S&P Downgrade: Its the Institutions, Not the Debt

S&P just downgraded US government bonds from "AAA" to "AA+".  Their explanation:

We lowered our long-term rating on the U.S. because we believe that the prolonged controversy over raising the statutory debt ceiling and the related fiscal policy debate indicate that further near-term progress containing the growth in public spending, especially on entitlements, or on reaching an agreement on raising revenues is less likely than we previously assumed and will remain a contentious and fitful process. We also believe that the fiscal consolidation plan that Congress and the Administration agreed to this week falls short of the amount that we believe is necessary to stabilize the general government debt burden by the middle of the decade.

That is, the downgrade has as much to do with the US political system as it does with debt levels.  The ugly spectacle of a faction of one political party taking the economy hostage in the debt ceiling debate has trashed the rating agency's (and everyone else's) confidence in Washington's ability to make difficult compromises.

July Employment: Merely Bad

Arriving the day after a stock market plunge set off renewed talk of a "double dip" recession, the July employment report almost looks good because it is merely bad.  According to the BLS, in July the economy added 117,000 jobs and the unemployment rate ticked down to 9.1% (from 9.2%).

Employment growth of 117,000 is just about the "treading water" level needed to keep up with population growth and productivity improvements, so it doesn't represent any progress in digging out of a deep hole.   Government continued to be a drag - private employment rose by 154,000, but government jobs fell by 37,000 (of which state government accounted for 23,000, which the BLS says was "almost entirely" due to the Minnesota shutdown).

Also, the employment growth figures for May and June, which had contributed to the economic fears, were revised up to 53,000 and 46,000, respectively (still quite bad, but better than 25,000 and 18,000 previously announced).

Employment (Nonfarm Payrolls, Seasonally Adj.)

The decline in the unemployment rate was due to people leaving the labor force, not job gains - in the survey of households (different from the survey of firms from which the headline jobs number is calculated), the number of people employed fell by 38,000, but the number of people in the labor force fell by 193,000.  The labor force participation rate therefore decreased, as did the employment-population ratio.

Employment-Population Ratio (Seasonally Adj.)

Not a good report, but one that suggests the economy is stagnating, not falling into a recession.  That might take the some of the edge off of yesterday's panic, but, then again, a little panic might be what we need to rouse policymakers into action....

2Q GDP: Bad Present, Worse Past

Even with expectations low, today's advance estimate of second-quarter GDP from the BEA was disappointing.  Real GDP grew at a 1.3% annual rate in the second quarter of 2011, and the first quarter's growth rate was revised downward to 0.4% (from 1.9% previously estimated).

Government purchases - the G component in the national income accounting identity - was a drag on real GDP for the third consecutive quarter.  In the second quarter, G decreased at a 1.1% annual rate (larger declines in federal nondefense and state and local government spending were partly offset by an increase in defense spending).  Consumption was basically flat (increasing at 0.1% annual rate), while investment rose at a 7.1% pace.  Net exports also made a positive contribution: exports increased at a 6% rate, compared to 1.3% for imports.

Today's release incorporated a large "annual revision" of past data, and it indicates that the recession was worse than previously believed: real GDP shrank 0.3% in 2008 and 3.5% in 2009 (compared to previous estimates of 0% and -2.9%).  This graph from Calculated Risk shows the changes:

According to the revised numbers, real GDP has not returned to its pre-recession level, as we had previously believed.

This makes the badness of the labor market somewhat less of a puzzle - the rise in unemployment had been more than the fall in output seemed to warrant based on historical relationships, but now we know that output was lower than we thought.

In this deep hole (and with long-run interest rates remaining very low), the policy focus on budget cuts makes no sense, of course.  Ryan Avent has a good analogy:

IN 2007, the great ship of the American economy began encountering darkening skies. In 2008, it was suddenly faced with a violent storm which blew it miles off course, well south of where it ought to have been. The country's leaders didn't know how far from their charted path they'd been swept, but they recognised a need to make a course correction. Now, three years later, a look at the maps tells us that the storm was more powerful than previously believed, and it left the vessel much farther south than anyone had expected. The course corrections made earlier? Far too small to bring the ship back to its previous path. Yet none of America's leaders are trying to steer the ship back northward. Indeed, many seem anxious to yank on the tiller and drag the economy farther south still.

Brad Plumer has a nice post on what the data suggest about the recovery act (a.k.a., the "stimulus"), and Brad DeLong has some quick policy suggestions (though there's little reason to hope we'll see anything like them).   Real Time Economics rounds up Wall Street "economist" reaction.

The Most Interesting Man in the World?

The January issue of Economica included a symposium in honor of A.W. (Bill) Phillips, marking the 50th anniversary of his original "Phillips Curve" article.  The first article is a biographical essay by Alan Bollard, which is fascinating reading:

The young Bill was clearly very talented, but his parents reluctantly decided that they could not afford to keep him at school, and any dreams of a university education were abandoned. Aged 15, Bill signed up as an apprentice electrician with the government's Public Works Department, which at that time was building infrastructure around rural New Zealand. He spent the next few years roughing it at working men's camps in remote rural sites, helping to build hydroelectric dams to generate electricity for the national grid. Bill had played with photography and seen early movies, and he was fascinated by the idea of ‘talkies’. He hired a hall in the Tuai camp and set up the first talkies cinema. Recreation involved playing his violin, riding an acquired motorbike and reading his treasured encyclopaedia of world religions.
 

But rural New Zealand was not enough. Phillips wanted to sample the world. In 1935, still aged only 21, he packed his swag and his fiddle, and shipped to Australia. Here he spent a couple of years travelling the outback, hitching rides on freight trains and working in mining camps. Money came from a range of jobs: picking bananas, working on building sites, mining gold, running a cinema, and even crocodile hunting. These were tough jobs in a rough country, but at the same time Phillips had set his intellectual sights higher. He enrolled in a correspondence course in electrical engineering and remembers learning his first differential equations under a harsh Australian sun at an outback mining camp.
 

Phillips had a lifelong fascination with Eastern cultures. In 1937, despite the worsening international situation, he boarded a Japanese ship to travel to Shanghai. While he was at sea, the Japanese invaded Manchuria, and the ship was diverted to Yokohama. Phillips took advantage of this by travelling around the newly militarized Japan; at one point he was detained by the authorities, who suspected that he might be a spy. Eventually he made his way out through Korea, Manchuria and Harbin, and crossed Russia on the Trans-Siberian railway. With Antipodean optimism, he looked for casual jobs across Soviet Russia, only to find them all taken by political prisoners. From Stalin's Moscow he travelled on through threatened Poland and Nazi Germany during the fragile last years of peace. He settled in London, where he found work as an electrical engineer. Having continued his correspondence course, Phillips now graduated from the Institute of Electrical Engineers, gaining his first formal qualifications. He also took classes in several languages.

Fortunately, Economica has given free online access, so you can read the rest, including his World War II adventures.  There is also the story of his famous machine - I posted a video of it in operation here.

Rules-based Keynesian Policy?

John Taylor, who is one of the most prominent academic critics of administration and Fed policy over the past several years, grapples with the label "anti-Keynesian" that was pinned on him by The Economist.  He writes:

In a follow-up to the Economist article, David Altig, with basic agreement from Paul Krugman, argued that it was a misnomer because I developed and used macro models (now commonly called New Keynesian) with price and wage rigidities in which the government purchases multiplier is positive (though usually less than one), or because the Taylor rule includes real variables in addition to the inflation rate. In my view, rigidities exist in the real world and to describe accurately how the world works you need to incorporate such rigidities in your models, which of course Keynes emphasized. But you also need to include forward-looking expectations, incentives, and growth effects—which Keynes usually ignored.

In my view the essence of the Keynesian approach to macro policy is the use by government officials of discretionary countercyclical actions and interventions to prevent or mitigate recessions or to speed up recoveries. Since I have long been critical of the use of discretionary policy in this way, I think the Economist is correct so say that I am anti-Keynesian in this sense of the word. Indeed, the models that I have built support the use of policy rules, such as the Taylor rule for monetary policy or the automatic stabilizers for fiscal policy, which are the polar opposite of Keynesian discretion. As a practical prescription for improving the economy, the empirical evidence is clear in my view that discretionary Keynesian policy does not work and the experience of the past three years confirms this view. 

"Keynesian" means different things to different people - at its broadest, it means accepting that there are frictions in the economy which mean that aggregate demand matters and policy can have real effects.  This is in contrast to the pure classical view, in which Say's law holds, demand is irrelevant, and output depends on technology and preferences.  In the version of Keynesian economics in our undergraduate textbooks - the IS-LM/AS-AD framework - the frictions are nominal rigidities and the Keynesian model deals with "short run" fluctuations around a "long run" equilibrium determined by the classical model.  In this setting, both monetary and fiscal policy matter (by shifting the LM and IS curves, respectively), though early Keynesians emphasized fiscal policy and "monetarists" (most prominently Milton Friedman), gave primacy to monetary policy.  The version of Keynesian economics in our graduate textbooks and academic journals - "New Keynesian" - combines dynamic optimization with sticky prices, and explicitly addresses the lack of "forward looking expectations" in the traditional textbook version.  Furthermore, some argue that both the IS-LM and New Keynesian incarnations really miss the point and gloss over more fundamental irrationality and instability Keynes saw in the capitalist system.

As Taylor describes his views of the economy (and from what I know of his academic work), it seems consistent with mainstream New Keynesian economics (though his version has been less favorable to fiscal policy than some others).   His criticism of recent fiscal and monetary policy grows out of another longstanding conundrum in macroeconomics, "rules versus discretion."  He is not claiming that countercyclical fiscal and monetary policy are fundamentally impossible, which is what I would say is the true "anti-Keynesian" view.  Rather, he is arguing that discretionary policy may do more harm than good, and policy should be based on stable, predictable rules. 

A primary argument for rules is that discretionary "fine tuning" is impractical based on "long and variable" lags associated with (i) recognizing the state of the state of the economy, (ii) designing and implementing a policy and the (iii) the policy's impact reaching the economy.  Often lurking behind this argument is a political philosophy that is skeptical of government (no coincidence that Milton Friedman was the most famous proponent of rules - Brad DeLong recently argued this is how he resolved the contradiction between an economics that said monetary policy can be effective with a libertarian political philosophy).

Taylor is careful to say that he opposes "discretionary Keynesian policy" - I think "anti-discretion" might be a better characterization of his critique than "anti-Keynesian."  Of course, that only matters if it is possible to be "anti-discretion" without being "anti-Keynesian."  I think it is.

I don't share the political philosophy, but the experience of the last several years has underscored the practical difficulties of discretionary policy.  The early-2009 Obama administration with large congressional majority is about as close to government by center-left mainstream Keynesian technocrats as the American political system is likely to ever give us.  In retrospect, it is clear they misjudged the scope and duration of the downturn and were not able make adjustments as that became apparent.

Monday morning quarterbacking in April, I suggested that the stimulus should have been designed in a "state-contingent" fashion to remain in place until the recovery reached certain benchmarks.  It is a small step from there to a "rules based" countercyclical fiscal policy - policies like aid to state governments, extended unemployment benefits, payroll tax cuts and even increased infrastructure spending could be designed to kick in and ramp down automatically based on the state of the economy (e.g., with triggers based on the unemployment rate).   To me, that's very "Keynesian", but also "rules-based", and its easy to imagine that might have worked better than the actual policies that were put in place. 

Practical Lessons in Keynesian Economic Policy

Ezra Klein writes:

Keynes — and others who later elaborated on his work, like Hyman Minsky — taught us that although markets are usually self-correcting, they occasionally enter destructive feedback loops in which a shock to, say, the financial system scares business and consumers so badly that they hoard money, which worsens the damage to the system, which further persuades other economic players to hoard, and so on and so forth.

In that situation, the role of the government is to break the cycle. Because businesses and consumers have stopped spending, the government breaks the cycle by spending. As clean as that theory is, it turned out to be a hard sell.

The first problem was conceptual. What Keynes told us to do simply feels wrong to people. “The central irony of financial crises is that they’re caused by too much borrowing, too much confidence and too much spending, and they’re solved by more confidence, more borrowing and more spending,” Summers says.

The second problem was practical. “What I didn’t appreciate was the extent to which we only got one shot on stimulus,” Romer says. “In my mind, we got $800 billion, and surely, if the recession turned out to be worse than we were predicting, we could go back and ask for more. What I failed to anticipate was that in the scenario that we found we needed more, people would be saying that what was happening showed that stimulus, in general, didn’t work.”

Many of us economists believe Keynesian policies have been successful, and that more would have been better, but politics doesn't judge outcomes relative to a counter-factual scenario.  That is, the argument that things would have been far worse in the absence of a policy isn't a winner, even if it is correct.  Unfortunately, that means future policy makers are likely to draw exactly the wrong lessons, and do even worse next time (at least on the fiscal side; central bank independence gives monetary policy some space to follow academic rather than political views).

Furthermore, as Paul Krugman explains, the economics profession (or at least some parts of it) isn't playing an entirely helpful role.

Cavallo on Greece

Some have likened Greece's situation today to Argentina's in 2001, when, after repeated austerity "cures" failed, it ultimately was forced off its peg to the dollar and suffered a severe crisis, but a floating currency ultimately facilitated a recovery.   In a Vox column, former Argentine finance minister Domingo Cavallo offers some reflections on Argentina's experience and what it suggests for Greece.  Unfortunately for them, he says "Greece’s crisis is much more difficult to manage than the 2001 Argentinean crisis." (Yikes!!).   He offers some suggestions on how the debt restructuring should be done (and I think everyone who isn't a European government official sees that it needs to be done), but doesn't think Greece should leave the Euro.

June Employment: Bad Economy!

A really bad employment report - according to the BLS, the economy only gained 18,000 jobs in June and the unemployment rate ticked up to 9.2% (from 9.1%).

The government continues to be a drag - private sector payrolls increased by 57,000, but government employment shrank by 39,000.  The employment numbers are calculated from a survey of businesses; the numbers from the BLS' survey of households (from which the unemployment rate is calculated) are even worse - the number of employed persons dropped by 445,000 and labor force participation decreased to 64.1%.

On a non-seasonally adjusted basis, the unemployment rate rose from 8.7% to 9.3% because of a large increase in the labor force (1.089 million, presumably due to the end of the school year) outstripped a small increase in employment (101,000).  Non-seasonally adjusted payrolls rose by 376,000.  The comparison between seasonally-adjusted and unadjusted numbers shows that June is a month that normally sees a big increase in labor force participation and employment, and this June's increase in employment is disappointing compared to what we would expect for this part of the year (and what is needed to keep pace with changes in the labor force).

The discussion in Washington seems increasingly detached from reality...

See also: Tim Duy, Menzie Chinn, Calculated Risk, Greg Ip.

Orzag for State-Contingent Stimulus

In a column for Bloomberg, former CBO chief and White House budget director Peter Orszag writes:

...[P]olicy makers should provide additional macroeconomic support in 2012 by extending the existing payroll tax holiday. But more than that, Congress should link the payroll tax to the unemployment rate. This would allow the tax holiday to automatically calibrate itself to existing conditions, providing support only when the economy is weak. If necessary, the underlying payroll tax rate could be raised to make this mechanism budget-neutral. 

As I said back in April, one of the main lessons I've drawn from recent experience is that the recovery act would have been much better if the support for the economy had been made state-contingent like this.  This is a way of overcoming two problems: (i) uncertainty about the speed of recovery (or lack thereof) and (ii) the political system's utter inability to deal with timing issues (nicely explained in Orszag's piece), as evidenced by the absurdity that it appears that we are heading for significant fiscal tightening even as nearly 14 million people remain unemployed.

Krugman on Keynes

Vox has published Paul Krugman's speech at a conference commemorating the 75th anniversary of The General Theory.  The speech brings together a number of themes Krugman has addressed at his blog.  Among other things, Krugman says:

The brand of economics I use in my daily work – the brand that I still consider by far the most reasonable approach out there – was largely established by Paul Samuelson back in 1948, when he published the first edition of his classic textbook. It’s an approach that combines the grand tradition of microeconomics, with its emphasis on how the invisible hand leads to generally desirable outcomes, with Keynesian macroeconomics, which emphasises the way the economy can develop what Keynes called “magneto trouble”, requiring policy intervention. In the Samuelsonian synthesis, one must count on the government to ensure more or less full employment; only once that can be taken as given do the usual virtues of free markets come to the fore.

It’s a deeply reasonable approach – but it’s also intellectually unstable. For it requires some strategic inconsistency in how you think about the economy. When you’re doing micro, you assume rational individuals and rapidly clearing markets; when you’re doing macro, frictions and ad hoc behavioural assumptions are essential.

So what? Inconsistency in the pursuit of useful guidance is no vice. The map is not the territory, and it’s OK to use different kinds of maps depending on what you’re trying to accomplish. If you’re driving, a road map suffices. If you’re going hiking, you really need a topographic survey.

But economists were bound to push at the dividing line between micro and macro – which in practice has meant trying to make macro more like micro, basing more and more of it on optimisation and market-clearing. And if the attempts to provide “microfoundations” fell short? Well, given human propensities, plus the law of diminishing disciples, it was probably inevitable that a substantial part of the economics profession would simply assume away the realities of the business cycle, because they didn’t fit the models.

The result was what I’ve called the Dark Age of macroeconomics, in which large numbers of economists literally knew nothing of the hard-won insights of the 30s and 40s – and, of course, went into spasms of rage when their ignorance was pointed out.

I share Krugman's view that the "textbook" Keynesian apparatus remains a useful apparatus for thinking about the economy.  However, I think his portrayal of the turn macroeconomics has taken over the past forty or so years is a bit unfair.  As Krugman notes, contemporary macroeconomic models are grounded in microeconomic optimization.  Although a foolish desire for consistency can be the hobgoblin of our little economist minds, there is more to the story - the shift in methodology was also motivated by real deficiencies in the Keynesian framework identified by Friedman and Lucas, as well as the "stagflation" of the 1970's, which appeared to contradict Keynesian theory.