On the "Floor System"

Now that the Fed is paying interest on deposits, and doing so at the Fed funds target rate, much of what I tell students about how monetary policy works is out the window.  This Macroblog post on "the changing operational face of monetary policy" by David Altig looks like a good place to start when I re-write my lecture notes.

Are the Wheels Coming Off?

A couple of weeks ago, amid talk (now quiet) of a federally-aided Chrysler-GM merger, the Washington Post's Steven Pearlstein made the case that letting the companies go into bankruptcy would provide them the opportunity for necessary restructuring:

The real flaw in the government-financed merger proposal is that it spares the companies from bankruptcy reorganization, the very process they need to get their costs and structure in line with market realities.

Only a bankruptcy court can reduce the burden of pension and health benefits to 600,000 retirees that are slated to cost the companies $90 billion over the next decade.

Only a bankruptcy court can override the state laws that make it difficult and expensive for Chrysler and GM to pare back a combined network of 10,000 dealerships, about 10 times more than Toyota has in the United States.

And only a bankruptcy court can impose on members of the United Auto Workers pay and benefit packages comparable to those paid at the nonunionized plants of foreign manufacturers that have been stealing market share from the Big Three for decades.

However, the New Republic's Jonathan Cohn writes that the financial crisis means a liquidation would be the likely outcome of a GM bankruptcy:

In order to seek so-called Chapter 11 status, a distressed company must find some way to operate while the bankruptcy court keeps creditors at bay. But GM can't build cars without parts, and it can't get parts without credit. Chapter 11 companies typically get that sort of credit from something called Debtor-in-Possession (DIP) loans. But the same Wall Street meltdown that has dragged down the economy and GM sales has also dried up the DIP money GM would need to operate.

That's why many analysts and scholars believe GM would likely end up in Chapter 7 bankruptcy, which would entail total liquidation. The company would close its doors, immediately throwing more than 100,000 people out of work. And, according to experts, the damage would spread quickly. Automobile parts suppliers in the United States rely disproportionately on GM's business to stay afloat. If GM shut down, many if not all of the suppliers would soon follow.

In that sense, GM, like Bear Stearns, is "too interconnected to fail" - think of the parts suppliers and dealers as "counterparties." Furthermore, the unemployment generated by a GM liquidation would have some serious "aggregate demand externalities." While there is some merit in Perlstein's argument for chapter 11, it is hard to believe the benefits would not outweigh the costs of an intervention at least to the extent necessary to ensure that any bankruptcy would be a restructuring rather than a liquidation (e.g., providing a guarantee for DIP financing).

Cohn's piece also has some useful debunking of outdated stereotypes about the US auto industry. Unfortunately some - e.g., Thomas Friedman - persist in believing that the industry's problems arise mainly from a myopic over-reliance on trucks while Toyota virtuously purveys hybrids (GM and Ford also make small cars and hybrids - and the Chevy Volt is coming soon - while Tundras and Highlanders can be found along with the Priuses on Toyota lots).

While there may be a grain of truth in it, what is missing from that line of argument is that much of the real financial burden on the automakers is the legacy of the American system of relying on companies to provide welfare state benefits like pensions and medical care. This certainly has put older US manufacturing firms at a disadvantage relative to newer firms, "transplants," and foreign factories (the fact that Ontario surpassed Michigan in auto production is partly attributable to health care costs). Rather than criticize the automakers for treating their workers too well, perhaps we should recognize that their problems partly stem a history of filling the gaps left by US social policy.

Although some strings should certainly be attached to any Federal money, suggestions like this (from Friedman) should be viewed warily:

Any car company that gets taxpayer money must demonstrate a plan for transforming every vehicle in its fleet to a hybrid-electric engine with flex-fuel capability, so its entire fleet can also run on next generation cellulosic ethanol.

There is a serious need to reduce carbon emissions and energy use in transportation. The way to do so is not to force automakers to make different cars that nobody wants, but to get consumers to want them. The simplest way to do this would be to raise the gasoline tax (or, more broadly, a carbon tax). The automakers - domestic and foreign - respond to consumer demand; vehicles have gotten larger because people wanted them that way, and they can get smaller and more efficient for the same reason.

Bob Herbert draws a parallel with the New York near-bankruptcy in the 1970's, where the federal government did ultimately intervene, after the Daily News ran the famous headline "Ford to City: Drop Dead."

Full disclosure: I grew up in the Detroit area (Jonathan Cohn is from Michigan, too) where one of the local TV stations used to run adds exhorting us to "stand up and tell 'em you're from Detroit." Moreover, I'm looking forward to the new, smaller Cadillac that should be available by the time the lease is up on my current (um... well... Japanese...) car; if the policymakers get it right, there might be a turbodiesel version.

Update (11/16): The Economist's story assumes chapter 11 would be available, but has some reasons why that could be worse than you might think.

Update #2 (11/17): Jeff Sachs wants a Volt. See also Felix Salmon. Hmm... I'm starting to think it may just be my patriotic duty to buy a Solstice GXP Coupe.

Update #3 (11/17): I find this speculation to be implausible, but it would be a silver lining to Detroit's woes.

Update #4 (11/18): Autoworkers do not make $70 an hour, as Felix Salmon explains.

Issue the Go Code for Plan S

Paul Krugman guesstimates that we need a $600 billion stimulus:

So what kinds of numbers are we talking about? GDP next year will be about $15 trillion, so 1% of GDP is $150 billion. The natural rate of unemployment is, say, 5% — maybe lower. Given Okun’s law, every excess point of unemployment above 5 means a 2% output gap.

Right now, we’re at 6.5% unemployment and a 3% output gap – but those numbers are heading higher fast. Goldman predicts 8.5% unemployment, meaning a 7% output gap. That sounds reasonable to me.

So we need a fiscal stimulus big enough to close a 7% output gap. Remember, if the stimulus is too big, it does much less harm than if it’s too small. What’s the multiplier? Better, we hope, than on the early-2008 package. But you’d be hard pressed to argue for an overall multiplier as high as 2.

When I put all this together, I conclude that the stimulus package should be at least 4% of GDP, or $600 billion.

Here's another reason why $600 billion is a good number: it is bigger than China's recently announced $586 billion stimulus. We must not allow a stimulus gap!

(reference explained here; of course as a % of GDP, China's plan is much bigger....)

G-2

On the eve of a global summit about the financial crisis, the words "Bretton Woods" are appearing with more than usual frequency (this seems to be international analogue to all the domestic FDR talk). In the FT, Stanford's Ronald McKinnon notes that the Bretton Woods negotiations were essentially a bilateral haggle between the US and Britain. Now, he argues, the real bargain to be struck is between the US and China:

To deal with the global crisis, how should the US and Chinese governments proceed?

First, the US should stop China-bashing in several dimensions. In particular, the PBC should be encouraged to stabilize the yuan/dollar exchange rate at today’s level­, both to lessen the inflationary overheating of China’s economy and to protect the renminbi value of its huge dollar exchange reserves.

Since July 2008, the dollar has strengthened against all currencies save the renminbi and the yen, and the PBC has stopped appreciating the RMB against the dollar. So now is a good time to convince the Americans of the mutual advantages of returning to a credibly fixed yuan/dollar rate.

There is a precedent for this. In April 1995, Robert Rubin, then US Treasury secretary, ended 25 years of bashing Japan to appreciate the yen­ and announced a new strong dollar policy that stopped the ongoing appreciation in the yen and saved the Japanese economy from further ruin.

But this policy was incomplete because the yen continued to fluctuate, thus leaving too much foreign exchange risk within Japanese banks, insurance companies, and so forth, with large holding of dollars. This risk locks the economy into a near zero interest liquidity trap.

Second, after the PBC regains monetary control as China’s exchange rate and price level stabilize, the Chinese government should then agree to take strong measures to get rid of the economy’s net saving surplus that is reflected in its large current account and trade surpluses.

This would require some combination of tax cuts, increases in government expenditures, increased dividends from enterprises so as to increase household disposable income, and reduced reserve requirements on commercial banks.

Then, as China’s trade surplus in manufactures diminishes, pressure on the American manufacturing sector would be relaxed with a corresponding reduction in America’s trade deficit. Worldwide, the increase in spending in China would offset the forced reduction in U.S. spending from the housing crash.

The new stimulus announced by China is potentially a huge step towards increasing China's domestic demand - i.e., getting rid of the net saving surplus. Meanwhile, the large slowdown in consumer spending in the US reduces the net saving deficit (though government spending should, at least temporarily, make up much of the gap). So there are indications of a non-exchange rate driven rebalancing (i.e., closing of China's current account surplus and America's deficit).

While McKinnon is correct that it is a good thing to take some of the pressure off exchange rates to do all adjusting, fixing the exchange rate would completely close off this channel and leave the Yuan undervalued. Furthermore, intervening to keep the exchange value of the Yuan low is what has been interfering with the PBC's domestic monetary control.

Because China has piled up so many Dollar-denominated assets, it is understandable that they would like to protect their value in Yuan terms (i.e., prevent a big Yuan appreciation...), and a nod in this direction may be part of an international negotiation, but fixing the Yuan-Dollar rate only seems to defer a necessary adjustment.

Update (11/10): Arvind Subramanian offers nearly opposite policy advice; he would have the WTO go after countries that keep their currencies undervalued (he proposes some carrots to get China to go along).

Q: How Many Hondurans

does it take to screw in a light bulb?

A: None, they get Hugo Chavez to pay for Cuban technicians to do it for them.

So I learn from The Economist, which reports:

Venezuela has offered to buy Honduran bonds worth $100m, whose proceeds will be spent on housing for the poor. Mr Chávez has also offered a $30m credit line for farming, 100 tractors, and 4m low-energy light bulbs (Cuba will send technicians to help to install them, as well as more doctors and literacy teachers.)

Not Since the Depression?

The Washington Post's Dan Balz writes:

After a victory of historic significance, Barack Obama will inherit problems of historic proportions. Not since Franklin D. Roosevelt was inaugurated at the depths of the Great Depression in 1933 has a new president been confronted with the challenges Obama will face as he starts his presidency.

Hmm... unemployment is currently at 6.1%; I wouldn't be surprised to see it rise by January, but it is unlikely to be much worse than when Clinton was inaugurated in Jan. 1993 (7.3%) or when Reagan took office in Jan. 1981 (7.5%).

Financial crises occur with some regularity; this may be the worst since the depression, but Clinton and Reagan faced other problems.

When Clinton took office, the Federal budget deficit was over 4% of GDP and investment was slumping. The deficit has re-emerged as a problem recently, but it has not reached the chronic severity of the 1980's and 1990's, when it became a central political issue (remember Ross Perot and Paul Tsongas?).

Inflation was in double-digits when Reagan entered office, and the Volcker Fed had embarked on a painful effort at disinflation which entailed extremely high interest rates (the Fed Funds rate exceeded 19% at a couple of points in 1980 and '81).

So, yes, problems of "historic proportions" await President-Elect Obama: he will confront problems of roughly similar proportions to those faced by other Presidents in recent history. I'd guess a little worse than '93 but not as bad as '81. We didn't start the fire...

Update: Floyd Norris on the Reagan parallel.

Update #2 (11/7): Unemployment rose to 6.5% in October. The level is still modest by historical standards, but the change looks bad, according to Krugman:

The unemployment rate has now risen more than 2 percentage points from its pre-recession low. In 1990-1992 the unemployment rate rose 2.6 percentage points. Given what’s happening to retail sales, manufacturing, and so on, it’s now a certainty that unemployment has a lot further to rise. So the “worst recession in 25 years” thing is now baked in. The only question is whether we hit “worst slump since the Great Depression” territory.

The unemployment rate rose from 4.6% in October 1973 to 9% in May 1975 and from 5.6% in May 1979 to 10.8% in November 1982, increases of 4.4 and 5.2 points respectively. If we take this cycle's pre-recession low as 4.4% in March 2007, we need to get to 9.6% to be in "worst since the depression" territory by the change metric, and 10.8% by the level metric. Either way, still a long way to go (yes, I am ignoring underutilization; this is important but the data don't go back as far. I would expect that the trends would be similar, though; i.e. that past recessions also saw increases in underemployment).

Update #3 (11/9): Justin Fox notes that the combined September-October job loss amounts to 0.38% of total employment.

Democratic Econ Policy Kumbaya

When President Clinton took office, he was forced to choose between keeping campaign promises of more public investment and middle-class tax cuts or focusing on deficit reduction. The conflict played out among his advisors, with Robert Reich representing the former "traditional Democratic" view and Robert Rubin taking the "Eisenhower Republican" side, which ultimately carried the day.

That is a useful reminder that an administration's policies can take a very different direction from what a candidate promises or expects. However, if Barack Obama wins tomorrow, it appears he will not face such fundamental differences of opinion among Democratic policy advisors. In the Times, Robert Rubin and Jared Bernstein (of a left-ish think tank) were able to smooth over the differences enough to write a joint op-ed.

Though if one reads carefully, it seems the smoothing over is not quite complete; for example, they write:

In more stable times, a budget deficit equivalent to roughly 2 percent of G.D.P. will keep the debt-to-G.D.P. ratio constant, a legitimate fiscal policy goal. In flush times, a smaller deficit would lower the debt ratio and that might be desirable.

"Might be desirable"? Sounds like something written by two people who don't fully agree...

Anyhow, Ezra Klein says:

[W]hat you can see, at least in the short-term, is an incredible level of consensus on large scale stimulus targeted at infrastructure investment. And this sort of elite unanimity matters, as all manner of wavering congressfolk will go to their chosen sage and get the same answer, rather than being divided by slightly esoteric, intra-wonk rivalries.

Matthew Yglesias writes:

The real question going forward will be whether self-described centrist legislators are willing to heed the advice of Rubin, Summers, and others about the essential need for stimulus, for new spending on infrastructure, and for major investments in health care and education or whether they’re going to choose to play the role of spoilers and try to grab as much special interest cash as possible for their troubles.

See also: EconomistMom, who says "we can get along." (yes, we can?)

The 18th Brumaire of the Rational Expectations Revolution?

As the financial crisis and incipient global slump only reinforce our appreciation for Keynes - in "textbook Keynesian" form and otherwise - the peerless YouNotSneaky calls for macroeconomics to throw off the shackles of the dynamic, optimizing rational expectations paradigm that is the legacy of Lucas et al. In support, he (she?) invokes the famous billiard player analogy from Milton Friedman's "Methodology of Positive Economics" -

What have they brought us? It is true that our texts were fallible. And it is true that, in the beginning, their critiques shone light upon our misunderstandings. But we mistook a lighting of a candle for a conflagration of divine knowledge. And ecstatic with a small dose of illumination we threw our books upon Savoranola’s fire. Even Michelangelo himself threw his Madonnas onto the pyre (find a relevant link yourself. All I get is wiki).

Yet in end, their promises fizzled once the glow of the ambers died. Having abandoned our faith we were left with trying to build a house out of ashes – micro founded ashes – rather than ad-hoc oaken beams. It is time. It is time we returned to the practical knowledge which had allowed us to built a shelter, no matter how shabby, but which could stand up well in the hail storms, even if we did not understand the engineering principles involved. A good pool player knows how to sink the final ball in its pocket at the end of the game, avoiding the eight ball. The knowledge of the laws of physics is immaterial. Perhaps if the game was played on a table with no friction our detractors would have had something useful to say.

But we have been in the wilderness for a long time. We are weak. It is the truth and let us admit it, our spirits have been starved of intellectual substance for some time. And they may be for some time yet. But our path is righteous. And if we are going to ever get back upon it we need to first assert our own existence. We are MACROECONOMISTS! We have insights which cannot be derived from the cult of Some- kind- of- Maximization- somewhere- by- somebody- for- some- reason (and who knows who or what) = Microfoundations.

Read the whole thing (this means you, Econ 617 students).

Chin Up, People!

The Times reports:

Consumer confidence fell to its lowest level in at least 40 years, a survey said Tuesday, as falling home prices and steep declines in the stock market took a sharp toll on the faith of Americans in the economy.

A widely watched survey by the private Conference Board, which dates back four decades, plunged to its lowest reading on record in October as Americans reported fewer jobs and smaller incomes and curtailed plans for major purchases like cars and appliances.

Americans also say they believe the economy will worsen before it improves — a sign of deeply engrained pessimism that reflects a year of painful declines in stocks, jobs and home values....

Lowest in forty years? Lower than 1981-82? 73-74? We have a long way to go before it's that bad, and I doubt things will get that far.

We Are All Keynesians Now

Robert Lucas: "I guess everyone is a Keynesian in a foxhole." From Justin Fox, "The Comeback Keynes" (extended quote here).

Apparently you can't get out of a foxhole by assuming a ladder...