Naive and Sophisticated Friedman

My ten words or less version of monetarism is: "the Fed should maintain a constant rate of money growth."  By that standard, Milton Friedman would probably not be pleased with the Fed:

David Beckworth and William Ruger, who have a more sophisticated understanding of Friedman's views, come to a similar conclusion in an op-ed, "What Would Milton Friedman Say About Fed Policy Under Bernanke?" They write:

Friedman would likely make the case today for more aggressive monetary action. It is time for "Helicopter Ben" to earn his nickname.

Beckworth has more at his blog.

On a related note, Brad DeLong argues that neither Friedman nor Keynes would be pleased with the new British government's austerity policy.

QE2 Is Already Working!

I have some sympathy for worries that quantitative easing may not be very effective - that it will prove to be another incarnation of "pushing on a string" (see e.g., Annie Lowrey; Mark Thoma), but this Times story about tensions stemming from the declining dollar indicates its already having an impact:

The dollar’s decline is being driven by what everyone in global markets is now expecting: another round of so-called quantitative easing by the United States. In the next few weeks, the Federal Reserve is expected to inject vast sums of money into the economy in another attempt to spur growth....
Financial markets expect the Fed to announce at its meeting early next month that it will proceed with more quantitative easing, involving purchases of bonds, which reduces longer-term interest rates and puts further downward pressure on the dollar.
That worries other countries. A stronger United States economy is in everyone’s interest, but they fear that investors will flee America’s low interest rates and declining dollar and instead pour capital into their markets, overheating their economies and creating the types of asset bubbles in stocks and housing that burst with such devastating effects in the 1990s.
Already there is evidence of this: American investment in overseas stock funds, which was running at about $4 billion a month over the summer, has surged since Ben S. Bernanke, the Federal Reserve chairman, suggested the possibility of another round of quantitative easing at the end of August. About $19 billion has flowed into these funds since Aug. 1, according to TrimTabs, a funds researcher. 

The great thing about expectations is that a policy can have an effect before it is implemented - the mere fact that the Fed is expected to announce a new round of expansion in November has been enough to help get the dollar down after its summer spike due to the Euro crisis.

Zooming out to a five-year view, we can see that the effect of the rush to buy dollar assets in the financial crisis still hasn't fully reversed, but its getting there:

Exchange rate movements tend to have a significant lag in their effect on the economy, but if the decline in the dollar persists, it will benefit tradable goods sectors and improve the trade balance (i.e., increase the NX component of GDP).

So, while I am concerned about whether pushing down long-term interest rates really will do much to stimulate investment (I in GDP), anticipation of the policy is already building in a stimulative effect through the exchange rate channel (and, moreover, the markets are speaking).

So, what of the worries of those "other countries" that financial inflows will "overheat" their economies?  If they choose to hold their currencies down, that would be a problem; the solution is to allow them to rise.  As Jim Hamilton writes at Econbrowser:

If other countries want to prevent their exchange rates from appreciating, they should respond with easing of their own, which from my perspective would be a win-win outcome for everybody. If other countries feel that easing is contraindicated for their domestic situation, then isn't that part of the case why the dollar needs to depreciate relative to their currencies, given the current economic conditions in the U.S.?

Or, more bluntly, "the dollar may be our currency, but your problem."  That, of course, is what Nixon's Treasury Secretary John Connolly famously said in 1971, as the Bretton Woods system collapse.  While I doubt Tim Geithner would speak so directly today, perhaps we are indeed at the end of the so-called Bretton Woods II regime, as Tim Duy predicted recently (see also Ryan Avent and the amusingly hysterical Ambrose Evans-Pritchard).

Raise Greg Mankiw's Taxes, Please!

I should start out by saying that I'm a fan of Greg Mankiw.  He has written some important (and good!) papers that have made influential contributions to both business cycle and growth theory.  Moreover, he is a very good writer - his academic work is enjoyable to read (which is rare!) and he communicates well to a general audience (though sometimes his political biases - which are different from mine - do show through).  I've used several of his papers in classes I've taught, and I've been a (mostly) satisfied user of his intermediate macroeconomics textbook since I began teaching the course as a grad student back in 2003.

In a column for the NY Times, he uses himself as an example of how a change in marginal tax rates could reduce labor supply:

Suppose that some editor offered me $1,000 to write an article. If there were no taxes of any kind, this $1,000 of income would translate into $1,000 in extra saving. If I invested it in the stock of a company that earned, say, 8 percent a year on its capital, then 30 years from now, when I pass on, my children would inherit about $10,000. That is simply the miracle of compounding.

Now let’s put taxes into the calculus. First, assuming that the Bush tax cuts expire, I would pay 39.6 percent in federal income taxes on that extra income. Beyond that, the phaseout of deductions adds 1.2 percentage points to my effective marginal tax rate. I also pay Medicare tax, which the recent health care bill is raising to 3.8 percent, starting in 2013. And in Massachusetts, I pay 5.3 percent in state income taxes, part of which I get back as a federal deduction. Putting all those taxes together, that $1,000 of pretax income becomes only $523 of saving.

And that saving no longer earns 8 percent. First, the corporation in which I have invested pays a 35 percent corporate tax on its earnings. So I get only 5.2 percent in dividends and capital gains. Then, on that income, I pay taxes at the federal and state level. As a result, I earn about 4 percent after taxes, and the $523 in saving grows to $1,700 after 30 years.

Then, when my children inherit the money, the estate tax will kick in. The marginal estate tax rate is scheduled to go as high as 55 percent next year, but Congress may reduce it a bit. Most likely, when that $1,700 enters my estate, my kids will get, at most, $1,000 of it.

HERE’S the bottom line: Without any taxes, accepting that editor’s assignment would have yielded my children an extra $10,000. With taxes, it yields only $1,000. In effect, once the entire tax system is taken into account, my family’s marginal tax rate is about 90 percent. Is it any wonder that I turn down most of the money-making opportunities I am offered?

By contrast, without the tax increases advocated by the Obama administration, the numbers would look quite different. I would face a lower income tax rate, a lower Medicare tax rate, and no deduction phaseout or estate tax. Taking that writing assignment would yield my kids about $2,000. I would have twice the incentive to keep working.

So, if Mankiw's marginal tax rate reverts to its Clinton-era levels as scheduled under current law, when his editor calls to tell him its time for a new edition of his textbook, he would decline?

If we're doing a social cost-benefit analysis of changing Greg Mankiw's marginal taxes, we should account for externalities, positive and negative.  Following Mankiw's lead, I'll use myself as an example, and explain a benefit to reducing Mankiw's labor supply that should be accounted for in his analysis.

I would be better off if he decided the marginal benefit of an cranking out eighth edition was less than the marginal cost, and so would my students.  The churning of textbook editions (and this isn't Mankiw's fault, to be sure) is a real headache to instructors, and helps keep the cost high for students.  Though I'm sure it was well-intentioned (and thoroughly focus-grouped) a number of the changes from the sixth to seventh edition of his textbook made it worse from my point of view.  For example, I rather liked his discussion of New Keynesian and Real Business Cycle theory, which were supplanted by a "dynamic aggregate demand and supply" chapter that I'm not inclined to mess with.  And don't tell me I need my book "updated" for "current events." One of the fun things about teaching macroeconomics is that the world is always giving us interesting new examples to talk about.  But I can handle that quite well without some new "economics in the news" sidebars grafted into the textbook.

However, while the theoretical case that marginal tax rates can change behavior is clear, I'm not convinced, as an empirical matter, that Mankiw's would actually change.  After all, his book was first published in 1992, and he issued new editions in 1994 and 1997 when higher marginal tax rates on high levels of income (and capital gains and estates) were in effect.

Mark Thoma and Brad DeLong suggest some other possible shortcomings in his argument.

September Employment Report

According to the BLS, in September the economy lost 95,000 jobs, and the unemployment rate held steady at 9.6%.  Neither of those headline numbers is pleasant, but the first is more discouraging than the second - I suppose the choice of which one to emphasize depends on whether one sees the glass 10% full or 90% empty.

In this case, the reason for the discrepancy is the fact that the jobs number comes from a survey of businesses while the unemployment rate is calculated from a separate survey of households.  (Another potential explanation would be a decline in labor-force participation, but in September it remained unchanged.)  According to the household survey, the number of people employed actually increased by 141,000 (the payroll number from the establishment survey is usually preferred because it has a larger sample).

The decline in payrolls of 95,000 is the sum of an increase in 64,000 in private-sector jobs and a loss of 159,000 government jobs.  Federal government employment fell by 76,000 (77,000 temporary census jobs ended), state government employment fell by 7,000 and local government employment fell by 76,000 (of which 49,800 were in education).

So, ironically enough, the headlines from the last BLS report before the election will probably give a little more momentum to those who think "government spending" is the problem, even though the report shows that cuts in government spending are already acting as a drag on the economy.

One potential bit of good news from the bad news is that the gloomy report provides another piece of evidence to support the case within the Fed for more aggressive quantitative easing ("asset purchases").

The headline numbers are all seasonally adjusted to remove regular fluctuations that occur during the year.  On a non-seasonally adjusted basis, the unemployment rate fell from 9.5% to 9.2% (i.e., the seasonal adjustment factor raises the unemployment rate in September).  Also, non-seasonally adjusted payrolls rose 428,000 - including an increase of 865,800 in the "local government-education" category, so I think the correct interpretation of the government job loss is that fewer teachers and education workers were hired this year than usual.  Also, non-seasonally adjusted private payrolls fell by 412,000, so the seasonally-adjusted gain of 64,000 means that the private sector did not shed as many jobs as usual for this time of year.

See also: Economix, Free Exchange, Calculated Risk and RTE's round up of reactions.

The Output Gap

The Washington Post's Neil Irwin has a nice slide show to illustrate the output gap under several scenarios.  Check it out!

TARP: A Failure to Communicate

The Times reports that the estimated cost of TARP (a.k.a. "the bank bailout") has been revised downwards yet again:

Treasury reckons that taxpayers will lose less than $50 billion at worst, but at best could break even or even make money. Its best-case assumptions, however, assume that A.I.G. and the auto companies will remain profitable and that Treasury will get a good price as it sells its corporate shares in coming years. 

The Treasury has come out ahead on the money invested in the banking system - for example, it is making a profit on its investment in Citigroup.  The losses, if there are any, will come from the investments in the auto industry, and in AIG (which has announced a plan for unwinding its government ties).

The reality is certainly far different from the widespread perception that the government simply gave away $700 billion to Wall Street.  The failure to get the facts through people's thick skulls out appears to have had significant political consequences - would there be a "tea party" without this persistent misconception?  The Times story provides an example of the political consequences of this ignorance:

Among those who voted for the program in 2008, several Republicans have lost nominating contests for re-election or for another office, and others are on the defensive in fall races. Senator Robert F. Bennett of Utah was “Bailout Bob” to Republicans who refused to re-nominate him for a fourth term.
“For those who were screaming at me — and screaming was the operative word — ‘You’ve just saddled our children and grandchildren with $700 billion,’ I said, ‘No, I haven’t,” Mr. Bennett said in an interview.
“My career is over,” he added. “But I do hope that we can get the word out that TARP, number one, did save the world from a financial meltdown and, number two, did so in a manner that, I believe, won’t cost the taxpayer anything. And even if it did not all get paid back, it was still the thing to do.”

However, it should be noted that, while the financial cost of TARP will be much less than people think, the taxpayer is on the hook for some other costs because of the takeover of Fannie Mae and Freddie Mae (an indirect bank bailout).  The real cost, Simon Johnson argues, is that TARP (and the Dodd-Frank financial regulation bill) failed to create an incentive structure that will prevent financial crises.  He writes:

The first draft of its history, looking back over the past two years, may be this: TARP was an essential piece of a necessary evil – that is, it saved the American financial system from collapse — but it was implemented in a way that was excessively favorable to the very bankers who had presided over the collapse. And this sets up exactly the wrong incentives as we head into the next credit cycle.

He may be right.  But, for now, we are getting most of the money back, and our politics would be significantly different if people understood that much.

Inflation Above (Official) Target

Among its other benefits, a policy regime of inflation targeting, where a central bank has a clear primary focus of keeping inflation as close as possible to a certain level, has a pleasing clarity.  For example, the Bank of England Act of 1998 states:

In relation to monetary policy, the objectives of the Bank of England shall be –
(a) to maintain price stability, and
(b) subject to that, to support the economic policy of Her Majesty’s Government, including its objectives for growth and employment.  

Compared to the mushy "dual mandate" of the Federal Reserve Act,

The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.  

Matthew Yglesias finds the unambiguity of the Bank of England's regime refreshing:

The genius of this is that you now don’t need to have monetary policy matters be the subject of debates on op-ed pages and blogs with various board members giving interviews and speeches. If 2 percent inflation is too much inflation, well that’s on the heads of the politicians who set the target. If inflation is over 2 percent, then the Bank of England needs to tighten. And if inflation is below 2 percent, then the Bank of England needs to expand. Consequently, when faced with a giant downturn the Bank of England has had none of the self-induced paralysis of the Fed, the ECB, or the Bank of Japan. 

Yes, but... the Bank of England has been missing its target lately:

I think the BofE deserves great credit for being aggressive in its response to the economic crisis, but the inflation targeting regime forces it into making awkward excuses, like this from its inflation report:

CPI inflation remained well above the 2% target, elevated by temporary effects stemming from higher oil prices, the restoration of the standard rate of VAT to 17.5% and the past depreciation of sterling.  And the forthcoming increase in the standard rate of VAT to 20% will add to inflation throughout 2011.  As these effects wane, downward pressure on wages and prices from the persistent margin of spare capacity is likely to pull inflation below the target.  But the pace and extent of that moderation in inflation are impossible to predict precisely.  

The FT's Money Supply blog notes that the IMF approves of Britain's current loose monetary/tight fiscal policy mix (see also Free Exchange's comments).  But it is not clear that the inflation target has been helpful... indeed, the risk is that, by allowing inflation exceed the target, the Bank of England is damaging the "credibility" that inflation targeting was designed to buy.  Considering the circumstances, I'm inclined to believe that's a risk worth taking, it does raise questions about the whole inflation targeting concept. 

Inflation targeting is still relatively new. New Zealand was the first country to implement it, in 1988. The current global slump is inflation targeting's first real test, and, after the dust settles it will be interesting to evaluate how it performed.

Inflation Below (Unofficial) Target

In its Tuesday statement, the Federal Open Market Committee said that inflation is too low for its taste:

Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability. With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to remain subdued for some time before rising to levels the Committee considers consistent with its mandate.  

Of course, we're used to central banks worrying about inflation becoming too high, so this is an unusual thing to see.  As Gavyn Davies writes:

The Federal Reserve broke a taboo yesterday when it said quite baldly that inflation in the US is now below the level “consistent with its mandate”. In other words, it is too low. This is a very big statement for any central banker to make, since the greatest feather in their collective cap is that they successfully combated inflation after the 1970s debacle. Led by the Fed’s Paul Volcker, they re-asserted the importance of monetary policy, after two decades of failed wage and price controls. Since that period, most central bankers have been careful to avoid any language which even hints that a rise in inflation is acceptable to them. I can certainly find no previous record of the FOMC saying that inflation is too low, so it was a jolt to see this stated so starkly in the Fed statement yesterday.  

Those who are still worrying about inflation, in spite of the data, are fighting the last war.  Fortunately, the Fed isn't interpreting the "price stability" part of its mandate to mean "zero inflation." The projection of board members' for inflation in the "longer run" can be taken as its unofficial target; as of the last release in June, they were aiming for expecting 1.7%-2.0% (as measured by the deflator for personal consumption expenditures). 

Both the consumer price index (red line) and core PCE deflator are consistent with the notion that the Fed is missing its target.

Moreover, the markets are skeptical that the Fed will hit it in the future, according to the Cleveland Fed:

The Federal Reserve Bank of Cleveland reports that its latest estimate of 10-year expected inflation is 1.54 percent. In other words, the public currently expects the inflation rate to be less than 2 percent on average over the next decade.

Moreover, the Cleveland Fed's estimates are for CPI inflation, which is generally higher than PCE inflation.

The Fed didn't actually do anything about this, but the acknowledgment of the problem is a step in the right direction.

The NBER Calls It

Today's announcement from the NBER Business Cycle Dating Committee:

[A] trough in business activity occurred in the U.S. economy in June 2009. The trough marks the end of the recession that began in December 2007 and the beginning of an expansion. The recession lasted 18 months, which makes it the longest of any recession since World War II. Previously the longest postwar recessions were those of 1973-75 and 1981-82, both of which lasted 16 months.

In determining that a trough occurred in June 2009, the committee did not conclude that economic conditions since that month have been favorable or that the economy has returned to operating at normal capacity. Rather, the committee determined only that the recession ended and a recovery began in that month. A recession is a period of falling economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales. The trough marks the end of the declining phase and the start of the rising phase of the business cycle. Economic activity is typically below normal in the early stages of an expansion, and it sometimes remains so well into the expansion.

While this was the correct call in terms of consistency with their definition and past practice (and I thought they should have made it sooner), it highlights the limitations of the "recession"/"expansion" dichotomy in describing the state of the economy. As they were careful to note, the economy continues to operate substantially below capacity. The "expansion" state is about the rate of change, not the (still lousy) level; as the NBER's FAQ puts it:

Q: Isn't a recession a period of diminished economic activity?

A: It's more accurate to say that a recession—the way we use the word—is a period of diminishing activity rather than diminished activity.

So, since June, we've been in a period of non-diminishing activity. That's certainly better than continuing contraction, but growth has not been fast enough to make a substantial dent in unemployment.

In the chart below, the red line shows retail and food service sales, and the blue line is the industrial production index, both normalized to 100 at the Dec. 2007 peak. Both turn up around the end of 2009, but 14 months into the recovery, their levels remain below the previous peak. Employment (green line) continued to fall for several months after the end of the recession and has only improved slightly since.

The phrase "growth recession" describes this state of slow growth and non-declining unemployment, but its somewhat cumbersome. I've found myself using the word "slump" alot.

See also: Mark Thoma and Catherine Rampell (who talked to Robert Gordon).

Raising the Speed Limit

At Project Syndicate, Barry Eichengreen writes that one of the Great Depression's lessons is that slumps can be good for productivity growth:

Output expanded robustly after 1933. Between 1933 and 1937, the US economy grew by 8% a year. Between 1938 and 1941, growth averaged more than 10%.

Rapid output growth without equally rapid capital-stock or employment growth must have reflected rapid productivity growth. This is the paradox of the 1930’s. Despite being a period of chronic high unemployment, corporate bankruptcies, and continuing financial difficulties, the 1930’s recorded the fastest productivity growth of any decade in US history.

How could this be? As the economic historian Alexander Field has shown, many firms took the “down time” created by weak demand for their products to reorganize their operations. Factories that had previously used a single centralized power source installed more flexible small electric motors on the shop floor. Railways reorganized their operations to make more efficient use of both rolling stock and workers. More firms established modern personnel-management departments and in-house research labs.

There are hints of firms responding similarly now. General Motors, faced with an existential crisis, has sought to transform its business model. US airlines have used the lull in demand for their services to reorganize both their equipment and personnel, much like the railways in the 1930’s. Firms in both manufacturing and services are adopting new information technologies – today’s analog to small electric motors – to optimize supply chains and quality-management systems.

A similar argument has been made that extensive business restructuring around the time of the 2001 recession contributed to productivity growth in the following years.

Indeed, productivity growth recently has been quite strong:

(Business sector output per hour - Bureau of Labor Statistics)

Eichengreen goes on to argue that policy support is necessary:

But this positive productivity response is not guaranteed. Policymakers must encourage it. Small, innovative firms need enhanced access to credit. Firms need stronger tax incentives for R&D. Productivity growth can be boosted by public investment in infrastructure, as illustrated by the 1930’s examples of the Hoover Dam and the Tennessee Valley Authority.

Which sounds alot like the Obama administration's recent initiatives to increase small-business credit, build more infrastructure and make the R&D tax deduction permanent. While a case can be made for the first two as short-run stimulus, the benefits of the research and development tax credit are almost entirely of the long run variety.

In the long run, higher productivity is good news: it means more output per worker and, therefore, higher average wages. However, it also means less employment is needed for any given level of output, which means the increase in unemployment during the recession was than the decline in output would normally imply (see this previous post).

By increasing potential output, ceteris paribus, productivity growth increases the distance between actual economic activity and the economy's capacity sometimes known as the "output gap." This suggests that even stronger demand growth is necessary to close the gap.

The resurgence of productivity growth in the mid-1990's is one of the factors that allowed the Fed to keep interest rates low and allow unemployment to fall to 4% without igniting inflation (whatever else we say about Alan Greenspan now, he deserves credit for recognizing this early on). If Eichengreen is correct, the "productivity boom-in-waiting" will raise the economy's speed limit, and this is one more reason for the Fed to step on it.