

Liz Alderman and Nelson Schwartz of the New York Times:

On Sunday, French government officials braced for possible ratings downgrades by Moody’s Investors Service of France’s three largest banks, BNP Paribas, Société Générale and Crédit Agricole, whose shares were among the biggest losers last week. The biggest banks in Europe, especially in France, hold billions of euros’ worth of Greek bonds, and investors fear even a partial default by Greece would sharply diminish the value of those assets, eroding already weak capital positions.

American financial institutions, typically heavy lenders to their French counterparts, have begun to pull back on these loans, but United States banks’ exposure to France remains substantial.

It looks like we'll have something to talk about in Econ 270 this spring....

Update (9/12): A nice column today from Paul Krugman on the subject.

The American Jobs Act

2011-09-10T17:31:00.002-04:00

The big ticket items in the $447 billion ~~stimulus~~ ~~recovery~~ jobs act that President Obama announced in his address at the Capitol on Thursday include:

$65 billion in cuts to employer payroll taxes
$35 billion for employment of teachers, police and firefighters
$30 billion for school modernization
$50 billion infrastructure investment
$175 billion in cuts to employee payroll taxes
$49 billion for extended unemployment insurance/UI reforms

The most straightforwardly effective components of the package for increasing aggregate demand are #2, #3, #4 and #6. Direct spending on school buildings (#3) and infrastructure (#4) increase the government purchases component of demand (and "Ricardian" or "crowding out" effects that would reduce the impact in some models are irrelevant now). Cutbacks by state and local governments have become a big drag on the economy - state and local governent employment has fallen by over 650,000 over the past three years. The funding for employing teachers and "public safety and first responder personnel" (#2) will put a brake on that trend. That is, it will be an increase in demand (again through the government purchases component) and employment relative to what would occur otherwise.

Extending unemployment insurance (#6) is effective because much of the money goes to people who will spend it (i.e., people who are "credit constrained" from smoothing out their consumption over time). This increases the consumption component by raising disposable income. The release from the White House discusses some possible reforms to the unemployment insurance program as well - these are not detailed enough to evaluate, but possibly they might help mitigate one of the downsides of unemployment insurance, which is that it can reduce incentives to work (though I don't think that is a really significant contributor to unemployment now).

There is more uncertainty about the effectiveness of the social security payroll tax components. Payroll taxes are the "contributions" paid equally by employers and employees (although employees only observe half of the tax through the "FICA" line on their pay stubs, in the long run, the burden of the entire tax - the "incidence" - largely falls on employees because their wages would be higher if employers did not have to make their contribution).

The largest part of the act (#5) is a one-year reduction in the employee contribution to 3.1% - the standard contribution is 6.2%, but was temporarily cut to 4.2% for this year in the deal that was struck in late 2010. So, basically, this extends the existing cut, and adds another 1.1% to it. As with unemployment insurance, the effect of a tax cut in increasing consumption depends on whether it is spent. Households that are credit-constrained (living "paycheck to paycheck") are more likely to change their behavior. In this regard, it is less well targeted than the unemployment insurance extension, but it is superior to an overall income tax cut. Because the payroll tax is somewhat regressive, only applying to the first $106,800 of wages (and not at all to capital income), the benefits go largely to the "middle class." Although the primary desired effect is to increase consumption demand, even the parts of the tax cut that are not spent do have the benefit of helping improve the financial position of households. Large debt burdens are part of the reason recoveries from "balance sheet recessions" are typically slow, so if part of the tax cuts goes to pay down debt, that could serve to hasten the return to normal household spending behavior.

The employer part of the payroll tax cut (#6) can be thought of as a positive "supply shock" lowering unit labor costs (in the short run, with lots of labor market slack, it won't lead them to raise wages). In a traditional Keynesian framework, this would shift out the aggregate supply curve (or, equivalently, shift down the Phillips curve). In a "New Keynesian" model, this is a reduction in the real marginal cost term in the New Keynesian Phillips Curve. Since the binding constraint on the economy is on the demand side, the usefulness of this part of the policy appears questionable. Indeed, reducing costs is deflationary, and deflation is a very bad thing. But it is a bad thing that the Fed is determined to prevent, and that is why this part of the package may have a positive effect. The Fed seems very averse to letting inflation become negative, but also very careful to try to keep it from going above 2% (in doing so, its placing too much weight on the "price stability" part of its mandate relative to the "maximum employment" part, as this justly-praised speech by Chicago Fed President Charles Evans argued). By putting downward pressure on costs, and therefore prices and inflation, the employer-side tax cuts may create more space for the Fed to act more aggressively.

An important part of the proposal is still to come - President Obama said that he would deliver plans to "pay for" the jobs act (i.e., offsetting tax and spending changes, presumably within the standard 10-year window customarily used to assess budget proposals). This may be politically necessary, but, as I argued recently, there is no economic urgency for doing this, and I worry that political gridlock over paying for the bill could derail taking action now, which is urgent.

Its also worth noting that, while the exact timing of some of the provisions is unclear, it looks like most of the effect occurs in 2012. That's a good thing, but even under the optimistic assumptions that something like this bill is enacted, and the Fed finds a will and a way to take more effective action, the economy is in a very deep hole and unemployment will still be elevated at the end of 2012. The expiration of the tax cuts puts in place an automatic fiscal contraction for 2013 (this is where the idea of "state contingent" policies would help, but would raise the headline cost, which is politically unpalatable right now).

Private-sector estimates suggest the bill would have a significant impact: Macroeconomic Advisors says it will raise GDP by 1.3% and increase employment by 1.3 million next year; Moody's economy.com (via Brad Plumer) puts it at 2% of GDP and 1.9 million jobs. See also: Gavyn Davies, Paul Krugman, Ezra Klein, Mark Thoma.

August Employment: Flat Line

2011-09-02T12:59:00.000-04:00

The BLS employment report for August is not a good one. Total employment was unchanged - i.e., no net jobs were added - which is really losing ground because about 130,000-ish jobs need to be added each month just to keep up with population growth and technological progress.

Government continues to be a drag - government employment dropped by 17,000, and this would have been worse without 22,000 workers returning to work after the Minnesota shutdown. The Verizon strike also had an effect, reducing payrolls by about 45,000. That is, without the Verizon strike, there would have been a gain in private-sector payrolls of 62,000, which isn't particularly good. Also, the employment growth for June and July were revised downward.

The payroll employment number is calculated from a survey of employers. The unemployment rate comes from a survey of households. Overall, the household survey looks a little better (though it is considered less reliable because it has a smaller sample). The unemployment rate held steady at 9.1% and the number of people employed rose by 331,000. The labor force participation rate and employment-population ratio also ticked up slightly.

Overall, this report should help convince the Federal Open Market Committee to take more steps in the direction of "easing" policy, and add urgency to further fiscal policy action to try to stimulate job growth.

On a non-seasonally adjusted basis, payrolls increased by 118,000 (i.e., August is a month that normally has a slight gain, which is removed by the seasonal adjustment). Non-seasonally adjusted unemployment was also 9.1% (but down from 9.3% in July).

The Fed's Mandate (an Explanation for Sen. DeMint)

2011-08-31T10:30:00.001-04:00

Sen. Jim DeMint is describing the Fed's emergency lending during the financial crisis as a "shadow TARP." In an opinion column for Politico, he writes:

The U.S. government was never meant to be a giant lender for the world’s most powerful banks.

Actually, that is exactly what the Fed was originally meant to do. The preamble to the Federal Reserve Act is:

An Act To provide for the establishment of Federal Reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes.

"Furnish an elastic currency" is another way of saying that the Fed should be a "lender of last resort" - lend money to banks whose funding sources can suddenly disappear in financial crises in order to prevent the system from collapsing. The Fed was founded because the frequent financial "panics" of the late 19th and early 20th century made clear that the US needed a central bank to perform this function.

During the financial crisis, the Fed performed this function with ingenuity and determination, and we would be in a very different - and much, much worse (think "Mad Max") - world if it hadn't.

What is questionable is whether the Fed is fulfilling section 2A of the Federal Reserve Act (added in 1978), "Monetary Policy Objectives":

The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.

Some of us believe that the Fed could be doing a better job (or at least try harder) of getting us closer to "maximum employment". Somehow DeMint manages to be concerned that the Fed is failing to achieve "stable prices". He says:

Americans are feeling inflationary pangs at home, too. The congressional Joint Economic Committee found that since the Fed launched its program of quantitative easing in late November 2008, the value (trade weighted) of the U.S. dollar has declined 14 percent, which translates into higher food and fuel costs.

The graph below shows inflation, measured by the CPI (though I think a 'core' measure, which would show lower inflation recently, is a more appropriate guide for monetary policy) and the unemployment rate.

By historical standards, unemployment is very high now, while inflation is low (and the little tick upward at the end will likely vanish as the effect of the oil price increase earlier this year dissipates).

DeMint also approvingly cites the criticism of Chinese and German government officials:

Leaders from around the world have openly complained about the way the U.S. is intentionally weakening the dollar, since doing so cheapens the value of U.S. debt they hold. After the second round of quantitative easing was announced, Chinese Vice Finance Minister Zhu Guangyao said America “does not recognize, as a country that issues one of the world’s major reserve currencies, its obligation to stabilize capital markets.

German Finance Minister Wolfgang Schaeuble was more blunt, calling the Fed “clueless.”

DeMint appears to believe that US monetary policy should heed the criticism of foreign government officials. Perhaps the mandate of the Fed be changed to focus on the interests of other countries. I think some people may believe that it should, since the US dollar is the global "reserve currency", but if we're going to do that, we might as well abolish the Fed and turn US monetary policy over to the United Nations. It doesn't appear that the wording of the Federal Reserve Act is explicit on this point, but I think its pretty well understood that the language quoted above about "the economy", etc., refers to the US economy. If they don't like our monetary policy, China and Germany (and everyone else) are free to choose other assets to buy.

This San Francisco Fed Economic Letter from 1999 describes nicely how and why the Fed's mandate has evolved. It might be good reading for Senator DeMint.

Austerity

2011-08-30T18:00:00.000-04:00

Washingtonpost.com reports:

A Better Analogy for the Deficit?

2011-08-23T21:46:00.000-04:00

The recurrent "government should balance its budget like a household" trope has been one of the more infuriating aspects of recent debates over economic policy. Its easy to see the appeal for politicians who want to appear to be talking "common sense," but the policy implications are destructive. In the LA Times, I suggest a different analogy:

Politicians of both parties have furthered the misunderstanding by frequently drawing an analogy between the federal budget and household budgets. "Families across this country understand what it takes to manage a budget," President Obama declared in a February radio broadcast. "Well, it's time Washington acted as responsibly as our families do." While this comparison appeals to a general belief that we should "live within our means," it's also misleading.

Decisions about the federal budget are fundamentally different from those of individual households, because policymakers need to account for how their choices affect the economy as a whole. It is more appropriate to liken government budget deficits to prescription medicine. Just as medication can be helpful to a sick patient, deficits can aid a failing economy.

The debt ceiling debate showed how hard it is for the political system to deal with something that can be good in some circumstances, bad in others. I hope this is a way of thinking of it that is simple and intuitive, but also right.

Of course, the ideal is to simultaneously have an expansionary policy now, but also a plan for a (roughly) balanced budget in the long run (i.e., after the economy has returned to health). But the debt ceiling fight illustrated how raising the issue of long term projected imbalances starts a big fight over the ultimate size of government (which isn't what countercyclical policy is about). With 14 million people unemployed - and interest rates very low - that is a dangerous distraction.

Time to Cash in the Fed's "Credibility"?

2011-08-07T00:24:00.001-04:00

Ezra Klein talks to Ken Rogoff:

Since 2008, Rogoff has recommended that the Federal Reserve commit to an extended period in which it will seek to set inflation at 4 percent. That would effectively make debt worth less. That’s anathema to central banks, which have spent the past few decades building their credibility as inflation fighters. But Rogoff is unimpressed. “All the central banks of the world have been fighting the last war,” he says. “This is a once-every-75-years great contraction where you spend your credibility. This is what that credibility is for.”

Update (8/12): Rogoff explains his thinking more in this FT column.

A Silver Lining to the Debt Ceiling Fiasco?

2011-08-07T00:16:00.001-04:00

In a recent Project Syndicate column, Stephen Roach shared some observations from recent conversations with Chinese policymakers, who were not pleased with the debt ceiling mess:

Senior Chinese officials are appalled at how the United States allows politics to trump financial stability. One high-ranking policymaker noted in mid-July, “This is truly shocking… We understand politics, but your government’s continued recklessness is astonishing.”

Roach suggests that China may be losing its appetite for US Treasuries, and this, he believes, spells trouble for the US:

So China, the largest foreign buyer of US government paper, will soon say, “enough.” Yet another vacuous budget deal, in conjunction with weaker-than-expected growth for the US economy for years to come, spells a protracted period of outsize government deficits. That raises the biggest question of all: lacking in Chinese demand for Treasuries, how will a savings-strapped US economy fund itself without suffering a sharp decline in the dollar and/or a major increase in real long-term interest rates?

The US should hope he's right. An abrupt reversal would be very disruptive, though it would probably do more harm to China than the US (provided the Fed steps in to limit the increase in US interest rates). But China's massive purchases of US assets aren't a benefit to the US overall - they are part of a policy that has distorted the US economy away from tradable goods production and towards excess homebuilding (and asset bubbles).

The reason China has accumulated gigantic holdings of US Treasuries is that it has been intervening in foreign exchange markets - selling renminbi for dollars - to keep the value of its own currency down and the dollar up. It then invests the dollars in Treasuries (i.e., the Treasury bond holdings are a consequence of the foreign exchange policy). The result is US-produced goods are more expensive relative to Chinese goods. This contributes to the trade imbalance and reduces the size of US exporting and import-competing sectors. Furthermore, many other countries feel the need to undertake similar interventions to maintain competitiveness vis a vis China, so it is not just the bilateral trade balance that is affected.

According to Roach, China has recognized the need to "rebalance" its own economy to rely less on exports and more on domestic consumption:

China has adopted a very transparent response. Its new 12th Five-Year Plan says it all – a pro-consumption shift in China’s economic structure that addresses head-on China’s unsustainable imbalances. By focusing on job creation in services, massive urbanization, and the broadening of its social safety net, there will be a big boost to labor income and consumer purchasing power. As a result, the consumption share of the Chinese economy could increase by at least five percentage points of GDP by 2015.

If the debt ceiling mess has given China's leadership a greater sense of urgency to get on with that, that's a good thing for them, and for us.

Roach's column came out before the S&P downgrade, but that may have reinforced China's views.

S&P Downgrade: Its the Institutions, Not the Debt

2011-08-05T21:14:00.001-04:00

S&P just downgraded US government bonds from "AAA" to "AA+". Their explanation:

We lowered our long-term rating on the U.S. because we believe that the prolonged controversy over raising the statutory debt ceiling and the related fiscal policy debate indicate that further near-term progress containing the growth in public spending, especially on entitlements, or on reaching an agreement on raising revenues is less likely than we previously assumed and will remain a contentious and fitful process. We also believe that the fiscal consolidation plan that Congress and the Administration agreed to this week falls short of the amount that we believe is necessary to stabilize the general government debt burden by the middle of the decade.

That is, the downgrade has as much to do with the US political system as it does with debt levels. The ugly spectacle of a faction of one political party taking the economy hostage in the debt ceiling debate has trashed the rating agency's (and everyone else's) confidence in Washington's ability to make difficult compromises.

July Employment: Merely Bad

2011-08-05T10:41:00.001-04:00

Arriving the day after a stock market plunge set off renewed talk of a "double dip" recession, the July employment report almost looks good because it is merely bad. According to the BLS, in July the economy added 117,000 jobs and the unemployment rate ticked down to 9.1% (from 9.2%).

Employment growth of 117,000 is just about the "treading water" level needed to keep up with population growth and productivity improvements, so it doesn't represent any progress in digging out of a deep hole. Government continued to be a drag - private employment rose by 154,000, but government jobs fell by 37,000 (of which state government accounted for 23,000, which the BLS says was "almost entirely" due to the Minnesota shutdown).

Also, the employment growth figures for May and June, which had contributed to the economic fears, were revised up to 53,000 and 46,000, respectively (still quite bad, but better than 25,000 and 18,000 previously announced).

Employment (Nonfarm Payrolls, Seasonally Adj.)

The decline in the unemployment rate was due to people leaving the labor force, not job gains - in the survey of households (different from the survey of firms from which the headline jobs number is calculated), the number of people employed fell by 38,000, but the number of people in the labor force fell by 193,000. The labor force participation rate therefore decreased, as did the employment-population ratio.

Employment-Population Ratio (Seasonally Adj.)

Not a good report, but one that suggests the economy is stagnating, not falling into a recession. That might take the some of the edge off of yesterday's panic, but, then again, a little panic might be what we need to rouse policymakers into action....

2Q GDP: Bad Present, Worse Past

2011-07-29T16:53:00.000-04:00

Even with expectations low, today's advance estimate of second-quarter GDP from the BEA was disappointing. Real GDP grew at a 1.3% annual rate in the second quarter of 2011, and the first quarter's growth rate was revised downward to 0.4% (from 1.9% previously estimated).

Government purchases - the G component in the national income accounting identity - was a drag on real GDP for the third consecutive quarter. In the second quarter, G decreased at a 1.1% annual rate (larger declines in federal nondefense and state and local government spending were partly offset by an increase in defense spending). Consumption was basically flat (increasing at 0.1% annual rate), while investment rose at a 7.1% pace. Net exports also made a positive contribution: exports increased at a 6% rate, compared to 1.3% for imports.

Today's release incorporated a large "annual revision" of past data, and it indicates that the recession was worse than previously believed: real GDP shrank 0.3% in 2008 and 3.5% in 2009 (compared to previous estimates of 0% and -2.9%). This graph from Calculated Risk shows the changes:

According to the revised numbers, real GDP has not returned to its pre-recession level, as we had previously believed.

This makes the badness of the labor market somewhat less of a puzzle - the rise in unemployment had been more than the fall in output seemed to warrant based on historical relationships, but now we know that output was lower than we thought.

In this deep hole (and with long-run interest rates remaining very low), the policy focus on budget cuts makes no sense, of course. Ryan Avent has a good analogy:

IN 2007, the great ship of the American economy began encountering darkening skies. In 2008, it was suddenly faced with a violent storm which blew it miles off course, well south of where it ought to have been. The country's leaders didn't know how far from their charted path they'd been swept, but they recognised a need to make a course correction. Now, three years later, a look at the maps tells us that the storm was more powerful than previously believed, and it left the vessel much farther south than anyone had expected. The course corrections made earlier? Far too small to bring the ship back to its previous path. Yet none of America's leaders are trying to steer the ship back northward. Indeed, many seem anxious to yank on the tiller and drag the economy farther south still.

Brad Plumer has a nice post on what the data suggest about the recovery act (a.k.a., the "stimulus"), and Brad DeLong has some quick policy suggestions (though there's little reason to hope we'll see anything like them). Real Time Economics rounds up Wall Street "economist" reaction.

The Most Interesting Man in the World?

2011-07-22T09:00:00.000-04:00

The January issue of Economica included a symposium in honor of A.W. (Bill) Phillips, marking the 50th anniversary of his original "Phillips Curve" article. The first article is a biographical essay by Alan Bollard, which is fascinating reading:

The young Bill was clearly very talented, but his parents reluctantly decided that they could not afford to keep him at school, and any dreams of a university education were abandoned. Aged 15, Bill signed up as an apprentice electrician with the government's Public Works Department, which at that time was building infrastructure around rural New Zealand. He spent the next few years roughing it at working men's camps in remote rural sites, helping to build hydroelectric dams to generate electricity for the national grid. Bill had played with photography and seen early movies, and he was fascinated by the idea of ‘talkies’. He hired a hall in the Tuai camp and set up the first talkies cinema. Recreation involved playing his violin, riding an acquired motorbike and reading his treasured encyclopaedia of world religions.

But rural New Zealand was not enough. Phillips wanted to sample the world. In 1935, still aged only 21, he packed his swag and his fiddle, and shipped to Australia. Here he spent a couple of years travelling the outback, hitching rides on freight trains and working in mining camps. Money came from a range of jobs: picking bananas, working on building sites, mining gold, running a cinema, and even crocodile hunting. These were tough jobs in a rough country, but at the same time Phillips had set his intellectual sights higher. He enrolled in a correspondence course in electrical engineering and remembers learning his first differential equations under a harsh Australian sun at an outback mining camp.

Phillips had a lifelong fascination with Eastern cultures. In 1937, despite the worsening international situation, he boarded a Japanese ship to travel to Shanghai. While he was at sea, the Japanese invaded Manchuria, and the ship was diverted to Yokohama. Phillips took advantage of this by travelling around the newly militarized Japan; at one point he was detained by the authorities, who suspected that he might be a spy. Eventually he made his way out through Korea, Manchuria and Harbin, and crossed Russia on the Trans-Siberian railway. With Antipodean optimism, he looked for casual jobs across Soviet Russia, only to find them all taken by political prisoners. From Stalin's Moscow he travelled on through threatened Poland and Nazi Germany during the fragile last years of peace. He settled in London, where he found work as an electrical engineer. Having continued his correspondence course, Phillips now graduated from the Institute of Electrical Engineers, gaining his first formal qualifications. He also took classes in several languages.

Fortunately, Economica has given free online access, so you can read the rest, including his World War II adventures. There is also the story of his famous machine - I posted a video of it in operation here.

Rules-based Keynesian Policy?

2011-07-21T00:44:00.000-04:00

John Taylor, who is one of the most prominent academic critics of administration and Fed policy over the past several years, grapples with the label "anti-Keynesian" that was pinned on him by The Economist. He writes:

In a follow-up to the Economist article, David Altig, with basic agreement from Paul Krugman, argued that it was a misnomer because I developed and used macro models (now commonly called New Keynesian) with price and wage rigidities in which the government purchases multiplier is positive (though usually less than one), or because the Taylor rule includes real variables in addition to the inflation rate. In my view, rigidities exist in the real world and to describe accurately how the world works you need to incorporate such rigidities in your models, which of course Keynes emphasized. But you also need to include forward-looking expectations, incentives, and growth effects—which Keynes usually ignored.

In my view the essence of the Keynesian approach to macro policy is the use by government officials of discretionary countercyclical actions and interventions to prevent or mitigate recessions or to speed up recoveries. Since I have long been critical of the use of discretionary policy in this way, I think the Economist is correct so say that I am anti-Keynesian in this sense of the word. Indeed, the models that I have built support the use of policy rules, such as the Taylor rule for monetary policy or the automatic stabilizers for fiscal policy, which are the polar opposite of Keynesian discretion. As a practical prescription for improving the economy, the empirical evidence is clear in my view that discretionary Keynesian policy does not work and the experience of the past three years confirms this view.

"Keynesian" means different things to different people - at its broadest, it means accepting that there are frictions in the economy which mean that aggregate demand matters and policy can have real effects. This is in contrast to the pure classical view, in which Say's law holds, demand is irrelevant, and output depends on technology and preferences. In the version of Keynesian economics in our undergraduate textbooks - the IS-LM/AS-AD framework - the frictions are nominal rigidities and the Keynesian model deals with "short run" fluctuations around a "long run" equilibrium determined by the classical model. In this setting, both monetary and fiscal policy matter (by shifting the LM and IS curves, respectively), though early Keynesians emphasized fiscal policy and "monetarists" (most prominently Milton Friedman), gave primacy to monetary policy. The version of Keynesian economics in our graduate textbooks and academic journals - "New Keynesian" - combines dynamic optimization with sticky prices, and explicitly addresses the lack of "forward looking expectations" in the traditional textbook version. Furthermore, some argue that both the IS-LM and New Keynesian incarnations really miss the point and gloss over more fundamental irrationality and instability Keynes saw in the capitalist system.

As Taylor describes his views of the economy (and from what I know of his academic work), it seems consistent with mainstream New Keynesian economics (though his version has been less favorable to fiscal policy than some others). His criticism of recent fiscal and monetary policy grows out of another longstanding conundrum in macroeconomics, "rules versus discretion." He is not claiming that countercyclical fiscal and monetary policy are fundamentally impossible, which is what I would say is the true "anti-Keynesian" view. Rather, he is arguing that discretionary policy may do more harm than good, and policy should be based on stable, predictable rules.

A primary argument for rules is that discretionary "fine tuning" is impractical based on "long and variable" lags associated with (i) recognizing the state of the state of the economy, (ii) designing and implementing a policy and the (iii) the policy's impact reaching the economy. Often lurking behind this argument is a political philosophy that is skeptical of government (no coincidence that Milton Friedman was the most famous proponent of rules - Brad DeLong recently argued this is how he resolved the contradiction between an economics that said monetary policy can be effective with a libertarian political philosophy).

Taylor is careful to say that he opposes "discretionary Keynesian policy" - I think "anti-discretion" might be a better characterization of his critique than "anti-Keynesian." Of course, that only matters if it is possible to be "anti-discretion" without being "anti-Keynesian." I think it is.

I don't share the political philosophy, but the experience of the last several years has underscored the practical difficulties of discretionary policy. The early-2009 Obama administration with large congressional majority is about as close to government by center-left mainstream Keynesian technocrats as the American political system is likely to ever give us. In retrospect, it is clear they misjudged the scope and duration of the downturn and were not able make adjustments as that became apparent.

Monday morning quarterbacking in April, I suggested that the stimulus should have been designed in a "state-contingent" fashion to remain in place until the recovery reached certain benchmarks. It is a small step from there to a "rules based" countercyclical fiscal policy - policies like aid to state governments, extended unemployment benefits, payroll tax cuts and even increased infrastructure spending could be designed to kick in and ramp down automatically based on the state of the economy (e.g., with triggers based on the unemployment rate). To me, that's very "Keynesian", but also "rules-based", and its easy to imagine that might have worked better than the actual policies that were put in place.

Practical Lessons in Keynesian Economic Policy

2011-07-19T14:51:00.000-04:00

Ezra Klein writes:

Keynes — and others who later elaborated on his work, like Hyman Minsky — taught us that although markets are usually self-correcting, they occasionally enter destructive feedback loops in which a shock to, say, the financial system scares business and consumers so badly that they hoard money, which worsens the damage to the system, which further persuades other economic players to hoard, and so on and so forth.

In that situation, the role of the government is to break the cycle. Because businesses and consumers have stopped spending, the government breaks the cycle by spending. As clean as that theory is, it turned out to be a hard sell.

The first problem was conceptual. What Keynes told us to do simply feels wrong to people. “The central irony of financial crises is that they’re caused by too much borrowing, too much confidence and too much spending, and they’re solved by more confidence, more borrowing and more spending,” Summers says.

The second problem was practical. “What I didn’t appreciate was the extent to which we only got one shot on stimulus,” Romer says. “In my mind, we got $800 billion, and surely, if the recession turned out to be worse than we were predicting, we could go back and ask for more. What I failed to anticipate was that in the scenario that we found we needed more, people would be saying that what was happening showed that stimulus, in general, didn’t work.”

Many of us economists believe Keynesian policies have been successful, and that more would have been better, but politics doesn't judge outcomes relative to a counter-factual scenario. That is, the argument that things would have been far worse in the absence of a policy isn't a winner, even if it is correct. Unfortunately, that means future policy makers are likely to draw exactly the wrong lessons, and do even worse next time (at least on the fiscal side; central bank independence gives monetary policy some space to follow academic rather than political views).

Furthermore, as Paul Krugman explains, the economics profession (or at least some parts of it) isn't playing an entirely helpful role.

Cavallo on Greece

2011-07-15T22:17:00.000-04:00

Some have likened Greece's situation today to Argentina's in 2001, when, after repeated austerity "cures" failed, it ultimately was forced off its peg to the dollar and suffered a severe crisis, but a floating currency ultimately facilitated a recovery. In a Vox column, former Argentine finance minister Domingo Cavallo offers some reflections on Argentina's experience and what it suggests for Greece. Unfortunately for them, he says "Greece’s crisis is much more difficult to manage than the 2001 Argentinean crisis." (Yikes!!). He offers some suggestions on how the debt restructuring should be done (and I think everyone who isn't a European government official sees that it needs to be done), but doesn't think Greece should leave the Euro.

June Employment: Bad Economy!

2011-07-09T01:03:00.000-04:00

A really bad employment report - according to the BLS, the economy only gained 18,000 jobs in June and the unemployment rate ticked up to 9.2% (from 9.1%).

The government continues to be a drag - private sector payrolls increased by 57,000, but government employment shrank by 39,000. The employment numbers are calculated from a survey of businesses; the numbers from the BLS' survey of households (from which the unemployment rate is calculated) are even worse - the number of employed persons dropped by 445,000 and labor force participation decreased to 64.1%.

On a non-seasonally adjusted basis, the unemployment rate rose from 8.7% to 9.3% because of a large increase in the labor force (1.089 million, presumably due to the end of the school year) outstripped a small increase in employment (101,000). Non-seasonally adjusted payrolls rose by 376,000. The comparison between seasonally-adjusted and unadjusted numbers shows that June is a month that normally sees a big increase in labor force participation and employment, and this June's increase in employment is disappointing compared to what we would expect for this part of the year (and what is needed to keep pace with changes in the labor force).

The discussion in Washington seems increasingly detached from reality...

See also: Tim Duy, Menzie Chinn, Calculated Risk, Greg Ip.

Orzag for State-Contingent Stimulus

2011-07-01T14:31:00.000-04:00

In a column for Bloomberg, former CBO chief and White House budget director Peter Orszag writes:

...[P]olicy makers should provide additional macroeconomic support in 2012 by extending the existing payroll tax holiday. But more than that, Congress should link the payroll tax to the unemployment rate. This would allow the tax holiday to automatically calibrate itself to existing conditions, providing support only when the economy is weak. If necessary, the underlying payroll tax rate could be raised to make this mechanism budget-neutral.

As I said back in April, one of the main lessons I've drawn from recent experience is that the recovery act would have been much better if the support for the economy had been made state-contingent like this. This is a way of overcoming two problems: (i) uncertainty about the speed of recovery (or lack thereof) and (ii) the political system's utter inability to deal with timing issues (nicely explained in Orszag's piece), as evidenced by the absurdity that it appears that we are heading for significant fiscal tightening even as nearly 14 million people remain unemployed.

Krugman on Keynes

2011-06-22T01:16:00.000-04:00

Vox has published Paul Krugman's speech at a conference commemorating the 75th anniversary of The General Theory. The speech brings together a number of themes Krugman has addressed at his blog. Among other things, Krugman says:

The brand of economics I use in my daily work – the brand that I still consider by far the most reasonable approach out there – was largely established by Paul Samuelson back in 1948, when he published the first edition of his classic textbook. It’s an approach that combines the grand tradition of microeconomics, with its emphasis on how the invisible hand leads to generally desirable outcomes, with Keynesian macroeconomics, which emphasises the way the economy can develop what Keynes called “magneto trouble”, requiring policy intervention. In the Samuelsonian synthesis, one must count on the government to ensure more or less full employment; only once that can be taken as given do the usual virtues of free markets come to the fore.

It’s a deeply reasonable approach – but it’s also intellectually unstable. For it requires some strategic inconsistency in how you think about the economy. When you’re doing micro, you assume rational individuals and rapidly clearing markets; when you’re doing macro, frictions and ad hoc behavioural assumptions are essential.

So what? Inconsistency in the pursuit of useful guidance is no vice. The map is not the territory, and it’s OK to use different kinds of maps depending on what you’re trying to accomplish. If you’re driving, a road map suffices. If you’re going hiking, you really need a topographic survey.

But economists were bound to push at the dividing line between micro and macro – which in practice has meant trying to make macro more like micro, basing more and more of it on optimisation and market-clearing. And if the attempts to provide “microfoundations” fell short? Well, given human propensities, plus the law of diminishing disciples, it was probably inevitable that a substantial part of the economics profession would simply assume away the realities of the business cycle, because they didn’t fit the models.

The result was what I’ve called the Dark Age of macroeconomics, in which large numbers of economists literally knew nothing of the hard-won insights of the 30s and 40s – and, of course, went into spasms of rage when their ignorance was pointed out.

I share Krugman's view that the "textbook" Keynesian apparatus remains a useful apparatus for thinking about the economy. However, I think his portrayal of the turn macroeconomics has taken over the past forty or so years is a bit unfair. As Krugman notes, contemporary macroeconomic models are grounded in microeconomic optimization. Although a foolish desire for consistency can be the hobgoblin of our little economist minds, there is more to the story - the shift in methodology was also motivated by real deficiencies in the Keynesian framework identified by Friedman and Lucas, as well as the "stagflation" of the 1970's, which appeared to contradict Keynesian theory.

Toles on Austerity

2011-06-04T16:33:00.000-04:00

I've been thinking I should say something about the contradiction between Washington's new obsession with budget cutting and the still-struggling economy, but this cartoon from Tom Toles nails it better than anything I could have said:

May Employment: Where are the Flowers

2011-06-03T19:10:00.000-04:00

looks like no "green shoots" this spring....

The May employment situation report from the BLS confirms the impression from other bits of data (see Gavyn Davies and David Leonhardt from last week) that the already sluggish recovery is wobbling. Payroll employment (from the BLS survey of firms) rose by 54,000, which is quite a bit less than the 130,000 or so needed to keep unemployment steady as the labor force grows and productivity increases. The unemployment rate (from the survey of households), ticked up to 9.1% (from 9% in April).

The underlying numbers in the household survey (which gets second billing because it has a smaller sample) are slightly less unpleasant. The number of people employed increased by 105,000, while the number of unemployed increased by 167,000. This partly reflects re-entry into the labor force, 105,000 fewer people reported not being in the labor force, and the labor force participation rate ticked up from 64.15 to 64.22.

Mark Thoma has collected links to commentary on the report from around the econo-blogosphere.

Antidumping in Action

2011-05-23T12:00:00.000-04:00

Today's Washington Post provides another example of our dysfunctional "Antidumping" rules in action. This case is about antidumping tariffs imposed on furniture imports from China:

But do tariffs work? In the case of bedroom furniture, they’ve clearly helped slow China’s export machine. In 2004, before tariffs went into force, China exported $1.2 billion worth of beds and such to the United States. The figure last year was just $691 million.

Over the same period, however, imports of the same goods from Vietnam — where wages and other costs are even lower than in China — have surged, rising from $151 million to $931 million. The loss of jobs in America, meanwhile, only accelerated.

This may be a case where the differential tariff treatment between Chinese and Vietnamese furniture which resulted from the antidumping case induced "trade diversion" - i.e., an efficiency loss because the trade preferences result in imports coming from someplace other than the low cost producer. However, in this example, it could also be the case that comparative advantage shifted to Vietnam as China's labor costs have risen.

Furthermore:

The only Americans getting more work as a result of the tariffs are Washington lawyers, who have been hired by both U.S. and Chinese companies. Their work includes haggling each year over private “settlement” payments that Chinese manufacturers denounce as a “protection racket.”

Fearful of having their tariff rates jacked up, many Chinese furniture makers pay cash to their American competitors, who have the right to ask the Commerce Department to review the duties of individual companies. Those who cough up get dropped from the review list.

It is clear from the article that workers in the US industry have suffered from a disruptive wave of furniture imports. While it may indeed be the case that the US no longer has a comparative advantage in furniture production, standard comparative static trade theory fails to account for the adjustment costs associated with reallocating resources. That is, trade theory assumes full employment and that workers will be shifted to another sector, ignoring the fact that this process involves losing their jobs in one industry and, usually, a period of unemployment before finding a job in another.

Although it is also less than perfect, a more appropriate remedy in this case would be the application of "safeguard tariffs" which the President can impose (following the recommendation of the International Trade Commission) in cases where industries are disrupted by import surges. Relative to antidumping tariffs, safeguards have the advantages of being (i) time limited, (ii) at the discretion of the president (who presumably can consider the interest of the nation as a whole, rather than just an affected industry or region), and (iii) not requiring any allegation of "unfair" trade practices on the part of the exporters (which are usually somewhat bogus).

Resetting European Bonds

2011-05-21T16:16:00.000-04:00

When I saw this headline on the Washington Post's website

I thought the president was going over there to work out a debt restructuring, but that's not the kind of bonds they mean.

It would be kind of weird if a US president to be directly involved in a European sovereign debt crisis (though it has global repercussions so the US is not disinterested), but Europe sure seems in need of some kind of intervention. It is easy to understand why politicians prefer to hope they can get through the next election before things blow up rather than confronting a debt crisis. Unfortunately the two institutions best placed to push Europe's politicians into a restructuring of Greek (and maybe Irish) debt that everyone knows is necessary - the ECB and IMF - are not being helpful, according to Steven Pearlstein:

At the time of his arrest, Strauss-Kahn was headed to a meeting with German Chancellor Angela Merkel, reportedly to talk her out of a debt restructuring plan for Greece. The official IMF view, like that of the European Central Bank, is that allowing any euro-zone country to restructure its debt will trigger another global financial crisis as investors rush to indiscriminately dump all their European bonds, forcing European banks, which hold large piles of them, into insolvency. In this scary scenario, a debt default or restructuring in any euro-zone country would cause the collapse of the euro.

Pearlstein goes on to explain why this logic is flawed. Indeed, Kash Mansouri argues that the ECB is, in effect, pushing Greece out of the Euro (though he seems to interpret this as an unintended consequence...).

Its not really President Obama's job to tell Europe how to sort out their debt problems - indeed, he's got his hands full with a Congress that seems to want to set off a much bigger crisis by not raising the debt ceiling - but hopefully he can give them a friendly nudge in the right direction while he's over there. And the US should be using its influence over the IMF to get them to play a more constructive role.

April Employment Report

2011-05-06T09:35:00.001-04:00

The BLS reports this morning that the economy added 244,000 jobs in April, but the unemployment rate ticked up to 9% (from 8.8%). In this case, the reason for the apparent contradiction is that the two numbers come from different surveys - the first is from a survey of firms (the "establishment survey"), and the unemployment rate from a survey of households. The household survey reported a decrease of 190,000 in the number of people employed. In general, the two track each other well, but may diverge in any given month; when that happens people tend to trust the establishment survey more because it has a larger sample.

Nonfarm Payrolls, Seasonally Adjusted

Overall, this report seems to be consistent with an economy digging out of a very deep hole at a very slow pace. While the increase in 244,000 jobs more than what is needed just to keep pace with labor force growth (130,000-ish), 13.7 million people remain unemployed. The economy is about 4.6 million jobs short of a "normal" (but still not great) unemployment rate of 6% - at this pace, we'd get there in about three and a half years.

The report also included slight upward revisions of the February and March employment numbers (41,000 and 5,000 respectively).

Average hourly earnings have increased by 1.9% over the past year. That's more evidence that inflation is not a problem: wages should rise somewhat due to productivity growth, so that's not an inflationary number at all.

Private payrolls were up 268,000, but government shed 24,000 jobs, of which 8,000 was at the state level and 14,000 at the local level.

On a non-seasonally adjusted basis, the unemployment fell from 9.2% to 8.7% in April (i.e., this is a month with a large seasonal job increase, which the BLS tries to remove from all of the numbers discussed above, which are seasonally adjusted).

The Graduate Curriculum

2011-05-02T00:29:00.000-04:00

Macro navel-gazing turns (again) to the graduate curriculum....

Brad DeLong:

The fact is that we need fewer efficient-markets theorists and more people who work on microstructure, limits to arbitrage, and cognitive biases. We need fewer equilibrium business-cycle theorists and more old-fashioned Keynesians and monetarists. We need more monetary historians and historians of economic thought and fewer model-builders. We need more Eichengreens, Shillers, Akerlofs, Reinharts, and Rogoffs – not to mention a Kindleberger, Minsky, or Bagehot.

Yet that is not what economics departments are saying nowadays.

Perhaps I am missing what is really going on. Perhaps economics departments are reorienting themselves after the Great Recession in a way similar to how they reoriented themselves in a monetarist direction after the inflation of the 1970’s. But if I am missing some big change that is taking place, I would like somebody to show it to me.

As if it weren't bad enough that some assistant professors are writing blogs, a Michigan grad student named Noah Smith is blogging, too. After a description of his first-semester macro class, he says:

This course would probably have given Brad DeLong the following reasons for complaint:

1. It contained very little economic history. Everything was math, mostly DSGE math.
2. It was heavily weighted toward theories driven by supply shocks; demand-based theories were given extremely short shrift.
3. The theories we learned had almost no frictions whatsoever (the two frictions we learned, labor search and menu costs, were not presented as part of a full model of the business cycle). Other than Q-theory, there was nothing whatsoever about finance* (Though we did have one midterm problem, based on the professor's own research, involving an asset price shock! That one really stuck with me.).

At the time I took the course, I didn't yet know enough to have any of these objections...

Paul Krugman:

[M]odern graduate-level macroeconomics has managed to bury and forget what earlier generations knew, so that what was billed as intellectual progress ended up being, in crucial ways, intellectual regress.

Hmmm.... yes and no...

Grad school is trying to produce "productive" scholars, good practitioners of what Thomas Kuhn would call "normal science", who generate publications in academic journals. As such, much of it, especially the first year, is about learning techniques and terminology. Most of what I remember from my first year is doing alot of algebra - and that's not a bad thing, being at least somewhat good at algebra turns out to be pretty important, as is knowing about things like Kuhn-Tucker conditions, Hamiltonians, and Bellman equations.

In that sense, I don't think economics PhD programs do such a bad job. My first year graduate course was mostly growth theory and dynamic consumption theory, which were good vehicles for exposing us to the nuts and bolts of macroeconomic models. What is missing, is a sense of perspective and context. Contemporary academic models are grounded in "microfoundations" - the optimization problems of forward-looking agents - and, as such are very different from the models taught to undergraduates. First-year graduate students learn quickly that macroeconomics is very different from what they expected (i.e., its "micro with time subscripts"), but they don't know why. Time is precious in putting together a course, but I think a prologue which develops the motivation behind contemporary methods - principally the Lucas Critique and rational expectations revolution - would be time well spent (this article by Greg Mankiw is a good place to start).

DeLong and Krugman lament the lingering prominence of the "saltwater" Real Business Cycle (RBC) paradigm, and they have pointed out some startling statements by prominent true believers. However, there is good reason for nonbelievers to learn these models, as the methods used by them are also at the core of many state-of-the-art New Keynesian models.

If a PhD program can get its students through some growth theory and consumption theory, which come together in the Ramsey-Cass-Koopmans model, and take the small step from there to RBC models in the first year, those students would be well-prepared to study models with frictions and market failures more relevant to current problems in the second year.

Previously, I have also argued for including history of economic thought in the graduate curriculum. The trick would be to get people to take it seriously. This would help recover some of the insight that Krugman (rightly) believes have been obscured. Moreover, this might get students thinking more broadly, which would improve the likelihood that they might actually be in a position to re-think and change existing paradigms, rather than just being "productive" within them.

Null Hypothesis

2011-05-01T11:10:00.000-04:00

XKCD:

1Q GDP: Bleh

2011-04-28T11:51:00.001-04:00

The US economy grew at a 1.8% annual rate in the first quarter, according to the BEA's advance estimate. That's not good - it less than the 2.5%-ish pace needed to keep the unemployment rate stable as the labor force grows and productivity increases - and way short of what we need to significantly bring unemployment down.

The slow growth wasn't a surprise, and much the slowdown is being attributed it to temporary factors, including the severe weather in January, and a slowdown in defense purchases.

The main positive contributions came from consumption, which grew at a 2.7% rate, and inventory investment, which was something of a "bounceback" effect - the actual amount added to inventories was modest, but it was an acceleration relative to the fourth quarter, when there had been a big slowdown.

The government purchases component was a drag, falling at a 5.1% annual rate (defense fell at a 11.7% rate while state and local government declined at a 3.3% pace).

The inflation rate, measured by the GDP deflator, was 1.9%. Personal consumption expenditures (PCE) inflation was 3.8%, but excluding food and energy - i.e., "core PCE" - was 1.5%. If one believes that the core measure is the right one to guide monetary policy, then inflation is still low.

Disposable income was up sharply due to the payroll tax cut that took effect in January - 6.9% in nominal terms - but only 2.9% in real terms (I think that's where you see the effect from energy prices).

Meanwhile the Department of Labor says that unemployment claims are rising again...

The next revision of the GDP figures comes out on May 26.

See also: Free Exchange, Ezra Klein, Calculated Risk.

FOMC TV

2011-04-28T00:24:00.000-04:00

Ben Bernanke held his first post-FOMC meeting press conference today:

Reactions: Mark Thoma, Tim Duy, Paul Krugman, Brad DeLong, David Beckworth, Calculated Risk, Free Exchange, Catherine Rampell. The conference was liveblogged by the Times' Floyd Norris and by WSJ reporters.

The general tenor of the reactions (particularly the first five in the list above) is disappointment that it sounds highly unlikely that the Fed will undertake further expansionary policy beyond the $600 billion quantitative easing program currently in progress. This is particularly frustrating in light of the Fed's own revised projections, released today:

The "longer run" unemployment number can be taken as the Fed's estimate of the "natural rate," the lowest rate consistent with non-inflationary growth. The Fed is saying that it expects the unemployment rate to be significantly above the natural rate for at least three more years.

I think this statement was particularly telling:

I think that while it is very, very important for us to try to help the economy create jobs and to support the recovery, I think every central banker understands that keeping inflation low and stable is absolutely essential to a successful economy and we will do what is necessary to ensure that that happens.

While Bernanke is always careful to explain policy decisions in terms of the Federal Reserve Act's "dual mandate" of low unemployment and price stability, here he is subtly putting more weight on the inflation part ("absolutely essential"), relative to employment ("very, very important"). I think this is because "every central banker" is deeply afraid of repeating the mistakes of the 1970's, when high inflation became embedded in the economy, and could only be brought back under control with a very painful dis-inflation in the early 1980's. It may be that, in addition to hurting consumer sentiment, by providing a reminder of "stagflation" of the seventies, the recent run-up in oil prices is also casting a large shadow over the psyche of central bankers.

Also, the academic literature places significant emphasis on expectations and credibility, so the "hawkish" talk is likely partly motivated by a desire to keep a lid on inflation expectations. Of course, credibility ultimately depends on actions consistent with the talk.

While some of us academic types were disappointed in what we see as an excessive emphasis on inflation relative over employment (this is not universal: for a contrary view, see Steve Williamson), the markets may have read things differently. Treasury yields rose today, which suggests that the news from the Fed was slightly less hawkish than expected.

ARRA MMQB

2011-04-27T00:54:00.001-04:00

Another round of Monday morning quarterbacking of the Obama administration's initial fiscal policy drive, which led to the $800bn "stimulus" (the American Recovery and Reinvestment Act - ARRA) in February 2009...

One criticism, made Paul Krugman and many others, is that it simply wasn't big enough - in retrospect, it looks like a field goal when we really needed a touchdown.

A natural villain is Larry Summers, in this case because he prevented Christina Romer's case for a bigger program from getting to the president (this doesn't look so funny now). New York Magazine's Krugman profile has Summers' response:

"[T]here is some element of [Krugman] that is like the guy in the bleachers who always demands the fake kick, the triple-reverse, the long bomb, or the big trade."

Summers concedes that a bigger stimulus would have been the optimal policy in 2009. “The Obama administration asked for less than all that it recognized pure macroeconomic analysis would have called for, and it only got 75 cents on the dollar. But political constraints and practical problems with moving spending quickly constrained us. The president’s political advisers felt, and history bears them out on this since the bill only passed by a whisker, that asking for even more would have put rapid passage at risk.”

Ezra Klein suggests we should be asking a different question:

[T]he interesting counterfactual is not “what would have happened if the stimulus had been a bit bigger” but “what would have happened if Barack Obama had been inaugurated a couple of months later?” By June, unemployment was over 9 percent, and the full scope of the emergency was a lot clearer. If that had been the context behind the initial stimulus, I think it’s plausible to think it could’ve turned out very differently.

His post illustrates one of the problems with discretionary economic policy - the "recognition lag" - that the state of the economy only becomes clear in retrospect, after the data comes in. This is particularly difficult because, by the time sufficient information to identify trends and turning points is available, the economy may have changed directions again. In most cases, that's a good argument against "fine tuning" macro policies. But I think it was plenty clear in February 2009 that there was serious trouble - payroll employment had declined by over 400,000 in each month from September 2008 through January 2009, and the shock of the fall 2008 financial panic was still fresh in the collective consciousness.

What was unclear was the shape the eventual recovery would take. Some of us hoped that the economy would bounce back quickly, as it had from previous severe recessions (e.g., in 1982, unemployment peaked at 10.8%, but the recovery was brisk; real GDP grew 4.5% in 1983 and 7.2% in 1984). However, the 1990-91 and 2001 recessions, which were much milder, had been followed by sluggish "jobless recoveries." Moreover, as Reinhardt and Rogoff showed, the typical historical pattern is that recoveries in the wake of financial crises are very slow.

Therefore, looking back, in my capacity as another "guy in the bleachers," the main flaw I see is that the stimulus should have been state contingent. That is, the aid to states and many other spending provisions, as well as tax cuts, could have been designed to stay in place as long as they were needed. The act could have contained a trigger to phase out after some recovery benchmark had been achieved, e.g., after the unemployment rate has been below 7% for six months, the stimulus steps down by 50%, with the rest coming off after 6.5% or less unemployment is maintained for a period. Some parts of it could have been tied to state, rather than national, conditions. That might have spared us the ugly spectacle of severe cuts in state services, even as unemployment remains at an appallingly high level. Moreover, knowing that the fiscal support would be in place as long as needed might have served to create more confidence in the recovery, leading to a stronger improvement in private activity. (The natural counter-argument is that such an open-ended fiscal commitment would undermine confidence in the government's ability to handle its debt burden, but I don't think it would have been a problem).

I don't recall the idea of a state-contingent stimulus being raised anywhere at the time, and I have no idea whether it would have been politically feasible or not. Arguably, its just an amplification of the "automatic stabilizers" already built in to the system. Hopefully, there is no next time, but when it comes, perhaps we should give this aspect of the design of policy some further thought.

The Economist's Ryan Avent has another question:

[W]hat if Congress had failed to pass a stimulus at all? Would the Fed have acted sooner or more aggressively or both, and how might recovery have gone differently?

Which reminds me of the other thing the administration should have done differently (and this one is harder to explain) - they have allowed several seats on the Federal Reserve Board to remain unfilled for long periods. I agree with Avent that "QE2" appears to have worked. A different Board might have done more of it, sooner, and for longer, and that would have been better. On this point, Brad DeLong is yelling from the bleachers.

Change We Can Believe In (1980s Edition)

2011-04-25T17:47:00.002-04:00

In introducing the concept of fractional-reserve banking to my students today, I said that a bank which held reserves equal to its deposits wouldn't be profitable. I'd forgotten this classic example of another way banks could make money:

That was even funnier back in the late 1980s when TV viewers were inundated with the annoying Citibank ads being parodied. Also see this follow-up.

Two Notes on the Continuing Resolution

2011-04-12T11:06:00.000-04:00

From the appropriations committee summary of the continuing resolution (i.e, the budget deal):

The legislation also eliminates four Administration “Czars,” including the “Health Care Czar,” the “Climate Change Czar,” the “Car Czar,” and the “Urban Affairs Czar.”

Anastasia screamed in vain.

And:

For the Department of Transportation, the bill eliminates new funding for High Speed Rail and rescinds $400 million in previous year funds, for a total reduction of $2.9 billion from fiscal year 2010 levels.

I didn't realize it was possible to throw trains under the bus.

Petty and shortsighted.

Macroeconomic Impact of the Budget Deal: Very Quick Estimate

2011-04-09T14:33:00.002-04:00

In the e-mail age, there aren't as many envelopes lying around to do calculations on the back of, but I've nonetheless managed to do some rough figurin':

Last night's deal on the budget cuts $37.8 billion in spending. I haven't seen the exact composition yet, but most of it is presumably "domestic discretionary spending" - i.e., the stuff that counts as government purchases in the national income accounts.

Generally we do our macroeconomic calculations at 'annual rates', and since there is about six months left in the fiscal year covered by the budget (i.e., the government budgets start in October), the cut is $75.6 billion at an annual rate. The most recent GDP estimate is an annual rate of $14,871 billion for the fourth quarter of 2010, so lets call it $15,350 billion for the second third quarters of 2011 (based on roughly 5% nominal GDP growth, consistent with FOMC members' forecasts); that implies the cuts are 0.5% of GDP at an annual rate.

If we put the multiplier at 1.75, which is the midpoint of the CBO's range of estimates, the cuts reduce GDP by 0.875% at an annual rate. The rule of thumb known as Okun's law says that, for every percentage point less of GDP growth, the unemployment rate increases half a percentage point. So, over the course of a year, that would put unemployment at 0.4375 higher. Since this is over six months, we're talking about an 0.22 point increase in the unemployment rate. On a labor force of 153.4 million, that translates to a loss of 337,500 jobs.

Like Ezra Klein says, 2011 is not 1995:

Right now, the economy is weak. Giving into austerity will weaken it further, or at least delay recovery for longer. And if Obama does not get a recovery, then he will not be a successful president, no matter how hard he works to claim Boehner’s successes as his own. Clinton’s speeches were persuasive because the labor market did a lot of his talking for him. But when unemployment is stuck at eight percent, there’s no such thing as a great communicator.

Notes:
A more conservative multiplier estimate of 1 implies a job loss of about 191,750.

The macroeconomic argument for a positive effect from such a deal would rely on the idea that deficit reduction improves confidence in the future. In particular, if the government's future borrowing needs are reduced, there would be less "crowding out" of investment, and if future taxes are reduced, then lifetime disposable income has increased, which would generate higher consumption today. I don't think either of those are relevant to a short-term budget deal when there is significant slack in the economy. However, since many Americans seem to erroneously believe that government spending is hurting the economy, perhaps they will also think this is good for it. Confidence, even for the wrong reasons, matters...

Not much has been said about the composition of the cuts, but I suspect they will be uglier than people realize. While $38 billion sounds small relative to some of the numbers that get thrown around in budget discussions, it is quite significant relative to "nondefense discretionary spending" - i.e., what people usually think of as "the federal government" (see this previous post).

Update (4/14): Maybe not so bad. It appears that the actual cuts are significantly smaller - apparently a significant portion of the $38.5 billion in "budget authority" being cut is money that probably wouldn't have been spent this year anyway.

The ECB Tightens

2011-04-09T00:19:00.002-04:00

The European Central Bank just announced an increase its policy interest rate from 1% to 1.25%. Their decision highlights some current monetary policy dilemmas.

Core versus overall measures of inflation. As ECB President Jean-Claude Trichet explained:

Euro area annual HICP inflation was 2.6% in March 2011, according to Eurostat’s flash estimate, after 2.4 % in February. The increase in inflation rates in early 2011 largely reflects higher commodity prices. Pressure stemming from the sharp increases in energy and food prices is also discernible in the earlier stages of the production process. It is of paramount importance that the rise in HICP inflation does not lead to second-round effects in price and wage-setting behaviour and thereby give rise to broad-based inflationary pressures over the medium term. Inflation expectations must remain firmly anchored in line with the Governing Council’s aim of maintaining inflation rates below, but close to, 2% over the medium term.

That is, the recent blip in inflation is largely due to energy prices, but the worry is that this will lead to higher wage demands and ultimately more general price increases. This would be particularly bad if people began to make plans based on expectations of higher inflation (i.e., expectations became un-"anchored"). Those worries are ill-founded, says Paul Krugman:

Overall eurozone numbers look very much like US numbers: a blip in headline inflation due to commodity prices, but low core inflation, and no sign of a wage-price spiral. So the same arguments for continuing easy money at the Fed apply to the ECB. And the ECB is not making sense: it’s raising rates even as its official acknowledge that the rise in headline inflation is likely to be temporary.

Former Fed governor Larry Meyer had a nice op-ed on the subject in the Times last month.

Inflation targeting and "credibility." A temporary energy-price driven inflation spike may be harder for an inflation-targeting central bank like ECB to brush off. The goal of inflation targeting is to make monetary policy credible - i.e., to keep inflation expectations anchored - but it only works if the announced target is met. Gavyn Davies writes:

Of course, when an adverse supply shock hits the economy, there are no easy paths for the central bank to adopt, and the ECB will protest that its mandate requires it to hit its CPI inflation target regardless of the consequences for GDP growth. But it can expect no praise if it pushes the economy back into recession.

The optimum currency area problem. Or, really, the problem that the euro zone isn't one. The single currency means a single monetary policy. That works if the economies of Europe move together, but they aren't. This map of unemployment rates across Europe illustrates the problem:

The lightest yellow shade are countries with unemployment rates below 7% and the darkest red have rates above 13%, including 14.9% in Ireland and 20.5% in Spain. (A small irony: Eurostat's nifty map tool makes it very easy to illustrate the fundamental flaw of the euro project). In the high unemployment countries, it is hard to imagine that workers would be in a strong position to demand higher wages to make up for the increase in energy prices. But Trichet's worry may make more sense in the parts of Europe where labor markets are tighter. And Trichet can only make one monetary policy. As Floyd Norris puts it:

“If you take the euro area as a whole . . .”
So began a response Thursday from Jean-Claude Trichet, the president of the European Central Bank, as he explained the central bank’s decision to raise interest rates in Europe.
If only there were a “euro area as a whole.”

This is exacerbated by the fact that several of the smaller eurozone countries are also undergoing sovereign debt crises. David Beckworth has the appropriate musical reference - it may be the final countdown for Europe:

[T]his move may have begun the countdown to the Eurozone breakup. It is hard to see how else this can turn out. The Germans--the folks who really call the shots in Europe--are reluctant to see the needed debt restructuring in the periphery and are equally reluctant to provide bailouts large enough to fix the problem. So far the Germans have been kicking the can down the road on these issues. With ECB monetary policy now tightening they will soon run out of road to kick the can down.

One irony here is that many of the same sorts of people who have taken to criticizing the Fed for "printing money" are also prone fretting that America is sliding down the slippery slope to "European socialism" (trains and universal healthcare - quelle horreur!). Next time Ron Paul says we need to return to "sound money", someone needs to tell him to move to Europe!

March Employment: Sluggish Acceleration Continues

2011-04-01T11:51:00.000-04:00

If the US economy was a car, Motor Trend would not be impressed with its acceleration...

The BLS reports that nonfarm payrolls (i.e., "jobs") increased by 216,000 and the unemployment rate decreased to 8.8% in March (from 8.9% in February).

That's the best payroll number since last spring - the economy appeared to be entering a more rapid recovery with 277,000 and 458,000 jobs added in April and May 2010, respectively, before it wobbled last summer. Overall, the March numbers are consistent with an economy climbing out of a deep hole (13.5 million people remain unemployed) at a painfully slow pace.

The slow employment recovery is consistent with the pattern established by the two recessions of the "great moderation" era, in 1990-91 and 2001, but those recessions were quite mild by comparison. This is a disappointment to those of us who were hoping that the a severe recession would be followed by a sharp recovery, like in the last downturn of comparable magnitude, in 1981-82.

The payroll number comes from a survey of firms, and the unemployment rate is calculated from a survey of households. The household survey reported an increase of 291,000 in the number of people employed; the number of unemployed decreased by 131,000 and the labor force increased by 160,000. Labor force participation was steady at 64.2%.

On a non-seasonally adjusted basis, the unemployment rate fell from 9.5% to 9.2%, and payroll employment rose by 925,000. That is, the economy actually added alot of jobs in March, but a large part of that is a normal seasonal increase, so we shouldn't get excited about it.

See also: Calculated Risk, Ezra Klein, Sudeep Reddy.

The Spaghetti Bowl is Not Deep

2011-03-28T17:03:00.000-04:00

At Vox, Theresa Carpenter and Andreas Lendle ask, "How Preferential is World Trade?" Their answer:

We find that around half of world imports are from countries that are granted some preference – yet that does not mean that all of that trade is actually preferential. MFN rates may be zero or a product can be excluded from preferences. Overall – but not including intra-EU trade – just 16.3% of global trade has a positive preferential margin. Preferential margins are distributed as follows:
10.5% of total trade has a margin of 5 percentage points or less, 3.9% has a margin of 5-10 percentage points, 1.3% has a margin of 10-20 percentage points and only 0.5% has a margin of 20 percentage points and above.
Around 30% of global trade is not eligible for preferences and subject to non-zero MFN rates, although almost 2/3 of that trade faces tariffs of 5% or less.
More than half (52%) of world trade is at MFN zero, so no preferences can be granted.

By "preferential margin," they mean the gap between the "most favored nation" tariff, which all WTO members are expected to apply to imports from other members, and the lower tariffs which might apply under regional and bilateral trade agreements. For example, if the US has a 10% MFN tariff on cogs, but under NAFTA, cogs from Mexico enter the US tariff-free, that would mean a 10% preferential margin.

This addresses one of the main complaints about trade agreements: that they lead to preferences. This can lead to "trade diversion," whereby a country imports a good from someplace that isn't the most efficient producer - in the above example, if Brazilian cogs were 5% less costly than Mexican cogs, without NAFTA, the US would import them from Brazil; NAFTA causes the US to shift to Mexican cogs (and lose the tariff revenue). As a political economy matter, this might also mean that Mexico is less likely to support multilateral liberalization - e.g., a reduction in cog duties in the WTO Doha round talks - because it enjoys its privileged access to the US market. That is, preferential agreements lead to worries about "preference erosion" which could hinder broader tariff reductions.

These are two aspects of the general criticism that regional trade agreements create what is known as the "spaghetti bowl phenomenon" described thus in an academic article by Jagdish Bhagwati, David Greenaway and Arvind Panagariya:

The result [of the proliferation of regional trade agreements] is…the ‘spaghetti bowl’ phenomenon of numerous and crisscrossing PTAs and innumerable applicable tariff rates depending on arbitrarily-determined and often a multiplicity of sources of origin. In short, the systemic effect is to generate a world of preferences, with all its well-known consequences, which increases transaction costs and facilitates protectionism. In the guise of freeing trade, PTAs have managed to recreate the preferences-ridden world of the 1930s as surely as protectionism did at the time. Irony, indeed!

One of the interesting questions in trade is whether "free trade" agreements really deserve the name. Carpenter and Lendle's evidence suggests that perhaps some of the criticisms - while valid in theory - may be overdone in practice.

Glasnost!

2011-03-24T17:15:00.002-04:00

Ben Bernanke will be meeting the press, the Fed announced:

Chairman Ben S. Bernanke will hold press briefings four times per year to present the Federal Open Market Committee's current economic projections and to provide additional context for the FOMC's policy decisions.

In 2011, the Chairman's press briefings will be held at 2:15 p.m. following FOMC decisions scheduled on April 27, June 22 and November 2. The briefings will be broadcast live on the Federal Reserve's website. For these meetings, the FOMC statement is expected to be released at around 12:30 p.m., one hour and forty-five minutes earlier than for other FOMC meetings.

The introduction of regular press briefings is intended to further enhance the clarity and timeliness of the Federal Reserve's monetary policy communication. The Federal Reserve will continue to review its communications practices in the interest of ensuring accountability and increasing public understanding.

Wow. It wasn't too long ago that I remember watching one of Bank of England Governor Mervyn King's press conferences and thinking "that will never happen here."

This is another step that follows from a significant evolution in what is seen as good practice by central banks. The Fed and other central banks once believed in the importance of using secrecy to cultivate a mystique. It was not for nothing that William Grieder titled his 1987 classic about the Fed "Secrets of the Temple." The Fed only began announcing changes in its policy stance in 1994, announcements of explicit Fed Funds rate targets followed in 1995.

This trend towards openness partly reflects the influence of academic views, as modern macroeconomic models assign important roles to expectations, information and credibility (which can be cultivated by making policy announcements and then sticking to them). Its not surprising to see Bernanke pushing in this direction, given his background as a prominent academic economist (in contrast to his predecessor). The previous procedural step in this direction was in November 2007, when Bernanke instituted the practice of having the FOMC members release their forecasts. Bernanke also appeared on 60 minutes last December, which would have been unthinkable to the previous generation of central bankers.

Update: Real Time Economics has reaction from some Fed watchers and a chronology of the Fed's increasing openness.

DeLong on Friedman

2011-03-21T09:20:00.000-04:00

Although it was once considered the big divide in macroeconomics, contemporary "Keynesianism" and "Monetarism" may not be so far apart (some would argue that's because modern "New Keynesians" aren't really Keynesians at all, but I digress...). These days, they are mostly on the same side in arguing that policy can do something (other than damage) to smooth economic fluctuations and, by extension, persistent high unemployment is a policy failure.

This reveals a contradiction between how Milton Friedman is perceived and what his ideas really meant, Brad DeLong explains:

In the 1950s and 1960s and 1970s Milton Friedman faced a rhetorical problem. He was a laissez-faire libertarian. But he also believed that macroeconomic stabilization required that the central bank be always in the market, buying and selling government bonds in order to match the supply of liquid cash money to the demand, and so make Say's Law true in practice even though it was false in theory.

Such a policy of constant government intervention to continually rebalance aggregate demand is hardly a laissez-faire hands-off libertarian policy, is it?

Friedman, however, set about trying to maximize the rhetorical distance between his position--which was merely the "neutral," passive policy of maintaining the money stock growth rate at a constant--and the position of other macroeconomists, which was an "activist," interventionist policy of having the government disturb the natural workings of the free market. Something went wrong, Friedman claimed, only when a government stepped away from the "neutral" monetary policy of the constant growth rate rule and did something else.

It was, I think, that description of optimal monetary policy--not "the central bank has to be constantly intervening in order to offset shocks to cash demand by households and businesses, shocks to desired reserves on the part of banks, and shocks to the financial depth of the banking system" but "the central bank needs to keep its nose out of the economy, sit on its hands, and do nothing but maintain a constant growth rate for the money stock"--that set the stage for what was to follow in Chicago.

First, Friedman's rhetorical doctrine eliminated the cognitive dissonance between normal laissez-faire policies and optimal macro policy: both were "neutral" in the sense of the government "not interfering" with the natural equilibrium of the market. Second, Friedman's rhetorical doctrine eliminated all interesting macroeconomic questions: if the government followed the proper "neutral" policy, then there could be no macroeconomic problems. Third, generations of Chicago that had been weaned on this diet turned out to know nothing about macro and monetary issues when they became important again.

It is in this sense, I think, that I blame Milton Friedman: he sold the Chicago School an interventionist, technocratic, managerial optimal monetary policy under the pretense that it was something--laissez-faire--that it was not.

February Employment: Slightly Better

2011-03-04T10:05:00.002-05:00

According to today's report from the BLS, the unemployment rate ticked down to 8.9% (from 9.0%) in February, and payrolls increased by 192,000.

Those are both solid improvements, though I had been hoping for better in light of other very positive recent data like the ISM index.

The labor force participation rate was unchanged at 64.2, so at least the decline in the unemployment rate was not driven by people leaving the labor force (to be counted as unemployed, a person must report that they are looking for work). That is in contrast to the big decline in the unemployment rate in December and January, where declining participation was a major factor.

If the recovery gets stronger, the participation rate should be expected to start rising.

The unemployment rate and labor force participation rate are calculated from a survey of households, which reported an increase of 250,000 in the number of people employed (the payroll number cited above comes from the survey of businesses, which has a larger sample). February is one of the months where the seasonal adjustment to the unemployment rate is downwards; on a non-seasonally adjusted basis, the unemployment rate was 9.5% (down from 9.8% in January).

The BLS also revised upward the payroll employment increase estimates for December, to 152,000 (from 121,000) and January, to 63,000 (from 36,000). It may be that some of the February increase really occurred in January, but wasn't properly counted due to the weather in January - a rough way to correct for this is to look at the average of the two months, which is an unimpressive 127,500 (that's roughly the pace needed to keep the unemployment rate stable as the population grows).

Worth noting amid the sturm-und-drang over state budget cuts:

Employment in both state and local government edged down over the month. Local government has lost 377,000 jobs since its peak in September 2008.

U-6, the BLS' broadest measure of unemployment and underemployment, which includes people who are "marginally attached" to the labor force and those who are working part-time but want to work full-time stands at 15.9% (seasonally adjusted), down from 16.1% in January.

Update: More reactions/analysis from Mark Thoma, Paul Krugman, David Leonhardt, Floyd Norris, Calculated Risk, Free Exchange, Gavyn Davies and RTE's round up of Wall Street commentary.

Scientists vs Engineers?

2011-03-04T00:48:00.000-05:00

The House Republicans' plan to cut federal spending by $61 billion for the remainder of the fiscal year (i.e., the period between now and the end of October) will be a drag on the economy and reduce employment, according to both Goldman Sachs and Moody's Mark Zandi, who says:

The House Republicans’ proposal would reduce 2011 real GDP growth by 0.5% and 2012 growth by 0.2 percentage points This would mean some 400,000 fewer jobs created by the end of 2011 and 700,000 fewer jobs by the end of 2012.

This shouldn't come to a surprise to macroeconomics students, who know that a decrease in government purchases reduces aggregate demand and - outside of the special "classical" case of vertical aggregate supply - output.

John Taylor disagrees, however. Ezra Klein explains:

Mark Zandi says the GOP's proposed spending cuts will cost about 700,000 jobs. John Taylor says they will "increase economic growth and employment." Both are respected economists who immerse themselves in data, research and theory. So how can they disagree so sharply?

The dispute comes down to how much weight you give to "expectations" about future deficits. Taylor's argument is that Zandi's model -- which you can read more about here -- doesn't account for the upside of deficit reduction -- namely, that when the government spends less, the private sector will spend more. Taylor thinks individuals and businesses are hoarding their money because they're afraid of the high taxes, sharp spending cuts and assorted other nastiness that deficit reduction will eventually require. "The high unemployment we are experiencing now is due to low private investment rather than low government spending," he writes. "By reducing some uncertainty and the threats of exploding debt, the House spending proposal will encourage private investment."

A similar disagreement is playing out over monetary policy. In a recent NY Times column, Christina Romer wrote:

The debate is between what I would describe as empiricists and theorists.

Empiricists, as the name suggests, put most weight on the evidence. Empirical analysis shows that the main determinants of inflation are past inflation and unemployment. Inflation rises when unemployment is below normal and falls when it is above normal.

Though there is much debate about what level of unemployment is now normal, virtually no one doubts that at 9 percent, unemployment is well above it. With core inflation running at less than 1 percent, empiricists are therefore relatively unconcerned about inflation in the current environment.

Theorists, on the other hand, emphasize economic models that assume people are highly rational in forming expectations of future inflation. In these models, Fed actions that call its commitment to low inflation into question can cause inflation expectations to spike, leading to actual increases in prices and wages.

She sides with the "empiricists" and argues that the influence of the "theorists" has held the Fed back from taking bolder, more effective action. Stephen Williamson begs to differ:

Romer says some things about economic history in her piece, but of course she is very selective, and seems to want to ignore the period in US economic history and in macroeconomic thought that runs from about 1968 to 1985. Let's review that. (i) Samuelson/Solow and others think that the Phillips curve is a structural relationship - a stable relationship between unemployment and inflation that represents a policy choice for the Fed. (ii) Friedman (in words) says that this is not so. There is no long-run tradeoff between unemployment and inflation. It is possible to have high inflation and high unemployment. (iii) Macroeconomic events play out in a way consistent with what Friedman stated. We have high inflation and high unemployment. (iv) Lucas writes down a theory that makes rigorous what Friedman said. There are parts of the theory that we don't like so much now, but Lucas's work sets off a methodological revolution that changes how we do macroeconomics.

The divides between Goldman/Zandi and Taylor over fiscal policy and between Romer and Williamson over monetary policy both reminded me of Greg Mankiw's distinction between "scientific" and "engineering" macroeconomics. The models used by the "engineers" - the people in Washington and on Wall Street who need to make practical, quantitative assessments of the impact of policy alternatives on the economy - are more elaborate versions of the "textbook" Keynesian IS-LM aggregate supply and demand framework that most of us (still) teach our macroeconomics students. As Williamson points out, the models used by academics - Mankiw's "scientists" - in our research are fundamentally different.

The engineering models are built on relationships among aggregate macroeconomic variables like the Phillips curve, which relates inflation and unemployment, and the consumption function, which connects consumption and disposable income. As Williamson alludes to, Robert Lucas and others won a methodological war in the profession (or at least the academic branch of it) in the 1970s and 1980s. The result of their victory is that the macroeconomic models published in leading journals today are expected to be grounded in the optimizing, forward-looking behavior of rational individuals.

Such individuals might believe, for example, a reduction in government spending today implies that their future taxes will be lower (because the government will be servicing a smaller debt burden). The resulting increase in their lifetime disposable income means that they will immediately increase their consumption. So any negative impact of a cut in government purchases is offset by an increase in consumption. Rational, forward-looking optimizers might also recognize that any monetary expansion will erode their real wages and demand an offsetting increase in nominal wages. This means that employment will remain unchanged (because the real cost to the firms of a worker is the same) even as inflation rises.

At its most extreme, the assumption of dynamic optimization under rational expectations was once believed to imply the Lucas-Sargent "Policy Ineffectiveness" proposition, which Bennett McCallum explained in a 1980 Challenge article:

Macroeconomic policies - sustained patterns of action or reaction - will have no influence because they are perceived and taken into account by private decision-making agents. Thus, the adoption of a policy to maintain "full employment" will not, according to the present argument, result in values of the unemployment rate that are smaller (or less variable) on average than those that would be experienced in the absence of such a policy.

Of course, in a world of rationally optimizing people, where prices adjust to clear markets, it is hard to explain how we could get to such large deviations from the natural rate of unemployment in the first place...

More generally, while macroeconomic science has continued on the methodological path established by Lucas, many of its practitioners have worked to re-incorporate real effects of monetary policy. This is a large part of the "New Keynesian" project, which is arguably now the reigning paradigm and best hope for reuniting "science" and "engineering" (and arguably is as much "monetarist" as it is "Keynesian").

Fiscal policy has received less attention - the implausibility of managing aggregate demand through the slow, cumbersome and messy budget process means that, in general, the focus has been on the Fed.

That has started to change as the global slump has pushed conventional monetary policy to its limits (and beyond into unknown worlds of unconventional policy), and governments around the world have made fitful attempts at fiscal policy. For example, recent papers by Christiano, Eichenbaum and Rebelo, Gauti Eggertson and Michael Woodford have shown that it is possible for fiscal policy to have significant multiplier effects when monetary policy is at the zero lower bound (as it is today) in New Keynesian models.

So, while, at a superficial level, it appears that the split between "scientists" and "engineers" persists, some of the "scientific" work being done today is finding that the remedies proposed by the "engineers" are not wholly inconsistent with forward-looking rational behavior after all.

Econ Journal Footnote of the Year

2011-02-21T23:32:00.002-05:00

Foletti, L., Fugazza, M., Nicita, A. and Olarreaga, M. (2011), Smoke in the (Tariff) Water. The World Economy, 34: 248–264

9 The song ‘Smoke on the Water’ was written by Deep Purple and refers to the fire that took place at the Montreux Casino during Frank Zappa’s concert in the 1971 Festival. Montreux is at the opposite end of Lake Geneva from the WTO.

As the article explains, the gap between the tariff limits countries have agreed to under the WTO - "tariff bindings" - and the tariffs they actually impose is known as the "tariff water." This means that, in practice, countries could raise many tariffs without violating their WTO commitments. After accounting for tariff bindings that are above prohibitive levels and the constraints of regional trade agreements, the paper looks whether countries have used their available "policy space" to increase protection during the global recession (and finds that, generally, they haven't very much).

Or, one might say they decided not to go (Policy) Space Truckin'.

For a follow-up, might I suggest: Woman from (the) Tokyo (Round) ?

If you think you're not familiar with "Smoke on the Water," after the first 20 or so seconds of this you will realize that you are (its the holy trinity of rock). Also: Space Truckin' and Woman from Tokyo.

Central Bank Independence

2011-02-20T12:48:00.000-05:00

Ben Bernanke's British counterpart, Mervyn King, is taking alot of heat for supporting the government's harsh package of spending cuts and tax increases. Paul Krugman writes:

Mervyn King, governor of the Bank of England, has stepped way over the line by turning into a cheerleader for the current government’s policies. He’s wrong on the economics — front-loaded spending cuts are the wrong policy for a still-depressed economy — but that’s not the key point; rather, the point is that if you’re going to have an independent central bank, the people running that bank have to be careful to stay above the political fray.

A Guardian story quotes Ed Balls, the Labour party shadow chancellor (i.e., the opposition's point person on economic policy):

"The last thing you ever want is for the Bank of England to be drawn into the political arena," said Balls, who was involved in Labour's move in 1997 to give the Bank independence to set interest rates. "Central bank governors have to be very careful about tying themselves too closely to fiscal strategies, especially when they are extreme and are making their job on monetary policy more complicated."

One of the things that comes with central bank independence is the expectation that central bankers should be neutral technocrats who keep a narrow focus on monetary policy. In part, this is because central bank independence is a fragile thing, which could be undone by a change to the Federal Reserve Act in the US, or, in the UK, the Bank of England Act. While respect for the principle of central bank independence - exemplified by the fact that Greenspan and Bernanke, both Republicans, were re-nominated by Democratic presidents - has evolved over time, it could be eroded if the central bank was seen to be a partisan actor.

However, I have a bit more sympathy for Governor King than Krugman and Balls do. Central bankers face a dilemma because, while they are rightly expected to stay out of "politics" generally, fiscal policy and monetary policy are interdependent. The central bank is responsible for one part of a fiscal and monetary "policy mix," and its decisions depend on (and are constrained by) the government's tax and spending decisions, and vice-versa.

In the UK, the Bank of England is accommodating "tight" fiscal policy with "loose" monetary policy. To a slightly less dramatic degree, this also occurred between the Clinton administration and the Greenspan Fed in the early 1990's. The early 1980's saw the opposite mix in the US: simultaneously tight monetary policy and loose fiscal policy. While the monetary tightening was seen as necessary to bring inflation under control, it probably wouldn't have had to have been so severe if the Reagan administration's tax cuts and spending increases weren't occuring at the same time.

Since the ultimate impact of a fiscal policy depends on how monetary policy will react, the political system, in theory, could make better-informed decisions if the central bank communicated its views and intentions. Moreover, because monetary policy has to react to fiscal policy, it is arguably legitimate for the central bank to have preferences about it.

The argument Krugman and Balls are making implies that the benefits from a more explicit coordination of monetary and fiscal policy, which requires central banks to speak about fiscal policy, is outweighed by the damage to central bank independence that occurs when central bankers like King express themselves on "political" tax and spending matters.

A Real Appreciation for China (Cont'd)

2011-02-19T11:36:00.000-05:00

Another day brings more evidence that inflation in China may be taking care of the undervalued renminbi problem (see this previous post).

The Economist:

In adjusting current accounts, what matters is the real exchange rate (which takes account of relative inflation rates at home and abroad). Movements in nominal exchange rates often do not achieve the desired adjustment in real rates because they may be offset by changing domestic prices. For example, the yen’s trade-weighted value is around 150% stronger than it was in 1985. Yet Japan’s current-account surplus remains big because that appreciation has been largely offset by a fall in domestic Japanese wholesale prices, so exporters remain competitive.

An alternative way to lift a real exchange rate is through higher inflation than abroad. To an American buyer, a 5% increase in the yuan price of Chinese exports is the same as a 5% appreciation of the yuan against the dollar.

Fred Bergsten (interviewed by Michael Casey):

The real [inflation-adjusted] renmimbi exchange rate has appreciated against the dollar at an annual rate of about 12% since last June, although considerably less on a trade-weighted basis. The dollar has fallen against most other currencies, so on a trade-weighted basis, the renmimbi has risen less. On the other hand, one has to accept that the Chinese think of this totally in dollar terms. So the dollar exchange rate is a legitimate focus for them, and if you believe that the dollar is going to bounce around and come back over time it will drag the renmimbi back up with it [against those other currencies.]

They have been letting [the real exchange rate] go up an average of 10 to 12% on an annual basis so it’s fair to say that if they would let that continue for another couple of years they would achieve a restoration of underlying equilibrium in the exchange rate. That would take away most, if not all, of the distortions that their persistent interventions have created....

[G]iven China’s history of hyperinflation, it would be far better to adjust via the nominal rate. It has always surprised me that they seem to prefer to do part of it through inflation. And now that they are really worried about inflation, which has become the focal point of their economic policy, this would be the perfect time for them to let the currency adjust. They know the currency is going to adjust over time anyway and it is better to let it happen through the nominal rate. At the same time, it’s an ideal time for us if they make the move now because it will help rebalance our external accounts and help deal with our high unemployment. From the standpoint of both sides there couldn’t be a better time to adjust the nominal exchange rate for the renmimbi.

See also Bergsten's commentary "A Breakthrough on the Renminbi?" at the Peterson Institute's blog.

The Savings Glut, Revisited

2011-02-18T13:50:00.003-05:00

In a speech on "Global Imbalances" today in Paris, Ben Bernanke revisited the "savings glut" hypothesis he offered in 2005. The current account balance (CA) is the difference between investment (I) and net national saving (NS):

CA = NS-I

A current account deficit occurs when investment is greater than domestic saving - the gap is filled by selling assets to the rest of the world.

Although it is commonplace to criticize deficit countries for low savings - and the savings rate in the US did indeed become very low - Bernanke argued in 2005 that the US current account deficit was driven by foreign savings. The financial inflows stemming from the foreign "savings glut" drove up the prices of US assets (including bonds, thereby driving down interest rates), and the decline in US savings followed from the resultant increase in wealth.

As a share of GDP, the US current account deficit peaked at just over 6% of GDP in early 2006.

I today's speech, Bernanke cites evidence that there was strong international demand for "safe" US assets, which supports his 2005 hypothesis.

He is careful not to blame the financial inflows for the crisis. The failure was how the US dealt with them. This has a parallel to the 1997 Asian financial crisis:

The preferences of foreign investors for highly rated U.S. assets, together with similar preferences by many domestic investors, had a number of implications, including for the relative yields on such assets. Importantly, though, the preference by so many investors for perceived safety created strong incentives for U.S. financial engineers to develop investment products that "transformed" risky loans into highly rated securities. Remarkably, even though a large share of new U.S. mortgages during the housing boom were of weak credit quality, financial engineering resulted in the overwhelming share of private-label mortgage-related securities being rated AAA. The underlying contradiction was, of course, ultimately exposed, at great cost to financial stability and the global economy.

To be clear, these findings are not to be read as assigning responsibility for the breakdown in U.S. financial intermediation to factors outside the United States. Instead, in analogy to the Asian crisis, the primary cause of the breakdown was the poor performance of the financial system and financial regulation in the country receiving the capital inflows, not the inflows themselves. In the case of the United States, sources of poor performance included misaligned incentives in mortgage origination, underwriting, and securitization; risk-management deficiencies among financial institutions; conflicts of interest at credit rating agencies; weaknesses in the capitalization and incentive structures of the government-sponsored enterprises; gaps and weaknesses in the financial regulatory structure; and supervisory failures.

Ouch. That's harsh, though he could take the Asia analogy one step further - as Simon Johnson does - and acknowledge that the "breakdown" in the US was partly because we have our own form of "crony capitalism" where the financial industry has, to a degree, captured the regulatory and political system.

Bernanke also has an uncomfortable analogy for the surplus countries that are not allowing their currencies to appreciate:

These issues are hardly new. In the late 1920s and early 1930s, the U.S. dollar and French franc were undervalued, with the result that both countries experienced current account surpluses and strong capital inflows. Under the unwritten but long-standing rules of the gold standard, those two countries would have been expected to allow the inflows to feed through to domestic money supplies and prices, leading to real appreciations of their currencies and, with time, to a narrowing of their external surpluses. Instead, the two nations sterilized the effects of these capital inflows on their money supplies, so that their currencies remained persistently undervalued. Under the constraints imposed by the gold standard, these policies in turn increased deflationary pressures and banking-sector strains in deficit countries such as Germany, which were losing gold and foreign deposits. Ultimately, the unwillingness of the United States and France to conduct their domestic policies by the rules of the game, together with structural vulnerabilities in financial systems and in the gold standard itself, helped destabilize the global economic and financial system and bring on the Great Depression.

In his central banker-ly caution, he refuses to name names, but he's obviously alluding to China's policy of keeping renminbi undervalued.

Although he has a knack for giving very comprehensive speeches sometimes, there are some important closely-related issues that Bernanke did not touch on this time. In particular, the demand for US assets was partly due to the fact that the dollar is the most widely-used "reserve currency" (i.e., held in official portfolios). This periodically generates complaints from the rest of the world (and for the US, its a mixed blessing), but Bernanke did not point to any alternative. Nor did he suggest that it gives the US any special responsibility (and, personally, I don't believe that it does). Also, one significant motive for reserve accumulation is self-insurance - countries burned by reliance on inflows of foreign savings decided to build up their own. An better international insurance mechanism would reduce that need. In theory, that is part of what the IMF is supposed to provide.

Update: A nice response to the gold standard analogy from Free Exchange.

Who Needs Paris?

2011-02-14T16:52:00.000-05:00

Not us lucky denizens of Middletown, CT, according to the National Trust for Historic Places. At the top of their list of "Most Romantic Main Streets":

Middletown, Connecticut. Middletown’s allure includes an artful Main Street brimming with elegant restaurants, an award-winning local chocolatier, and the romantic Inn at Middletown, offering the best of New England charm.

Not to mention the drama of our collapsing buildings!

The Big Squeeze on Little G

2011-02-12T01:01:00.002-05:00

When I introduce the GDP figures to my macroeconomics students, I point out that the federal government accounts for a much smaller portion of the economy than many believe. Federal government purchases - i.e., the federal part of G in the national income accounts - was 8.3% of GDP in 2010, and more than two-thirds of that was military spending. The federal nondefense part - all the stuff that we think of as "the federal government" like the FBI, NASA, the State Dept. and so on - was a mere 2.7% of GDP.

One reason that people think that the federal government is larger is that federal spending was $3.7 trillion last year, which would be 26.5% of GDP. But most of that is transfer payments - money sent to people (and, to a lesser extent, state governments). Mainly, this is social security and medicare. In the national income accounts, most transfers end up in the "C" (consumption) component of GDP when the recipients spend the money.

The chart below, from BEA data, illustrates that nondefense federal government purchases are only about 10% of federal spending.

That is, the turquoise pie slice is $396.6 out of $3890.6 billion.

So when zealous congressional republicans say that they are going to cut our "big government" by $100 billion*, the consequences are quite severe because the cuts almost entirely come out of that small slice. This analysis by the Center on Budget and Policy Priorities provides some of the bloody details, including cuts of 12.7% in Labor, Health and Human Services and Education, 14.5% in Interior and Environment and 26.1% in Transportation and Housing and Urban Development.

*It depends on how you measure it; as the CBPP analysis explains, the "$100 billion" figure is relative to the president's proposal and is for an entire fiscal year (which runs from October through September), while the cuts are for the remainder of fiscal 2011.

The CBPP analysis comes to my attention via the invaluable Ezra Klein.

Update: Paul Krugman has more.
Update #2: So does Bruce Bartlett.

Real Exchange Rates Under Fixed and Floating Regimes

2011-02-07T00:33:00.001-05:00

On Saturday, Paul Krugman posted on a favorite topic of mine (how did he know it was my birthday?) - the interaction between real and nominal exchange rates. Krugman takes the fact that they are very highly correlated as evidence against the classical view that money is "neutral" (i.e., it does not affect real quantities):

If you have a classical view of the world, you would argue that nominal shocks should affect the nominal, not the real exchange rate: the real exchange rate is a real phenomenon, and money is a veil. Specifically, you’d expect any nominal shock to move the price level by the same amount that they move the exchange rate.

Moreover, Krugman explains:

Now, a classical economist could (and some did) try to explain away this observation by arguing that what’s going on here is that there are real shocks, and that monetary policy was used to stabilize each country’s price level. But then you run into another problem, highlighted in a classic paper by Mike Mussa (haven’t found the original online, but he summarized the argument here (pdf)). Mussa pointed out that the behavior of both nominal and real exchange rates changed dramatically when the exchange rate regime changed, becoming vastly more volatile with the end of Bretton Woods....

You can, if you’re desperate, try to explain this away by saying that there was some fundamental structural change in the early 1970s, but at that point you’re deep into epicycle territory. And there’s more — for example, Ireland went abruptly from having a stable real exchange rate against the UK to having a stable rate against Germany when it joined the European exchange rate mechanism, etc..

A paper of mine in the October 2010 issue of Economic Inquiry adds to the "and there's more" evidence. It looks at the US-UK real exchange rate over 1794-2005, during which the nominal exchange rate switches from fixed to floating and back a number of times (5 floating periods and 4 fixed periods). In this graph of the rolling average of the absolute monthly change, one can see that the real exchange rate is more volatile in floating (shaded) periods than in the adjacent fixed rate periods (the dashed lines denote the periods of government controls around the two world wars).

The biggest change in volatility is after Bretton Woods ends in 1971. In earlier periods, the differences in real exchange rate behavior between fixed and floating regimes are not as stark, but they are there (there's more evidence in the paper). That suggests that the classical assumption of money neutrality is invalid (in the short run), but it may have been less so in the 19th century than it is now.

Incidentally, I believe the Mussa paper Krugman is referring to is in the Carnegie-Rochester Conference Series in 1986 (vol. 25) (subscription required).

January Employment Muddle

2011-02-04T16:48:00.000-05:00

According to the Bureau of Labor Statistics, there was a significant drop in the unemployment rate, from 9.4% to 9.0%, in January while payrolls increased by a meager 34,000.

The two figures sometimes give conflicting indications because they are drawn from different data: the unemployment rate is calculated from a survey of households, while the payroll number comes from a survey of firms.

The interpretation is further complicated this month by several other factors, including a revised estimate of the population, and the possible impact of unusually severe January weather. Calculated Risk, the Times' David Leonhardt, the Economist's Greg Ip, John Hilsenrath of the WSJ, and Real Time Economics' round-up of assorted pundits provide some guidance in sorting out the numbers.

Overall, it looks like the news is consistent with a picture of a recovery gaining momentum, but with a long way to go. Hopefully the February report, which is due on March 4, will give a clearer picture.

Rebalancing Watch

2011-01-30T23:22:00.002-05:00

International trade fell sharply during the worst days of 2008-09, and this was reflected in a sharp decline in the US trade deficit. One of the big questions in the recovery is whether the trade deficit (or, more broadly, the current account deficit) will return to its pre-crisis level. That is, was the reduction in the deficit temporary, or have we achieved some "rebalancing"?

Friday's advance estimate of GDP provides some encouragement in this regard. The US economy still has a long way to go, but it is now at least back to its pre-recession level of output. The trade deficit remains smaller than it was before the recession - it was 3.3% of GDP in the 4th quarter of 2010, versus 4.9% in the last quarter of 2007.

The widening trend that began in mid-2009 appears to have leveled off or reversed. ~~Menzie Chinn~~ James Hamilton suspects that the decline in the trade deficit in the quarter was tied to the decline in inventory accumulation:

But the fact that a huge negative contribution of inventories coincided with a huge positive contribution of imports does not seem to be a coincidence. There's a clear pattern in the recent data that when one of these makes a positive contribution to GDP growth, the other makes an offsetting negative contribution. Although we often think of inventories as a substitute for production (you could either produce a good or sell it out of inventories), in the current environment inventories seem to act more as a substitute for imports (you could either import the good, or sell it out of inventories).

Nonetheless, it looks like the trade deficit may not headed back to where it was. What happens going forward depends in large part on what happens with the US' trading partners. Faster growth in the rest of the world should reduce the trade deficit. We're seeing this in much of the developing world, which is recovering more quickly (indeed many emerging markets now face a danger of inflationary overheating).

At Project Syndicate, Martin Feldstein argues that one of the major surpluses, China's, will come to an end because its astronomical saving rate is headed down:

China’s national saving rate – including household saving and business saving – is now about 45% of its GDP, which is the highest rate in the world. But, looking ahead, the five-year plan will cause the saving rate to decline, as China seeks to increase consumer spending and therefore the standard of living of the average Chinese.

The plan calls for a shift to higher real wages so that household income will rise as a share of GDP. Moreover, state-owned enterprises will be required to pay out a larger portion of their earnings as dividends. And the government will increase its spending on consumption services like health care, education, and housing.

These policies are motivated by domestic considerations, as the Chinese government seeks to raise living standards more rapidly than the moderating growth rate of GDP. Their net effect will be to raise consumption as a share of GDP and to reduce the national saving rate. And with that lower saving rate will come a smaller current-account surplus.

Of course, declining savings only reduces the current account if investment doesn't also fall with it.

Real exchange rates play a role, too, and in this regard, inflation in China is causing its exports to become more expensive, its intervention to hold down the nominal exchange rate notwithstanding. The Times' Keith Bradsher reports:

Inflation is starting to slow China’s mighty export machine, as buyers from Western multinational companies balk at higher prices and have cut back their planned spring shipments across the Pacific...

Already, the slowdown in American orders has forced some container shipping lines to cancel up to a quarter of their trips to the United States this spring from Hong Kong and other Chinese ports.

See also this recent post. Whether it comes by inflation or a movement in nominal exchange rates, a Chinese real appreciation would take some pressure off other developing countries which are shadowing China in holding down their currencies.

3.2

2011-01-28T11:09:00.000-05:00

That's a B+ grade point average; its the limit imposed by several western states on the alcohol content on the beer that can be sold in grocery stores; and its the BEA's advance estimate of 4th quarter 2010 real GDP growth. 3.2 is hard to get excited about (though it could be worse).

Real GDP is finally back above its pre-recession (Q4 2007) peak. However, while growth has accelerated from the 2nd and 3rd quarters, is still not fast enough to close the "output gap" anytime soon. The red line below is real GDP (quarterly, at annual rates) and the blue line represents what would have happened if the economy continued to grow at 2.5% (roughly the average rate for 2002-07) after the end of 2007.

If real GDP grows at 3.2%, the red line catches up to the blue line in about 10 years.

Consumption grew at a 4.4% pace, and the rate of increase for durable goods purchases was 21.6%. Exports increased at a rate of 8.5% and imports fell 13.6%, bringing the trade deficit down to 3.3% of GDP.

The main source of disappointment would be investment: nonresidential fixed investment increased at a 4.4% rate. Since investment is the most volatile component of GDP, one would expect it to grow rapidly during the recovery (just as it shrank rapidly during the recession). This is particularly true given how well corporate profits are doing.

The overall investment component shrank at a 22.5% rate, because inventory accumulation slowed dramatically (from a $138.6bn rate in the third quarter to $5.2bn in the fourth). That means that growth is no longer dependent on inventory restocking. This had a fairly big effect on the overall number - if inventory accumulation had stayed the same, growth would have been 6.9%. So one could argue that things are perhaps a little better than the headline number suggests.

Government was also a drag on growth as decreases in state and local government and federal defense purchases outweighed a federal non-defense increase.

For the full year 2010, real GDP growth was 2.9% (after falling 2.6% in 2009). The GDP deflator rose by 1%.

In the first quarter of 2011, disposable income will get a boost from the temporary payroll tax cut agreed to in December, which should help.

That's just the first of several estimates - the updated "second estimate" is due Feb. 25.

SOTU

2011-01-26T15:38:00.000-05:00

A couple of thoughts on the "State of the Union" -

As an economist, I don't find the rhetoric of "competitiveness" very appealing (see Paul Krugman's classic on this). International trade is mutually beneficial* - not a zero sum struggle to beat other countries to the "good jobs." From an economist's point of view, the rapid growth in China is a great story about an dramatic increase in human welfare. However, while competitiveness rhetoric can be used to justify bad policies like subsidies and tariffs, Obama is employing it to promote policies like investment in infrastructure, basic research and education that are beneficial regardless of what is going on in other countries. Though it is a mistake to feel threatened by the success of other countries, Obama seems to be exploiting this sentiment to embarrass us into getting our act together, which isn't entirely a bad thing. He's like our national "Tiger mother."

Unfortunately, President Obama appears to have conceded the rhetorical war on two important fronts: global warming and the budget deficit.

On global warming, which is the most important policy issue we face, the President chose not to even mention it directly. So much for having "adult conversations" in our politics... Even if the towel has been thrown in on cap-and-trade, the administration does appear to be trying to confront the problem, sotto voce, in other, less efficient ways. At least, that is how I interpret the call that 80% of energy should come from "clean sources" by 2035.

As for the deficit, the idea that the government is like a family that needs to "tighten its belt" seems to have won out. That's simple, intuitive and wrong. The basic principle of countercyclical fiscal policy - that when households are cutting back, government needs to step in and make up for it with offsetting spending increases or tax cuts - also seems simple and intuitive. But apparently not enough so. President Obama is a very good speech-maker, but has proven not to be enough of a great communicator to get the public thinking correctly about this.

It looks like we'll get some "cuts" and "freezes." These may manage to be a drag on the recovery and damage some important government functions without making much of a dent in the real long run problem because domestic discretionary spending is a fairly small part of the overall budget (as Howard Gleckman says: "that makes Obama the anti-Willie Sutton. He is going whether the money isn’t"). It seems that we're done with counter-cyclical fiscal policy and its all up to the Fed now. With 14.5 million still unemployed, that is a mistake, and a real shame. While I hope (and believe) the President is correct in presuming the recovery will continue, it still could benefit from a fiscal push.

See also: Paul Krugman, Mark Thoma and Ezra Klein.

*There are number of possible caveats on that, including that while a country as a whole benefits, some within it are hurt (Stolper-Samuelson theorem) and that a trade deficit can reduce aggregate demand which is bad for employment in the short-run.

Residential Investment vs Construction Payrolls

2011-01-15T15:21:00.001-05:00

There's some disagreement out there between those who see the recession as a "reallocation" shock resulting from a change in the composition of output (with the implication that a significant proportion of unemployment is "structural," because workers have the wrong skills and are in the wrong locations), and those who see it as primarily a phenomenon of aggregate demand (AD). The two stories are not mutually exclusive, but I'm with those who would put more weight on the AD side. After all, the economy is continually reallocating resources, creating and destroying firms and jobs, and usually manages this without an aggregate downturn; as Brad DeLong puts it:

"Reallocation" occurs when people are pulled out of unemployment or jobs in which their marginal product is low by opportunities in expanding businesses. "Reallocation" does not occur when people lose their jobs and pile up as unemployed. "Reallocation" occurs not in depressions but in booms.

Arguing against the reallocation story, Scott Sumner points out that most of the decline in housing occurred prior to the recession:

Yes, housing output was low in 2009 and unemployment was high. But is there a causal relationship? I say no. Housing starts peaked in January 2006, and then fell steadily for years:
January 2006 — housing starts = 2.303 million, unemployment = 4.7%
April 2008 — housing starts = 1.008 million, unemployment = 4.9%
October 2009 — housing starts = 527,000, unemployment = 10.1%
So housing starts fall by 1.3 million over 27 months, and unemployment hardly changes. Looks like those construction workers found other jobs...

You can see this in a graph of real residential investment (red), which falls from nearly $800bn to $500bn (in 2005$, at annual rates) from the beginning of 2006 through the end of 2007. Most of the increase in the unemployment rate (green) occurs later, in 2008 and early 2009.

That seems to suggest that the economy was smoothly managing a significant reallocation of resources out of construction until the end of 2007. However, while residential investment was falling like a rock in 2006-07, the decline in construction payrolls comes later, and really gets going in 2008-09.

My hunch is that what is going on here is an example of "labor hoarding" - the tendency of firms not to adjust inputs immediately when output changes, because it is costly to do so. Initially, construction companies may not have been sure whether the decline was temporary or permanent; it may therefore have made sense to keep people on the payroll so that they would be ready to respond if business picked up.

That doesn't validate the reallocation hypothesis, but it is true that there were alot of construction workers among those losing their jobs in 2008 (but there were job losses throughout the economy, not just construction, of course, as an AD decline implies).

Inflation (or Lack Thereof)

2011-01-14T10:11:00.000-05:00

According to the BLS, inflation blipped up in December:

The Consumer Price Index for All Urban Consumers (CPI-U) increased 0.5 percent in December on a seasonally adjusted basis, the U.S. Bureau of Labor Statistics reported today. Over the last 12 months, the all items index increased 1.5 percent before seasonal adjustment.

Much of that increase was due to the cost of energy, which rose 7.7% in December (gasoline prices were up 13.8%). The "core" CPI, which excludes food and energy prices, was up 0.1% in the month, and 0.8% for the year.

While there was some energy-induced inflation in the month, the annual rates of change in both overall (red) and core (blue) inflation remain subdued:

Those rates remain well-below the Fed's informal 2% target. The traditional inflation-unemployment dilemma of monetary policy just isn't an issue for the Fed right now.

The increase in energy prices is a sign of a recovering global economy, but it has a negative impact on the trade balance (the NX component of GDP).

Kittens are Cute

2011-01-12T23:35:00.001-05:00

In chapter 12 of The General Theory, Keynes made a famous analogy:

[P]rofessional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one's judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.

NPR's Planet Money decided to put this to a test. They posted three cute animal videos - a loris, a kitten and a baby polar bear - on their website (videos here). One group of people was asked to vote on which was the cutest (i.e., to make a judgment about "fundamentals"), while the other voted on which was most likely to be voted cutest (to be the "speculators" in the market). The first group voted for the kitten, which received 50% (vs. 27% for the loris and 23% for the bear), and the second group also favored the kitten, by 76%.

That's a clever test, but if prices in financial markets played out like this example, then there wouldn't be a problem - the speculators are moving the market towards the correct fundamental value (that kittens are cutest). Indeed, the speculators get it right more decisively than the fundamental investors.

That's not the point Keynes was trying to make. He was very skeptical of the workings of financial markets. In the same chapter, Keynes wrote:

The outstanding fact is the extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made. Our knowledge of the factors which will govern the yield of an investment some years hence is usually very slight and often negligible. If we speak frankly, we have to admit that our basis of knowledge for estimating the yield ten years hence of a railway, a copper mine, a textile factory, the goodwill of a patent medicine, an Atlantic liner, a building in the City of London amounts to little and sometimes to nothing; or even five years hence. In fact, those who seriously attempt to make any such estimate are often so much in the minority that their behaviour does not govern the market.

I think that indicates a weakness of the experiment - there really is no uncertainty that kittens are cute, or that kittens will be cute in the future, so the market can get that one right pretty easily.

Personally, though, I liked the polar bear.

Real Appreication of Chinese Inflation

2011-01-12T20:47:00.000-05:00

The Times' Keith Bradsher reports on inflation in China:

In China, consumer prices were 5.1 percent higher in November than a year earlier, according to official government data. And many economists say the official figures actually understate the rate of inflation, which might in reality be twice as high.

“Four percent, China can bear it — beyond 5 percent, people will complain a lot,” said Huo Jianguo, president of the Chinese Academy of International Trade and Economic Cooperation here.

Higher global commodity prices, as well as rising wages in China, play roles in the increasing cost of Chinese goods. But economists say the main reason for the inflation now is China’s foreign exchange reserves, which surged by a record amount in the fourth quarter.

The central bank has been pumping out currency at an ever-accelerating pace over the past decade to limit the renminbi’s appreciation against the dollar. That strategy has helped preserve a competitive advantage of Chinese exporters by keeping their prices relatively low on global markets — while also protecting the jobs of tens of millions of Chinese workers in export factories.

Now, though, that cheap currency policy seems to be reaching its limits. The extra renminbi are feeding inflation. That is starting to undermine exporters’ price competitiveness — just as a stronger renminbi would do if Beijing was not intervening to begin with.

That is, there are two ways for a real exchange rate to appreciate: through changes in (i) nominal exchange rates and (ii) relative prices (i.e., inflation). The real exchange rate is defined as the nominal exchange rate, e, (e.g., the dollar price of renminbi) times the ratio of the two countries' price levels:

real exchange rate = e x P(China) / P(US)

While China intervenes heavily by selling renminbi for dollars to keep e from rising (and piles up massive "reserves" of dollars in the process), faster inflation in China - the increase in P(China)/P(US) - means that Americans must give up more stuff to get a unit of Chinese stuff. That is, the relative price of Chinese goods is rising.

China is intervening as hard as ever in the foreign exchange market, according to Bradsher's article:

China’s foreign reserves leaped by $199 billion in the fourth quarter. The increase was much larger than economists had expected, and they suggested that China had roughly doubled its intervention in currency markets to around $2 billion a day.

But the policy only works to the extent that China can offset the inflationary effects of the extra renminbi - for example by raising bank reserve requirements - and it appears they're no longer effectively able to do so.

The real increase in the price of Chinese goods will show up in US prices, but only modestly due to limited "exchange rate pass through". In part, this is because consumer prices we pay reflect not only the price of the Chinese goods, but also the local retail and distribution costs, which are often a large portion of the retail price and not affected by the real exchange rate. Of course, that means to effectively shift demand away from Chinese goods, the movements in the real exchange rate need to be even larger (somebody wrote a dissertation about this...).

A more important margin of adjustment may be substitution away from Chinese goods to those produced in other developing countries (i.e., this is great news for Mexico). This Financial Times article by James Mackintosh discusses the problems created by the efforts other countries feel obligated to make in order to hold their own currencies down because of China. Secretary Geithner raised this issue in a speech:

The undervaluation of the Chinese currency, the renminbi, and restrictions on capital flows in and out of China gave Chinese companies “a competitive advantage” and “impose substantial costs on other emerging economies that run more flexible exchange rates,” Mr. Geithner said.

“This is not a tenable policy for China or for the world economy,” he added.

Politically, its sensible strategy for the US to try to frame China's currency policy as one that mainly hurts other developing countries rather than the US - it lets them be the bully, not us (as The Onion reported, China's closing the gap here, too). But the real appreciation also helps in terms of easing the pressure on the other countries that compete with China in export markets.

As David Leonhardt writes in his Times column:

Without taking inflation into account, the renminbi has risen 3 percent against the dollar since last summer, when China began letting it rise. Once inflation is accounted for, the real increase has been about 5 percent. At that pace, the renminbi could erase its artificial undervaluation — as some economists estimate it — in less than two years.

Will this ease tension between the US and China? Perhaps, but Leonhardt argues that there are bigger things to argue about:

For the United States, the No. 1 problem with China’s economy is probably intellectual property theft. Technology companies, for example, continue to notice Chinese government agencies downloading software updates for programs they have never bought, at least not legally.

No wonder China has become the world’s second-largest market for computer hardware sales — but is only the eighth-largest for software sales.

Next on the list, say people who work in China or do business there, is the myriad protectionist barriers China has put up. These barriers make this country’s recent efforts at “buy American” protectionism look minor league. In some cases, Beijing has insisted that products sold in China must not only be made there but be conceived and designed there.

Hmm....

There has been more interesting stuff written recently on the issue of "rebalancing" the current account relationship between the US and China - see Martin Feldstein, David Altig, Paul Krugman and Free Exchange.

Eichengreen on the Dollar

2011-01-12T17:13:00.000-05:00

At Project Syndicate, Barry Eichengreen sees some interesting similarities between today's debates over the dollar's global role and those of the 1960's, when the Bretton Woods system was nearing its collapse:

In 1964, it was the rapidly growing economies of Europe, still catching up to the US, that were howling about the Federal Reserve. As a result of a recklessly expansionary American policy, they argued, they were being flooded with imported finance. The US was “exporting inflation.”

American officials countered that the financial inflows reflected Europe’s underdeveloped capital markets. Europe’s inflation problem was a byproduct of its central banks’ reluctance to tighten policy more aggressively, and European countries’ hesitancy to let their currencies rise, reflecting their long-standing commitment to export-led growth.

The effort to replace the dollar with IMF "Special Drawing Rights" (SDRs) ultimately failed, and no agreement was reached on achieving greater flexibility within the context of the Bretton Woods system:

The other focus of negotiations in the 1960’s was an effort to enhance exchange-rate flexibility. Proposals to this effect – a response to the emergence of chronic surpluses in Germany and Italy, and chronic deficits in the US – attracted growing attention once the SDR negotiations sputtered to a close in 1968.

But, with other countries having enjoyed two decades of export-led growth as a result of pegging their currencies to the dollar, there was a reluctance to mess with success. While the IMF, in a high-profile report on exchange rates in mid-1970, endorsed the principle of greater flexibility, it offered no new ideas for getting countries to move in this direction and proposed no new sanctions against countries that resisted. International imbalances continued to mount until the system came crashing down in 1971-1973.

A crucial difference between then and today's informal "Bretton Woods II" system is that the dollar is no longer linked to gold, and, therefore the US no longer has to worry about a drain on its gold reserves. President Nixon ended the original Bretton Woods system in August 1971 with the announcement that the US would no longer redeem dollars for gold at the request of foreign governments (US citizens had lost their ability to exchange dollars for gold in 1933).

This means the "system" doesn't come to an end when the US pulls the plug, but when the surplus countries decide to stop holding and accumulating dollars. There are really two issues: (i) the composition of official reserves - i.e., what currency they are denominated in (ii) and the level of reserves - whether surplus countries continue to intervene sell their own currencies in exchange for reserves to prevent appreciation.

In terms of the composition of reserves, writing at Vox, the prolific Prof. Eichengreen explains that there is no plausible alternative to the dollar. The euro isn't looking so great right now, of course, and, as for the others:

There are of course a variety of smaller economies whose currencies are likely to be attractive to foreign investors, both public and private, from the Canadian loonie and Australian dollar to the Brazilian real and Indian rupee. But the bond markets of countries like Canada and Australia are too small for their currencies to ever play more than a modest role in international portfolios.

Brazilian and Indian markets are potentially larger. But these countries worry about what significant foreign purchases of their securities would mean for their export competitiveness. They worry about the implications of foreign capital inflows for inflation and asset bubbles. India therefore retains capital controls which limit the access of foreign investors to its markets, in turn limiting the attractiveness of its currency for international use. Brazil meanwhile has tripled its pre-existing tax on foreign purchases of its securities. Other emerging markets have moved in the same direction.

China is in the same boat. Ten years from now the renminbi is likely to be a major player in the international domain. But for now capital controls limit its attractiveness as an investment vehicle and an international currency. Yet this has not prevented the Malaysian central bank from adding Chinese bonds to its foreign reserves. Nor has it prevented companies like McDonald’s and Caterpillar from issuing renminbi-denominated bonds to finance their Chinese operations. But China will have to move significantly further in opening its financial markets, enhancing their liquidity, and strengthening rule of law before its currency comes into widespread international use.

So the dollar is here to stay, more likely than not, if only for want of an alternative.

Flawed as they are, Eichengreen notes, the alternatives will look more attractive if US policies severely undermine confidence in the dollar. Not raising the debt ceiling, for example, would do the trick (and it appears the Republicans' business backers may be forcing some sense into them on this one). As Eichengreen has it, a form of Spiderman's motto applies: "with exorbitant priviledge comes exorbitant responsibility."

Cowen on Finance and Inequality

2010-12-29T21:32:00.000-05:00

In his American Interest essay, "The Inequality That Matters," Tyler Cowen offers a number of reasons not to be too troubled by the general rise in income inequality over the last 30 years (not surprising given his generally libertarian-ish outlook). As he notes, much of the increase in inequality is really occuring within the top 1% of incomes, and much of that is driven by the financial sector. That, according to Cowen, is where the real problem lies. Along the way he also offers one of the best nutshell explanations for why financial sector incomes exploded to such monsterous proportions:

The first factor driving high returns is sometimes called by practitioners “going short on volatility.” Sometimes it is called “negative skewness.” In plain English, this means that some investors opt for a strategy of betting against big, unexpected moves in market prices. Most of the time investors will do well by this strategy, since big, unexpected moves are outliers by definition. Traders will earn above-average returns in good times. In bad times they won’t suffer fully when catastrophic returns come in, as sooner or later is bound to happen, because the downside of these bets is partly socialized onto the Treasury, the Federal Reserve and, of course, the taxpayers and the unemployed.

Furthermore,

To this mix we can add the fact that many money managers are investing other people’s money. If you plan to stay with an investment bank for ten years or less, most of the people playing this investing strategy will make out very well most of the time. Everyone’s time horizon is a bit limited and you will bring in some nice years of extra returns and reap nice bonuses. And let’s say the whole thing does blow up in your face? What’s the worst that can happen? Your bosses fire you, but you will still have millions in the bank and that MBA from Harvard or Wharton. For the people actually investing the money, there’s barely any downside risk other than having to quit the party early. Furthermore, if everyone else made more or less the same mistake (very surprising major events, such as a busted housing market, affect virtually everybody), you’re hardly disgraced. You might even get rehired at another investment bank, or maybe a hedge fund, within months or even weeks.

Like Keynes said:

A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him.

Back to Cowen:

In short, there is an unholy dynamic of short-term trading and investing, backed up by bailouts and risk reduction from the government and the Federal Reserve. This is not good. “Going short on volatility” is a dangerous strategy from a social point of view. For one thing, in so-called normal times, the finance sector attracts a big chunk of the smartest, most hard-working and most talented individuals. That represents a huge human capital opportunity cost to society and the economy at large. But more immediate and more important, it means that banks take far too many risks and go way out on a limb, often in correlated fashion. When their bets turn sour, as they did in 2007–09, everyone else pays the price.

Run-RMB

2010-12-22T01:10:00.000-05:00

Taiwan's next media animation illustrates Sino-American tensions over currency policy with a rap video:

The Failure of Say's Law

2010-12-22T00:59:00.000-05:00

as illustrated by the Washington Post's Tom Toles:

A Semi-Defense of the Textbook Money Multiplier

2010-12-21T16:41:00.001-05:00

John Taylor approvingly cites a JPMorgan note criticizing economics textbooks' treatment of the money multiplier. The money multiplier relates the monetary base, which is directly manipulated by the Fed's open market operations, to the money supply, which is what actually affects the economy in most economic models. The very simple version of the calculation is that the money multiplier is 1/rr where rr is the "reserve ratio" of bank reserves to deposits.

If one assumes a constant money multiplier, then the dramatic increase in the monetary base since mid-2008 implies a huge (and frighteningly inflationary) increase in the money supply.

According to JP Morgan:

The growth of the Fed’s balance sheet, which has been funded by an increase in commercial banks’ reserve balances at the Fed, has sparked fears that the “money multiplier” mechanism would translate those reserves into an explosion in bank lending, bank deposits, and inflation. None of these things has happened, because the money multiplier no longer makes sense given the institutional framework of the contemporary banking system. In spite of being almost totally divorced from reality, the money multiplier is still taught in undergraduate economics textbooks, with much resulting confusion.

While there have been quite a number of changes in the "institutional framework," which textbooks (and professors) may not want to treat in detail, the most basic flaw in the analysis which is being attributed to "undergraduate economics textbooks" is naively assuming a constant money multiplier.

I don't think that is a fair accusation. Indeed, the only reason why money multipliers are interesting to talk about in class is that they can change. In normal times, it makes sense for banks to hold as few reserves as they can get away with (they can lend excess reserves on the "interbank" loan market, and if they're short, they can borrow them, too). But in unusual times, the calculation changes and banks respond to a riskier environment by holding more reserves, which reduces the money multiplier.

This issue normally enters an undergraduate economics course in a discussion of the Great Depression. Milton Friedman and Anna Schwartz showed that the money multiplier fell during the banking panics of the early 1930's. Because of the fall in the money multiplier, the money supply actually was decreasing even as the Fed increased the monetary base. This example has become part of the case the Fed bungled the depression. Both the Mankiw and Abel and Bernanke intermediate macroeconomics textbooks discuss this case immediately after algebraically deriving the money multiplier.

The sudden increase in the monetary base (blue line) occurred in late 2008. In the same period, deposits (red) also rose, but much less dramatically, which means there was a large increase in the reserve ratio.

The Fed announced on October 6, 2008 that it would begin paying interest on reserves. This is is the dominant factor in the increase in both the quantity of reserves and the reserve ratio. Interest on reserves does indeed represent a significant change in the institutional framework which isn't included in traditional textbook treatments.

However, looking a little more closely at the graph one can see that reserves began to increase in September. Reserves rose from $9bn on Sept. 10, to $47bn on Sept. 17 and $104bn on Sept. 24 - a more than tenfold increase over two weeks. Those two weeks, of course, were the absolute worst days of the financial panic of 2008 (Lehman declared bankruptcy on Sept. 15). At a time when the interbank lending market suddenly appeared risky, it is not surprising that banks would exercise more caution and increase reserves, thereby reducing the money multiplier. And that is likely quite consistent with what students read in their undergraduate economics textbooks.

Stimulus III: Return of the EGTRRA

2010-12-08T18:19:00.001-05:00

Not surprisingly, our political discourse has a hard time wrapping its head around the fiscal policy conundrum that we currently face, which is that we need more stimulus (bigger deficits) now, but long-run budget projections imply that we need to make future deficits smaller, because we are likely to still have a deficit when the economy returns to full employment and it may balloon further in the future mainly because of rising healthcare costs.

There is a valid concern that, when the economy recovers, the federal government's large borrowing needs could "crowd out" investment. While there is absolutely no evidence that this is a problem now or in the immediate future (as evidenced by continued low Treasury yields), the scheduled reversion of the tax code to the status quo ante-Bushum does create a unique opportunity to deal with the long run problem.

As it happens, the projected level of revenue if the tax cuts expire looks close to about right in the long run (see the "extended baseline" in the CBO's long-run outlook). While the Clinton-era tax code isn't ideal in terms of equity or efficiency, clearly we didn't do too badly when it was in effect. The beauty of "current law" is that it makes Washington's natural tendency towards gridlock work for, rather than against, a solution. All we need is for any of (i) congress to not agree, (ii) a Senate filibuster not to be overcome, or (iii) the president not to sign, and our deficit problem is largely solved.

If unemployment wasn't 9.8%, I might therefore be in the "let them expire" camp (even the "middle class" parts), but, as things stand, the economy urgently needs more fiscal policy support now. A tax increase is the exact opposite of what we need in the short run.

Before this week's deal between the administration and Republican leadership, my preferred outcomes, in order of preference, would have been:

The expiration of the tax cuts is used to force a tax reform that simplifies the tax code and eliminates tax expenditures (i.e., closes loopholes). This broadening of the tax base could raise revenue, and maintain progressivity (since it is high incomes that benefit most from loopholes), while keeping marginal rates low. The Bowles-Simpson proposal did move in this direction - on progressivity, it landed between the Clinton and Bush tax codes (according to the TPC) - but it had an arbitrary cap on revenue at a too-low level. At full employment, the ideal reform would be revenue neutral compared to a "current law" baseline (i.e., it would bring in the same revenues as the Clinton tax code over the long-run). The short-run negative effect of the resulting tax increase would be offset (and thensome) with explicitly temporary fiscal stimulus, perhaps with a built-in trigger mechanism to unwind it automatically as the economy recovers, which would serve to minimize the inevitable push for extensions.
The tax cuts are allowed to expire, reverting to the Clinton-era tax code, but accompanied by the same type of stimulus described above.
The original Obama-Democratic policy of making the "middle class" tax cuts permanent while reinstating the Clinton-era rates for income above $250K. Raising taxes on the rich is anti-stimulative, but not very (the multiplier is low), so the long-run deficit reducing benefit outweighs the short-term cyclical cost.
The whole thing expires (which may still happen - its not clear the deal will get through Congress), which solves our long run problem, but leaves us hoping even more fervently that Fed gets enough traction to keep the recovery going, even as the tax increase makes the headwinds stronger.
The preferred Republican policy of making all the tax cuts permanent, which has the virtue of not making things worse in the short run, but will eventually lead us back to the low-investment economy of the late 1980's and have us talking about cutting social security and medicare.

I'd put this week's deal somewhere between #2 and #3, and given that #3, 4 and 5 seemed to be what was realistically on the table, I can't be too disappointed (even if I sympathize with the widespread concern that President Obama's poker skills seem to have mysteriously diminished). One concern is that extending the Bush tax cuts entrenches them further and increases the risk that they become one of those features like the alternative minimum tax "patch" that we expect to be perenially "fixed." But the two-year extension does leave open the possibility of something like #1 or #2 happening in 2012, and at least we haven't decisively dug the long-term hole deeper as #5 (and, to be honest, #3) would. We have also averted the short-run damage that would result from #4 (and to a much lesser extent, #3). Not only have we avoided that anti-stimulus, but the deal includes other demand-enhancing provisions, like the one-year payroll tax cut (which replaces the expiring "making work pay" credit from the 2009 stimulus bill, but is bigger, though less progressive).

David Leonhardt calls it a "second stimulus" (third, if you count the spring 2008 tax rebate). The Center for American Progress applied existing multiplier estimates to the deal's provisions to estimate that it would increase employment by about 2.2 million (relative to unemployment of 15 million). Macroeconomic Advisors estimates a GDP growth bump of 0.5-0.75 percentage points. (Both of these come to my attention via the invaluable Ezra Klein).

Of course, it would be better still if the unemployment insurance extension was for two years (even if the recovery gathers steam, there will still be many people unemployed in 2012), and included something for the "'99ers" who have hit the 99-week limit on benefits (recall that the recession began at the end of 2007). They also should have raised the debt ceiling, so it doesn't become the next "hostage". One might hope the outrage of Congressional Democrats gives them some leverage to make improvements (indeed, if the Democrats were an organized political party, I might think there was a clever "good cop, bad cop" routine being employed here).

Note: the title of the post refers to the official name of the 2001 tax cut, the Economic Growth and Tax Relief Reconciliation Act.

Barack Obama's Time Consistency Problem?

2010-12-07T23:09:00.000-05:00

When I explain the time-consistency problem to my students, I begin by asking them what the stated position of the government is about negotiating with hostage takers. They know, of course, that the official line is that the government will not negotiate.

The reason why governments always say they will not negotiate with hostage takers is that, if they won't negotiate, there is no incentive to take them in the first place. But, once hostages have been taken, the government has a strong incentive to negotiate because they don't want to be responsible for the hostages getting killed. And the problem is that the would-be hostage takers understand this, and therefore do not believe the government will follow its announced policy of not negotiating.

That example may not work next semester, if my future students saw President Obama's press conference:

I’ve said before that I felt that the middle-class tax cuts were being held hostage to the high-end tax cuts. I think it’s tempting not to negotiate with hostage-takers, unless the hostage gets harmed. Then people will question the wisdom of that strategy. In this case, the hostage was the American people and I was not willing to see them get harmed.

One of the implications of the time consistency problem is that a better outcome would be achieved if the government didn't have discretion to negotiate with the hostage takers. In the real world, no perfect "commitment technology" exists so, in practice, we think about "credibility". That is, how can the government behave so that the prospective hostage takers believe the authorities really mean it when they say they won't negotiate?

So, the question is: did President Obama diminish his credibility, thereby increasing the likelihood of future political "hostage" situations, or did he just say what everyone already knows? And was the Republican threat credible to ~~kill the hostages~~ let the tax code revert to its 2000 levels if the tax cut extension for incomes over $250,000 wasn't included? (John Boehner's slip in September notwithstanding).

For background on time consistency and more examples, see Greg Mankiw, this speech by Charles Plosser, and the Nobel Prize information about Kydland and Prescott.

Bernanke on 60 Minutes

2010-12-06T16:17:00.000-05:00

Euro Trouble

2010-12-06T01:41:00.000-05:00

Another sign the euro is in trouble: this week's Economist has an article on how a member country might leave the currency union. It concludes:

The cost of breaking up the single currency would be enormous. In the ensuing chaos and recrimination, the survival of the EU and its single market would be in jeopardy. But by believing that a break-up cannot happen, the euro zone’s authorities will always tend to stop short of the radical measures needed to hold the project together. Given the likely and devastating chaos, it would be a mistake for a country to choose to leave. But mistakes occur in times of stress. That is why some are beginning to contemplate the unthinkable.

Germany may be the country that walks - the Guardian reports:

At the Brussels dinner on 28 October attended by 27 EU heads of government or state, the presidents of the European commission and council, and the head of the European Central Bank, witnesses said Papandreou accused Merkel of tabling proposals that were "undemocratic".

"If this is the sort of club the euro is becoming, perhaps Germany should leave," Merkel replied, according to non-German government figures at the dinner. It was the first time in the 10 months since the euro was plunged into a fight for its survival that Germany, the EU's economic powerhouse and the lynchpin of the euro's viability, had suggested that quitting the currency is an option, however unlikely.

Much of the difficulty in Europe stems from German attitudes on monetary policy (though their deeply ingrained aversion to inflation is understandable) and their influence on the ECB. Ryan Avent put it well last week:

A demonstration of commitment to Europe requires a little bit from everyone, and what it requires from the ECB is that it act like the European Central Bank, rather than just a Bundesbank that gets to impose unreasonably hard money on everyone in the single currency. Mr Trichet, who has had to earn his post by acting as German as a Frenchman can possibly be expected to act, seems to be realising that that's not actually what's required of the ECB.

The recent "bailout" of Ireland does not impress Barry Eichengreen:

The Irish “programme” solves exactly nothing – it simply kicks the can down the road. A public debt that will now top out at around 130% of GDP has not been reduced by a single cent. The interest payments that the Irish sovereign will have to make have not been reduced by a single cent, given the rate of 5.8% on the international loan.

According to the deal, not just interest but also principal is supposed to begin to be repaid after a couple of years. At that point, Ireland will be transferring nearly 10% of its national income as “reparations” to the bondholders, year after painful year.

This is not politically sustainable, as anyone who remembers Germany’s own experience with World War I reparations should know. A populist backlash is inevitable. The Commission, the ECB, and the German Government have set the stage for a situation where Ireland’s new government, once formed early next year, rejects the budget negotiated by its predecessor.

Even measures like this, which fall far short of what would be necessary to end the crisis, are tough to get the Germans to sign off on. Though its not surprising that loans to Greece and Ireland are bad politics in Germany, it needs to be remembered that the problems of some of the peripheral countries are due, in part, to the fact that ECB policy, which placed more weight on Germany (because its bigger) was too loose for them. This helped create the bubbles that have now burst. Moreover, much of the debt involved is owed to German (and other European) financial institutions, so this is really a "bailout" of Germany's banks.

Europe faces both sovereign debt and monetary policy problems. Some of the countries have too much debt, and a restructuring is probably in order. But if they're going to avoid that - and they seem determined to (though don't they always?) - a more expansionary monetary policy would help them grow (and inflate) their way out of trouble. Without more inflation, the peripheral countries really need not just loans, but fiscal transfers from those that are in better shape (i.e., some kind of fiscal union is needed - on this, see Gavyn Davies).

Neither way out seems palatable to Germany. The Economist's article argued that the disruption of leaving the euro would be considerably lower for Germany than for the peripheral countries, since the likely appreciation of the Mark would ease some of the tangles associated with re-denominating debt. Perhaps the rest of the eurozone should consider taking Chancellor Merkel up on her offer...

Now, That's an Economic Message

2010-12-05T14:47:00.000-05:00

When I read the "Economic View" column in today's NY Times:

Uncertainty is likely holding back the recovery. But its sources are far more fundamental than the tax and environmental issues that typically top the list of complaints. And the solution is certainly not for the government to do less. Rather, it needs to do much more...

Wall Street analysts often cite possible government regulations on the environment as another source of damaging uncertainty. But as with the deficit, inaction could be far more damaging than action. Climate change and dependence on foreign oil are problems that won’t go away on their own. Tabling plans to deal with them doesn’t make it easier for companies to plan and invest; it makes it harder.

Until businesses and communities know the costs and incentives for developing renewable energy, nuclear power and natural gas — and whether we will address climate change through prices or direct regulation — it will be very hard to invest in new power sources and related industrial technologies.

The deepest and most destructive uncertainty we face centers on the overall health of the economy and its prospects for growth. Unlike other postwar recessions that were caused by tight monetary policy and high interest rates, the recent downturn resulted from the bursting of a housing bubble and a financial crisis. Because we are in largely uncharted territory, figuring out how and when the economy will recover is much harder than usual...

How do we resolve uncertainty about future growth? The Federal Reserve, Congress and the president need to reaffirm that they will do whatever it takes to restore the economy to full health. They could take a lesson from President Franklin D. Roosevelt, who declared in his 1933 inaugural address that he would treat the task of putting people back to work “as we would treat the emergency of a war.”

I think: now that is exactly the kind of message we need to hear from the White House. And then I see that the column was written by Christina Romer, who was, until very recently, chair of the Council of Economic Advisors....

What We Believe and the Tools We Use

2010-12-05T14:35:00.000-05:00

At Worthwhile Canadian Initiative, Nick Rowe writes:

What we research, and what we believe, aren't necessarily the same thing. What gets published in the journals is a survey of what we are currently researching. It isn't an accurate survey of what we currently believe. The whole point of a journal is not to publish what everybody already believes. The journals are a map of where we are currently exploring for gold. They are not a map of existing gold deposits. They are not a map of where we think gold might be found in places we can't currently explore.

To which I might add, economic models can be thought of as tools. Using a particular tool (model) to do a job (normal science) shouldn't be taken to imply a belief that the model is the right one for all economic phenomena. In many cases, its much easier to make progress (and get papers accepted) if one uses existing tools. For instance, I've used a real business cycle model in my own research - it turned out to be an effective device to implement an idea I had about real exchange rate volatility. But it does not mean that I believe that real business cycle theory is a correct explanation of economic fluctuations.

Its Hard to Hold a Candle

2010-12-03T12:37:00.001-05:00

in the cold November rain....

The BLS November employment report is a bummer, especially in the wake of mostly improving economic reports (e.g., consumer confidence, unemployment insurance claims, regional manufacturing surveys, etc).

According to the BLS, employment increased by a mere 39,000 and the unemployment rate rose from 9.6 to 9.8%.

The rise in the unemployment rate was not, alas, due to people re-entering the labor force - the participation rate was unchanged at a (depressed) 64.5%. According to the household survey, 173,000 fewer people were employed in November (recall that the headline employment number comes from the separate survey of businesses, while the unemployment rate is calculated using the household survey).

If the other, positive, economic reports are ultimately reflected in strong fourth quarter GDP, the employment numbers would be an indication of rising productivity (for the third quarter, the BLS reported 2.3% labor productivity growth).

Out of the 15.1 million unemployed (!!!!), 6.3 million have been unemployed for more than 27 weeks. There was a good article yesterday in the Times on how long-term employment can have persistent effects, as people who have been unemployed for a long time become less employable (a form of what is sometimes called "hysteresis" in the economics literature).

Hopefully the report will concentrate some minds in Washington (but don't hold your breath). It should strengthen the President's attempt to salvage an extension of unemployment benefits from the negotiations with the Republicans on extending the Bush tax cuts.

November is one of the months when the seasonal adjustment makes things look worse - on an unadjusted basis, the unemployment rate was 9.3% (up from 9% in October), and payroll employment increased by 217,000.

For more on the employment report, see Calculated Risk, David Leonhardt, Free Exchange, and Real Time Economics' roundup.

Update: Mark Thoma is critical of the White House response. Floyd Norris has a reason to hope for an upward revision.

The Counterfactual

2010-11-30T02:13:00.000-05:00

"It could have been worse" isn't a winning political argument (and probably wouldn't have been even if the White House managed to consistently make it), but its probably true. Compared to a counter-factual of no stimulus, real GDP is between 1.4% and 4.1% higher because of the recovery act (ARRA), according to the Congressional Budget Office. This has been nicely illustrated by the Center for Budget and Policy Priorities:

Also, the stimulus has lowered the unemployment rate by 0.8 to 2 percentage points - i.e., without it we'd be looking at 10.4% - 11.6%, instead of 9.6%.

$700 Billion Bailout Update

2010-11-30T00:25:00.000-05:00

From the Congressional Budget Office, another downward revision to the estimated cost of that "$700 Billion Bailout":

CBO estimates that the cost to the federal government of the TARP’s transactions (also referred to as the subsidy cost), including grants that have not been made yet for mortgage programs, will amount to $25 billion. That cost stems largely from assistance to American International Group (AIG), aid to the automotive industry, and grant programs aimed at avoiding mortgage foreclosures: CBO estimates a cost of $45 billion for providing those three types of assistance. Other transactions will, taken together, yield a net gain of $20 billion to the federal government, CBO estimates.

It was not apparent when the TARP was created two years ago that the costs would be this low.

Indeed. And I don't think its apparent to most people now that the costs were this low (which is a real problem, as I discussed in this previous post).

Better (But Still Not Good Enough)

2010-11-23T13:08:00.000-05:00

The BEA announces:

Real gross domestic product -- the output of goods and services produced by labor and property located in the United States -- increased at an annual rate of 2.5 percent in the third quarter of 2010, (that is, from the second quarter to the third quarter), according to the "second" estimate released bythe Bureau of Economic Analysis.

That's an acceleration from the 1.7% annual growth rate in the second quarter, and an improvement over the "advance" estimate of 2%. Growth is still below average, and far below the pace necessary to close the output gap (i.e., get the economy back to some semblance of "full employment"). But at least the second derivative is positive....

Of the 2.5% growth, consumption accounted for 2%, investment for 1.5% (of which 1.3% was due to inventories), government purchases 0.8%, and net exports -1.8% (i.e., imports grew faster than exports).

Richard's Blog

2010-11-20T18:13:00.001-05:00

My Wesleyan colleague Richard Grossman has started a blog, Unsettled Account, which shares its title with his new book on the history of banking. Check it out!

And Keynes, too

2010-11-18T17:52:00.000-05:00

Ahem. A notable Bloomsbury figure is curiously omitted from the Times' report on 36 Hours in Cambridge:

Punting down the River Cam in a flat-bottom boat is the classic way to see Cambridge, but mastering the long wooden pole takes practice. Book a 90-minute lesson with Scudamore’s Punting Company (Granta Place, Mill Lane; 44-1223-359750, scudamores.com), which will assign a well-muscled tutor to punt you down the gorgeous stretch of river that runs behind the colleges. Halfway through, the pole is handed to you, for a lesson in propelling the unwieldy craft. If you didn’t come to Cambridge for tutoring, rent a kayak from Scudamore’s and paddle to the Orchard Tea Garden (45-47 Mill Way, Grantchester; 44-1223-551125; orchard-grantchester.com), where E. M. Forster, Virginia Woolf, and Bertrand Russell hung out a century ago.

Its a bit of a hike, but you can walk there (though it was beastly hot the day I did it - punting might have been better).

Marginal, at Best

2010-11-18T13:25:00.001-05:00

In an Economix post about the Bush tax cuts, David Leonhardt writes:

The theory for why tax cuts should create growth and jobs is a strong one. When people are allowed to keep more of each dollar they earn, they are likely to work longer and harder. The uncertainty is the magnitude of this effect. With everything else that’s happening in a $15 trillion economy, how large of an effect on growth do tax cuts have?

Every available piece of evidence seems to suggest that the Bush tax cuts did little to lift growth.

Indeed, its fairly easy to demonstrate in simple economic models that higher marginal tax rates distort the economy and might lead to less labor effort and less saving (and hence a smaller capital stock). To be careful, though, in most models the effect of a tax reduction would be on the levels of income and output, not on the long run growth rate.

Nonetheless, there are pretty solid economic theory reasons why economists - even those of us with generally liberal (in the contemporary American sense) political inclinations - would favor tax reforms that would broaden the tax base (i.e., reduce deductions and credits) and lower marginal tax rates. But perhaps not as fervently as Glenn Hubbard, who recently wrote:

When I left my job as the deputy assistant Treasury secretary for tax policy in 1993, I left a message on my office blackboard for my successor. I wrote, “Broaden the base, lower the rates” repeatedly until I filled the entire space. I then had it covered with wax so it could not be erased. (Yes, the government charged me for my bit of vandalism. But it was worth it.)

I share his instinctive sympathy for this aspect of the Simpson-Bowles proposal (though I basically agree with Paul Krugman that the package is bad overall).

However, as Leonhardt points out, as an empirical matter, its not clear that tax rates make that much of a difference to overall economic performance. The best decade for growth in the postwar period was the 1960's, when the top marginal income tax rate was over 70% (as I noted in the second-ever post here). The economy did well after the 1993 increase in the top marginal tax rates, and not particularly well after the 2001 and 03 rate cuts.

Of course, that doesn't prove anything - the effect of any policy should to be judged relative to a counter-factual. That is, perhaps the economy would have done even better in the 1990's without the tax increase, and even worse in the 2000's without the tax cuts. Nonetheless, I think a brief glance at historical evidence is enough to convince us that lower marginal tax rates aren't some magical economic elixir. As an economist, I'll never say that people don't respond to incentives, but, in the case of taxes, it looks like they don't respond very much.

Thanks Again, Europe?

2010-11-16T00:31:00.000-05:00

As Free Exchange noted last week, early in 2010, the recovery appeared to be gaining momentum, but something happened in the spring. This is visible in the data on private payroll employment (I've used the private sector to avoid the effect of the winding down of census employment), where the rate of growth clearly slips after April:

Free Exchange's preferred story is that the debt crisis in Europe - remember Greece? - is to blame for the wobble in the recovery:

In late April, fears of a serious European debt crisis began to emerge. These fears sparked a mild panic and a renewal in the flight to safety. This flight manifested itself, in part, as a rush to buy American government debt. Treasury yields had been rising in the months prior to the crisis, but plunged from April through the summer. The dollar shot up; the trade-weighted dollar rose nearly 5% from late April to early June. In response to the pressure within markets, the Fed reopened currency swap lines it had used in previous stages of the crisis. It did not, however, take steps to offset the impact of the financial hiccup on growth expectations.

Markets reacted. The Dow fell over 13% from late April to early July, and was still 10% off its April peak in late August. From January to April, 10-year inflation expectations were stable at around 2%. These began falling sharply, and were down to around 1.5% by the end of the summer. Every signal available began flashing a decline in economic expectations starting in late April.

And now, just as things are starting to look better again, the Times says:

Sigh. Stupid Euro.

Cross of Stupidity

2010-11-15T17:09:00.000-05:00

International contention over currencies and the Fed's announcement of another round of quantitative easing seem to have induced another bout of misplaced gold standard nostalgia. In the Financial Times last week World Bank president Robert Zoellick called for a "cooperative monetary system" employing gold as "an international reference point." Saturday's Times included an op-ed by James Grant which was even more direct:

Let the economists gasp: The classical gold standard, the one that was in place from 1880 to 1914, is what the world needs now. In its utility, economy and elegance, there has never been a monetary system like it.

I didn't gasp, I groaned. Here is a plot of the US price level from January 1879, when the US rejoined the gold standard after relying on paper "greenback" money during the Civil War, through December 1913 (the gold standard collapsed around the outbreak of World War I 1914), normalized to 100 at the beginning.

Although the price level in the gold standard era lacked a long run trend, that doesn't mean it was stable. While the change in the price level from Jan. 1879 to Dec. 1913 was modest (average annual inflation of about 0.5%), there were significant runs of high inflation, and even more perniciously, deflation. Deflation raised the real value of debt burdens, which exacerbated the economic downturns of the time, which were frequent and severe (according to the NBER chronology, 189 out of 420 months were spent in recession). Moreover, financial crises were a regular occurrence; the severity of the 1907 "panic" helped motivate the founding of the Fed, which Grant so dislikes, in 1913. Its little wonder, then, that the gold standard was not universally liked at the time. The monetary system was one of the most bitterly contentious issues of the day, with the debate reaching its high point in the 1896 election, when William Jennings Bryan carried the south and west on a platform of freeing the US from the "cross of gold".

There are plenty of reasons to criticize the Fed and its management of the modern "fiat money" system, but even with all of its mistakes, its doing far better than the gold standard.

Regrets, They've Had a Few

2010-11-07T00:36:00.000-04:00

From the Washington Post's Neil Irwin, an interesting report on a conference sponsored by the Atlanta Fed commemorating the 100th anniversary of the conclave at Jekyll Island that laid some of the groundwork for the Fed's founding.

On the issue of the day:

"There's a sense out there that, quote, quantitative easing or asset purchases are some completely foreign, new, strange kind of thing and we have no idea what . . . is going to happen," Bernanke said, sitting onstage in a conference space that was once J.P. Morgan's indoor tennis court. "Quite the contrary - this is just monetary policy. . . . It will work or not work in much the same way that ordinary, more conventional, familiar monetary policy works."

It is reassuring to have a Fed chairman who knows enough economic history that he's seen (or at least studied) it all before.

The Ultimate Response to "the Chinese Professor"

2010-11-06T23:59:00.000-04:00

One unfortunate aspect of tough economic times is that the fear and anxiety that people feel can be exploited with appeals to tribalism. For example, a group called "citizens against government waste" has been pushing a right-wing political agenda with this ad:

There are any number of substantive flaws in the ad's argument I could point out, but I could not hope to respond better than this hilarous parody, from Taiwan's Next Media Animation:

That comes to my attention via James Fallows (see also his post on the original ad).