Paradox of Thrift

in cartoon form.

In Ben We Trust

In The American Prospect, Brad DeLong explains how we've gotten to this:

Ben Bernanke is the closest thing to a central economic planner the United States has ever had. He bestrides our narrow economic world like a colossus. Unelected (he was appointed by President George W. Bush and confirmed by an overwhelming majority in the Senate) and unaccountable (unless the Congress decides that it wishes to amend the Federal Reserve Act and take the blame for whatever else goes wrong with the economy), he is responsible only to his conscience -- and his open-market committee of himself, the other six governors of the Federal Reserve Board, and the 12 presidents of the regional Federal Reserve banks.

The fate of the economy in the next administration depends far less on the president than on this moral-philosopher-prince to whose judgment we have entrusted a remarkable share of control over our destiny....

Definitely on the reading list for Eco 317 in the spring.

Too Manic About the Depression

In a commentary for our local NPR station, I make the argument, which I've also made on this blog, that we're getting a little carried away with the depression comparisons.

Update (11/24): Slate's Daniel Gross makes a similar argument, to which Paul Krugman responds.

Global Rebalancing and the Depression

On his China Financial Markets Blog, Michael Pettis draws a parallel between the global imbalances of the depression and those today, with the US of the 1920's in surplus the country role played by China today:

In the 1920s excess and rising capacity in the US could be exported, mostly to Europe, while massive foreign bond issues floated by foreign countries in New York permitted countries to run large deficits, but as the US continued investing in and increasing capacity without increasing domestic demand quickly enough, it was inevitable that something eventually had to adjust. The financial crisis of 1929-31 was part of that adjustment process, and it was not just the stock market that fell – bond markets collapsed and bonds issued by foreign borrowers were among those that fell the most. This, of course, made it impossible for all but the most credit-worthy foreigners to continue raising money, and by effectively cutting off funding for the current account deficit countries, it eliminated their ability to absorb excess US capacity.

The drop in foreign demand forced the US either massively to increase domestic demand or massively to cut back domestic production. The fact that another consequence of the financial crisis was a collapse of parts of the domestic banking system, leading to banking panics and cash hoarding, meant, as it often does in a global crisis, that the US had to adjust to a drop in demand both domestically and from abroad. But instead of expanding aggressively, as Keynes demanded, FDR expanded cautiously, and in 1937 even decided to put the fiscal house back in order by cutting fiscal spending, thereby stopping the recovery dead in its tracks.

In this situation, Pettis believes that the surplus countries - most especially China - need to generate additional demand. The recently announced Chinese stimulus package seems like a good step in this direction, but he sees some counter-productive moves as well:

...I worry that the global problem has never been a lack of US demand – it has been lack of Asian demand. The US has already provided a greater share of global demand than is healthy for either the US or, as we have clearly seen, for the world.

A massive fiscal expansion by the US would certainly boost global demand, but it would do so at the expense of increasing US indebtedness by far more than it increases demand for US goods (much of the expansion in demand would simply be exported to countries that continue to suffer from overcapacity) and of course it would not solve the global overcapacity problem. It might even exacerbate it. The best that one could hope for, if the US took the lead in fiscal expansion, is that Asian countries make heroic efforts to shift their economies as quickly as possible from export dependence to domestic demand dependence, but I have already argued that with the best will in the world this will be a long and difficult process, and I am not sure anyway that most countries have the political will to force the shift. China, for example, is raising export rebates and talking about depreciating the currency – hardly the actions of a country working hard to reduce global overcapacity.

Hm... under the circumstances, I think we might want to try the "massive fiscal expansion" and worry about imbalances later. There is no sign that the US Treasury will have any trouble borrowing as much as it wants.

Fiscal Policy, in the Wrong Direction

The NY Times reports on widespread budget cuts by state governments, who are seeing tax revenues fall and are much more constrained then the federal government in their ability to run deficits.

A good candidate for any fiscal stimulus legislation would be increased federal aid to state and local governments. The state cuts do have macroeconomic consequences - state and local government purchases accounted for 12.1% of GDP last year and are the bulk of the "G" component of aggregate demand (bear in mind that much of federal spending is on transfer programs; federal government purchases were 7.1% of GDP in 2007, and this was mostly military spending).

The Times story is accompanied by a nifty interactive graphic with state-specific information; they put Ohio's gap at $1.3 billion, or $111 per resident.

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.)