Dirty Mario?

From a story by the Times' Landon Thomas about ECB President Mario Draghi:

“You do not go back to the lira or the drachma or whatever,” Mr. Draghi declared at that same early-August news conference. By alluding to the former currency of his home country, Italy, and seeming to place it in the same category of woebegone Greece, Mr. Draghi — who played a crucial policy role in the euro’s creation — signaled that he was taking the bears’ skepticism personally. 

“It’s like Dirty Harry saying, ‘Make my day,”’ said Stephen Jen, a former economist at the International Monetary Fund who now manages a hedge fund based in London. “You can’t imagine Greenspan or Bernanke saying something like this,” he said, referring to the previous and current U.S. central bank chairmen, Alan Greenspan and Ben S. Bernanke. “It was very Italian and very powerful.” 

Mr. Draghi’s weapon of choice, of course, is more subtle than the Smith & Wesson .44 Magnum favored by Clint Eastwood in the “Dirty Harry” movies. But from a financial markets perspective, there is no less firepower in his suggestion that the E.C.B. might buy the bonds of countries like Spain and Italy if they commit to tough measures to reduce deficits and restructure their economies. 

Of course, what made Eastwood's Inspector Callaghan "Dirty" was his willingness to break the rules.  If he really means to save the Euro,  Mario Draghi may need to show a similar disregard for legal niceties.  I'm not an expert on the ins and outs of the Maastricht treaty, so I won't take a position on whether large-scale purchases of the bonds of distressed governments by the ECB exceeds its authority (or on the related question of whether the "European Stability Mechanism" is constitutional), but some - particularly in Germany - have been making that case (see, e.g., here and here).

Some of the relevant language from the Maastricht treaty:

Article 104 1. Overdraft facilities or any other type of credit facility with the ECB or with the central banks of the Member States (hereinafter referred to as “national central banks”) in favour of Community institutions or bodies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments...

Article 104b 1. The Community shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of any Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project. A Member State shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law or public undertakings of another Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project.

If Draghi is serious about doing whatever it takes to save the Euro, he won't let that slow him down.

Critics of intervention can make appeals - perhaps with some validity - to the "rule of law," but this is a case where following the letter of the law (at least if its interpreted strictly) would lead to a real human disaster if the Euro cracked up in a crisis.

Some people found Dirty Harry's rule-breaking objectionable (Pauline Kael called it "fascist medievalism"). But John Wayne's perspective - in the context of explaining why he turned down the role - might be instructive for Draghi:

I thought Harry was a rogue cop. Put that down to narrow-mindedness because when I saw the picture I realized that Harry was the kind of part I'd played often enough: a guy who lives within the law but breaks the rules when he really has to in order to save others.

A little rule breaking is part of the tradition of central banking - as Brad DeLong explained, modern central banking came into being when the Bank of England acted outside its legal authority by assuming the role of "lender of last resort" during the panic of 1825.

Unlike Dirty Harry, whose magnum had six bullets, there will be no question of whether or not Dirty Mario has run out of firepower.  The question that remains is the extent of his willingness to use it, even if it means risking having to turn in his badge later.

Draghi probably wouldn't like the analogy, but I'd imagine its preferable to being called "Super Mario" all the time.

Rich and Paul

From Ryan Lizza's New Yorker profile of Paul Ryan:

In 1988, Ryan went to Miami University, in Ohio, where he got to know an economics professor named William R. Hart, a fierce and outspoken libertarian in a faculty dominated by liberals. The two quickly discovered their shared fascination with Rand and Hayek. Ryan got his first introduction to movement conservatism when Hart handed him an issue of National Review. “Take this magazine—I think you’ll like it,” he said.

Rich Hart (nobody calls him "William" or "Bill") was a colleague of mine for several years when I worked at Miami.  He certainly was "outspoken" - I figured that much out on my visit to Oxford as a job candidate, when I quickly realized politics probably wasn't the safest subject. After one of his colleagues - Rich wasn't the only conservative there - described Hillary Clinton as a "communist" I changed the topic.  After getting know Rich a little better, I'm sure he wouldn't have held the fact that our political views were very different against me.  Indeed, he was always quite kind in his dealings with me and supportive of the junior faculty.

I never had a precise sense of what Rich taught in his macroeconomics class, but, while he may have reinforced the political inclinations Paul Ryan brought with him to Miami, I highly doubt he could be held responsible for Ryan's absurdly ignorant take on monetary policy:

Perhaps Ryan’s most unconventional opinion on monetary policy came in the summer of 2010, when he told Ezra Klein that the Federal Reserve should actually raise interest rates even as the U.S. economy was still struggling: “[T]here’s a lot of capital parked out there, and we need to coax it out into the markets,” he said. “I think literally that if we raised the federal funds rate by a point, it would help push money into the economy, as right now, the safest play is to stay with the federal money and federal paper.”

Maybe America has a Greek Problem After All

I was asked recently if I was worried that the US was turning into Greece.  "I'm not worried about that at all," I said.  I gave the standard economist's explanation: the crucial difference is that the US government is borrowing in its own currency, and the primary evidence that markets aren't worried is the low yield on long-term Treasuries. 

However, reading Paul Krugman's column today about Mitt Romney's taxes, I realized that the US-Greece parallel may be valid in one unfortunate respect: both countries appear to have a serious tax-avoidance problem on the part of their elites. 

Wonkblog's Brad Plumer wrote about a study of tax evasion in Greece:

A bigger question is why Greece hasn’t been able to crack down on tax evasion. The authors note that Greek officials seem to have a very good idea of who’s avoiding taxes: In 2010, the parliament took up a bill that specifically targeted doctors, dentists, lawyers, architects, engineers and so forth. As the authors note, these are precisely the groups evading the most taxes (largely because they receive much of their income in bribes). But the crackdown bill failed — possibly because, as the authors discover, these are the professions best represented within the Greek parliament.

In the US, we have a problem of illegal tax evasion - the "tax gap" - which, while significant, may not be on the same scale as Greece's.  The bigger problem in the US is the ability - and willingness - by corporations and very high-earners to legally avoid taxes. 

Though its hard to know for sure what's going on without more information, Mitt Romney's IRA might be an example. According to Krugman:

I.R.A.’s are supposed to be a tax-advantaged vehicle for middle-class savers, with annual contributions limited to a few thousand dollars a year. Yet somehow Mr. Romney ended up with an account worth between $20 million and $101 million. 

I doubt Romney did anything illegal by the letter of the law, but the complexity of our tax system provides lots of ways for people and corporations that can muster legal and accounting firepower to minimize their taxes.  Moreover, the same people and corporations who benefit from the messiness of the tax code have disproportionate influence in Washington which may help them keep their loopholes open, and perhaps get them widened a little here and there.

The obvious policy answer is a simpler, and better-enforced tax code.  But, given the political economy, that's probably not realistic.  And focusing on the tax rules may miss the real issue, both here, and perhaps in Greece, that there is not a strong enough sense that taxes are a duty (one might even say noblesse oblige) and some attempts to avoid them - even if legal - might be wrong. 

Krugman noted that, in contrast to his son, George Romney was notably transparent about his finances:

Those returns also reveal that he paid a lot of taxes — 36 percent of his income in 1960, 37 percent over the whole period. This was in part because, as one report at the time put it, he “seldom took advantage of loopholes to escape his tax obligations.” 

There probably always have been and will be "loopholes", but what matters is the willingness to take advantage of them.  That depends, in part, on how socially acceptable it is to do so.  While the details are different (and the macroeconomics is very different), the US and Greece seem to share a significant failing in the "social norms" department.

A Trigger for the "Fiscal Cliff"

Under current law, taxes will rise significantly and government spending will be cut next year.  This scenario has been called the "fiscal cliff" and the CBO recently estimated it would lead to a recession in early 2013.

In the Hartford Courant, I suggest going over it, but gradually, when the circumstances are more favorable:

The tax increases could be made to occur at a more appropriate time by instituting triggering criteria that would delay them until the state of the economy has improved and then phase them in. For example, the tax changes could be set to begin once the unemployment rate has fallen to a more reasonable level, like 5.5 percent, and remained there for six months. At that point, the increases could occur in three or four steps, with each one occurring as long as the unemployment rate has remained below a specified level for six months.

This would minimize the risk of pushing the economy back into recession by waiting until the economy has recovered enough to bring the unemployment rate down to a level more consistent with a healthy economy. It would also create confidence that the U.S. is not headed for a debt crisis (though low interest rates suggest that financial markets are not worried about this now). An automatic trigger would take the guesswork out of deciding on an appropriate time frame for an extension of the tax cuts, and spare the country further political brinksmanship over renewing them again.

This is another form of "state contingent" fiscal policy that I've suggested previously on this blog.

In the piece, I asserted that allowing the 2001/03 income tax cuts and the 2010 temporary payroll tax cuts to expire would generate revenue "roughly consistent with the amount of spending required to maintain current programs." This is based on the idea that this would be pretty close to the "extended baseline scenario" in the CBO's projections where the US debt-to-GDP ratio gradually declines over time.  As Jared Bernstein notes, the implication is that the US can afford its current entitlement programs, if it allows scheduled tax increases to take place.

In addition to the tax increases - essentially a reversion to the tax code at the end of the Clinton administration (we did pretty ok back then, didn't we?) - the "fiscal cliff" scenario also involves some spending cuts under the "sequester" mandated by last summer's debt ceiling deal.  Since I was trying to keep the piece to op-ed length, I focused on the tax part because it is larger, but similar logic could be applied to the spending aspects.

The argument is not that this is an ideal economic policy - I'd like to see more stimulus now, and a simpler, more progressive tax code in the long-run; others would like cuts to entitlement programs and lower taxes - but rather that, as a modest change to existing law, it might be a politically feasible alternative to unrealistic hopes of a fiscal "grand bargain" that can achieve a "not bad" outcome in the short- and long-run.

Hans-Werner Sinn is for Hanging Separately. Is Germany?

In a NY Times op-ed attempting to explain "Why Berlin is Balking on a Bailout" Hans-Werner Sinn writes:

Even a European nation, however, should not socialize debt, a lesson demonstrated by the United States in the 19th century. 

When Secretary of the Treasury Alexander Hamilton socialized the states’ war debt after the Revolutionary War, he raised the expectation of further debt socialization in the future, which induced the states to over-borrow. This resulted in political tensions in the early 19th century that severely threatened the stability of the young nation. 

Wow.  

Every American schoolkid learns that Ben Franklin said "we must all hang together or assuredly we shall all hang separately." The point is that the we succeeded by hanging together.  Sinn somehow manages to draw the opposite lesson.  Wow.

The more widely-held (until today, I would have said "universally") view is that Hamilton's plans - which faced a great deal of opposition at the time - helped establish the creditworthiness of the United States and provided a foundation for its financial and economic development. Bob Wright and David Cowen, in Financial Founding Fathers explain:

The positive effects of funding and assumption of the debt upon not only the country's credit standing but also its commerce were felt almost immediately. Writing from Hartford in 1791, Noah Webster, the "schoolmaster of America," boasted about the era of prosperity brought on by assumption. "The establishment of funds to maintain public credit," he noted, "has an amazing effect upon the face of business and the country." "Commerce," he continued, "revives and the country is full of provision. Manufactures are increasing to a great degree, and in the large towns vast improvements are making in pavements and buildings."

Moreover, Europe's capital markets magically opened to the United States. As early as March 1791, United States securities were selling from 1 to 40 percent above par in Europe. In November 1791, European-based broker John Fry assured Hamilton that American credit overseas was secure and that European funds would stabilize securities prices. "The American Funds," Fry claimed, "had inspired no Confidence in this market 'til they had acquired a high price at home & three months ago a sale of them must have been effected here with the greatest difficulty." "The Case is now so materially alter'd," he wrote, "that one friend of mine has bought & sold near a Million of Dollars." Fry noted that Europeans at that time had more money than local investment opportunities and were looking to employ their capital in the United States. In short, Americans were able to borrow money in Europe at between 3 and 6 percent and use it to fund projects that returned 10, 15, even 20 percent per year. 

That is, Hamilton's plan for the national debt mostly worked out pretty well and is a good example of something that was controversial at the time but vindicated by history.

I really hope Sinn's view isn't representative of German opinion.  If it is, we're in way more trouble than I realized.

Economic Pessimism in Historical Perspective

US industrial production (log scale), 1790-2011:

From Davis, QJE 2004 (1790-1915); Miron and Romer, JEH 1990 (1916-1918); Federal Reserve, 1919-2011.

J.M. Keynes (Economic Possibilities for Our Grandchildren, 1930):

The prevailing world depression, the enormous anomaly of unemployment in a world full of wants, the disastrous mistakes we have made, blind us to what is going on under the surface - to the true interpretation of things.  For I predict that both of the two opposed errors of pessimism which now make so much noise in the world will be proved wrong in our own time - the pessimism of the revolutionaries who think that things are so bad that nothing can save us but violent change, and the pessimism of the reactionaries who consider the balance of our economic and social life so precarious that we must risk no experiments.

The Subordination of Economic Theory to Society

At Project Syndicate, Schlomo Ben-Ami writes:

Europe, however, has always found it difficult to come to terms with an over-confident, let alone arrogant, Germany. The current political turmoil in Europe shows that, regardless of how sensible Chancellor Angela Merkel’s austerity prescriptions for debt-ridden peripheral Europe might be in the abstract, they resemble a German Diktat. The concern for many is not just Europe’s historic “German problem,” but also that Germany could end up exporting to the rest of Europe the same ghosts of radical politics and violent nationalism that its economic success has transcended at home.

Once the crisis became a sad daily reality for millions of unemployed – particularly for what appears to be a lost generation of young, jobless Europeans – EU institutions also became a target of popular rage. Their inadequacies – embodied in a cumbersome system of governance, and in endless, inconclusive summitry – and their lack of democratic legitimacy are being repudiated by millions of voters throughout the continent.

Europe’s experience has shown that the subordination of society to economic theories is politically untenable. Social vulnerability and frustration at the political system’s failure to provide solutions are the grounds upon which radical movements have always emerged to offer facile solutions.

If "economic theories" is taken to mean the theories of economists, the "subordination of society to economic theories" is not the problem in Europe right now.

The euro project was driven by politicians and businessmen - not economists - from the outset.  In terms of economic theory, giving up autonomous monetary policy is highly problematic, especially in the absence of fiscal union and when labor mobility is limited. 

Moreover, according to economic theory, the "austerity prescriptions" are anything but "sensible."   Economic theory says that these policies are pro-cyclical (i.e., exacerbate the current economic slump) and that the adjustment of economic imbalances through "internal devaluation" is extremely painful.

The underlying motives for the push for austerity in Europe are largely political.  I cannot claim to have any insight about domestic politics in Germany, but the last several years in the United States have demonstrated that interventions grounded in basic economic ideas - counter-cyclical fiscal policy, expansionary monetary policy, and "lender of last resort" financial interventions - can be deeply unpopular.  Even though these policies can deliver what appears to be a (nearly) "free lunch," they are profoundly unappealing to the instinct and intuition of voters.  What the voters ("society") seem to want are economic policies that reward virtue and punish profligacy (last year, Stephen Gordon nicely observed a parallel between German attitudes and the US "Tea Party").

Economists and our theories are far from perfect, but the problem in Europe is not economic theories, or at least it isn't the economic theories of economists.  Europe would be doing much better right now if it was subordinated to economic theory (not the same thing as "technocrats").   The problem is that voters have their own economic theories, grounded in their perceptions of fairness and virtue, and these stand in the way of resolving the crisis.  That is, Ben-Ami has it exactly backward: what is underlying the European crisis is the subordination of economic theories to society.

Update:  Empirical evidence, tweeted by the Economist's Greg Ip:

Apparently many voters mistrust IS-LM. YouGov Economist poll: How stimulate econ? 47%=>gov't infrastructure spending; 46%=> reduce deficit.

And related thoughts in Paul Krugman's blog.

May Employment

The headline numbers from the BLS' May employment report are disappointing.  Employment only rose by 69,000, which is short of the rate needed to keep pace with population growth and technological progress, and the unemployment rate ticked up to 8.2%.

For reactions, see the Times' David Leonhardt, Free Exchange's Ryan Avent, Mark Thoma and Calculated Risk.

Although the payroll employment number rightly gets higher billing because it comes from a survey of businesses which has a larger sample, its worth noting that the numbers from the survey of households were a bit more encouraging.  According to the household survey, 422,000 more people were employed in May than April, and the reason the unemployment rate rose is that there was an even bigger increase in the labor force, partly reversing the decline in labor force participation. 

On a non-seasonally adjusted basis, the unemployment rate in May was 7.9%, up from 7.7% in April, and employment rose by 789,000.  That is, May is normally a month with big jumps in both employment and the labor force, which are removed by the seasonal adjustment.

Flo Doesn't Know the Lucas Critique

In the March issue of Automobile magazine, Ezra Dyer recounted his experience with Progressive insurance's "snapshot" system, the latest innovation in trading privacy for money (which we all seem pretty well inured to these days).  Customers who sign up for snapshot receive discounts for "safe driving," which is measured with a device that transmits data to Progressive from your car using the cell network.

Dyer explains:

According to the rules, Snapshot can generate a discount but not a surcharge -- unless you live in Rhode Island. The device logs your speed, but that's not a factor in the calculations because Progressive doesn't know where you are -- you might be doing 65 mph in a 70 zone or 45 mph through a car wash (although one wonders if a few trips into the triple digits would disqualify you from a safe-driver discount). The deciding factors are what time of day you drive, how far you drive, and how forcefully you brake.

The reason for the braking criteria is that "gentle braking apparently correlates to low insurance claims".  Anyone familiar with the Lucas critique will spot the problem with this, as Dyer does: 

If you're approaching a yellow light, Snapshot is an incentive to risk running the red rather than hitting the brakes. If a deer jumps out in front of you, Snapshot would prefer that you swerve into the oncoming lane rather than mash that brake pedal.

That is, the past relationship between braking behavior and driving safety reflects the behavior of agents under one set of incentives - if you change their incentives, their behavior will change, and the previous relationship between braking and safe driving will no longer be valid.

What Progressive really needs is a "structural" model that embodies the underlying preferences of their customers, which will be invariant to the policy change.  Of course that's a much harder thing to do (as macroecomists have discovered over the past several decades...).

Employment: April is Meh

According to today's report from the BLS, employment rose by 115,000 in April and the unemployment rate ticked down to 8.1%.

Nonfarm Payroll Employment (BLS; Seasonally Adj.)

The employment figure comes from a survey of businesses and is roughly consistent with a pace of job growth needed to keep the unemployment rate steady over time, but not nearly fast enough to bring it down.

Unemployment Rate (BLS; Seasonally Adj.)

The unemployment rate is calculated from a survey of households.  Unfortunately, the reason for the decrease isn't gains in employment, but rather a decrease in he labor force (the number of people who are working or looking for work, which is the denominator in the unemployment rate calculation).  In the household survey, the number of people reporting that they were working decreased by 169,000, while the labor force shrank by 342,000.  That brings the employment-population ratio down to 58.4 and the labor force participation rate is now 63.6.

Employment-Population Ratio (BLS; Seasonally Adj.)

The improvement in the unemployment rate over the past year (it was 9% in April, 2011) is due to the fact that the labor force has grown slowly relative to the population. Compared to a year ago, the "civilian noninstitutional" population (over 16) is 3.6 million higher, while the labor force has only grown by 0.95 million.  The number employed has increased by 2.2 million.  The employment-population ratio is the same as it was a year ago.  The declining labor force participation is probably a combination of demographic factors and discouragement.

April is a month with a large seasonal adjustment, and the month when the adjustment switches from positive to negative.  On a non-seasonally adjusted basis, the unemployment rate fell from 8.4% to 7.7%, the employment-population ratio rose from 63.7 to 64.1, and employment grew by 896,000.  That is, comparing the adjusted and non-adjusted numbers tells us that April is always a month with big employment gains, but this month's weren't impressive relative to that pattern.  There has been some discussion about whether the seasonal adjustment is slightly off, partly because of the warmer than usual weather this winter, which would mean that some of the hiring that normally might occur in the spring could have happened earlier.

The February and March payroll employment figures were revised upward a bit, by 19,000 and 24,000 respectively.

Overall, this report is consistent with the picture we've had from most of the data releases over the past year of an economy that is growing, but not quickly enough to make up for the ground lost in the 2008-09 recession - i.e., to close the "output gap."  12.5 million people remain unemployed.

Update: More reaction from Brad Plumer, Greg Ip, Floyd Norris, Mark Thoma, Calculated Risk, and the econ "twitterverse".