Tom Wolfe, Schumpeterian

A year ago, just before the credit market crisis began, Tom Wolfe visited the New York Stock Exchange and declared: "we may be watching the end of capitalism as we know it." The Times' Andrew Ross Sorkin has an interesting follow up:

When I asked Mr. Wolfe about his comment on the floor of the stock exchange, he said, “I didn’t realize anyone would take me seriously.” He says he has since made up an explanation of why he thought it could be the end of capitalism.

Citing Joseph A. Schumpeter, the economist, Mr. Wolfe said, “Stocks and bonds are what he called evaporated property. People completely lose touch of the underlying assets. It’s all paper — these esoteric devices. So it has become evaporated property squared. I call it evaporated property cubed.”

Then he cautioned, “Of course, I’m not an economist.” Maybe that’s why he’s gotten it so right.

So, does this mean the 1980's are over for real this time?

GPM = 1/MPG

One might think of the "fuel economy" of a car as the amount of gas needed to travel a given distance - the number of gallons per mile - which is the reciprocal of the common miles per gallon measure. Discussing fuel economy in terms of miles per gallon is therefore somewhat deceptive - e.g., the improvement in efficiency of going from 25 to 43 MPG is about the same as going from 10 to 12 MPG (in both cases 0.0167 GPM). The Guardian reports on a study by two Duke management professors explaining exactly that.

The Candidates get a Fiscal Exam

The Tax Policy Center has made a preliminary analysis (with slight revisions) of McCain and Obama's tax plans. Under current law, most of the tax cuts passed in 2001 and 2003 are scheduled to expire after 2010 - i.e., if nothing is done, there will be a significant tax increase in 2011 (returning us to the higher tax rates we had back in the Clinton years, when the economy was growing faster, unemployment was lower, and the federal budget was in surplus...). Relative to this, both candidate's plans would reduce revenue - McCain by $3.6 trillion and Obama by $2.7 trillion over 10 years (or, compared to keeping the current tax code in place, Obama would raise revenue by $262 billion while McCain would reduce it by $615 billion). Federal tax revenue was 18.8% of GDP in 2007 - under McCain's plan it is projected to be 17.9% of GDP over 2009-2018, versus 18.4% under Obama's.

Both candidates' proposals are multifaceted; highlights include:

McCain would extend almost all of the 2001-03 tax cuts (except that a 15% tax would remain in place on estates over $5 million), increase the tax exemption for dependents and reduce the maximum corporate tax rate from 35% to 25%.

Obama would extend the portions of the tax cuts affecting lower- and middle- income households, but allow the top tax rates to revert to their 2000 levels (e.g. the top income tax rate would return to 39.6% from its current 35%) and raise capital gains and dividend taxes. Lower and middle-income families would also be the beneficiaries of more tax credits: he would add a $500 "Making Work Pay" tax credit, expand the Earned Income Tax Credit (EITC) and the child and dependent care tax credits.

The distributional effects of the two plans are very different: Obama's plan would raise the average federal tax rate in 2009 for the highest-income quintile (i.e. the top 20%), and lower it for the remaining 80%. The cut would be 5.3 percentage points for the bottom quintile and 2 pts for the middle quintile, while the top 20% would see a 1.5 pt increase (and the top 1% would see their tax rate increase by 6.1 pts). Under McCain's plan, the average federal tax rate for all groups, but the decrease for the bottom quintile (0.2 pts) and middle (0.6 pts) are small compared to the change at the top (2.2 pts for the top quintile).

The study has a number of caveats. The center had to make some assumptions because proposals are vague - the report says "no one - not even inside the campaigns - knows exactly what the proposals are. Stump speeches and campaign white papers are often short on the technical details needed to analyze the proposals fully." Also, the analysis did not tackle the candidates' plans regarding health care, which will also affect the tax code (the TPC promises a separate study on this).

EconomistMom examined the distributional consequences; here's her answer to the Telly Savalas question ("who loves ya, baby"):

So in aggregate, at least in terms of tax cuts, McCain loves taxpayers (even) more than Bush loves taxpayers, and Bush loves taxpayers more than Obama loves taxpayers. All of them are not so fond of our children and grandchildren though, because they’re all willing to have our children and grandchildren (aka future taxpayers) pay for all that love they’re willing to give to us current taxpayers.

But how much the candidates love you, in particular, depends a great deal on how “rich”, or not, you are. With his tax cuts, Senator Obama loves those who are not so rich a lot more than he loves those who are. Senator McCain, on the other hand, really loves the really rich. In fact, with his tax cuts, Senator McCain loves the really rich even more than President Bush has loved them.

And Paul Krugman says:

The key point, again: because of all those middle-class tax cuts in the Obama plan, he collects only 0.4% of GDP more in taxes than McCain. The tax collection comes from different people: lower and middle-income Americans would be substantially better off under the Obama plan. But where is the money for health care reform?

Krugman also wrote a column on the subject (his numbers are slightly different because they are prior to the TPC's revision of its estimates), and Clive Crook did too.

The TPC's analysis does not include Obama's proposal - which is still lacking specifics (maybe we should call it a "gambit" for now) - to apply the social security payroll tax to higher-income owners (currently, income above $102,000 is not subject to social security contributions). Back in November, this came up in a debate between Clinton and Obama (see this post for a discussion). Obama says that the tax would kick back in for incomes above $250,ooo (i.e. there would be a 'donut hole'). While the problems of social security are often exaggerated, this would make the tax code more progressive (and the top marginal rate would be getting pretty high, for those who worry about such things) and reduce the amount the government needs to borrow from the "public" (or, really, China), because the social security trust fund would buy some of the Treasury bonds that would otherwise have to be sold to finance the deficit. That should be a plus for investment (less "crowding out") and the current account. The TPC says:

Senator Obama not been clear about what rate would apply, when the tax would take effect, or even what the tax base would be. (See our follow-up blog post.) Assuming that the proposal would apply the full 6.2 percent OASDI (old age survivors and disability insurance) tax, paid by both employers and employees, to earnings above the threshold, TPC estimates that the proposal would raise $629 billion, or about 0.4 percent of GDP, over the ten-year budget period.

For a good analysis of the donut, see this post from EconomistMom.

Update (6/19): The Times' David Leonhardt has three questions for McCain.

Obama, Breaker of (Nontariff) Barriers

One man's environmental or health regulation is another's non-tariff barrier (i.e. a trade restriction in disguise). Barack Obama apparently sees alot of them, according to this useful NY Times examination:

“You can’t get beef into Japan and Korea, even though, obviously, we have the highest safety standards of anybody, but they don’t want to have that competition from U.S. producers,” Mr. Obama said last month in a speech to farmers in South Dakota. Last week, near Detroit, he asserted that “if South Korea is selling hundreds of thousands of cars to the United States and we can only sell less than 5,000 in South Korea, something is wrong.”

Yes, "highest safety standards of anybody" - I guess he hasn't been reading Paul Krugman (see the post immediately below). As for the cars, the article explains that while Korea's auto imports have dramatically risen, the US share has fallen:

One reason for the decline may be a longstanding engine displacement tax levied on automobiles by motor size, which appears to have benefited Japanese and European carmakers like Honda, BMW and Volvo. The United States considers the tax an unfair trade barrier and has sought to have it and other requirements “streamlined,” but defenders describe it as part of a Korean government strategy to reduce consumption of ever-more-costly imported gasoline and related carbon emissions.

“You can say that people in Korea don’t like American cars, but then you have to say why in nearby places people do seem to like them,” Mr. Goolsbee [Obama's economic advisor] said. He added, “The Koreans have designed a system that will prevent competition from a segment of the market that is different from what they produce, and that is a nontariff barrier.”

Pretty weak stuff - I don't think that argument would win a WTO case. This cheesy populism isn't exactly inspiring, but at least he hasn't (yet) suited up as a hockey goalie in a TV ad (as Bob Kerrey infamously did in 1992).

Update (6/18): At How the World Works, Andrew Leonard defends Obama against the charge of "protectionism."

The EU is Watching Out for You

Paul Krugman sees deregulatory ideology run amok as the culprit in food safety crises that have tomatoes being pulled off the shelves and Koreans protesting importation of US beef. He writes:

[H]ard-core opponents of regulation were once part of the political fringe, but with the rise of modern movement conservatism they moved into the corridors of power. They never had enough votes to abolish the F.D.A. or eliminate meat inspections, but they could and did set about making the agencies charged with ensuring food safety ineffective.

They did this in part by simply denying these agencies enough resources to do the job. For example, the work of the F.D.A. has become vastly more complex over time thanks to the combination of scientific advances and globalization. Yet the agency has a substantially smaller work force now than it did in 1994, the year Republicans took over Congress.

Perhaps even more important, however, was the systematic appointment of foxes to guard henhouses.

Thus, when mad cow disease was detected in the U.S. in 2003, the Department of Agriculture was headed by Ann M. Veneman, a former food-industry lobbyist. And the department’s response to the crisis — which amounted to consistently downplaying the threat and rejecting calls for more extensive testing — seemed driven by the industry’s agenda.

The primary market failure at work here is one of imperfect information - it is prohibitively costly for consumers to obtain detailed information about how every available food ingredient was produced (and, really, would you want to?) in order to make a judgment about the associated risks. In such cases, basic microeconomics tells us that the free market outcome is not optimal and government intervention - possibly through regulation (which is only effective if credibly enforced) - can be welfare-improving. That is, the "free market" view does not represent sound economics.

The same logic applies to the chemicals in everyday products. In the absence of effective government intervention, consumers may be taking greater than optimal levels of risk (i.e. we are taking chances we wouldn't if we had complete knowledge of what's in all that stuff we buy). The uncertainty could also have the effect of deterring consumers from buying products that are indeed perfectly safe (this is why credible regulation is good for producers).

While Washington may be asleep at the switch, the Brussels isn't, and one pleasant side-effect of globalization is that tougher EU regulation may benefit US consumers, or so suggests this fascinating Washington Post story:

Europe this month rolled out new restrictions on makers of chemicals linked to cancer and other health problems, changes that are forcing U.S. industries to find new ways to produce a wide range of everyday products.

The new laws in the European Union require companies to demonstrate that a chemical is safe before it enters commerce -- the opposite of policies in the United States, where regulators must prove that a chemical is harmful before it can be restricted or removed from the market...

Adamantly opposed by the U.S. chemical industry and the Bush administration, the E.U. laws will be phased in over the next decade. It is difficult to know exactly how the changes will affect products sold in the United States. But American manufacturers are already searching for safer alternatives to chemicals used to make thousands of consumer goods, from bike helmets to shower curtains.

The European Union's tough stance on chemical regulation is the latest area in which the Europeans are reshaping business practices with demands that American companies either comply or lose access to a market of 27 countries and nearly 500 million people.

From its crackdown on antitrust practices in the computer industry to its rigorous protection of consumer privacy, the European Union has adopted a regulatory philosophy that emphasizes the consumer. Its approach to managing chemical risks, which started with a trickle of individual bans and has swelled into a wave, is part of a European focus on caution when it comes to health and the environment.

Regulation in the US is weaker than you might think:

The EPA has banned only five chemicals since 1976. The hurdles are so high for the agency that it has been unable to ban asbestos, which is widely acknowledged as a likely carcinogen and is barred in more than 30 countries. Instead, the EPA relies on industry to voluntarily cease production of suspect chemicals.

"If you ask people whether they think the drain cleaner they use in their homes has been tested for safety, they think, 'Of course, the government would have never allowed a product on the market without knowing it's safe,' " said Richard Denison, senior scientist at the Environmental Defense Fund. "When you tell them that's not the case, they can't believe it."

Eep. Because the EU is a large market, it may make sense for producers to conform to their stronger regulations and therefore the same products sold here will live up to European standards. The bad news is that logic only applies insofar as the products are the same, which will depend on the marginal costs associated with producing up to EU standards (the fixed costs of developing products that can be sold there will likely worth bearing for multinationals) relative to the economies of scale gained from producing the same product for both markets.

There would be more incentive for producers to conform to European regulations if US consumers start to look for the CE mark which is used to label products that meet European standards.

Now, if only we could find a way to get the EU involved with our domestic food supply... (that is, Americans would feel much more confident eating Brussels sprouts if they are Brussels-certified).

Unemployment = 5.5%

Since I'm on the road, I haven't dug into the (bad) unemployment news, but Andrew Samwick has (he notes that a big part of the rise is due to increased labor force participation).

Transport Costs

I'm traveling (hence light blogging) and incurring transport costs - which won't deter my vacation, but may reduce world trade. This is an interesting topic of discussion amongst Menzie Chinn, Paul Krugman and Free Exchange.

Peak Guano?

The NY Times reports:

ISLA DE ASIA, Peru — The worldwide boom in commodities has come to this: Even guano, the bird dung that was the focus of an imperialist scramble on the high seas in the 19th century, is in strong demand once again.

Surging prices for synthetic fertilizers and organic foods are shifting attention to guano, an organic fertilizer once found in abundance on this island and more than 20 others off the coast of Peru, where an exceptionally dry climate preserves the droppings of seabirds like the guanay cormorant and the Peruvian booby...

Ironically, the birds that produce the guano eat the anchovies that caused inflation in the 1970s.

Gold Bars and a Shotgun

One occupational hazard of being an economist is getting asked for investment advice. I sometimes respond to such queries with a recommendation of "gold bars and a shotgun." I'm joking, of course (and trying to dodge the question), but the idea appears in a more serious form in Steve Waldmann's argument that the rise in commodity prices reflects a broader loss of confidence in financial assets:

It is common to invest in commodities as an "inflation hedge". If the central bank prints too much money, you need wheelbarrows to buy bread. If you have a sack of wheat, you will have your bread whatever the central bank does. But if everyone buys wheat, the price of grains will rise, even if the central bank does nothing at all.

Just as the fear of a bank's insolvency can precipitate a run that drives a bank to ruin, loss of confidence in a central bank can provoke a great inflation. The Federal Reserve, much I might criticize it, has not gone on a printing spree. It has lowered interest rates, and altered the composition of bank assets by replacing less liquid with more liquid securities. But the most these measures should do is bring us back, monetarily speaking, to the status quo ante, back to a year ago when asset-backed securities were liquid. The Fed's actions are best described as antideflationary, not inflationary.

But confidence is a funny thing. Central bankers are supposed to be dour and dependable. The current crop is not. Rather than "taking away the punchbowl", central bankers have become the life of the party. Japan's central bankers hand out Yen like free acid. China's guy will give you a microwave oven and a DVD player if you draw him a picture (and sign Henry Paulson's name to it). Our man Ben is an Amadeus-cum-Macguyver, he's brilliant, unpredictable, he'll improvise a Delaware company from paper clips and vacuum up your derivative book with a toenail clipper. Even the ECB's Trichet, who at first comes off like a sourpuss, turns out to be alright, when you've got some Spanish mortgages to pawn.

Some of us think that something's wrong, and these guys we're drinking with aren't serious enough to fix it. We know that trillions of dollars in presumed housing wealth have disappeared, but we don't know who's ultimately going to bear the loss. Americans know that as a nation, we cannot afford our clothes, furniture, or gas, unless the people who are selling it to us lend us our money back. Economists fret about "imbalance" and "adjustment", but we've yet to see a serious plan, other than let's-keep-this-party-going.

So, we lose faith. When we lost faith in Northern Rock, Bear Stearns, Citigroup, or Lehman, the central bankers stepped into the fray, and stood behind them. So, we ask, who stands behind the central bankers? We take a peek, and all we see is our own money. Which we quickly start exchanging for something else.

Although commodity prices have been increasing for years, you'll notice that the very sharp run-up began last summer, at roughly the same time as the credit crisis. Commodities soared when interest rates were still high, but predicted to fall. Commodities are soaring today, even though US interest rates are now predicted to rise. Commodities have soared in euro terms, despite the ECB's refusal to drop interest rates....

But claims on future money are only promises, easily broken or devalued. A run on central banks, a flight from financial assets to stored goods, sacrifices the hope of future abundance for certain present scarcity. Governments can shut futures exchanges, confiscate gold, ban "hoarding, profiteering, and price-gouging". People will hoard anyway if they don't believe in the paper. People are losing faith in financial assets for good reason. Rather than organizing productive economies, the machinery of finance has recently functioned as an anesthetic, masking the pain while resources were mismanaged and stolen. We need a solid financial system, but confidence cannot be imposed or legislated. It will have to be earned. There has to be a plan. Earnest promises to do better soon won't suffice. Nor will yet another drink from the punch bowl...

His sentiments are seconded and amplified by Yves Smith, who writes:

In times of crisis, people look to leaders for guidance. But in our prevailing doctrine of free markets, there are no leaders, just agents interacting in ways purported to produce virtuous outcomes. And the parties who ought to step into the breach fail to understand the need for that role right now. That is why an old fashioned (and very tall) banker like Volcker is so reassuring. He handled a crisis; he's not afraid to take the reins or say things are bad and changes are needed.

We are at the end of a paradigm: large scale OTC markets, lightly regulated players and instruments, dollar as reserve currency, US as the most important global economic actors...

Hmmm... It is useful to remember the economic purpose of the financial system - to channel savings by households into investment by firms. Deep, liquid markets with lots of people trading lots of different types of assets can facilitate that function. However it does sometimes seem like the growth of resources devoted to finance - and the rewards of its practicioners - has outrun its economic purpose. Recent events (and the corporate financial scandals of 2000-01) have reminded people of the instability and market failures inherent in the financial system. So, yes, it is perhaps time for soul-searching, even angst, in the world of finance....

But that does not mean the gloom extends to the real economy... there are plenty of non-trivial problems, to be sure, but nothing (yet) compared to the early 1980's. The financial sector may be nostalgic for the Volcker era, which arguably marked the beginning of a long boom for finance, but the real economy suffered severely from the high real interest rates and strong dollar and the ill-fated dalliance with monetarism hardly seemed like commanding leadership at the time.

So where should you put your savings in times like these? I have no idea.

NB: OTC: over the counter.

Socratic Solow

Brad DeLong reflects on a semester's teaching with a socratic dialogue on the Solow model; an excerpt:

Akhilleus: So why are you morose then?

Glaukon: Because, looking back over my syllabus this semester, I realized that I spent five full weeks--one third of the semester--teaching them the Solow growth model...

Khelona: It's a fine model...

Glaukon: And yet when the rubber hits the road, it doesn't do us any good. It doesn't tell us anything first-order about the world--aside from post-WWII Japanese convergence from a bouncing-rubble B-29 testfield to a prosperous OECD economy.

Khelona: Actually, I don't think the Solow growth model explains that...

Glaukon: You don't?

Khelona: Post-WWII Japan converged to the OECD norm. And the Solow growth model has some convergence in it--if you start out really poor because your economy's capital stock has been turned into rubble or worse by B-29 strikes, you will grow fast because a low capital stock gives you a high social marginal product of investment and depreciation cannot be a drag on growth if there is no capital to depreciate. But these have always struck me as second- or third-order mechanisms in the story of post-WWII economic growth. Trade. Technology transfer. Institutional reform. The survival of the economic-mobilization components of the fascist Tojo dictatorship. The destruction of the other components of the fascist Tojo dictatorship. The ability of large firms to strike high-productivity bargain with their core workforces by shifting risks onto small-scale producer-suppliers and secondary-sector workers. The neocolonial origins of comparative development--that for Cold War-fighting reasons the U.S. was willing to cut Japan an enormous amount of slack in terms of market access that it was not willing to cut Mexico or Argentina or anyone else outside NATO. You know the story. You know the story better than I do.

Glaukon: Great! So now you've depressed me further--you have gotten me down from one example of the model at work telling us something interesting down to zero....

I also had my students spend quite a bit of time - though not quite a third of the semester - on the Solow model, and I have no regrets. This is partly for the reasons expressed a while back by YouNotSneaky!, who also had the classics on the mind, in a post titled "Socrates would have taught the Solow model":

Socrates thought there were two, maybe three, kinds of people in the world and that you could arrange them in a hierarchy;

1. Those who don't know but think they know.
2. Those who don't know but know they don't know.

and then maybe some lucky ones;

3. Those who know and know they know.

There aren't many people in the 3rd category. But for some reason we always expect our models to move us from the 2nd category to the 3rd. And we're not satisfied if the movement is from the 1st to the 2nd.

The Solow model basically says that "it ain't capital accumulation" which is the cause of sustained growth, it's something else, the magical so called "Solow residual" .....

There've been many people over the years that've concluded that since the Solow model doesn't "explain" growth (because it lumps its major cause into an exogenous residual) it is useless and only an excercise in mathematics.

But people! When you thought you knew (it's capital accumulation!) and then you learn that you don't know (it can't be capital accumulation!) you've learned something just as important and valid as if you've acquired a "positive knowledge"....

Moses Abramowitz called the Solow residual a "measure of our ignorance" - and that is indeed a useful thing. I've posted previously on the joys of growth accounting (measuring the residual).

The Solow model is somewhat unsatisfying because it (i) attributes growth to an exogenous constant and (ii) it does not do a good job of explaining the vast differences in incomes between countries. But it is invaluable as a starting point for teaching economic growth because

• It forces students to really learn some key economic concepts, like:
• the implications of diminishing marginal returns
• the difference between levels and growth rates
• The subsequent research on economic growth - endogenous growth theory and the neoclassical counter-reformation as well as the renewed emphasis on institutions (which admittedly is not really new) - can be understood as attempts to resolve the dissatisfaction due to (i) and (ii).

So while Solow doesn't really answer the questions that we would like growth theory to answer, it is tremendously useful for learning some economics and about how economics works.