Reminder: Globalization Not Inevitable

The conflict in Georgia prompts Paul Krugman to issue a gloomy reminder in his column this morning that globalization is not new, nor is it inevitable:

Writing in 1919, the great British economist John Maynard Keynes described the world economy as it was on the eve of World War I. “The inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth ... he could at the same moment and by the same means adventure his wealth in the natural resources and new enterprises of any quarter of the world.”
And Keynes’s Londoner “regarded this state of affairs as normal, certain, and permanent, except in the direction of further improvement ... The projects and politics of militarism and imperialism, of racial and cultural rivalries, of monopolies, restrictions, and exclusion ... appeared to exercise almost no influence at all on the ordinary course of social and economic life, the internationalization of which was nearly complete in practice.”
But then came three decades of war, revolution, political instability, depression and more war. By the end of World War II, the world was fragmented economically as well as politically. And it took a couple of generations to put it back together.
So, can things fall apart again? Yes, they can.

Inefficient Labor Market Outcomes (NY Yankee Edition)

One point made by Keynes is that the classical assumption that labor supply is based on the marginal disutility of working ignores the fact that people care about their relative wages. For example, SI's John Heyman reports:

Saw a headline the other today in an NY paper: "Pavano Solid.'' And I can't think of any bigger waste of space. To learn what Pavano's about, read John Feinstein's interesting book Living on the Black, about Mike Mussina and Tom Glavine. In one story, when Mussina was offered slightly less than $10 million a year in a new contract by the Yankees, he told Cashman, "I can't be paid less than Pavano,'' or words to that effect, and Cashman understood completely. Mussina was then paid $11.5 million a year, or slightly more than the sedentary Pavano.

Keynes (General Theory, ch. 2):

Though the struggle over money-wages between individuals and groups is often believed to determine the general level of real-wages, it is, in fact, concerned with a different object. Since there is imperfect mobility of labour, and wages do not tend to an exact equality of net advantage in different occupations, any individual or group of individuals, who consent to a reduction of money-wages relatively to others, will suffer a relative reduction in real wages, which is a sufficient justification for them to resist it....

In other words, the struggle about money-wages primarily affects the distribution of the aggregate real wage between different labour-groups, and not its average amount per unit of employment, which depends, as we shall see, on a different set of forces. The effect of combination on the part of a group of workers is to protect their relative real wage. The general level of real wages depends on the other forces of the economic system.

Of course, the marginal product of Mussina's labor is way, way higher than Pavano's (a fixed nominal contract the Yankees surely regret).

Details of the Housing Bill

The Onion explains with an "info-graphic."

(Can't Get No) Stimulation

Contrary to stereotype, Americans saved most of the fiscal stimulus checks they received earlier this year, according to Michigan's Shapiro and Slemrod, who write for Real Time Economics:

Data for May and June suggest that the rebate payments provided by the Economic Stimulus Act of 2008 may not yet have provided much of a boost to consumption. The increase in personal saving in May and June approximately matched the size of the rebate checks in those months.

Here are the official numbers from the Bureau of Economic Analysis. Personal saving was $45.6 billion in May, compared to $48.1 billion in stimulus payments in May. Personal saving in June was $23.0 billion, compared to $27.9 stimulus payments in June. In stark contrast, personal saving averaged only $2.9 billion per month during the first four months of the year.

The personal saving rate tells the same story. After running under 0.5% during the first four months of 2008, it jumped to 4.9% in May and 2.5% in June. The change in the personal saving rate corresponds closely to the size of the rebate as a percentage of disposable income. The figure shows how most of the rebate payments appear to have gone straight into saving.

The fact that personal saving jumped by nearly as much as the increase in stimulus payments suggests that most of the rebate checks were saved, at least temporarily, but does not establish it definitively because we cannot be sure what the level of personal consumption expenditures would have been without the rebate checks. If personal consumption expenditures would have collapsed absent the stimulus payments while personal disposable income would have held steady, then the personal saving rate would have spiked up in May and June in any event, and its sharp rise when the rebates arrived does not then indicate that most of the rebate payments were saved.

That most of the rebate checks were saved is, though, consistent with the results we find using the University of Michigan Survey of Consumers. When consumers were asked whether their stimulus check would lead them to “mostly spend, mostly save, or mostly pay down debt,” only 18% answered that it would lead them to mostly spend more.

For those keeping score: that appears roughly consistent with the permanent income hypothesis, or perhaps Ricardian equivalence, but not the Keynesian consumption function. One caveat: as Shapiro and Slemrod note, we can't assume savings rates would have remained constant. Or, well, economists can assume whatever we want of course, but its not necessarily correct - negative shocks to household wealth (housing market) and expected future income (sluggish economy), if unanticipated, would have led people to save more. So the stimulus "worked" to the extent consumption spending was higher than it otherwise would have been, and to the extent this had a multiplier effect. Therefore, we need a structural model to estimate the counter-factual (i.e., the Lucas critique applies). In any case, as Shapiro and Slemrod note (and some argued at the time), one way to make sure the money is spent is for the government to spend it directly.

Andrew Samwick notes:

So, in the cold light of day, what happened with the rebates was that the government issued more debt than it would otherwise have issued, and consumers now hold less debt than they otherwise would have. That looks like a shifting of liabilities from individual balance sheets to the government balance sheet. In other words, it was a bailout of consumer debt.

Of course, our government's liabilities are our liabilities, but they carry a lower rate of interest than household debt, so we are saving on interest and since we are net borrowers from the rest of the world, that does represent a net national saving, rather than just a redistribution (its sort of like one of those "loan consolidations" where you combine your bills into "one low monthly payment"). There is a redistributional impact, though, to the extent that the future tax code is progressive, a larger share of debt will be paid by higher-income households.

In the Journal a few days ago, Martin Feldstein opined that the policy (which he had supported) was a flop. That generated a number of responses, nicely rounded up and added to by Mark Thoma.

Slugged by a Sluggish Economy

Last week's economic data releases, the GDP numbers from the BEA, and unemployment from the BLS, were consistent with an economy growing sluggishly (and thereby skirting an official "recession") but too slowly to keep unemployment from rising.

Real GDP growth came in at an annual growth rate of 1.9% for the second quarter (April-June), and the unemployment rate increased again, to 5.7% for July (up from 5.5% in June):
(GDP growth: blue line, left scale; unemployment: red line, right scale).

In the second quarter, GDP growth was driven by increases in exports (9% annual rate) and decreases in imports (-6.6%); hooray for the declining dollar! An increase in federal government purchases (6.7%) also gave a boost. New housing construction (a.k.a. "residential fixed investment," -15.6%) continued to plummet, and, while overall consumption was up, durable goods expenditures fell at a 3% annual rate (as reflected by the car industry's woes). As James Hamilton noted at Econbrowser, one silver lining in the report was a negative contribution from "inventory investment," which suggests firms have less stuff laying around and will need to produce more in the future.

The GDP release included the "annual revisions": now the BEA estimates that growth was indeed negative during the fourth quarter of last year (-0.2% vs. previously estimated 0.6% annual rate; this is not evident on the graph above since it plots % change from 1 year ago) and overall growth for 2007 is now pegged at 2.0% (previous estimate: 2.2%).

As for the labor market, this NY Times story about workers who are reduced from full- to part-time reminds us the unemployment rate does not tell the whole story. Brad DeLong recommends another series, "U-6 Total unemployed, plus all marginally attached workers, plus total employed part time for economic reasons, as a percent of the civilian labor force plus all marginally attached workers," which the BLS explains:

Marginally attached workers are persons who currently are neither working nor looking for work but indicate that they want and are available for a job and have looked for work sometime in the recent past. Discouraged workers, a subset of the marginally attached, have given a job-market related reason for not currently looking for a job. Persons employed part time for economic reasons are those who want and are available for full-time work but have had to settle for a part-time schedule.

Based on this measure (above), which rose to 10.3% in July, DeLong calls a "recession."

Find the Cost of Freedom

and represent it with nifty graphics. These graphs of the costs of US wars were created by ProPublica (hat tip: M. Yglesias).
Adjusted for inflation, the Iraq war is the third most expensive in US history:But as a share of GDP it is a relatively small one:
(that is the share of GDP in the year the war costs peaked)
That is, because of economic growth, the US is a much richer country which can afford (financially, at least...) more of everything, including war.

Core Inflation and Inflation Targeting

As I mentioned recently, inflation doesn't look nearly as scary if one focuses - as the Fed does - on "core" inflation, which excludes food and energy prices. Some Fed critics - e.g., Willem Buiter - seem to see core inflation as an excuse for going soft. Here is a counter-argument from NYU's Mark Gertler - a co-author of Bernanke's back in his academic days - defending the Fed's focus on "core" inflation in the FT:

Why care about headline inflation versus core inflation? Simply put, a sustained move of headline inflation to the levels of the 1970s is unlikely without an accompanying increase in the core component. The reason is simple: although they can be highly persistent, rapid increases in the relative prices of energy and food cannot go on indefinitely. Once this process dies down, as long as core inflation remains anchored, headline inflation must converge to it.

One criticism of using a core measure is that higher overall (or "headline") inflation feeds into inflationary expectations, which, in turn, influence wage and price setting behavior. Gertler addressed this issue:

Could it be that high headline inflation is unmooring inflation expectations, leading us back to the 1970s through this painful route? Some measures of inflation expectations are edging upwards. This needs to be taken seriously. However, where we should expect the impact of increasing expectations to show up is exactly in the behaviour of core prices and wages.

So far this is not happening. Not only has core inflation remained stable but the growth in nominal unit labour costs, on which most pricing of core items is based, also remains benign. It may very well be that the Fed’s reputation for keeping core inflation stable has kept the expectations relevant for price- and wage-setting in line. Also relevant is that, at least to date, wage- setters appear to understand that, however unfortunate, the relative increase in energy and food prices is something beyond the central bank’s control that they must live with.

Fed governor Frederic Mishkin (also a Bernanke co-author), who is leaving for Columbia University, seems a little more concerned about the expectations issue. In his last speech as a Fed official, Mishkin argued that explicit inflation targets - such as that of the European Central Bank - help stabilize, or "anchor" expectations:

[T]here is substantially greater disagreement in long-run inflation forecasts for the United States than for the euro area. As shown in figure 2, the standard deviation of U.S. inflation forecasts at each survey date is higher than the standard deviation of corresponding euro area inflation forecasts. Moreover, the degree of dispersion in the views of individual forecasters has gradually declined towards negligible levels for the euro area but not for the United States. One obvious interpretation of these patterns is that professional forecasters in the United States are less certain about the Federal Reserve's longer-term inflation goal.

That uncertainty may also explain differences in the behavior of inflation compensation as implied by the gap between nominal and real yields on long-term bonds. Figure 3 depicts far-forward inflation compensation (that is, the one-year-forward rate nine years ahead) for the United States and the euro area. Inflation compensation, sometimes referred to as "breakeven inflation," reflects not only inflation expectations but also a premium that compensates for uncertainty about inflation outcomes at the specified horizon. Evidently, far-forward inflation compensation for the euro area displays much smaller fluctuations than for the United States, consistent with greater stability of inflation expectations and a lower degree of uncertainty about longer-run inflation outcomes. Moreover, regression analysis confirms that U.S. far-ahead forward inflation compensation exhibits statistically significant responses to surprises in macroeconomic data releases--consistent with the view that market participants are continuously revising their views about the longer-run outlook for U.S. inflation. In contrast, euro-area inflation compensation does not respond significantly to economic news.

Mishkin goes on to suggest that inflation targeting does not result in worse performance in terms of stabilizing output:

One concern might be that these benefits in anchoring inflation expectations could come at the expense of the performance of output growth. However, the empirical evidence suggests that central banks with explicit inflation goals do not have worse output performances than central banks, such as the Federal Reserve, that have not specified an explicit numerical goal for inflation.

So far, this is true, but inflation targeting is relatively new, so I think it is too soon to tell (perhaps a good research topic a few years from now...).

Mishkin did not address the issue of which inflation measure to use, though all of the current inflation targeters use headline inflation. His strategy for implementation is for the Fed to incorporate a target into its long-run forecast:

In light of these considerations, I would like to suggest several specific modifications to the Federal Reserve's current communication strategy.

• First, the horizon for the projections on output growth, unemployment, and inflation should be lengthened. This change might involve simply an announcement of FOMC participants' assessment of where inflation, output growth, and unemployment would converge under appropriate monetary policy in the long run. Alternatively, the horizon for the projections could be extended out further, say to five or more years.
• Second, FOMC participants should work toward reaching a consensus on the specific numerical value of the mandate-consistent inflation rate, and this consensus value should be reflected in their longer-run projections for inflation.
• Third, the FOMC should emphasize its intention that this consensus value of the mandate-consistent inflation rate would only be modified for sound economic reasons, such as substantial improvements in the measurement of inflation or marked changes in the structure of the economy.

If the deviations between core and non-core inflation induced by oil price fluctuations, etc., are indeed transitory (i.e. they die out in a shorter time period than the forecast horizon) there is no tension between tolerating headline inflation spikes in the short run and stabilizing it in the long run. However, a commitment to "long run" inflation targeting which allows substantial "short run" deviations seems rather squishy, and I wonder if it really would earn the Fed the additional credibility that true inflation targeters have.

There Will Be Subsidies

An interesting report from the Times' Keith Bradsher on oil subsidies in developing countries:

From Mexico to India to China, governments fearful of inflation and street protests are heavily subsidizing energy prices, particularly for diesel fuel. But the subsidies — estimated at $40 billion this year in China alone — are also removing much of the incentive to conserve fuel.

The oil company BP, known for thorough statistical analysis of energy markets, estimates that countries with subsidies accounted for 96 percent of the world’s increase in oil use last year — growth that has helped drive prices to record levels.

The subsidies prevent the price mechanism from working in a significant part of what is a global market, therefore the adjustments of price and quantity demanded must be larger elsewhere.

I would suspect that policymakers in these countries realize these subsidies are bad policies - indeed, the article describes how many countries are raising prices, but their price increases are falling short of the increase in world prices, so the costs to the governments are nonetheless increasing, even as citizens protest higher prices.

Is Preferential Trade Freer Trade?

Not everything with the word "free trade" in it really represents genuine trade liberalization. In particular, regional (or "preferential") trade agreements among pairs or small groups of countries, like NAFTA or the pending deals between the US and Colombia and Korea are criticized by some true free traders.

Some see these deals as distractions from the multilateral WTO negotiations (which currently continue to be very much bogged down), and, in theory, they can reduce economic efficiency through trade diversion (e.g. if Taiwan is a more efficient producer of monitors than Korea, if our tariff treatment of the two countries is the same, we will import monitors from Taiwan, but if we lower trade barriers preferentially with Korea, they may end up producing our monitors). One of the leading critics of preferential trade agreements from a free trade perspective is Jagdish Bhagwati - see this Economists' View post about his book "Termites in the Trading System." On the other hand, Richard Baldwin has argued that the WTO needs to embrace the "spaghetti bowl" of regional trade agreements (see also, this Economist article).

Perhaps free traders should not worry too much. At VoxEU, Antoni Estevadeoral, Caroline Freund and Emanuel Ornelas summarize their recent research on preferential trade agreements. They find that:

Our results imply that regionalism is a building bloc to free trade. There is no clear evidence that trade preferences lead to higher tariffs or smaller tariff cuts. There is strong evidence that preferences induce a faster decline in external tariffs in free trade areas. For example, if a country that follows a strict policy of non-discrimination offers free access to another country in a sector where it applies a 15% multilateral tariff, the country would tend to subsequently reduce that external tariff by over 3 percentage points. This complementarity effect is stronger in sectors where trade bloc partners are more important suppliers, precisely where trade discrimination would be more disrupting.

Exchange Rates Are Predictable

in the long run, but not in the short run (so reading this won't help you make any money...). That's one of the points made by this useful recent Dallas Fed Economic Letter surveying exchange rate economics, "Why Are Exchange Rates So Difficult to Predict," by Jian Wang.

One relationship that works well in the long run is purchasing power parity (PPP), which says when one currency is exchanged for another, the ability to purchase goods and services forgone in one country should be equal to the purchasing power gained in the other. A well-known example is The Economist's Big Mac index. According to this measure, the British pound is overvalued (i.e. too expensive) relative to the dollar because a Big Mac costs, on average, $3.57 in the US, and £2.29 in Britain, but $3.57 (i.e., enough to by a Big Mac in the US) exchanged into pounds at the exchange rate of $2 per £ would only give £1.79, not enough to buy a Big Mac in Britain.

The Economist has a chart of the latest update of the index (alongside a very distressed-looking - Grimace-ing? - Ronald McDonald). The Norwegian Kroner is the most over-valued currency, with the Euro, Swiss Franc and Argentine Peso (!) also among the dear ones. On the other side, the currencies that are cheaper than their Big Mac parity values include the Yen, Rouble and Yuan.

Of course, "purchasing power" is more than Big Macs (hopefully!), but since national price indexes are made up of many different goods with different weights, etc, making a similar calculation with a complete bundle of goods and services is highly impractical, so we turn to the "relative" form of PPP, which links changes in exchange rates to changes in price levels (i.e. inflation rates). If the exchange rate, e, is the "home" price of "foreign" currency, and ph and pf denote the home and foreign price levels, respectively, relative PPP says %Δe = %Δph - %Δpf.

A bit of my own research helps illustrate that this works well in the long run:


The real exchange rate is q = e x pf/ph, so if relative PPP holds, %Δq = %Δe + %Δpf - %Δph = 0, which means the graph should be a straight line if it holds constantly. Clearly it doesn't: there are substantial and persistent deviations from PPP, but they do tend to die out, and, remarkably, the total change from January, 1794 to December, 2005 is about 3%.

PPP is one of the tools used by Agnes Benassy-Quere, Sophie Bereau and Valerie Mignon to ponder the Euro-Dollar rate at VoxEU. They write:

In the “very long run”, the real exchange rate (the relative price of the same basket of goods across two countries) is expected to come back to a constant level, due to the convergence of the prices of both traded goods (due to international arbitrage) and non-traded goods (due to productivity equalisation all over the world). In the jargon, this is called purchasing power parity, and it acts as a very long run attractor.

They believe this implies "in the long and very-long run, the equilibrium value of the euro [currently $1.57] is found much lower – around 1.10. Thus, our work suggests that the euro may have peaked and be due to fall."