Stagflation Redux?

The latest inflation report from the BLS has generated some concern about "stagflation," an ugly artifact of the 1970's, making a comeback (can avocado appliances be far behind?). The word is a combination of "stagnation" (i.e. high unemployment and slow growth) and "inflation." We already knew that unemployment has been creeping up (4.9% in January, up from 4.4% last March). And now we learn that over the past 3 months, CPI inflation has been running at a 6.8% annual rate. Partly that reflects oil prices - just as 1970's inflation did - but the "core" CPI (i.e. with food and energy prices removed) has been increasing at a 3.1% annual rate. Ominous portents, but we have some distance to go before things look this bad:
(the red line is the unemployment rate, and the blue is CPI inflation)

One reason stagflation is so pernicious is that it puts the Fed in an awkward spot. High inflation requires the Fed to tighten monetary policy (i.e. raise the fed funds rate target), while the proper response to stagnation is to loosen. At Econbrowser, James Hamilton examines the numbers and the Fed's dilemma.

Paul Krugman believes the appropriate parallel is to early 1990's rather than the late 1970's. He writes:

...I don’t believe we’re really facing anything comparable to 1970s stagflation. For one thing, we’re less dependent on oil: America has more than twice the real G.D.P. it had in 1979, but consumes only slightly more oil. For another, there’s no sign of the wage-price spiral that once drove inflation into double digits — in fact, wage growth has been declining even as inflation rises.

What’s much more likely is that we’ll have an economy like that of the early 1990s, only worse.

The first President Bush presided over the 1990-1991 recession. But his real problem came during the alleged recovery, which was hobbled by financial problems at many banks, which had been badly damaged by the collapse of the late-1980s real estate bubble, and by sluggish consumer spending, held down by high levels of household debt.

As a result, the unemployment rate just kept rising, not reaching its peak of 7.8 percent until June 1992.

If all this sounds familiar, it should. Many economists have pointed out the parallels between the current situation and the early 1990s: another real estate bubble, subprime playing more or less the same role formerly played by bad loans by savings and loan institutions, financial trouble all around.

The difference is that the problems look a lot worse this time: a much bigger bubble, more financial distress, deeper consumer indebtedness — and sky-high oil prices added to the mix...

This Wall Street Journal article has some very informative background on stagflation, including:

British Parliamentarian Iain Macleod is credited with first using the word stagflation in 1965. "We now have the worst of both worlds -- not just inflation on the one side or stagnation on the other, but both of them together. We have a sort of 'stagflation' situation."

None More Black

This has nothing to do with economics, but I can't resist. The Washington Post reports:

Researchers in New York reported this month that they have created a paper-thin material that absorbs 99.955 percent of the light that hits it, making it by far the darkest substance ever made -- about 30 times as dark as the government's current standard for blackest black...

"It's very deep, like in a forest on the darkest night," said Shawn-Yu Lin, a scientist who helped create the material at Rensselaer Polytechnic Institute in Troy, N.Y. "Nothing comes back to you. It's very, very, very dark."

Or, in the immortal words of Nigel Tufnel: "It's like, 'how much more black could this be?' and the answer is none. None more black."

Helping Africa?

The NY Times reports that President Bush accentuated the positive on his trip to Africa:

“This is a large place with a lot of nations, and no question, everything is not perfect,” Mr. Bush said during a brief visit to Benin before arriving Saturday evening here in the capital of Tanzania. “On the other hand, there’s a lot of great success stories, and the United States is pleased to be involved with those success stories.”

Mr. Bush’s short stay in Benin — just three hours, enough time for an airport news conference with President Thomas Yayi Boni and for Air Force One to refuel — made him the first American president to visit that tiny West African nation. It was on Mr. Bush’s itinerary because it represents the kind of success he wants to highlight — how American aid has helped fight poverty and disease in some of the world’s poorest nations.

The administration considers its aid efforts to be one of its successes. In an interview with the Council on Foreign Relations, Steve Radelet of the Center for Global Development offers a mostly positive assessment of the administration's efforts. The centerpiece is the Millennium Challenge Corporation, a program Bush announced in 2002 - Radelet says:

The Millennium Challenge Corporation (MCC) has evolved into what I think is an imaginative and creative new way to think about foreign assistance. It has done many things well, in terms of how it is thinking about foreign assistance, but it has also been quite slow in getting off the ground and dispersing money. What it has done well is recognizing that not all countries are the same and that we should deliver assistance differently to different countries. It separates out those that are better governed, countries that have made choices toward democracy, toward better governance, and toward better health and education policies. It gives those countries the responsibility to set their priorities and design the programs. This is a huge change and a huge step forward in how we think about foreign assistance, to actually give the recipient countries much more responsibility....

They’ve been very slow to disperse the funds so there haven’t been huge benefits on the ground yet. The African countries that have qualified and have signed compacts include Benin, Cape Verde, Ghana, Lesotho, Madagascar, Mali, Morocco, Mozambique. Those are the African countries that have signed compacts for $3.8 billion, which are beginning to be implemented, but it’s still very early in the day. So far, the MCC has only dispersed $150 million worldwide. So, their disbursements have been slow. It still remains to be seen if the great promise of the MCC turns into reality in terms of real benefits for people on the ground.

The structure of the program represents the growing appreciation by economists (and others) of the importance of institutional factors like governance for development.

Since most people do not realize how small a fraction of our income is spent on foreign aid, it is useful to put it in context: According to the OECD, US "Official Development Assistance" was $23.5 billion in 2006. That's a large amount of money, but it is 0.18% of Gross National Income (aka GNP) and less than 0.9% of federal budget outlays - that is, less than one cent from each tax dollar. This chart breaks down American aid by region and category. Although the US is the largest giver by amount, most rich countries give a higher percentage of their incomes in development aid. In percentage terms, Sweden is the most generous (1.02%), followed by Luxembourg and Norway (both 0.89%). In dollar terms, Britain is #2 at $12.5 bn, followed by Japan at $11.2 bn.

But does it do any good? That is the subject of sometimes heated debate. A good starting point on this issue is Nicholas Kristof's review article in the New York Review of Books. Kristof, who is a NY Times columnist, will be speaking at Miami on Mar. 4.

Globalization and Divergence

The gap between the rich and poor nations has widened over the past two centuries, rather than narrowed as neoclassical growth theory (e.g. the Solow model) predicts. At Vox EU, Oded Galor and Andrew Mountford offer a hypothesis to explain this "great divergence":

[W]e suggest that international trade has played a significant role in the differential timing and pace of the demographic transitions across countries and has been a major determinant of the distribution of world population as well as the 'Great Divergence' in income per capita across countries. International trade has an asymmetrical effect on the evolution of industrial and non-industrial economies: While in the industrial nations the gains from trade have been directed primarily towards investment in education and growth in output per capita, a greater portion of the gains from trade in non-industrial nations has been channelled towards population growth...

The expansion of international trade has enhanced the specialisation of industrial economies in the production of industrial, skilled intensive, goods. The associated rise in the demand for skilled labour has induced a gradual investment in the quality of the population, expediting a demographic transition, stimulating technological progress and further enhancing the comparative advantage of these industrial economies in the production of skilled intensive goods. In non-industrial economies, in contrast, international trade has generated an incentive to specialise in the production of unskilled intensive, non-industrial, goods. The absence of significant demand for human capital has provided limited incentives to invest in the quality of the population and the gains from trade have been utilised primarily for a further increase in the size of the population, rather than the income of the existing population. The demographic transition in these non-industrial economies has been significantly delayed, increasing further their relative abundance of unskilled labour, enhancing their comparative disadvantage in the production of skilled intensive goods and delaying their process of development. This implies that international trade has persistently affected the distribution of population, skills, and technologies in the world economy, and has been a significant force behind the 'Great Divergence' in income per capita across countries...

The "demographic transition" they refer to is the reduction in fertility rates that tends to occur as countries develop. In contrast to neoclassical models, their hypothesis implies that investment in human capital and population growth be treated as endogenous variables - i.e. determined within the model, rather than taken as exogenously given.

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.