Sunday, January 31, 2010

Okun's Law, In the News

The AP reports:
Mark Zandi, chief economist at, and Bill Cheney, chief economist at John Hancock, agree that the economy would have to grow roughly 5 percent for all of 2010 just to ratchet down the average unemployment rate for the year by 1 percentage point — to a still-high 9 percent.

Their math is based on Okun's law, named for economist Arthur Okun. In 1962, Okun produced a formula for the connection he saw between unemployment and economic activity.

Though, as Brad DeLong pointed out recently unemployment has actually been worse than Okun's law would imply.

Saturday, January 30, 2010

Wrong Button Blues

On a cold day in New England, there's nothing like hot chocolate that foamy light brown sugar-water the vending machine calls "cappuccino."

Wasn't there something I used to tell principles of microeconomics students about "sunk costs"...

New Keynesian Bastards?

When I teach the IS-LM model to my students, I am careful to describe it as "Keynesian" rather than Keynesian, in deference to the argument made by some that it does not accurately and/or fully represent what Keynes really meant. Although I still find that model framework quite useful for thinking about economic policy, I also explain to them why economic research has moved on from it.

Following the work of Friedman in the 1950's and 60's and Lucas in the 70's, there was an increasing emphasis on establishing microeconomic foundations for macroeconomics, and thinking seriously about expectations, with the idea of "rational expectations" becoming the new benchmark. This methodological revolution led to Real Business Cycle (RBC) models in the 1980's that explained economic fluctuations as the optimal responses of a forward-looking representative agent to productivity shocks. The models were "real" because monetary variables played no role. That ultimately proved too implausible for much of the profession to swallow (see e.g., Lawrence Summers (pdf)).

The real business cycle theorists did not succeed in taking over the field, but they did win the methodological war. It is now standard practice to derive macroeconomic models from the microeconomic foundations of optimizing behavior of agents with rational expectations. Much of the "New Keynesian" macroeconomics which is widespread today is essentially Real Business Cycle models with "sticky" prices grafted on (and the sticky prices mean that monetary policy has real effects).

In the FT, Roger Farmer argues that the "New Keynesians" aren't very good Keynesians, either:
For 30 years, macroeconomists have been of two stripes: new-classical and new-Keynesian. Neither has anything interesting to say about the current crisis.

In new-classical and new-Keynesian economics, all unemployment is temporary and unemployed workers will quickly find jobs. According to the Keynes of The General Theory, very high unemployment can persist forever. Nobody has taken this Keynesian idea seriously in respectable academic circles since the 1950s. But given the current jobless recovery, it’s an idea that makes sense and needs to be reconsidered.

Keynesian economics as we know it today is a watered down version of The General Theory given to us by American Keynesians like Paul Samuelson. Samuelson turned Keynesian economics into a digestible series of bite-sized pieces that the Cambridge economist and contemporary of Keynes, Joan Robinson, has referred to as “bastard Keynesianism”. Samuelson’s interpretation of Keynes evolved into a modern incarnation - new-Keynesian economics.

According to new-Keynesians, recessions occur because some firms are stubbornly unwilling to lower their prices in the face of a fall in demand. Workers quit their jobs and choose to take a prolonged vacation. This is not the main theme of The General Theory. But the idea that some firms are slow to change prices is central to new-Keynesian economics. To explain why firms don’t change prices, the new-Keynesians assume that a firm must wait until it’s randomly chosen to be given the privilege to change its price. This option is facetiously referred to as a ‘visit from the Calvo fairy’ after a paper by economist Guillermo Calvo who first introduced the idea into macroeconomics. I don’t believe in fairies.

The Calvo fairy is not the only unrealistic feature of new-Keynesian economics. Perhaps more damning is the fact that there is no unemployment in the benchmark new-Keynesian model. Instead, all variations in the employment rate occur as rational maximizing households choose to vary their hours in response to changes in the real wage. It is hard to take this model seriously as an explanation for the Great Depression or the current financial crisis. But it continues to dominate the discussion at academic conferences because - until now -there has been no good theoretical alternative.

While Farmer has his own alternative that involves more fundamental change, there is some progress being made on the labor market front within the existing New Keynesian paradigm. Several recent papers (which happen to be sitting on my desk right now) by Carl Walsh, Antonella Trigari and Olivier Blanchard and Jordi Gali include involuntary unemployment by integrating search and matching processes into the model.

It remains to be seen whether good "normal science" like this will save the New Keynesian framework in the wake of the global slump, or whether it is time for a scientific revolution...

Friday, January 29, 2010

Roaring Back?

Real GDP grew at an annual rate of 5.7% in the last three months of 2009, according to the BEA's "advance" estimate. That puts growth for the year at -2.4%. One note of caution, however, is that of that 5.7% rate of increase, 3.4% is attributable to inventories. Firms were still reducing inventories in the fourth quarter, but at a much slower pace than the third quarter - real inventory 'investment' was -$33.5 bn in Q4, vs. -$139.2 bn in Q3 (measured in 2005 dollars) - but a smaller negative number is an increase. At Econbrowser, James Hamilton has the best explanation I've seen of how to interpret this.

Consumption increased at a 2% annual rate. Both exports and imports grew, but exports grew more, so net exports made a positive contribution. Overall, government purchases made a slight negative contribution - while federal nondefense spending increased, defense spending and state and local government spending were down. The most hopeful sign is that business investment is finally increasing - equipment and software investment rose at a 13.3% annual rate.

Measured by the GDP deflator, the inflation rate was 0.6% in the fourth quarter, and 1.2% for the year.

Real Time Economics has a roundup of reactions. Brad DeLong notes that unemployment is higher than Okun's law implies it should be.

Of course, these estimates are subject to revision - the BEA will release an update on Feb. 26.

(N.B.: in the graph, the recession shading ends in July, but the NBER has not yet officially declared the business cycle trough).

Wednesday, January 27, 2010

Deficit Update

The Congressional Budget Office updated its budget outlook yesterday. They are estimating a $1.3 trillion federal budget deficit for fiscal year 2010 (9.2% of GDP), down from $1.4 trillion (9.9% of GDP) in FY 2009 (the federal "fiscal year" begins on Oct. 1 and ends on Sept. 30, so we are already about 4 months into FY 2010).

There are deficits as far as the eye can see, but they are projected to get considerably smaller over the next several years. In part, this is because the CBO is required to make projections assuming current law is followed, which means the 2001 and '03 tax cuts would expire. If they are extended, the deficit picture looks considerably worse, as can be seen in this picture I created using their nifty new website:
(The black line is the baseline forecast, the purple line adds the effect of making the Bush tax cuts permanent.)

As I suggested in the previous post, letting them expire as scheduled would probably not be a good idea given the current state of the economy, but making them permanent would make the government's long-run budget problem much worse.

Monday, January 25, 2010

Un-Tastee Freeze

President Obama will propose a freeze on non-'security-related' discretionary spending in the State of the Union. The Times reports:
Fiscally conservative Democrats in the House and Senate have urged Mr. Obama to support a freeze, and it would suggest to voters, Wall Street and other nations that the president is willing to make tough decisions at a time when the deficit and the national debt, in the view of many economists, have reached levels that undermine the nation’s long-term prosperity. Perceptions that government spending is out of control have contributed to Mr. Obama’s loss of support among independent voters, and concern about the government’s fiscal health could put upward pressure on the interest rates the United States has to pay to borrow money from investors and nations, especially China, that have been financing Washington’s budget deficit.
Ahem. Who are these "many economists" you speak of?

While there is legitimate reason to be concerned the US government's projected borrowing needs could lead to higher interest rates and "crowding out" of investment when the economy recovers, we are not there yet, not even close. But don't take my word for it, ask the bond markets:
As long as unemployment remains severely elevated, cutting spending (and a nominal freeze is a real cut) is exactly the wrong policy. The magnitudes are small, but as Brad DeLong writes:
What we are talking about is $25 billion of fiscal drag in 2011, $50 billion in 2012, and $75 billion in 2013. By 2013 things will hopefully be better enough that the Federal Reserve will be raising interest rates and will be able to offset the damage to employment and output. But in 2011 GDP will be lower by $35 billion--employment lower by 350,000 or so--and in 2012 GDP will be lower by $70 billion--employment lower by 700,000 or so--than it would have been had non-defense discretionary grown at its normal rate. (And if you think, as I do, that the federal government really ought to be filling state budget deficit gaps over the next two years to the tune of $200 billion per year...)

And what do we get for these larger output gaps and higher unemployment rates in 2011 and 2012? Obama "signal[s] his seriousness about cutting the budget deficit," Jackie Calmes reports.

Andrew Leonard says:

If ever there was a time to pull out the old Karl Marx chestnut, "History repeats itself, first as tragedy, second as farce," that moment is now. Prominent members of Obama's own administration have warned against repeating the errors of 1937, namely, Franklin Roosevelt's decision to cut spending and balance the budget too quickly, thus strangling a nascent recovery from the Great Depression. But with the U.S. economy far from healthy, the president has decided, once again, to bow to the political winds and make the deficit priority number one.

If the President wants to do something serious about the long-run fiscal problem, without making the economy worse in the short-run, two options are:
  • Get health care reform passed. The main driver of increases in projected future deficits is growth in government health care spending (Medicare, etc.) due to rising health care costs. The bills passed by the House and Senate both take steps in the direction of curbing cost growth.
  • Let the Bush tax cuts expire. Maybe not as scheduled after this year - since unemployment will still be high, the "sunset" should be pushed back a year or two - but don't make them permanent.
Sigh. Hopefully this will look better when we see it in context of the other proposals in the State of the Union.

(And I cannot help but wonder: would all this be happening if the Democrats in Massachussetts hadn't managed to find the one person in New England who doesn't know who Curt Schilling is and nominate her for Senate?)

Update (1/27): See also Paul Krugman, Ezra Klein. James Kwak fears he's turning into Bill Clinton (though he says: "I'd rather be a really good one-term president than a mediocre two-term president").

Vice-President Biden's economic advisor Jared Bernstein defends the policy:
First, an important note on timing. No one is arguing that we should take our foot off the accelerator today, when the economic recovery remains fragile and job growth has yet to return. In fact, you’ll hear from the President tomorrow night about measures we should undertake right away jumpstart job creation. In his words and deeds, the President has made clear that recovery comes first. But that doesn’t mean we should wait to start changing the same bad habits in Washington that left a $1.3 trillion deficit on our doorstep when we entered office in January 2009, especially when we can do so without cutting back on our jobs agenda.

Second, a little background on freeze-eology: there are two ways to do a freeze like this: (1) an across-the-board freeze on every program outside of national security; and (2) a surgical approach where overall totals are frozen but some individual programs go up and others go down. In short, a hatchet versus a scalpel.

During the campaign, you may recall that John McCain touted option 1 – the hatchet approach of an across-the-board freeze.

The President was critical of that approach then, and we would be critical of it now. It’s not what we’re proposing. To the contrary, the entire theory of the President’s proposed freeze is to dial up the stuff that will support job growth and innovation while dialing down the stuff that doesn’t. Under our plan, some discretionary spending will go up; some will go down. That’s a big difference from a hatchet.

Noam Scheiber explains what they may be thinking.

Saturday, January 9, 2010

Lessons of 1937

Bruce Bartlett reminds us that the "Great Depression" was actually two recessions, from 1929-33, followed by a recovery and then a second recession in 1937. This second recesssion was attributable to a tightening of monetary and fiscal policy. Bartlett writes:
In early 1937, Roosevelt was preparing his budget for the next fiscal year, which began on July 1 in those days. Strong growth in the economy and tax increases over the previous three years, especially the institution of a new payroll tax for Social Security, had caused tax receipts to almost double from 2.8% of GDP in 1932 to 5% in 1936. Projections showed that budget balance was within reach with only a modest reduction of spending.

Roosevelt was also concerned about the reemergence of inflation. After falling 24% between 1929 and 1933, the Consumer Price Index rose by a total of 7% over the next three years and signs pointed to even higher prices in 1937. Indeed, the CPI rose 3.6% that year.

Rather than viewing this as a sign of progress, which had caused the stock market to almost double between 1935 and 1936, Roosevelt and the inflation hawks of the day were determined to pop what they viewed as a stock market bubble and nip inflation in the bud. Balancing the budget was an important step in this regard, but so was Federal Reserve policy, which tightened sharply through higher reserve requirements for banks. Between August 1936 and May 1937 reserve requirements doubled.

During 1937, Roosevelt pressed ahead with fiscal tightening despite the obvious downturn in economic activity. The budget deficit fell from 5.5% of GDP in 1936 to 2.5% in 1937 and the budget was virtually balanced in fiscal year 1938, with a deficit of just $89 million.

While Bartlett believes the mistake is unlikely to be repeated, there are some "hawkish" rumblings coming from parts of the Fed.

I discussed a similar argument from CEA chair Christina Romer in a post last June. The lessons of 1937 were also the subject of a recent Paul Krugman column.

Thursday, January 7, 2010


The economic kind, that is.

As the global economy recovers, the tension arising China's desire to restrain inflation while keeping the yuan undervalued through a de facto dollar peg is heightened. In an article about a small increase in interest rates, the Times' Keith Bradsher provides a nice explanation of the "sterilization" mechanism that China uses to reconcile the contradictory policy objectives:
Because China does not have a well-developed bond trading market, the yields on the weekly sales of central bank bills are widely watched as a barometer of the central bank’s intentions.

The central bank sells its bills mainly to banks, which pay in renminbi that the central bank then effectively takes out of circulation, slowing growth in the country’s money supply.

Weekly sales of central bank bills are part of a process that economists describe as “sterilization” of China’s extensive intervention in currency markets.

As U.S. dollars and other foreign currencies pour into China from its trade surplus and foreign investment, the central bank prints vast sums of renminbi and issues them to buy those dollars and other currencies.

To prevent all those extra renminbi from feeding inflation, the central bank then claws back the renminbi from the market through a series of measures that include the sale of central bank bills. China also requires commercial banks to keep large reserves on deposit at the central bank, partly to keep the banks from lending too recklessly but also so that the central bank can use that money to finance further purchases of dollars and other foreign exchange.

The goal of sterilization is to keep inflation under control in China while keeping the renminbi weak. That helps make China’s exports competitive overseas and preserves jobs in China, while contributing to unemployment in countries producing rival goods.

The U.S. dollars and other currencies go into China’s foreign exchange reserves, which stood at $2.27 trillion at the end of September; monthly figures through the end of December are due for release next week. China has the biggest foreign exchange reserves of any country, by far.

For this policy to be effective, China has to limit financial inflows, preventing speculators from putting pressure on the yuan by betting on an appreciation. Higher yuan interest rates increase the incentive to move funds to China. Surely, this cannot go on forever....

Tuesday, January 5, 2010

Economics Job Market

Inside Higher Ed reports:
[T]he American Economic Association, which started its annual meeting Sunday, is reporting a drop in new academic jobs listed of 19 percent in the 2009 calendar year. While plenty of new Ph.D. economists seek employment outside of academe, many of the companies that hire them are also facing financial turmoil. The drop in the association's job postings for work outside of academe was even greater: 24 percent.


Monday, January 4, 2010

Benefits of the Declining Dollar

In Sunday's Cincinnati Enquirer, I argue that:
In recent months, the value of the U.S. dollar has resumed the downward trend it was on prior to a big, but short-lived, spike in the financial panic last fall and winter. The falling dollar has been fodder for critics of the administration and Federal Reserve. While a "weak" dollar sounds like a bad thing, it just may help put the US economy on a more solid footing.
We sent that to them a while back, when the falling dollar was in the news. Of course, its strengthened a bit since then since then. At least they didn't print my e-mail address this time, so I haven't received any irate e-mails from the good people of Cincinnati. However, a comment on the Enquirer's website expressed one of the drawbacks:
Mr. Craighead, the seniors who will be drooling into the burgers they are flipping due to greatly reduced retirement savings can't wait for your lower-worth dollar. Maybe we can vacation at Branson and drink cheap beer with box-made grits instead of steak-frites avecvin de maison en France. Only an academic could intellectualize the disintingration of hard-earned wealth and quality of life with such eloquent assurance. Truth is, a weak dollar robs people of what they own and only helps those in a position to profit from others' misery: issuers of bonds, insurance companies, fastfood chains, etc. You teach this?
While I did mention in the piece that there is a downside for consumers, I think it is relatively modest... Overall, I suspect most people would rather be employed and drinking domestic beer than unemployed and borrowing to pay for Lowenbrau.

Sunday, January 3, 2010


Twenty-Cent Paradigms makes the "Best Econ Literacy" category of Bayesian Heresy's Economics Blog Awards. Thanks!