The Macroeconomic Situation

Paul Krugman offers an assessment of our current macroeconomic troubles. He says there are basically two problems. One is that the economy is "unbalanced," with unusually high consumption and a large trade deficit. That is, in terms of Output = Consumption + Investment + Government + Net Exports, the fact that net exports (i.e. the trade balance: exports - imports) is negative allows the other three components to add up to more than 100% of output, and for consumption to be unusually large relative to GDP. In the BEA's advance estimate of 2007 GDP, consumption was 70.3% of GDP, while net exports were -5.1%. Another imbalance Krugman notes is that, as a share of GDP, residential investment (new housing) has been unusually high, while nonresidential investment (new capital) has been lower than its average. The other problem, which has grabbed more headlines lately, are the troubles in the financial system, which may be creating a "credit crunch," making it harder for individuals and firms to borrow. Here's Krugman's take on what's ahead:

What we want, and will eventually get, is a rebalancing: smaller trade deficits, consumer spending more in line with income, more normal housing spending. The trouble is in getting there. At the moment it seems likely that consumption and housing investment will fall faster than net exports can rise — probably with additional downward pressure from at least some types of business investment, especially commercial real estate. The result will be a recession or at least something that feels like one.

The goal of monetary and fiscal policy should be to bridge the gap — to sustain spending until a falling trade deficit comes to the rescue, and to hasten the rise in net exports (remember, in the current context a weak dollar is good.)

The Trouble With Tweed

Brad deLong contempates the sartorial dilemmas of the professorate. He suggests that slovenly-dressed academics may be playing a mixed strategy:

• The most important signal of expertise that a professor can send is that he or she is so monomaniacally focused and on intellectual task as to be completely outside the normal status hierarchies
• Thus it is very important that their values and tastes appear visibly different from those of either the striving poor or the smug rich
• And the best way to do this, from a sartorial point of view, is to make it appear that the professor had better and more important things to think about than mere appearance while getting dressed that morning
  • There is a faction that thinks that the best way to appear to have had better and more important things to think about is to never care at all about appearance--so that whatever one thinks of is automatically more important than how one looks
  • There is another faction that thinks that true unconcern is too risky, and that one must utilize great art in appearing artless in one's dress
    • But systematic artful artlessness is an impossibility
    • Pulling things at random from one's closet may, however, come close

Personally, I like tweed, but as deLong rightly notes:

[T]he traditional tweedy professor male academic clothes are, from a thermodynamic point of view, appropriate only for some British or New England campus without effective central heating.

Growth Accounting is Useful (and Fun)

Dani Rodrik asks a question that perhaps some of my intermediate macro students are asking - that is, if they've started the problem set (seriously, folks, don't wait until Thursday night) - "What Use is Sources of Growth Accounting?"

I am teaching this stuff this week, and while I enjoy doing it and think it is important for students to know--no World Bank country economic memorandum is apparently complete without a sources-of-growth exercise--I wonder what purpose it really serves....

Aside from all kind of measurement problems, these accounting exercises say nothing about causality, and so are very hard to interpret. Say you found it's 50% efficiency and 50% factor endowments. What conclusion do you draw from it? You could imagine a story where the underlying cause of growth is factor accumulation, with technological upgrading or enhanced allocative efficiency as the by-product. Or you could imagine a story whereby technological change is the driver behind increased accumulation. Both are compatible with the result from accounting decomposition. Indeed, I have yet to see a sources-of-growth decomposition which answers a useful and relevant economic or policy question....

What growth accounting allows us to do is to break down output growth into its component parts. For example, growth in "labor productivity" (output per unit of labor) can be decomposed into "total factor productivity" (technological progress) and contributions from "capital deepening" (increasing the amount of equipment per worker), and sometimes also "labor quality" (changes in the education and experience of the labor force).

One recent example that I found interesting is Jorgenson, Ho and Stiroh's paper "A Retrospective Look at the US Productivity Growth Resurgence" which further sub-divides capital deepening and total factor productivity into information technology (IT) and Non-IT components. Their results indicate that the US "productivity resurgence" since the mid-1990's has two distinct sub-periods:

Robert Solow once said "we see the computers everywhere but in the productivity statistics," (this is the "Solow paradox") but they seem to have finally showed up in a big way in the late 1990's. The decomposition suggests that productivity growth in the late 1990's was an Information Technology story, reflected in the boom in IT investment and in productivity growth in the IT sectors. The second phase of the resurgence appears to have been much more broadly based.

I stumbled on another interesting example writing a problem set for my principles students. I asked them to break the 1974-95 slowdown period into sub-periods:The late 1970's were terrible for TFP (perhaps due to oil shocks, or maybe because we were distracted by "CHiPs") but still saw a respectable contribution from capital deepening, while the later period had decent TFP growth, but didn't get much from capital deepening. That might lend some creedence to the notion that the federal budget deficts that ballooned during that period "crowded out" investment.

Rodrik is right that growth accounting doesn't really explain what causes growth, but it is very useful for telling us where to look. That is, it doesn't really answer questions so much as help us figure out what questions to ask.

Consumption Inequality

is much lower than income inequality. The Dallas Fed's W. Michael Cox and Richard Alm explain in the New York Times, with the aid of a nifty chart. They write:

[I]f we compare the incomes of the top and bottom fifths, we see a ratio of 15 to 1. If we turn to consumption, the gap declines to around 4 to 1. A similar narrowing takes place throughout all levels of income distribution. The middle 20 percent of families had incomes more than four times the bottom fifth. Yet their edge in consumption fell to about 2 to 1.

Let’s take the adjustments one step further. Richer households are larger — an average of 3.1 people in the top fifth, compared with 2.5 people in the middle fifth and 1.7 in the bottom fifth. If we look at consumption per person, the difference between the richest and poorest households falls to just 2.1 to 1. The average person in the middle fifth consumes just 29 percent more than someone living in a bottom-fifth household.

Update: Paul Krugman is skeptical.

Update #2 (2/11): So are Mark Thoma, Dean Baker and Free Exchange.

Update #3 (2/12): And Barry Ritholtz.

Fiscal Policy in the Long and Short Runs

The Times' Edmund Andrews has a useful look (with nice charts) at the fiscal policy challenges that will confront the next administration. One major issue is that the tax cuts passed in 2001 and 2003 are scheduled to expire:

Extending them would reduce revenues by about $3 trillion over the next 10 years, according to the Congressional Budget Office. Those reductions would coincide with sharply rising costs for Social Security and Medicare as millions of baby boomers enter retirement.

Senator John McCain of Arizona, the front-runner for the Republican nomination for president, has flip-flopped on the issue. In 2001 and 2003, he alienated many Republicans by voting against the tax cuts, arguing that they were too heavily tilted toward the rich. But as a presidential candidate, Mr. McCain competed fiercely with his Republican rivals in vowing to not only make the tax cuts permanent but also to cut the corporate tax rate....

The Democratic contenders, Senator Barack Obama and Senator Hillary Rodham Clinton, would extend the tax cuts for most people but revoke them for families earning more than $250,000 a year. “I am not bashful about that,” Mr. Obama said at the Democratic candidates’ debate on Jan. 31. “What we have right now is a situation where we cut taxes for people who don’t need them.”

Clinton and Obama plan to use the additional revenue to finance their health care plans. Obama has also expressed a willingness to consider raising the social security payroll tax on earnings over the current cap of about $90,000 (see earlier post).

The steps discussed so far on the campaign trail are unlikely to close the gap between revenue and spending (and McCain, if he doesn't change his mind again, would widen it). None of the candidates (except Huckabee) has offered plans for fundamental changes to the tax system. Andrews puts it in context nicely:

Historically, federal taxes have averaged about 18.5 percent of the gross domestic product.

That percentage sank to 16.3 percent of the G.D.P. in 2004, largely because of Mr. Bush’s tax cuts, but it edged up to 18.8 percent last year as a result of booming corporate profits and investment income.

But government spending remains above 20 percent of G.D.P., and the gap between taxes and spending is likely to widen sharply as a result of the economic slowdown this year.

President Bush’s budget plan for 2009, which includes money for an economic stimulus package, calls for the federal deficit to more than double, to $410 billion, this year.

That is, in addition to the gap between revenue and spending expected over the long run, we can expect the deficit to increase in the short run, and that's not entirely a bad thing. The expected increase in the deficit this year is partly a reflection of the "automatic stabilizer" role of the federal budget - since most taxes are proportional to income, revenues automatically fall when incomes decrease, and spending on some government transfer programs like unemployment insurance rises in a downturn. On top of that, we are indeed going to get a "fiscal stimulus" - a one-off tax rebate intended to increase aggregate demand this year. The efficacy of this has been much-debated; I think Jared Bernstein has it about right:

It's both good news and a missed opportunity to craft a much more effective package.

On the plus side, those who said the political system was too clogged with partisanship to get this out the door quickly are proved wrong. The package is also much improved from the White House's first pass, which excluded low-income families and about 20 million elderly persons.

On the negative side, they could have crafted a package that would have had a lot more bang-for-the-buck....

By leaving out extended unemployment benefits and other more directly stimulative measures, like helping revenue-strapped states invest in infrastructure (roads, school repairs), the Congress and the White House missed the chance to get a significantly bigger return on our investment...

That said, and I know there's a fair bit of skepticism on this point, this package will surely help. It won't stave off recession, but it will mitigate the pain for many.

Speaking (Bob) Frankly

Economists' proofs that markets lead to "efficient" outcomes hold only under a specific set of assumptions, including perfect competition, perfect information, and the absence of externalities. These assumptions, of course, never completely hold - the world we live in is one of "market failure." The benefits of markets are often hard to see and appreciate; understanding them is an important contribution of economics, but it is also important to understand market failures. One of the most acute observers of market failure is Cornell's Bob Frank, who Steven Pearlstein writes about in his Washington Post column:

Think of skyrocketing tuitions among elite colleges and universities that spend lavishly on winning sports teams, rock-climbing walls and scholarships for those who don't even need them, all to attract top students.

Or the runaway compensation for chief executives who would be willing to take the job for half of what they are being paid.

Or the ridiculous prices paid for "it" handbags, fancy watches or houses in the Hamptons.

How do we explain why cities are still tripping over themselves to offer subsidies for baseball stadiums and convention centers in the face of overwhelming evidence that these diminish economic efficiency and welfare rather than enhance them?

And how is it rational that first-year associates at top law firms are paid more than federal judges?

One thread that runs through all these "market failures" is that they involve a kind of competition in which "winning" is more a relative concept than an absolute one -- that the goal is not so much to maximize profits, income or welfare, as economic models assume, but to beat the competitors. In the process, perfectly rational investors, businesses or consumers wind up doing things that are irrational, leaving them no better off than before.

The intellectual roots of this economic theory of relativity go back to Adam Smith, Alfred Marshall and Thorstein Veblen. It got a big boost from game theorists, among them University of Maryland's Thomas C. Schelling, who won a Nobel Prize for his work on unproductive arms races, both economic and military. More recently, the hot new area of behavioral economics has focused considerable light on the seemingly irrational side of homo economus.

Perhaps nobody has done more to expand our understanding of relative competition than Robert H. Frank of Cornell University. Frank's particular focus has been on the importance of status in consumer choices. His point is that the desire for ever-bigger homes, ever-fancier gas grilles, ever-more powerful SUVs is based not on some absolute notion of what is good or sufficient, but rather on the relative basis of what everyone else has.

It is this compulsion to keep up with the Joneses, Frank argues, which leads us to over-spend on status goods that, in the end, make us no happier. Meanwhile, we wind up under-investing in leisure time or "public goods," such as better schools and parks, that would give us more satisfaction.

The latest example of Frank at work is his piece in today's New York Times. He looks at the puzzle of why people contribute to political campaigns, which seems to go against our assumption that people behave in a narrowly self-interested manner:

The problem, as described by Mancur Olson in his classic book, “The Logic of Collective Action,” is that even those who share a presidential candidate’s policy goals will reap no significant material advantage by donating their time or money. After all, with cash donations legally capped at $2,300, even donors who give the maximum have no realistic hope of influencing an election’s outcome. Nor can any individual volunteer — even one whose efforts resulted in hundreds of additional votes for his candidate — realistically hope to tip an election.

Although the logic of the free-rider problem may seem compelling, people’s behavior strikingly contradicts many of its predictions. Last month alone, for example, the presidential campaign of Senator Barack Obama raised over $32 million from more than 250,000 individual donors and sent huge numbers of volunteers into the field. (Disclosure: I’m an Obama contributor myself.) Other campaigns have benefited in similar, if less spectacular, ways from their supporters’ willingness to set narrow self-interest to one side.

Frank goes on to describe a theory from Albert O. Hirschman that posits alternating periods dominated by collective action and by selfishness. So, while Obama was criticized for saying positive things about Ronald Reagan, his "movement" may be a sign that the Reagan era is over...

One crucial thing sometimes students (and professors) misunderstand about the free rider problem - and the assumptions we make about behavior in general - is that economics does not exist to tell people how to act. Economists are social scientists, and our task is to explain human behavior. In Frank's example, what is problematic is not the behavior of the donors, but the fact that economic theory has a hard time explaining it.

Panda Bearishness

Double-digit annual GDP growth has become almost routine for China, but in the Financial Times, Kenneth Rogoff argues a slowdown may be in the offing:

China’s remarkable resilience to both the 2001 global recession and the 1997-98 Asian financial crisis has convinced almost everyone that another year of double-digit growth is all but inevitable. In fact, the odds of a significant growth recession in China – at least one year of sub-6 per cent growth – during the next couple of years are 50:50. With Chinese inflation spiking, notable backpedalling on market reforms and falling export demand, 2008 could be particularly challenging.

The bar is pretty high when 6% growth counts as a "growth recession" (a period of below average growth, but not a full-blown recession where output actually falls). In the "Economists' Forum" comments, Rogoff's former professor Jagdish Bhagwati reminds us of some institutional issues that could yet derail the China growth story:

I think that Rogoff's analysis needs to be supplemented by a fuller recognition of the problems that Chinese authoritarianism poses. Unless you have the institutions of a liberal democracy - a free press, NGOs, opposition parties and an independent judiciary - you run the danger of "social disruptions" that China has and you are unable to channel dissent and distress into creative political channels. This is why a big question mark hangs over China's future.

And William Easterly expects "regression to the mean":

Growth forecasters are curiously oblivious of the overwhelming evidence for regression to the mean. Of course, a small number of countries can defy gravity for a while, as China has already done with the length of its current rapid growth episode. Until recently, the East Asian tigers (Hong Kong, Korea, Singapore, Taiwan) also defied gravity for an unusually long period, but in the last ten years gravity reasserted itself - their growth has decelerated back down towards world average growth.

Or, to put it on a more solid theoretical footing - neoclassical growth models (e.g. the Solow model) imply that the rate of growth will slow as an economy gets closer to its steady state.

More Sino-pessimism is available from Michael Pettis, who considers the possibility of Chinese stagflation on his China financial markets blog.

Update (2/10): The Cleveland Fed's "Economic Trends" has a good explanation of the relationship between inflation and China's exchange rate policy.

Aim Slightly Higher

The unusually aggressive reductions in the fed funds rate target in the last two weeks have been criticized for increasing the potential for future inflation. One defense of the Fed is that the risks it faces are asymmetric. In particular, the Fed wants to make sure to avoid falling into deflation and a "liquidity trap" where monetary policy becomes ineffective - when the price level is falling, even if nominal interest rates go to zero, real interest rates can still be high. This is the point made in the FT's Economists' Forum by Johns Hopkins' Christopher Carroll:

[T]he Fed's gamble seems well judged, not because the concerns of the inflation hawks are unwarranted but because they are balanced by a more dangerous possibility on the opposite side. Put it this way: if I'm hiking a narrow cliff-hugging mountain trail, I don't want to stroll right down the middle of the path. Instead I will edge to the to the side of the trail away from the precipice, even if this means an occasional scraped ankle or a bit of extra scrambling. This is the "precautionary principle" in mountain-climbing.

The cliff, for monetary policy, is the possibility of deflation, whose dangers were calamitously illustrated by the Japanese government during the 1990s. And the precautionary principle would say that it is worth risking a spell of extra inflation to avoid even a small risk of a deadly dose of deflation.

The uptick in long-term interest rates (noted previously) might suggest that the Fed's actions are denting its inflation-fighting credibility and that inflation expectations are rising. One way to enhance credibility and keep inflation expectations anchored would be for the Fed to adopt inflation targeting (i.e. announcing a goal for inflation and committing to adjusting monetary policy to meet it). As an academic, in addition to being a student of the depression, Ben Bernanke was an advocate of inflation targeting.

Most of the countries that have adopted inflation targeting (e.g. Britain) have set targets of 2% (or ranges centered on 2%). If the Fed is indeed strongly deflation-averse (as it should be), perhaps 2% would be cutting it too close. Setting a slightly higher target - say 3% - would give the benefits of inflation targeting without requiring it to walk so close to the edge of the cliff. For example, if we start from an equilibrium at an assumed "neutral" level of the real fed funds rate of 2.5% and an inflation target of 3%, the fed funds rate would be 5.5%, giving the Fed 550 basis points to work with in a downturn (as opposed to 450 bps with a 2% target).

The downside of that, of course, is higher inflation. But many of the problems with inflation come more from uncertainty and volatility rather than the rate itself. Its not clear that an economy with consistent, anticipated inflation of 3% is much worse than one with consistent, anticipated 2% inflation. Moreover, if nominal wages are sticky downwards, a little bit of inflation makes it easier to adjust real wages (as Akerlof, Dickens and Perry explained).

The Mandate Debate

Part of the discussion in last week's Democratic debate was over an "individual mandate" for health insurance. Clinton is for it - her health care proposal would require all people to get insurance (like most states require all drivers to be insured) - and Obama is opposed, which is why Clinton can say he wouldn't provide "universal coverage" since some people would choose to go without insurance.

For more, Jonathan Cohn of The New Republic has an even-handed assessment of the issue (and Krugman continues to take Obama to task, as does Ezra Klein). The plan instituted by Governor Romney in Massachusetts also includes an individual mandate.

For a broader look at the candidates' economic policy views, see the series by NY Times' David Leonhardt. Here's his article about Obama, Hillary Clinton and John McCain.

Obamamania

Part of Barack Obama's appeal comes from the notion that he can bring people together. Last week he collected the endorsements of Hulk Hogan and former Federal Reserve chairman Paul Volcker. Both are known for laying down some smack in the 80's - Hogan on the Iron Sheik and Andre the Giant, and Volcker on inflation. The victory over inflation was not without its cost - Volcker's tight, quasi-monetarist policies led to the 1981-82 recession, the deepest US recession since the great depression.

Obama talks of working as a community organizer in the 1980's in south Chicago neighborhoods devastated by factory closings. The unemployment he saw is at least partly attributable to the Volcker Fed's actions.

The red line is the Fed Funds rate, the blue line is inflation (CPI) and the unemployment rate is in green.
It should be noted that the Fed's policies were a response to the inflation that had developed over the 1970's, and some economic "pain" was arguably necessary in those circumstances.