Let's Get Fiscal

In recent years, countercyclical policy - the day-to-day "management" of aggregate demand - has largely come through monetary policy action by the Fed. However, current circumstances call for fiscal policy, says Lawrence Summers:

There is now a compelling case for the president and Congress to create a programme of fiscal stimulus to the US economy that could be signed into law in the next several months.

Given the market’s prediction of Fed policy actions, the debate now is not about whether or not to provide macro­economic stimulus. That question appears to be settled. The question is whether it is better for all the stimulus to come from discretionary monetary policy or for some of the stimulus to come from discretionary fiscal policy. A diversified policy approach seems clearly preferable in that (i) in a world where judging the impact of policy measures is difficult, the outcome is less uncertain with a diversified mix of stimulus measures; (ii) the proximate impact of fiscal policies is felt by the families bearing the brunt of recession, in contrast to monetary policies whose immediate impact is on financial institutions; (iii) use of fiscal policy reduces the amount by which interest rates have to be reduced, thereby reducing downward pressure on the dollar, which in turn contributes to upward pressure on US inflation and international instability; (iv) partial reliance on fiscal policy mitigates the various risks of bubble creation associated with excessively low interest rates.

Summers suggests that the government make equal payments to all income or payroll tax payers and increase unemployment insurance and food stamp benefits.

Of course, fiscal policy does not necessarily need to take the form of tax cuts, as Mark Thoma pointed out (about a month ago, in response to a similar argument from Martin Feldstein):

A tax cut creates an incentive for households to increase consumption, but there is no guarantee that they will, e.g. they could just retire debt instead. This is just the familiar split of a change in taxes and hence disposable income into a change in consumption and a change in saving, and most of the time consumption and hence aggregate demand will increase when taxes are cut, but we can't be sure in advance how a tax cut will be used. In addition, when the tax cut is temporary, as this one would be, the impact on consumption is generally lower than with a permanent change in taxes.

With government spending, however, the impact on aggregate demand is assured. A change in government spending impacts aggregate demand directly on a dollar for dollar basis so there is no uncertainty at all about whether or how much aggregate demand will increase with a change in fiscal policy. And, with all of our infrastructure needs, it's not as though we can't find places where government spending could increase output and employment and also improve our public capital (there are many other ways spending could help as well, infrastructure enhancement is not our only need).

One problem with fiscal policy is the time it takes (the "lags" we talk about in Econ 202) - it requires action by the Congress and President, and once the policy is implemented, it takes time to affect demand in the economy (also an issue with monetary policy). Moreover, recessions tend to be relatively short - the average postwar recession has been 10 months long (and the two most recent ones were eight months). If we take the gloomy December employment report as an indication that a recession began in late 2007, it is likely to be over by this fall (at least as the NBER defines recessions - the unemployment rate tends to remain elevated longer). It therefore is nearly impossible to time the "stimulus" correctly to precisely "fine tune" the economy.

For example, the stimulus package proposed at the beginning of the Clinton administration was defeated in April, 1993. In retrospect, that was for the best: the NBER subsequently dated the end of the recession in March, 1991, and the unemployment rate peaked in June, 1992.

The lags are likely worse with a spending program because it would take longer for the government to spend the money than to just mail out checks. However, the stimulus is likely to miss its moving target anyway, but we would at least get some roads and bridges out of a spending program...

The Washington Post reported that the Bush administration is considering a stimulus package. Real Time Economics reports on Barack Obama's proposal. Robert Reich had an interesting idea on the subject in December.

Econ Rules!

Though most of the trash-talking here in New Orleans is between the LSU and Ohio State fans who are sharing the town with the big economics convention, the American Economic Association did post this on its web site:

During 2006 and 2007, the American Economic Review was the most widely consulted journal among all 775 scholarly journals that are archived in JSTOR.

That's right, among all scholarly journals. Take that, other academic disciplines!

Not Constantinople

At least, not yet... In the FT, Niall Ferguson has "An Ottoman Warning for Indebted America" (and it has nothing to do with getting our feet off the furniture):

[We are] living through a global shift in the balance of power very similar to that which occurred in the 1870s. This is the story of how an over-extended empire sought to cope with an external debt crisis by selling off revenue streams to foreign investors. The empire that suffered these setbacks in the 1870s was the Ottoman empire. Today it is the US.

In the aftermath of the Crimean war, both the sultan in Constantinople and his Egyptian vassal, the khedive, had begun to accumulate huge domestic and foreign debts. Between 1855 and 1875, the Ottoman debt increased by a factor of 28. As a percentage of expenditure, interest payments and amortisation rose from 15 per cent in 1860 to 50 per cent in 1875. The Egyptian case was similar: between 1862 and 1876, the total public debt rose from E£3.3m to E£76m. The 1876 budget showed debt charges accounting for more than half of all expenditure.

The loans had been made for both military and economic reasons: to support the Ottoman military position during and after the Crimean war and to finance railway and canal construction, including the building of the Suez canal, which had opened in 1869. But a dangerously high proportion of the proceeds had been squandered on conspicuous consumption, symbolised by Sultan Abdul Mejid’s luxurious Dolmabahçe palace and the spectacular world premiere of Aïda at the Cairo Opera House in 1871. In the wake of the financial crisis that struck the European and American stock markets in 1873, a Middle Eastern debt crisis was inevit­able. In October 1875 the Ottoman government declared bankruptcy.

The crisis had two distinct financial consequences: the sale of the khedive’s shares in the Suez canal to the British government (for £4m, famously ad­vanced to Disraeli by the Rothschilds) and the hypothecation of certain Ottoman tax revenues for debt service under the auspices of an international Administration of the Ottoman Public Debt, on which European bondholders were represented. The critical point is that the debt crisis necessitated the sale or transfer of Middle Eastern revenue streams to Eur­opeans.

He sees a parallel to the growing accumulation of US assets by foreigners - particularly Asian and Middle Eastern sovereign wealth funds - including the recent sales of stakes in Bear Stearns, Citigroup, Merrill Lynch and Morgan Stanley.

[W]e need to recognise that these “capital injections” represent a transfer of the revenues from the US financial services industry into the hands of foreign governments. This is happening at a time when the gap between eastern and western incomes is narrowing at an unprecedented pace.

In other words, as in the 1870s the balance of financial power is shifting. Then, the move was from the ancient oriental empires (not only the Ottoman but also the Persian and Chinese) to western Europe. Today the shift is from the US – and other western financial centres – to the autocracies of the Middle East and east Asia.

The parallel is an interesting one, but somewhat strained. The US is the largest economy in the world, and near the top in terms of per capita output. The Ottoman empire occupied a very different relative position - according to Angus Maddison's estimates (in 1990 $), Turkey's per capita GDP in 1870 was $825 (and Egypt's $649), far below that of European countries like Germany ($1839) and Britain ($3190), as well as the US ($2445). Furthermore, the US debt situation has a long way to go before it becomes as severe as the Ottoman case. In terms of government debt, according to the CBO, of total federal outlays of $2655 billion in 2006, less than 10% ($227 bn) was spent on interest payments (the publicly-held debt is $4829 bn, and according to the BEA, $2215 bn of Treasuries are held by foreigners, so slightly less than half of the interest is going overseas). More broadly, according to the BEA, at the end of 2006, foreigners owned $16.2 trillion worth of US assets, and Americans owned $13.7 tr of foreign assets, making the US net position -$2.5 tr. Relative to GDP $13.2 tr, that is equivalent to a household with an income of $60,000 having a debt of $11,400.

Ferguson is no doubt correct that the "balance of financial power" is indeed shifting. Partly this reflects natural forces of economic growth (convergence), and partly it is due to US borrowing. A decline in the relative economic position of the US is to be expected as more of the world is catching up - China and India are growing faster, and contributing a larger share of world output - exactly as Solow's growth model tells us they should. Potentially more worrying is that, because our domestic saving is less than investment, the rest of the world is indeed accumulating financial claims on us. This may, in part, reflect some degree of profligacy and bad policy. Though Ferguson's Ottoman analogy is a bit of a stretch, perhaps we shouldn't be putting our feet up...

A Much-Appreciated Appreciation

The NY Times reports:

China’s currency rose steeply against the dollar this week, feeding speculation that Chinese authorities, yielding to international pressure and economic realities at home, were allowing their currency to appreciate more rapidly.

The currency, known as the yuan or renminbi, rose 0.9 percent this week — faster than over any week since China stopped pegging it to the dollar on July 21, 2005. Thursday, the yuan rose 0.37 percent, the largest one-day increase since the peg ended. On Friday, it rose 0.18 percent, to close at 7.3041 to the dollar in Shanghai trading. That may be a sign that China is moving away from its policy of intervening in foreign exchange markets to keep its currency undervalued.

That would be good news for US exporters - a stronger yuan means that China can buy more US goods. Of course, there are some down-sides for the US: (i) prices of all the goods we import from China will rise - though the process of "exchange rate pass through" tends to be slow - which will hurt consumers, and possibly add a bit to the Fed's inflation concerns and (ii) as the trade gap narrows, China will be purchasing fewer American assets, which will be bad for asset prices - in particular, the price of bonds (i.e. interest rates may rise as the "capital inflow" from China diminishes).

On balance, its a good thing - a situation where a relatively poor country was lending billions to a rich country seemed perverse and precarious (and presumably unsustainable, though there's been some debate about that). Allowing the yuan to appreciate more is a good step towards an unwinding of these imbalances. In the US, increased employment in exporting sectors may help make up for some of the ill-effects associated with the real estate market decline.

This will also help China raise its own living standards and contain inflation. Moreover, other developing countries that compete with China (e.g. Mexico) will also benefit.

Krugman on Trade (!)

Long before he became a pundit, Paul Krugman was one of the world's leading trade economists, so it was nice to see him take a break from picking on Barack Obama to write about trade in his NY Times column today. Interestingly, the argument he makes in the column implies that his own theory is becoming less relevant as a description of US trade patterns.

In standard textbook neoclassical trade theory ("Heckscher-Ohlin"), countries specialize according to their factor (resource) endowments - e.g. a country with a large amount of arable land (relative to other factors) will specialize in food production, while a capital-abundant country will specialize in manufactured goods. The countries will exchange food for manufactured goods. That is, trade occurs because the countries are different, and they specialize in different goods.

One significant weakness of this theory is that much of the trade that actually occurs in the world is between similar countries, trading similar products ("intra-industry" trade) - e.g. Canada exports cars to the US, and the US exports cars to Canada; Italy exports wine to France, and France exports wine to Italy.

In his earth-shattering paper "Increasing Returns, Monopolistic Competition and International Trade" (Journal of International Economics, 1979), Krugman developed a model to explain how two similar countries gain from trading similar products. In Krugman's model, firms in each country produce differentiated varieties of similar goods (e.g. Heineken and Samuel Adams are both varieties of beer). Trade allows the firms to produce on a larger, more efficient scale, because they can sell their product in a larger market, and consumers gain access to more varieties of goods.

This is what he is talking about here:

Trade between high-wage countries tends to be a modest win for all, or almost all, concerned. When a free-trade pact made it possible to integrate the U.S. and Canadian auto industries in the 1960s, each country’s industry concentrated on producing a narrower range of products at larger scale. The result was an all-round, broadly shared rise in productivity and wages.

What is new, according to Krugman, is:

We now import more manufactured goods from the third world than from other advanced economies. That is, a majority of our industrial trade is now with countries that are much poorer than we are and that pay their workers much lower wages.

On his blog, he provides a graph. In terms of trade theory, what is going on is that a larger share of trade is with countries that have different factor endowments - e.g. China is abundant in unskilled labor and the US is abundant in skilled labor (this recent Washington Post story has some good examples of this type of trade). Krugman:

Although the outsourcing of some high-tech jobs to India has made headlines, on balance, highly educated workers in the United States benefit from higher wages and expanded job opportunities because of trade. For example, ThinkPad notebook computers are now made by a Chinese company, Lenovo, but a lot of Lenovo’s research and development is conducted in North Carolina.

But workers with less formal education either see their jobs shipped overseas or find their wages driven down by the ripple effect as other workers with similar qualifications crowd into their industries and look for employment to replace the jobs they lost to foreign competition. And lower prices at Wal-Mart aren’t sufficient compensation.

That is, a growing share of our trade is explained by the neoclassical model (and a smaller share by the Krugman model). Neoclassical theory has very clear distributional implications - trade increases the relative returns to the abundant factor. For the US that means skilled workers will see increased wages, and wages for unskilled workers will fall. This leads to the conclusion:

It’s often claimed that limits on trade benefit only a small number of Americans, while hurting the vast majority. That’s still true of things like the import quota on sugar. But when it comes to manufactured goods, it’s at least arguable that the reverse is true. The highly educated workers who clearly benefit from growing trade with third-world economies are a minority, greatly outnumbered by those who probably lose.

As I said, I’m not a protectionist. For the sake of the world as a whole, I hope that we respond to the trouble with trade not by shutting trade down, but by doing things like strengthening the social safety net. But those who are worried about trade have a point, and deserve some respect.

Greg Mankiw promises we will hear more from Krugman in the Brookings Papers on Economic Activity.

Update (12/29): On his blog, Krugman responds (He says: "Earth-Shattering? I’m proud of my early work on trade, but not this proud still, thanks for the compliment." I could have said "seminal" but I don't think that would have quite done it justice... he, along with a few others, really did change trade theory. Unfortunately trade pedagogy and trade policy discussion haven't really caught up). Krugman also offered some background on the issue of trade and wages. His column prompted thoughts from KNZN on the politics and economics of trade, and Free Exchange weighed in, too.

Ingenious Mendacity

The "subprime fiasco" (and almost every other financial crisis ever) in a nutshell:

The good times too of high price almost always engender much fraud. All people are most credulous when they are most happy; and when much money has just been made, when some people are really making it, when most people think they are making it, there is a happy opportunity for ingenious mendacity. Almost everything will be believed for a little while, and long before discovery the worst and most adroit deceivers are geographically or legally beyond the reach of punishment. But he harm they have done diffuses harm, for it weakens credit still farther.

From Walter Bagehot, Lombard Street: A Description of the Money Market (1873).

I'll Have What He's Having

NY Times columnist Tom Friedman writes:

Today’s global economy has become like a monster truck with the gas pedal stuck, and we’ve lost the key.

Well.... I'm not sure what the appropriate fiscal and monetary policy response is for that, but the place to look for the key is, of course, under the street light.

New Inequality Data

The NY Times reported Friday:

The increase in incomes of the top 1 percent of Americans from 2003 to 2005 exceeded the total income of the poorest 20 percent of Americans, data in a new report by the Congressional Budget Office shows.

The poorest fifth of households had total income of $383.4 billion in 2005, while just the increase in income for the top 1 percent came to $524.8 billion, a figure 37 percent higher.

The total income of the top 1.1 million households was $1.8 trillion, or 18.1 percent of the total income of all Americans, up from 14.3 percent of all income in 2003. The total 2005 income of the three million individual Americans at the top was roughly equal to that of the bottom 166 million Americans, analysis of the report showed.

The data come from the latest update of the CBO's Historical Effective Tax Rates report, which combines the effects of all the federal taxes - income taxes, payroll (social security) taxes, corporate and excise taxes, to show how the tax burden is distributed across households of varying income levels. As part of figuring this, they put together data on income inequality. From the data in the supplemental tables, here is a picture of how the distribution of income has evolved since 1979 (when the data begins), by quintile (i.e. each slice is the share of income going to 20% of the population, with the poorest 20% on the bottom and highest-earning 20% on top):The share going to the top 20% has risen from 42.4% in 1979 to 51.6% in 2005, while all the others have decreased. I've used the after-tax data, so this is income after accounting for whatever redistribution occurs through taxes and transfers (in the pre-tax data, the distribution is even more unequal).

As the lede from the Times story suggests, much of the action is at the very top, as the highest earners are pulling away from what we might call the "upper middle class" (or UMC). In 1979, average income in the top 20% was 5 times that of the middle, and incomes in the top 1% were 10 times those in the middle. By 2005, these multiples increased to 9 and 27, respectively:

Presumably the greater volatility for the top 1% is because they receive a higher share of income from financial assets (the dip in 2001-02 coincides with a bear market; the Times story's focus on 2003-05 makes the change in distribution seem more sudden than it really is).

CBO Director Peter Orzag discussed the report (and methodology behind it) on his new blog. A further breakdown (and more charts) can be found in this brief analysis by the Center on Budget and Policy Priorities.

This issue came up in Greg Mankiw's interesting post on how economists of the "left" and "right" differ - his last point was:

There is one last issue that divides the right and the left—perhaps the most important one. That concerns the issue of income distribution. Is the market-based distribution of income fair or unfair, and if unfair, what should the government do about it?

Mark Thoma spoke for the "left" (or, probably really the "mainstream" since Democrats outnumber Republicans among economists by 2.9-to-1) in his response:

Fair or unfair depends upon how well markets are functioning. If you do not believe that markets are competitive, or that opportunity is equal, then the intervention and redistribution may be correcting the outcome toward what a perfectly competitive, equal opportunity system would produce rather than away from it. It's not that we don't believe that competitive markets are fair, though I can only speak for myself, it's that we don't believe markets that deviate from perfect competition in important ways, i.e. have important market failures, produce outcomes that have defensible equity properties.

There are good reasons for those on the right, who may have trouble seeing either injustice or market failure, to be concerned as well. This is because of two tensions -

1. The contradiction between Christian gospel teaching and extreme wealth, (see, e.g., Matthew 19:24). Growing inequality may lead the part of the "right" that is "Christian" to reconsider whether their politics is truly consistent with their religious views.
2. The tension between political equality and economic inequality. Extreme inequality could ultimately undermine political support for the "free market" economic system and generate more support for "populist" economic policies.

Throughout most of its history, the US has generally shown an exceptional ability to live with the contradiction between economic inequality and the political and moral equality of our political and (majority) religious creeds. As economic inequality continues to increase, thoughtful people of the right may want to consider whether this ability is limitless.

World-Changing and the PhD

Chris Blattman of Yale offers advice about graduate school for people "are young, idealistic, and want to pursue PhD research that makes life better for those less fortunate." This came to my attention via Dani Rodrik, who says:

In my experience, though, too many students who are interested in making a difference in the real world go on to the Ph.D--and for the wrong reason. As I always tell students asking me for advice on this, the only good reason to want to do a Ph.D. is that you want to be an assistant professor at some academic institution.

I'm inclined to agree with Rodrik - the PhD is a research-oriented degree, and since most jobs for PhDs are in academia and the job market is relatively thin (PhD economists can get good jobs, but usually have limited choices) people who go into PhD programs hoping to do something non-academic may be setting themselves up for disappointment. However, some of the commenters on Rodrik's blog make a case that a PhD is an important credential for working at multilateral institutions like the UN and World Bank.

This made me think of the last of Marx's Theses on Feuerbach (which, like Nigel Tufnel's amplifiers, go to eleven):

The philosophers have only interpreted the world, in various ways; the point, however, is to change it.

If you agree with that, a PhD may not be for you; if you're response is "interpreting the world, in various ways, sounds like a great job," then you should consider applying for graduate school.

To be sure, research and teaching do "make a difference," so an academic job does feel socially useful, but professors generally don't get the gratification of concrete or immediate results from their work.

We're #962,510!

According to Technorati, Twenty-Cent Paradigms has cracked the known universe's top million blogs. Some credit, and thanks, goes to Mark Thoma of the indispensible Economist's View who has linked to several posts here, thereby increasing the "authority" of this blog.