Vertical Specialization and Plunging Trade

The alarming collapse of world trade volumes has not been spread evenly around the world. At Vox, Kioyasu Tanaka argues that vertical specialization - the division of production processes among different countries - can help explain why Japan has seen a sharper drop in trade than the US.

Yet Another Episode of the Stimulus Debate

In which I take on "The Buckeye Institute":

I hadn't seen the other part of this until now; but wow, that's misguided... He's got a tie, but I'm wearing glasses. I win.

Not quite sure why I said potential severity... it's pretty bad now.

(Print version of story here).

The Quarterback of Supply-Side Economics Passes

One should not speak ill of the recently deceased, but is it ok to be a little bit snarky? Perhaps if you're very good at it, like Michael Kinsley is. Of Jack Kemp, the late Republican Congressman who championed "supply-side" economics, Kinsley writes:

As a rule, there are two ways to get a reputation in Washington for being “thoughtful,” neither of which requires having a lot of ideas rattling around in your head. In fact one method is to avoid, as much as possible, any ideas beyond a general desire for everyone to sit down in good faith and a cooperative spirit and reason things out.

Alternatively, you can simply be “unpredictable.” The more you can surprise people with your position on an issue, more thoughtful you are considered to be. This technique has served Arlen Specter, to choose a currently newsworthy example, well over the years.

Jack Kemp was not unpredictable, and he did not strike poses of moderation and statesmanship. He might be accused of a third device: Like Gary Hart on the Democratic side, he was deeply committed to the idea of ideas, as opposed to ideas themselves. And if he mentioned, say, Say’s Law (a famous principle of economics), he was likely to offer up the author’s full name -- Jean-Baptiste Say -- as a way to establish his bona fides.

But Kemp did have one idea that he was introduced to in the mid-1970s, stuck with, and saw triumph.

That, of course, is supply-side economics, and in particular its policy prescription: cut taxes and you will increase government revenues. Among Republicans, this became more like a religion than a policy, with all the fixin’s: miracles, saints (Ronald Reagan, Arthur Laffer, Kemp) and total immunity from factual refutation. Kemp probably went to his grave believing that this victory was an intellectual one -- a triumph of persuasion. In fact, it was an example on the other side of the argument: that material forces, not ideas, are what move history.

After all, the idea that tax cuts pay for themselves is not a hard sell. It comes with a built-in bribe. The inherent implausibility -- not to mention 30 years now of experience to the contrary -- is no match for money in your pocket....

Brad DeLong is, more appropriately under the circumstances, quite gracious:

One of the few senior Republicans to try to undo the curse of Richard Nixon, Jack Kemp 1935-2009 was a pillar of and an ornament to the American republic.

Howard Gleckman emphasizes the positive: Kemp's role in the 1986 tax reform. Kemp's former staffer, Bruce Bartlett looks back at the Kemp-Roth bill, which became the centerpiece of "Reaganomics." The NY Times obituary has more on Kemp's football and political careers.

Martin Feldstein is Worried About Flation

Both kinds.

De- :

The rate of inflation is now close to zero in the US and several other major countries. The Economist recently reported that economists it had surveyed predict that consumer prices in the US and Japan will actually fall this year as a whole, while inflation in the euro zone will be only 0.6 percent. South Korea, Taiwan and Thailand will also see declines in consumer price levels....

Deflation is potentially a very serious problem, because falling prices — and the expectation that prices will continue to fall — would make the current economic downturn worse in three distinct ways.

The most direct adverse impact of deflation is to increase the real value of debt. Just as inflation helps debtors by eroding the real value of their debts, deflation hurts them by increasing the real value of what they owe. While the very modest extent of current deflation does not create a significant problem, if it continues, the price level could conceivably fall by a cumulative 10 percent over the next few years.

If that happens, a homeowner with a mortgage would see the real value of his debt rise by 10 percent. Since price declines would bring with them wage declines, the ratio of monthly mortgage payments to wage income would rise.

In addition to this increase in the real cost of debt service, deflation would mean higher loan-to-value ratios for homeowners, leading to increased mortgage defaults, especially in the US. A lower price level would also increase the real value of business debt, weakening balance sheets and thus making it harder for companies to get additional credit.

The second adverse effect of deflation is to raise the real interest rate, that is, the difference between the nominal interest rate and the rate of “inflation.” When prices are rising, the real interest rate is less than the nominal rate since the borrower repays with dollars that are worth less. But when prices are falling, the real interest rate exceeds the nominal rate.

and In- :

So the potential inflationary danger is that the large US fiscal deficit will lead to an increase in the supply of money. This inevitably happens in developing countries that do not have the ability to issue interest-bearing debt and must therefore finance their deficits by printing money. In contrast, when deficits do not lead to an increased supply of money, the evidence shows that they do not cause sustained price increases...

But now the large US fiscal deficits are being accompanied by rapid increases in the money supply and by even more ominous increases in commercial bank reserves that could later be converted into faster money growth. The broad money supply (M2) is already increasing at an annual rate of nearly 15 per cent. The excess reserves of the banking system have ballooned from less than $3bn a year ago to more than $700bn (€536bn, £474bn) now.

The money supply consists largely of government-insured bank deposits that households and businesses are holding because of a concern about the liquidity and safety of other forms of investment. But this could change when conditions improve, turning these money balances into sources of inflation.

The link between fiscal deficits and money growth is about to be exacerbated by “quantitative easing”, in which the Fed will buy long-dated government bonds. While this may look like just a modified form of the Fed’s traditional open market operations, it cannot be distinguished from a policy of directly monetising some of the government’s newly created debt...

The deep recession means that there is no immediate risk of inflation. The aggregate demand for labour and goods and services is much less than the potential supply. But when the economy begins to recover, the Fed will have to reduce the excessive stock of money and, more critically, prevent the large volume of excess reserves in the banks from causing an inflationary explosion of money and credit.

Update: Larry Summers is too, according to Antonio Fatas.

Whee! (GDP -6%)

Real GDP fell at an annual rate of 6.1% in the first quarter, according to the BEA's advance estimate. This follows a 6.3% rate of decline in the fourth quarter of 2008...(Note: "annual rate" means that the pace of decline would result in a fall of 6.1% over a year, not that GDP decreased 6.1% in the first three months of the year).

The reaction from James Hamilton at Econbrowser, Catherine Rampell at Economix and Justin Fox of Curious Capitalist includes a couple of hopeful signs: while investment plummeted (fixed investment fell at a 37.9% rate), consumption began to pick up, increasing at a 2.2% rate (durable goods purchases rose at a 9.4% clip). Also, a significant part of the fall was accounted for by a decrease in inventories, which would suggest firms may need to start increasing production.

Of course, the data are subject to revision... we'll get the "preliminary" estimate on May 29.

Green Shoots

Last week, I took the international trade class outside. Since we happened to be sitting outside the external relations office, photos were taken...Opinions vary about whether I am a good professor, but I sure look like one, if I do say so myself.

Credit Easing

The Cleveland Fed's Economic Trends provides a useful overview of the Fed's alphabet soup of lending facilities.

New Econ PhD Rankings

US News has updated its rankings of Economics PhD programs. Their rankings are based on reputation, measured using surveys. This is, I think, the best way of getting at one of the main things prospective students should consider: in general, the programs which will give you the best chances at getting a good job are the ones that people think are the best. That is why I prefer the US News rankings over studies that try to quantify the research productivity of departments.

That said, any ranking is imperfect (especially any ranking where the University of Virginia is tied with Ohio State - good grief!) and there are many issues to consider; my advice for would-be economics PhD students is here.

Britain's Dark Days (1974)

While I have long had some vague awareness that the British economy was a mess in the 1970s, I hadn't fully appreciated how bad things were until I read this article by Andy Beckett in the Guardian about the "Three Day Week" in 1974. He writes:

The three-day week began at midnight on New Year's Eve in 1973, a Monday. The Heath administration decreed that until further notice all businesses except shops and those deemed essential to the life of the country would receive electricity only on Mondays, Tuesdays and Wednesdays, or on Thursdays, Fridays and Saturdays. Non-essential shops would get power only in the morning or the afternoon. When the electricity was off, affected businesses would have to make do with candles, gas lamps, private generators or moving their workers next to windows to make the most of the brief winter daylight. Employees would have to wear extra clothes to keep warm.

Beckett goes on to trace the roots of the crisis to the Heath government's economic policies - a tale of aggregate demand management gone awry - as well as the 1973 oil shock, and the militancy of the coal miners union.

From its election in 1970, his government had impatiently sought to boost the performance of the British economy. But from 1971, frustrated by a general lack of progress and spooked by a sudden surge in unemployment, the Heath administration had sought this transformation by increasingly bold - you could say reckless - means. During late 1971 and early 1972, the government cut interest rates, greatly loosened the rules that governed lending by banks, increased public spending and cut taxes. "No government has ever before taken so much action in the space of one year to expand demand," declared the chancellor Anthony Barber on New Year's Day in 1972.

For a time the results were spectacular: the gross national product, which had grown by a feeble 1.4% in 1971, grew by 3.5% in 1972, and by an almost precedented 5.4% in 1973 - the kind of rate usually achieved by Britain's economic superiors at the time, Germany and Japan. Between mid-1971 and mid-1973, house prices rose by almost three-quarters.

But the boom was too reliant on speculation and one-off government initiatives, and too removed from the underlying realities of the British economy, to last long. Shortages of skilled labour and of modern, flexible industrial premises - the legacy of decades of underinvestment and poor training and management - meant that the increased appetite for goods and services awakened by the government soon could not be efficiently met. The result was higher inflation and a growing reliance on foreign goods, which were themselves inflationary, as the other rich countries were experiencing feverish booms and price spirals of their own. Britain's trade balance worsened drastically and the pound, which in 1972 had been freed to rise and fall in value against other currencies, began to fall much more than the Heath government had allowed for.

In May 1973, Barber started to rein in its "dash for growth" by cutting public spending. In July, he raised interest rates to their highest level since 1914. Boom had not quite yet turned to bust; but the British economy entered the autumn in a delicate condition, even more vulnerable than usual to unforeseen problems. Then, on 6 October, came the biggest shock for western economies of the entire decade, and the second catalyst for the three-day week. In a surprise attack, Egyptian troops crossed the Suez Canal and invaded the Israeli-occupied Sinai Peninsula. The Yom Kippur war had started, and with it the 1973 oil crisis. The supply of Middle Eastern oil to Britain and other western countries was severely disrupted. By January 1974, the oil price was more than five times higher than two years earlier.

Even worse, the British economic crisis acquired a potentially lethal political dimension. The leadership of the National Union of Mineworkers rejected a pay offer from the National Coal Board. During November and December 1973, as the second national coal strike of his government changed from a possibility into a probability, Heath's conviction that the miners' militancy was ideological - rather than, as it also was, opportunistic and materialistic - became entwined with his wish to avoid the blackouts that had accompanied the earlier coal strike; with the oil crisis; with his tendency to dig his heels in under pressure; and with his proclivity for state initiatives and economic planning. The result was the three-day week.

And things didn't really get better from there - in 1976, Britain had to turn to the IMF for a loan (and now, there's talk they might have to do so again).

The Microfoundations Digression?

Commentary on the financial crisis has included a great deal of misplaced economist-bashing. Much of this seems based on a misunderstanding of what economists do - the people saying "those stupid economists totally missed the housing bubble" miss the fact the vast majority of us are not forecasters, we are social scientists, and, usually rather narrowly specialized in something other than the housing market.

Brad DeLong points us to FT columnist John Kay, who makes a more serious critique, that the rebuilding of macroeconomics on microeconomic foundations in the wake of the Lucas critique and the rational expectations revolution may have led us astray. He writes:

The past two years have not enhanced the reputation of economists. Mostly they failed to point out fundamental weaknesses of financial markets and did not foresee the crisis, and now they disagree on appropriate policies and on the likely future course of events. Although more economic research has been done in the past 25 years than ever before, the economists whose names are most frequently referenced today, such as Hyman Minsky and John Maynard Keynes, are from earlier generations.

Since the 1970s economists have been engaged in a grand project. The project’s objective is that macroeconomics should have microeconomic foundations. In everyday language, that means that what we say about big policy issues – growth and inflation, boom and bust – should be grounded in the study of individual behaviour. Put like that, the project sounds obviously desirable, even essential. I confess I was long seduced by it.

Most economists would claim that the project has been a success. But the criteria are the self-referential criteria of modern academic life. The greatest compliment you can now pay an economic argument is to say it is rigorous. Today’s macroeconomic models are certainly that.

But policymakers and the public at large are, rightly, not interested in whether models are rigorous. They are interested in whether the models are useful and illuminating – and these rigorous models do not score well here...

...That people respond rationally to incentives, and that market prices incorporate information about the world, are not terrible assumptions. But they are not universal truths either. Much of what creates profit opportunities and causes instability in the global economy results from the failure of these assumptions. Herd behaviour, asset mispricing and grossly imperfect information have led us to where we are today...

There is some truth in that, and I'm more convinced than ever that I made the right choice keeping the IS-LM model and some of chapters 12 and 22 of the General Theory in my intermediate macroeconomics course.

However, microeconomic foundations and departures from perfect rationality are not incompatible; just as the New Keynesians have been able to incorporate imperfect competition and nominal rigidities into dynamic, microfounded models, I would expect to see more "behavioral" elements integrated with some of the tools we currently use.

The broader lesson seems to be that we must keep in perspective the limitations of economic models. I wouldn't be here if I wasn't convinced that they are useful - and I also wouldn't trouble my students with all those equations (an exercise which makes my life harder, as well as theirs), if I didn't see value in them. But no economic model is ever a complete description of the world, and models should be complements to - not substitutes for - intuition.

Much of that intuition can come from studying economic history and history of economic thought; DeLong says:

I think that we ought to be turning out a lot of macroeconomic historians and historians of economic thought, and that only they should be allowed to serve in government or comment on public affairs at least as far as the business cycle is concerned.

Related:

A good reading on the tug-of-war between practicality and elegance in modeling is N.G. Mankiw, "The Macroeconomist as Scientist and Engineer" (JSTOR access required).

Last fall, in this earlier post I discussed a similar argument from YouNotSneaky!