Marginal, at Best

In an Economix post about the Bush tax cuts, David Leonhardt writes:

The theory for why tax cuts should create growth and jobs is a strong one. When people are allowed to keep more of each dollar they earn, they are likely to work longer and harder. The uncertainty is the magnitude of this effect. With everything else that’s happening in a $15 trillion economy, how large of an effect on growth do tax cuts have?

Every available piece of evidence seems to suggest that the Bush tax cuts did little to lift growth.

Indeed, its fairly easy to demonstrate in simple economic models that higher marginal tax rates distort the economy and might lead to less labor effort and less saving (and hence a smaller capital stock).  To be careful, though, in most models the effect of a tax reduction would be on the levels of income and output, not on the long run growth rate.

Nonetheless, there are pretty solid economic theory reasons why economists - even those of us with generally liberal (in the contemporary American sense) political inclinations - would favor tax reforms that would broaden the tax base (i.e., reduce deductions and credits) and lower marginal tax rates.  But perhaps not as fervently as Glenn Hubbard, who recently wrote:

When I left my job as the deputy assistant Treasury secretary for tax policy in 1993, I left a message on my office blackboard for my successor. I wrote, “Broaden the base, lower the rates” repeatedly until I filled the entire space. I then had it covered with wax so it could not be erased. (Yes, the government charged me for my bit of vandalism. But it was worth it.) 

I share his instinctive sympathy for this aspect of the Simpson-Bowles proposal (though I basically agree with Paul Krugman that the package is bad overall).

However, as Leonhardt points out, as an empirical matter, its not clear that tax rates make that much of a difference to overall economic performance.  The best decade for growth in the postwar period was the 1960's, when the top marginal income tax rate was over 70% (as I noted in the second-ever post here).  The economy did well after the 1993 increase in the top marginal tax rates, and not particularly well after the 2001 and 03 rate cuts.

Of course, that doesn't prove anything - the effect of any policy should to be judged relative to a counter-factual. That is, perhaps the economy would have done even better in the 1990's without the tax increase, and even worse in the 2000's without the tax cuts.  Nonetheless, I think a brief glance at historical evidence is enough to convince us that lower marginal tax rates aren't some magical economic elixir.  As an economist, I'll never say that people don't respond to incentives, but, in the case of taxes, it looks like they don't respond very much.

Thanks Again, Europe?

As Free Exchange noted last week, early in 2010, the recovery appeared to be gaining momentum, but something happened in the spring.  This is visible in the data on private payroll employment (I've used the private sector to avoid the effect of the winding down of census employment), where the rate of growth clearly slips after April:

Free Exchange's preferred story is that the debt crisis in Europe - remember Greece? - is to blame for the wobble in the recovery:

In late April, fears of a serious European debt crisis began to emerge. These fears sparked a mild panic and a renewal in the flight to safety. This flight manifested itself, in part, as a rush to buy American government debt. Treasury yields had been rising in the months prior to the crisis, but plunged from April through the summer. The dollar shot up; the trade-weighted dollar rose nearly 5% from late April to early June. In response to the pressure within markets, the Fed reopened currency swap lines it had used in previous stages of the crisis. It did not, however, take steps to offset the impact of the financial hiccup on growth expectations.

Markets reacted. The Dow fell over 13% from late April to early July, and was still 10% off its April peak in late August. From January to April, 10-year inflation expectations were stable at around 2%. These began falling sharply, and were down to around 1.5% by the end of the summer. Every signal available began flashing a decline in economic expectations starting in late April.

And now, just as things are starting to look better again, the Times says:

Sigh.  Stupid Euro.

Cross of Stupidity

International contention over currencies and the Fed's announcement of another round of quantitative easing seem to have induced another bout of misplaced gold standard nostalgia.  In the Financial Times last week World Bank president Robert Zoellick called for a "cooperative monetary system" employing gold as "an international reference point."  Saturday's Times included an op-ed by James Grant which was even more direct:

Let the economists gasp: The classical gold standard, the one that was in place from 1880 to 1914, is what the world needs now. In its utility, economy and elegance, there has never been a monetary system like it.

I didn't gasp, I groaned.  Here is a plot of the US price level from January 1879, when the US rejoined the gold standard after relying on paper "greenback" money during the Civil War, through December 1913 (the gold standard collapsed around the outbreak of World War I 1914), normalized to 100 at the beginning.

Although the price level in the gold standard era lacked a long run trend, that doesn't mean it was stable.  While the change in the price level from Jan. 1879 to Dec. 1913 was modest (average annual inflation of about 0.5%), there were significant runs of high inflation, and even more perniciously, deflation.  Deflation raised the real value of debt burdens, which exacerbated the economic downturns of the time, which were frequent and severe (according to the NBER chronology, 189 out of 420 months were spent in recession).  Moreover, financial crises were a regular occurrence; the severity of the 1907 "panic" helped motivate the founding of the Fed, which Grant so dislikes, in 1913.  Its little wonder, then, that the gold standard was not universally liked at the time. The monetary system was one of the most bitterly contentious issues of the day, with the debate reaching its high point in the 1896 election, when William Jennings Bryan carried the south and west on a platform of freeing the US from the "cross of gold".

There are plenty of reasons to criticize the Fed and its management of the modern "fiat money" system, but even with all of its mistakes, its doing far better than the gold standard.

Regrets, They've Had a Few

From the Washington Post's Neil Irwin, an interesting report on a conference sponsored by the Atlanta Fed commemorating the 100th anniversary of the conclave at Jekyll Island that laid some of the groundwork for the Fed's founding.

On the issue of the day: 

"There's a sense out there that, quote, quantitative easing or asset purchases are some completely foreign, new, strange kind of thing and we have no idea what . . . is going to happen," Bernanke said, sitting onstage in a conference space that was once J.P. Morgan's indoor tennis court. "Quite the contrary - this is just monetary policy. . . . It will work or not work in much the same way that ordinary, more conventional, familiar monetary policy works." 

It is reassuring to have a Fed chairman who knows enough economic history that he's seen (or at least studied) it all before.

The Ultimate Response to "the Chinese Professor"

One unfortunate aspect of tough economic times is that the fear and anxiety that people feel can be exploited with appeals to tribalism.  For example, a group called "citizens against government waste" has been pushing a right-wing political agenda with this ad:



There are any number of substantive flaws in the ad's argument I could point out, but I could not hope to respond better than this hilarous parody, from Taiwan's Next Media Animation:



That comes to my attention via James Fallows (see also his post on the original ad).

A Hint of a Pulse

......................................................................................................

.......................................................................................meep!.....



The October employment report isn't really that good, but its soooo much better than what we've seen over the last few months... In particular, after falling for four consecutive months, nonfarm payroll employment rose by 151,000 in October.

The June-September reports looked so bad partly because the government was shedding workers (some of them temporary census workers). Because of this, some observers (and the White House) preferred to focus on private-sector payrolls, which have increased every month since January, albeit at a faltering pace. October's increase in private employment was 159,000, which was the best since April.

Of course, with 14.8 million unemployed, that's not nearly good enough to make a dent.  Essentially employment growth is back to a "treading water" pace, which only looks good after several months of drowning.

That is consistent with the headline number from the household survey: the unemployment rate was unchanged at 9.6% in October.  The underlying numbers aren't so hot - the number employed fell by 330,000 and the labor force participation rate fell from 64.7% to 64.5%.

Indeed, given the recent pace of real GDP growth (1.7% in the second quarter; 2% in the third, according to the advance estimate), we're lucky the unemployment rate hasn't risen, as Okun's law - which says that unemployment rises when growth is below 3% -  would imply.

Note that October is a month where the seasonal adjustment is downward; on a non-seasonally adjusted basis, payrolls increased 919,000 (private payrolls increased 409,000), and the unemployment rate fell to 9% (from 9.2% in September).

Paul Krugman refuses to be encouraged (of course):

So, we have a “strong” jobs report — with total employment still 7 1/2 million less than it was three years ago, we had job gains slightly higher than the number needed to keep up with population growth.
At this rate we’ll return to full employment around 2030 or so.

QE2 Sets Sail

Finally, quantitative easing (round 2), is here.  The Federal Open Market Committee announces:

To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to expand its holdings of securities. The Committee will maintain its existing policy of reinvesting principal payments from its securities holdings. In addition, the Committee intends to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month. The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability. 

That would represent a roughly 25% increase in Fed assets (currently about $2.3 trillion, including $838 billion of Treasuries); and a drop in the bucket relative to $8.6 trillion in US debt held by the public.

Will it work?  That has been the subject of considerable debate, which echoes an old-school Keynesian versus Monetarist scrap: Among the Keynesian skeptics are Paul Krugman and Mark Thoma and Joe Stiglitz, who would prefer more fiscal expansion. On the other hand, David Beckworth and Scott Sumner are more optimistic that QE can be effective.

The markets appear to be siding with the pro-QE camp.  Stock prices and the dollar are little changed today, which indicates that the announcement was pretty close to what was expected.  However, since Ben Bernanke raised the possibility of further expansion in a speech on Aug. 27, the stock market has headed up,

and the dollar has fallen (graph is the dollar price of a euro, so up indicates a relative dollar decline)

Also, a recent auction of TIPS (Treasury Inflation Protected Securities) suggests that inflation expectations are rising (see this NYT story, and this Jim Hamilton Econbrowser post).

One FOMC member is not on board: Thomas Hoenig of the Kansas City Fed.  According to the announcement:

Mr. Hoenig believed the risks of additional securities purchases outweighed the benefits. Mr. Hoenig also was concerned that this continued high level of monetary accommodation increased the risks of future financial imbalances and, over time, would cause an increase in long-term inflation expectations that could destabilize the economy.  

That is similar to the view expressed by Martin Feldstein in this FT op-ed. Another worry, expressed by Ambrose Evans-Pritchard, is that QE will start "currency wars," to which I say, "bring it on" (see this previous post).

More details on the policy are available from the New York Fed, which will implement it.

Update: Economix has a more comprehensive set of links to views on QE.  In his Times column, David Leonhardt explains how "dovish" monetary views have been vindicated.  Real Time Economics rounds up reaction from "economists and others" (Mike Pence, really?!).  In a Washington Post op-ed, Bernanke explains "What the Fed did and why."  See also: Free Exchange, Gavyn Davies, Scott Sumner, James Hamilton.

Actual Consols

Today's macroeconomics class arrived at the point where I needed explain how bond prices and yields are inversely related.  Fortunately for us economists, the British government has issued perpetual bonds - i.e., bonds which pay a fixed amount ("coupon"*) to the holder with no end date - known as "consols," which make the concept easy to illustrate.

If one pays £100 for a consol with a coupon of £5, the yield is 5% (5/100).  If market interest rates rise to 10%, the consol would only be worth £50 (since 5/50 = 0.10).

I was asked if the consols, which were first issued in the 18th century, still exist today.  A little internet "research" confirms that, indeed, these long-ago loans to the British government are still providing the descendents of the aristocracy with the income to cruise around Kensington in Rolls-Royces.

This wikipedia entry explains briefly the history of consols. According to the UK Debt Management office, there is £177 million worth of "2.5% consolidated stock" still outstanding (there are several other issues, too).  As of today, according to a British trading website, the 2.5% consol is trading at 56.52, which means a yield of 4.4% (2.5/56.52 = 0.044).  This post at the FT Alphaville blog has a graph of consol yields going back to 1729.

Hmm... perhaps I should buy some, so that next time the question comes up, I can say, "yes, I have some."

*I'm not sure "coupon" is good terminology for consols - it comes from bonds that included coupons that the owner would physically cut off and redeem for the interest payments.  That wouldn't work with a perpetual bond.

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).