Wile E. Coyote Moments

As I mentioned recently, Paul Krugman has expressed a concern that we may experience a "Wile E. Coyote Moment" in regards to the dollar and the current account deficit. At VoxEU, Richard Baldwin responds to Krugman. Setting aside the substantive issue, I am intrigued by the possibility that "Wile E. Coyote Moment" may be entering the lexicon of economic jargon. Here's Baldwin's explanation:

...the markets are due for what Krugman calls a 'Wile E. Coyote' moment – a reference to the Warner Brothers’ cartoon where a greedy, shortsighted coyote chases a roadrunner off a cliff but doesn’t start falling until he looks down and realizes he’s left solid ground. Up until this 'Wile E. Coyote' moment, his belief that he’s on solid ground prevents him from falling. For investors in dollars, the 'Wile E. Coyote' moment comes when they realise that their expectations are inconsistent with any feasible adjustment path.

So, I wonder if in a few years I will be attending (or giving!) presentations at academic conferences with titles like "Wile E. Coyote Moments in a 2-Country DSGE Model," "Estimating the Probability of Wile E. Coyote Moments: A Bayesian Approach" and "Can Wile E. Coyote Moments Explain the Equity Premium Puzzle?"

If the "Wile E. Coyote Moment" becomes part of our language, it will eventuallly show up in our textbooks. I'm no theorist, but here's how I think the standard PhD micro text, Mas-Colell, Whinston and Green's Microeconomic Theory, which is beloved in some (but not all) quarters for its "rigor and generality," might define it:

If there are any theorists reading this, perhaps you can suggest some related theorems, lemmas and corollaries...

Krugman Gets an A

On his blog, Paul Krugman takes on Europe-bashing. "Its a fixed idea among Americans that Europe - France, in particular - is an economic wasteland," he writes. Among the bits of evidence he musters against the Euro-bashers (not to be confused with Euro-trashers):

French productivity – output per hour – is about the same as ours...
Now, it’s true that French GDP per capita is lower than ours. That reflects three things: the French work shorter hours; French people under 25 are less likely to be employed than young Americans, and the French are much more likely than Americans to retire early.

That would have been a good answer to question 3 on last Thursday's Econ 202 midterm:

(3 pts) France and the US have almost identical GDP per hour worked, but French GDP per capita is 27% lower than the US. How is this possible? In what regard does this imply that the French are better off than Americans?

Krugman goes on to explain:

Short working hours are a choice – and it’s at least arguable that the French have made a better choice than America, the no-vacation nation.

Low employment among the young is a complicated story. To some extent it may represent lack of job openings. But a lot of it is the result of good things: young French are more likely to stay in school than young Americans, and fewer French students are forced by financial necessity to work while studying.

Finally, the French retire early. That’s a real problem: their pension system creates perverse incentives. We, of course, have this superb program called Social Security, which does a much better job.

He did also mention that:

What’s more, even during the period 1995-2005 – the years when we Americans were boasting about our productivity boom – French productivity grew only half a point slower than US productivity. And the US productivity boom now seems to be over.

If he was in Econ 202 - and doing the assigned reading!* - he would also be aware that, while France lagged the US in labor productivity, it has actually done slightly better than the US in total factor productivity. [which, of course is not the correct answer to problem 3].

So maybe we shouldn't say that French economic performance is worse than the US, but we can still call them cheese-eating surrender monkeys! (though some might now think they were right about the Iraq war...)

*"A Productivity Primer," The Economist, Nov. 6, 2004.

Who Our Creditors Are

The corollary of massive borrowing by the United States - the current account deficit was $811 billion in 2006 - is accumulation of US assets by foreigners (a "capital inflow"). As I discussed recently, this has generated some worry about a crisis if our creditors lose their appetite for holding US assets.

On his outstanding international macroeconomics blog, Brad Setser looks at the data on official reserves (e.g. foreign asset holdings of central banks) and finds that "Central banks came close to financing the entire US current account deficit." He writes:

I estimate that the world's emerging economies -- if those emerging economies that don't report detailed data on the currency composition of their reserves acted like those who do report -- are now adding about $200b to their dollar reserves a quarter. That is a pace sufficient to finance the entire US current account deficit. Central banks continue to buy more dollars when the dollar is heading down than when it is going up to keep the dollar's share in the (aggregate) portfolio constant -- and effectively serve as the dollars buyers of last resort in the global financial system.

Private flows still matter, of course. But right now private inflows roughly match private outflows, so all the heavy lifting required to finance the US external deficit is being done by the world's central banks. Their willingness to hold dollars allows the US to finance itself in dollars even when there isn't a lot of global demand for dollar assets.

The tools economists use to examine exchange rates and current accounts are mostly based on optimal behavior of individuals - e.g. a European investor will make a decision about whether to hold a German bond or a US bond by comparing the return on the German bond to the expected return on the US bond, converted to euros, and the dollar-euro exchange rate is ultimately determined by the demand for dollars from such investors (and the parallel behavior of US investors on the other side of the market).

Setser's finding reminds us that governments play huge roles in foreign exchange markets, and their motives are very different. In particular, many countries - primarily "emerging markets," of which China is most prominent - intervene in foreign exchange markets to keep the values of their currencies artificially low, making their exports cheaper. This involves selling their currency (increasing the supply of it and lowering its value) for dollars. In the process, the governments accumulate dollar reserves.

We still need to be concerned that our creditors might reduce their willingness to finance our current account deficit, but it is crucial to bear in mind how much of that financing is coming from governments rather than private investors maximizing expected returns.

A Primer on "Core" Inflation

When explaining its monetary policy decisions, the Fed often speaks of "core inflation" - that is, an inflation rate calculated without food and energy prices, which tend to be rather volatile. Of course, food and energy are major expenses for most people, so you wouldn't want to throw them out of a calculation of the "cost of living." For the most part recently, "core" inflation has been lower than overall inflation, or as Daniel Gross explained, "If You Don't Eat or Drive, Inflation's No Problem." On his blog, Berkeley's Brad De Long defends the Fed's practice of focusing on "core" inflation:

The Federal Reserve's mandate to maintain price stability requires that whenever significant inflation threatens it is supposed to hit the economy on the head with a brick: raise interest rates, and so discourage investment spending, lower capacity utilization, raise unemployment, and so create excess supply. The Federal Reserve would rather not do this unless it has no other option. If the rise in inflation is thought to be (a) transitory and thus (b) self-limiting, the Fed would prefer to let sleeping dogs lie rather than hit the economy on the head with a brick.

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

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

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

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

Marginal Utility of What?!

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

P&G Launches Smart Toothbrush

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

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

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

A Most Useful Corrective

One of the things I like most about economists is that, in general, we are good critical thinkers who eschew dogma and ideology. Unfortunately, we seem to fall into some bad habits when it comes to certain issues - trade, in particular. That's why I found this paper, "Deconstructing the Argument for Free Trade" by Robert Driskill of Vanderbilt such a useful corrective. From the introduction:

The claim we make here is that, in light of economists' apparent settled judgment on the issue of trade liberalization, the profession has stopped thinking critically on the question and, as a consequence, makes poor quality arguments justifying their consensus.

It came to my attention via Dani Rodrik's blog. Rodrik says "Once in a while you come across a paper that makes you nod in agreement and go "yes!" with every sentence you read."

Outsourcing in Circles

Some of India's outsourcing firms are setting up shop outside India. Anand Giridharadas reports in the NY Times "Outsourcing Works, So India Is Exporting Jobs." Among the locations mentioned are the Czech Republic, Mexico, and the United States:

In a poetic reflection of outsourcing’s new face, Wipro’s chairman, Azim Premji, told Wall Street analysts this year that he was considering hubs in Idaho and Virginia, in addition to Georgia, to take advantage of American “states which are less developed.”

Don't Look Down!

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

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

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

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

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

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

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

People are from Earth, Economists are from Vulcan

In today's NY Times Economic Scene column, Austan Goolsbee looks at the departure from economically rational behavior known as "loss aversion," which may interfere with home sales as prices slump. He writes:

Economists and other humans don’t always see eye to eye. “Economists tend to think people are crazy because they won’t sell their houses for less than they paid for them — and people think economists are crazy for thinking things exactly like that,” said Professor Christopher Mayer, director of the Paul Milstein Center for Real Estate at Columbia Business School and an authority on real estate economics....

Classical economics can’t explain this behavior. That’s because people who refuse to sell their houses for less than they paid for them are violating a cardinal rule of the market: stuff is worth what it’s worth. It doesn’t matter what you paid for it. But when Professor Mayer and his co-author, David Genesove, a professor of economics at the Hebrew University in Jerusalem, studied the Boston condominium market in the 1990s — scene of one of the biggest real estate busts in recent American memory — the actual patterns of human behavior did not seem to follow the standard rules at all...

As any thinking student of economics realizes, our traditional assumptions about human behavior are not realistic. The goal of economic models is not "realism," however. Even the most elaborate economic model is a vast simplification of an infinitely complex reality. A model which accurately predicts how people will behave is a useful one - Milton Friedman's famous example* is that one could use physics to analyze the shots of a professional billiard player. Even though the player is using instinct and senses, the rules of physics can be used to make accurate predictions of the player's shots. Similarly, utility maximization may make good predictions of human behavior, even though people aren't solving constrained optimization problems in the grocery store.

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

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

Bernanke Credibility Watch

The Federal Reserve lowered its target for the federal funds rate by 50 basis points (hundredths of a percent) to 4.75%. James Hamilton at Econbrowser examines the reactions of the bond, stock, currency, oil and gold markets. This is cause for concern:

But the really interesting thing is what happened at the longer end of the yield curve. The ten-year nominal yield actually increased, which is in contrast to the usual historical pattern for long yields to move, albeit less dramatically, in tandem with the short. Taken together with today's fall in the 10-year inflation-adjusted Treasury yield, the bond market seems to view the Fed as having surrendered some on its long-run inflation goals.

Expectations are important for monetary policy. Long-term interest rates reflect, in part, inflationary expectations. The increase suggests that markets are now anticipating looser monetary policy, which will lead to more inflation. That is, the Fed's credibility as guarantor of low inflation seems to have been dented, early in Ben Bernanke's tenure as chairman.