An Inconvenient Mankiw

Food for thought for all the would-be Romney administration Kremlinologists out there:

The National Journal's Jim Tankersley has an interesting article about Mitt Romney and his economic advisors.  The gist of the article is that Greg Mankiw and Glenn Hubbard are well-respected economists, but Romney's statements on the campaign trail suggest he's not listening to them much.  Tankersley writes:

This, then, is the Romney Conundrum—for conservatives, liberals, and everyone else. Even on the economy, Romney’s signature issue, it’s hard to know where his heart lies—and how he would govern in the White House. Would the former Massachusetts governor listen to his best and brightest? Or to his party base?

“Romney’s got Glenn and Greg advising him, and they’re both top-notch economists,” said Keith Hennessey, who ran the National Economic Council for President George W. Bush. “But there’s more to economic policy than just economics.”

Of course this isn't entirely unique to Romney - politicians often fail to follow through on politically inconvenient suggestions from economists (though the universe of what is inconvenient for a Republican primary candidate to say is pretty scary these days).

The article comes to my attention from Greg Mankiw, who linked to it on his blog, without comment.  Hmmmmm...

As if to illustrate... Mankiw has a column in today's Times about tax reform.  Among his suggestions:

Consider the tax on gasoline. Driving your car is associated with various adverse side effects, which economists call externalities. These include traffic congestion, accidents, local pollution and global climate change. If the tax on gasoline were higher, people would alter their behavior to drive less. They would be more likely to take public transportation, use car pools or live closer to work. The incentives they face when deciding how much to drive would more closely match the true social costs and benefits.

Economists who have added up all the externalities associated with driving conclude that a tax exceeding $2 a gallon makes sense. That would provide substantial revenue that could be used to reduce other taxes. By taxing bad things more, we could tax good things less. 

Well, if Romney proposed that, it would probably take the attention off his tax returns!

Me and the "Mussa Puzzle"

The international economist, and former chief economist of the IMF, Michael Mussa, died earlier this week.  I never met the man, and reading these remembrances from the Peterson Institute makes me sorry I didn't.  But we have done some work in the same area: one of my own favorite papers confirms one of Mussa's most well-known findings, that the behavior of real exchange rates depends on whether nominal exchange rates are fixed or floating.  Paul Krugman explains:

Probably his most influential paper — certainly the one that had the biggest impact on me — was his 1986 paper (pdf) on currency regimes and the behavior of real exchange rates. This bore on the question of whether exchange rate changes make adjustments in relative costs and prices easier; it bore more broadly on the question of whether prices are flexible, as fresh-water economists like to assume, or instead sticky in nominal terms.

Mussa had a simple but powerful insight: if prices were flexible, then all relative prices should be determined by “real” factors, and their behavior shouldn’t change if, say, a country goes from a fixed exchange rate to a flexible rate or vice versa. As he pointed out, this proposition could be tested using a natural experiment, the breakdown of Bretton Woods and the move to floating rates. Did the behavior of real exchange rates — relative price levels expressed in a common currency — change?

I've seen the large increase in real exchange rate volatility under floats referred to as "the Mussa puzzle", though, as Krugman points out, "sticky" prices are a straightforward explanation.

I was able to address one significant limitation of Mussa's analysis. His paper relied heavily on a comparison of the periods immediately before and after exchange rates began to float in the early 1970's.  That left open the possibility that some other changes at around the same time led to the difference in real exchange rate behavior.  Vittorio Grilli and Graciela Kaminsky made that argument in a 1991 Journal of Monetary Economics paper:

In particular, the high volatility of the real exchange rate since the breakdown of the Bretton Woods system in the early 1970s may have arisen as a consequence of factors unrelated to the nominal exchange rate regime - such as the two oil price shocks of the 1970s or the wide fluctuations in interest rates during the late 1970s and early 1980s.

However, in "Across Time and Regimes: 212 Years of the US-UK Real Exchange Rate" (Economic Inquiry 48:4 [October 2010]), I exploited the fact that the exchange rate between the US and Britain has alternated a number of times between fixed and floating.  One of the tables in the paper shows the average monthly change in the real exchange rate during different regimes.

1. Jan. 1794-Apr. 1821 (floating): 2.66%
2. May 1821-Dec. 1861 (fixed): 2.02%
3. Jan. 1862-Dec. 1878 (floating): 2.52%
4. Jan. 1879-June 1914 (fixed): 1.17%
5. July 1914-Mar. 1919 (wartime controls): 1.75%
6. Apr. 1919-Apr. 1925 (floating): 2.03%
7. May 1925-Aug. 1931 (fixed): 0.98%
8. Sept. 1931-Aug. 1939 (floating): 1.77%
9. Sept. 1939-Sept. 1949 (wartime controls): 1.52%
10. Oct. 1949-July 1971 (fixed): 0.49%
11. Aug. 1971-Dec. 2005 (floating): 1.97%

The pattern of higher volatility in floating periods is a robust one (and there is more statistical evidence in the paper). However, the differences between fixed and floating are smaller in earlier periods, which suggests that perhaps price stickiness has become more important over time.

City of Yesterday, Today

Extremists who mistakenly believe they are defending liberty have the Detroit suburb where I grew up in their vise, the New York Times reports:

In what could be a new high water mark of anti-Washington sentiment, the city of Troy, Mich., is rejecting a long-planned transportation center whose construction would have been fully financed with federal stimulus money.

The terminal, which would help Troy become a transportation node on an upgraded Detroit-to-Chicago Amtrak line, was hailed by supporters as a way to create jobs and to spur economic development. But federal money is federal money, so with the urging of the new mayor, who helped found the local Tea Party chapter, the City Council cast a 4-to-3 vote this week against granting a crucial contract, sending the project into limbo.

“There’s nothing free about government money,” Mayor Janice Daniels said in an interview. “It’s never free, and it’s crippling our way of life.” 

The street signs at the city's entrances say "City of Tomorrow, Today!" but it sounds like Mayor Daniels is leading Troy backwards, with great conviction.

A Professorial Dilemma (RIP, Saab)

Sad news from Trollhättan, the NY Times reports:

The owner of Saab Automobile finally threw in the towel Monday, filing for bankruptcy after hopes of a life-saving investment from Chinese investors collapsed in the face of opposition from General Motors.

This creates a dilemma for those of us who feel a professional obligation to uphold the stereotype of the Swedish-car driving college professor, but believe we are too cool for Volvos.

The Economist's "Schumpeter" column gave a the brand a nice (though slightly premautre) obituary in September.  It is still possible someone will buy the company whole in bankruptcy and restart it, but most reports suggest liquidation is more likely.

No "Buts" About It

From the NPR website:

The story itself is fine, though the "but" in the headline suggests that the editor who wrote it expected austerity to lead to (short-term) growth.  Most of us economists don't find the coincidence of fiscal tightening and slumping growth so surprising (see e.g., Krugman).

Last week's summit agreement to tighten enforcement of the budget rules in the "stability and growth pact" doesn't help matters.  One is reminded of the old joke that the Holy Roman Empire was "neither Holy, nor Roman, nor an Empire."  I suppose actually enforcing the rules would make it more of a "pact," but forcing procyclical fiscal policies won't be good for stability or growth (see this post by Antonio Fatas). 

So its not surprising that the Washington Post reports "In Europe, summit optimism fades." The half-life of "summit optimism" seems to be declining, which means that Europe must either (a) really fix things or (b) hold summits more frequently.  I think they're converging towards continuous summit. 

November Employment: The Good, the Meh, and the Bleh

From the BLS November employment report:

• Good news: Significant drop in the unemployment rate, to 8.6% (from 9%)

• Less good: Mediocre employment growth of 120,000 jobs (a "treading water" pace)

• Not good: Labor force participation falls by 0.2 percentage points to 64%

 
The employment growth number comes from a survey of businesses (the "establishment survey") while the unemployment rate is calculated from a household survey (which has a smaller sample).  Continuing a recent pattern, employment growth looks better in the household survey: 278,000 more people said they were employed.  Also continuing the pattern of recent reports, the previous establishment survey numbers were revised upwards; September's job gain is now 58,000 higher and October's is up by 20,000.  Over the past several months, the revisions have been bringing the establishment report figures up closer to the better household survey numbers (which aren't subject to revisions).

By itself, 278,000 more people employed doesn't get the unemployment rate down by 0.4 percentage points.  The labor force fell by 315,000 (thus bringing the participation rate down).  The unemployment rate is measured as a percentage of the labor force, and to be counted in the labor force, someone must either be working or looking for work.  Another way of looking at it is that the number of people who were unemployed fell by 594,000 - roughly half of them got jobs, while the other half quit looking.

On a non-seasonally adjusted basis, the unemployment rate in November was 8.2% (down from 8.5% in October, mainly due to a big drop in participation) and payrolls rose by 339,000. That is, November is a month when the seasonal adjustment makes things look worse... it will be the opposite in January when all the extra holiday employees lose their jobs.

A Goolsbee is Haunting Europe

In a WSJ op-ed, further elaborated in an interview with Ezra Klein, Austan Goolsbee lays out some of the fundamental problems of the Euro, which go deeper than the immediate financial crisis.  In particular, the common currency closes off the avenue of exchange rate adjustment. That is, without the Euro, the DM would be rising and the Lira and Peseta falling, improving Italian and Spanish current account balances.  He concludes:

[E]ven if Europe addresses the banking-capitalization crisis of the moment, and even if it struggles its way through the near-term fiscal crises of Greece and Italy, then what? With little prospect for growth in its South, Europe remains on the romantic road to nowhere—a road that merely runs in a circle. Without growth there will always be another fiscal crisis ahead for yet another country unable to balance its budget but prevented from devaluing and exporting its way forward.

On this path, Europeans will forever need to fight off financial and fiscal panics while trying to build their castle on a hill.

What really matters is the real exchange rate - i.e., the price of one country's goods in terms of another's.  The real exchange rate between two countries is the nominal exchange rate times the ratio of the countries' price levels.  Even if both countries have the same currency, the real exchange rate changes if they have different inflation rates.  This means that Greece, Italy and Spain can have a real depreciation vis a vis Germany by having lower inflation, which would, over time, make their goods relatively cheaper.  Of course, to get very far with this, if German inflation is low, then the peripheral countries' price levels actually need to fall.  This is sometimes called "internal devaluation", and because it entails deflation, is quite painful.  This what Goolsbee is talking about when he says: "In the short run, that would mean directly and significantly grinding down wages to make them competitive—a grisly option, prone to causing mass unrest."

I think this would be significantly less painful if it didn't involve price levels actually falling and, in principle, it doesn't have to.  For simplicity, say the Eurozone consists of a "core" and "periphery" of equal size.  If Eurozone inflation is 4%, it could be 7% in the core and 1% in the periphery, which means the periphery experiences real depreciation at a 6% rate.  However, the ECB is quite firm about sticking to its mandate - which reflects German preferences - for inflation at or below 2%.

In a way, this is analogous to the Akerlof-Dickens-Perry case that slightly positive inflation facilitates real wage adjustment because it allows some real wages to fall without forcing very difficult nominal wage cuts.

Death, Taxes and Trade Disputes

Douglas Irwin, Free Trade Under Fire (3rd ed., 2009):

The tuna dispute was resolved in 1992 when the United States, Mexico, and eight other tuna-fishing nations signed an international agreement to regulate the conditions of tuna fishing.

Bridges Trade News Digest, Nov. 16, 2011:

At its last meeting on 11 November, the WTO Dispute Settlement Body (DSB) decided to extend the deadline for submitting an appeal on the latest Tuna-Dolphin (DS381) ruling issued in September (see Bridges Weekly, 21 September 2011).

In light of the Appellate Body’s substantial workload, the US and Mexico had jointly requested an extension of the normally sixty-day period, which otherwise would have expired on 15 November. In accordance with the agreed extension, an appeal will have to be submitted no later than 20 January.

Lesson: never use the word "resolved" when writing about trade disputes....

To be fair to Irwin, whose book I recommend (and assign to students), one could consider "Tuna-Dolphin" to be a series of disputes, one of which was resolved in 1992.

Is the ECB Determined to Go Down with the Ship?

With the risk premium on Italian government debt growing, the best hope for a resolution to the Euro crisis would seem to be for the European Central Bank to announce an unlimited intervention to cap the yield on sovereign bonds.  However, it steadfastly refuses to do so - presumably because it feels that such an action might risk a violation its prime directive of "inflation rates of below, but close to, 2% over the medium term."

In a recent Project Syndicate column, Brad DeLong argued that the ECB is failing to step up to the plate as the lender of last resort:

The ECB continues to believe that financial stability is not part of its core business. As its outgoing president, Jean-Claude Trichet, put it, the ECB has “only one needle on [its] compass, and that is inflation.” The ECB’s refusal to be a lender of last resort forced the creation of a surrogate institution, the European Financial Stability Facility. But everyone in the financial markets knows that the EFSF has insufficient firepower to undertake that task – and that it has an unworkable governance structure to boot.

Perhaps the most astonishing thing about the ECB’s monochromatic price-stability mission and utter disregard for financial stability – much less for the welfare of the workers and businesses that make up the economy – is its radical departure from the central-banking tradition. Modern central banking got its start in the collapse of the British canal boom of the early 1820’s. During the financial crisis and recession of 1825-1826, a central bank – the Bank of England – intervened in the interest of financial stability as the irrational exuberance of the boom turned into the remorseful pessimism of the bust.

Similarly, Barry Eichengreen writes:

Here’s where the political cover comes into play. Merkel and Sarkozy need to make the case that if the euro is to become a normal currency, Europe needs a normal central bank – one that does not merely target inflation like an automaton, but that also understands its responsibilities as a lender of last resort.

More on this from The Economist, Antonio Fatas, Gavyn Davies and Martin Wolf as well as a nice "news analysis" from the NY Times. 

If Italy is fundamentally solvent and merely facing a self-fulfilling "liquidity" panic (as investors sell bonds, yields rise, making it more costly to service its debts, which lowers the chances it will avoid default leading to investors selling bonds...), then it may not require much more than an announcement of a willingness to intervene to quell the crisis.  By restoring confidence, the ECB could bring yields down without having to do much actual bond-buying (i.e., Super Mario* can be Chuck Norris).

The crisis potentially spells the end of the Euro - so the ECB is putting its mandate ahead of its own self-preservation.  That is, it appears willing to risk its very existence for the sake of what it sees as its duty.  As a matter of economic policy, it looks disastrously foolish, and yet, there's something oddly noble-seeming about it.


*Admittedly, referring to Italian policymakers named Mario as "Super Mario" is getting stale quickly (and I can't imagine how much they must despise it); and the press needs to decide whether it is ECB President Mario Draghi or new Prime Minister Mario Monti who is called "Super Mario" (or perhaps not... a quick search of "Super Mario" on the FT reveals a potentially confusing solution: "Super Mario Brothers").  The Guardian compares two of the "Super Marios" and this FT profile argues Draghi earned his "super."

October Employment: Not Bad

Not really good, either...  The BLS reports that the unemployment rate ticked down to 9.0% (from 9.1%) in October.  Payroll employment increased (weakly) by 80,000; the private sector added 104,000 jobs but the public sector subtracted 24,000.   The numbers from the survey of households (which is used to calculate the unemployment rate) were a bit stronger - the number of people employed rose by 277,000.

Also, the payroll employment growth (from the survey of establishments) figures were revised upwards for August and September, by 57,000 and 55,000, respectively.

On a non-seasonally adjusted basis, the unemployment rate fell to 8.5% and payroll employment rose by 883,000.  That is, October is a month where a regular "seasonal" gain is removed to make the seasonally adjusted number.