Tag: Macroeconomics

What Should Central Bankers Do?

No, this is not a question on the final exam  for Money and Monetary Policy; however, it has been.  It’s also a question that pervades contemporary political economy in the US and Europe.

Federal Reserve Chair, Ben Benanke continues to be criticized from both those who advocate aggressive monetary policy and those who argue that the Fed has been too aggressive.  For example, today’s Wall Street Journal features “Fed bashing” from the House Financial Services Committee.

The Fed’s easy-money policy and actions taken to boost economic growth have prevented lawmakers from taking responsibility for shoring up the economic recovery and reducing the deep federal budget deficit, some Republicans said Tuesday at a hearing of a panel of the House Financial Services Committee.

“As the Fed does more, Congress is doing less and in the long term that slows our recovery,” said Rep. Kevin Brady (R., Texas).

How are we to interpret this?  Mr. Bernanke, since you did your job appropriately, we won’t (can’t?) do ours??  Of course, many pundits, especially those who fear a tripling of the Fed’s balance sheet since 2008, believe that the world would be better without the Fed.  Anyone ever heard of Ron Paul?

At the other extreme, Paul Krugman, not to be outdone in the world of political rhetoric Earth to Bernanke, has accused Fed Chair Bernanke of not following the advice that Professor Bernanke gave the Japanese in a 2000 paper.  He and others such as Scott Sumner of the Modern Monetarist Movement argue that the Fed should target nominal GDP and make monetary policy as expansionary as needed to reach that target.’

Where’s the center or at least some non-extreme view?  I suggest one look to Raghuram Rajan who yesterday posted “Central Bankers Under Siege” and for the current issue of Foreign Affairs wrote “True Lessons of the Recession.”  In these articles, Rajan argues that various versions of demand stimulus through credit creation will not address fundamental structural problems in the US economy.  He concludes the latter article as follows:

The industrial countries have a choice. They can act as if all is well except that their consumers are in a funk and so what John Maynard Keynes called “animal spirits” must be revived through stimulus measures. Or they can treat the crisis as a wake-up call and move to fix all that has been papered over in the last few decades and thus put themselves in a better position to take advantage of coming opportunities. For better or worse, the narrative that persuades these countries’ governments and publics will determine their futures — and that of the global economy.

So, what should Central Bankers do?  In my view, they should recognize that monetary policy has its limits and that using monetary policy as a means to generate sustained employment won’t work.  Longer term structural adjustments are required.  Such adjustments will be the subject of another blog posting.


Deidre McCloskey on Keynesian Pessimism

Quotation of the Day…  from Cafe Hayek

Posted: 29 Apr 2012 05:01 AM PDT

… is from page 134 of Deirdre McCloskey’s 2010 Bourgeois Dignity:

During the 1930s and early 1940s the prospect of diminishing returns deeply alarmed economists such as the British economist John Maynard Keynes and the American follower of Keynes at Minnesota and Harvard, Alvin Hansen.  They believed that the technology of electricity and the automobile were exhausted, and that sharply diminishing returns to capital were at hand, especially in view of declining birthrates.  People would save more than could be profitably invested, the “stagnationists” believed, and the advanced economies would fall into chronic unemployment.  In line with the usual if doubtful claim that spending on the war had temporarily saved the nonbombed part of the world’s economy, they believed that 1946 would see a renewal of the Great Depression.

But it didn’t.  Stagnationism proved false.

Is 2013 a Ripe Time for Fundamental U.S. Tax Reform?

Yes, trumpets Lawrence Summers in today’s Financial Times. Presumably, anyone who pays any attention to the Washington scene knows Larry Summers.  Just in case you haven’t been paying any attention for the past 20 years, the bullet point version of Summers’ CV might read as follows:

  • Harvard Professor of Economics
  • Chief Economist of the World Bank
  • Secretary of Treasury under President Clinton
  • President of Harvard University
  • Chief Economic Adviser to President Obama

Few people – economists, policy analysts, or politicians – defend the current tax codes filled with huge inequities in both horizontal and vertical directions (as argued here.)  Tax “loopholes,” tax expenditures (CBO estimates), or societal preferences – if you care to be generous – reduce taxable income by at least $800 billion per year.  Stated differently, if all special provisions (i.e., everything but the personal exemption) of the U.S. tax code were eliminated, income tax revenue would rise to at least $2 trillion and cover about two-thirds of the estimated U.S. Federal deficit for 2012.

So what makes 2013 so special?  Summers gives a variety of intriguing answers including the following:

  • President Bush’s tax cuts expire
  • Congress faces its mandated sequester of $1.2 trillion spending for the next decade
  • Congress must again vote on the legally binding Federal borrowing limit
  • Fundamental reform can happen in the year after a Presidential election
  • The last serious tax reform took place in 1986 (when a Republican President reached agreement with a Democratic legislature)

As Summers argues,equity, efficiency, and budgetary reasons all dictate that we need to fundamentally reform the tax structure.  The longer we wait, the more difficult the choices will be. If (when?) the rest of the world decides it no longer has a voracious appetite for U.S. Treasuries, our choices will be much more painful.  He argues, and I agree, a good place to start would be the recommendations of the Simpson-Bowles Commission appointed by President Obama, which unfortunately in my view, he chose not to back vigorously.

Man vs. the Machine. Man is Losing

This week many of you are reading Brynjolfsson and McAfee’s book Race Against the Machine.  The authors make reference to a September 28, 2011 Wall Street Journal article by Kathleen Madigan entitled “It’s Man vs. Machine and Man is Losing.”  Madigan provides the chart below to illustrate the relative growth of equipment and software in comparison with payroll employment since the trough of the recession in June 2009.

As I have previously argued here and here, Madigan notes how the relative price of labor compared to capital is consistent with the pattern shown in the above chart.  Again, job creation clearly is quite difficult if the incentives are perverse.



GDP Growth vs. Employment Growth

At last, the level of real GDP has rebounded past its previous peak in the fourth quarter of 2007.  Clearly, the trough for employment was both much deeper and trailed that for GDP.  In contrast, the recovery for real GDP has been more rapid as well.   Financial repression (extremely low interest rates) must be part of the story behind this chart.  Clearly, an increased cost of labor relative to capital induced a capital intensive recovery.

Low Interest Rates: the Addictive Policy Drug of Choice

Satyajit Das, in today’s Financial Times, argues that low interest rates generate a variety of economic distortions that expand rather than address structural problems in economies (whether those of the U.S., Europe, or elsewhere.)  These effects are especially pernicious when real interest rates (that is market interest rates minus the expected inflation rate) are negative.  He provides a laundry list of “side effects” to this economic drug of choice.

1.  Encourages the substitution of capital for labor. Is it any surprise that employment has been slow to respond eventhough GDP is now higher than it was at the beginning of the last recession?

2. Encourage the substitution of debt for equity funding

3. Discourage savings, especially when real rates are negative.  Of course, if households have a particular wealth target, low rates could induce additional savings.

4. Create a funding gap for defined benefit pension plans (which means either reduced benefits or attempts to increase returns through more risky financing)

5. Feed asset price inflation through the purchase of risky assets (related to point 4)

6. Reduce the cost of holding money (which inhibits the flow of capital to worthwhile activities)

7. Allow banks to borrow cheaply (from depositors) and achieve their income targets through purchase of governmental securities rather than through lending to the private sector

8. Distort currency values as deviations in interest rates across countries is one of the drivers of short term capital flows

9. Induce a reliance on low interest rates to continuously fuel aggregate demand

For the most part, those who argue for extended periods of low interest rates believe that aggregate demand drives aggregate output. They tend to underplay the importance of structural change in the economy (such as labor market, regulatory, or tax policy reform); such change cannot be addressed by replacing depressed elements of aggregate demand with policy induced aggregate spending.  The day of reckoning is just extended, not cancelled.   Just ask the Europeans.

Our Macroeconomic Future: A Chaos Theory for Investors.

Neel Kashkari, managing director and head of global equities for PIMCO, has recently posited an array of possible scenarios for America and Europe and employs a simplified version of chaos theory to sort through the results. Kashkari was Secretary of Treasury Hank Paulson’s assistant; he worked directly with implementing the Troubled Asset Relief Program (TARP.)  He plays a significant role in Andrew Ross Sorkin’s book Too Big to Fail.  The movie, starring William Hurt, does a nice job reflecting the book.

Western economies (mostly governments and households) have loaded themselves with debt that under most scenarios is not sustainable. Kashkari indicates the following five options policy makers have as well as the potential consequences for investors. Check out his analysis.
1. Austerity and deflation
2. Explicit default
3. Mild inflation
4. Runaway inflation
5. Miraculous growth

Which scenario do you think is most plausible? Least plausible? Do your answers differ for the U.S., Europe, and Japan? Why or why not?

Is Capitalism Sustainable?

During the winter term, we will focus on visions of the world economy and the role of economics. The Backhouse and Bateman book puts these topics in sharp relief.  This discussion continues questions raised by Schumpeter, Hayek, Keynes and many others. In a recent Project Syndicate article, Kenneth Rogoff, co-author of This Time is Different, argues that some version of capitalism will continue to exist because there are few viable alternatives. Furthermore, he argues that European welfare state versions and the Chinese authoritarian version have yet to prove their sustainability. Of course, the contemporary version of capitalism will need to make some serious adjustments to be sustainable. Rogoff posits the following:

In principle, none of capitalism’s problems is insurmountable, and economists have offered a variety of market-based solutions. A high global price for carbon would induce firms and individuals to internalize the cost of their polluting activities. Tax systems can be designed to provide a greater measure of redistribution of income without necessarily involving crippling distortions, by minimizing non-transparent tax expenditures and keeping marginal rates low. Effective pricing of health care, including the pricing of waiting times, could encourage a better balance between equality and efficiency. Financial systems could be better regulated, with stricter attention to excessive accumulations of debt.

Jim Lyon and the World of Money and Banking

Thursday, you will have two opportunities to engage with Jim Lyon, Lawrence alum and First Vice President of the Federal Reserve Bank of Minneapolis.  He will be discussing “Too Big to Fail” and the Dodd-Frank Act response at 9:00 in Money and Monetary Policy (Briggs 225).  He also will chair a mock Federal Open Market Committee meeting in which students in the course will represent members of the Board of Governors and Presidents of the 12 district Federal Reserve Banks.  You are welcome to join us for either part of the class.

At 4:30, we will have an Econ Tea with Mr. Lyon as well.  This will be an open and free-wheeling session for which the topic will be “Everything you always wanted to know about money and banking and ARE NOT afraid to ask.”  Come for the discussion or just come for the cookies and tea.

Third Annual Predict the Economics Nobel Contest… Wait, what?

Falling off the Cliffs?

Well, I didn’t manage to get the contest running this year and, lo!, the Nobel Prize in Economics committee met anyway and made its awards.

I’m no macro guy (who is these days?), but the Nobel Committee saw fit to award this year’s prize to Thomas Sargent and Christopher Sims for their work in empirical macroeconomics.  As per usual, Tyler Cowen at Marginal Revolution is all over it.

Sims here and Sargent here.

Though I disavow any knowledge of it now, I had Sargent for my macro texts back in grad school — known as  black Sargent and red Sargent because one was black and one was red (I forget which was which).  For some of us, the mathematics was on the challenging side, and we had to spend a lot of time solving those spectral analysis problems.  I remember this like it was yesterday, one of my classmates asked if there was a “Cliffs Notes” version of black Sargent.

The professor replied, “Black Sargent is the Cliffs Notes.”

UPDATE: Tim Taylor has a very readable, conversable even, commentary at his new blog.

The Piece I’ve Been Expecting about Robert Lucas

The Wall Street Journal has a short profile of Robert Lucas,  one of the most influential macroeconomists of at least the past 20 years (when I picked up my first grad macro text).  Lucas is probably best known for integrating “rational expectations” into macro models (he convinced his wife, at least).  He is also the namesake of the “Lucas Critique”  of using past behavior to predict the future.   Here’s a nice summary of his contributions.

Lucas might sound like someone affiliated with the Chicago School, and indeed, that is the case.  Someone you should know.

Excessive Monetary Easing is Part of the Problem

If short term interest rates drop from .1% to .02% does it generate more economic activity?  If long term rates drop from 3% to 2% (or even 1.7% as with 10 year US Treasury Notes), will people want to borrow more given the current economic environment?  Most readers know my pessimism regarding answers to these questions.  The IMF, in its latest global financial stability report, makes the case quite strongly.  Furthermore, as argued previously and by most “Austrians” since Mises and Hayek, overly cheap capital causes a great deal of mis-allocation of capital.  The Financial Times editorial today summarizes the IMF report.

The IMF’s latest global financial stability report says rightly enough that the eurozone crisis, and the row over the US debt ceiling, sparked an increase in risk aversion. But the IMF worries that exceptionally low interest rates are building a fresh credit problem. They have spurred a hunt for yield which, as widely broadcast, has sent too much capital to emerging markets. When capital is too cheap, it is mis-allocated.

The FT editorial concludes:

Either credit markets see reasons for economic cheer that have eluded everyone else, or low interest rates have sparked another round of irresponsible lending.

Is Time on Professor Finkler’s Side?

As you may have noticed, Professor Finkler and I are both keeping one eye on the doings in Washington, with the likes of Summers and Roberts weighing in on the deal.  To add to that lineup, Time Magazine has another five economists weigh in on the debt deal, including LU Econ Blog faves Alex Tabarrok and Simon Johnson.

It’s too bad we don’t have a macro course going on right now.

The Second Great Contraction

Professor Gerard’s posting on the debate about the role of fiscal policy starts with the Larry Summer’s point that the debt deal “solves the wrong problem.”  As pointed out previously (see here), I agree with that conclusion.  So, what is the “right problem?”  Kenneth Rogoff’s answer requires  that we understand that this recession is not a typically recession.

The phrase “Great Recession” creates the impression that the economy is following the contours of a typical recession, only more severe – something like a really bad cold. That is why, throughout this downturn, forecasters and analysts who have tried to make analogies to past post-war US recessions have gotten it so wrong. Moreover, too many policymakers have relied on the belief that, at the end of the day, this is just a deep recession that can be subdued by a generous helping of conventional policy tools, whether fiscal policy or massive bailouts.

But the real problem is that the global economy is badly overleveraged, and there is no quick escape without a scheme to transfer wealth from creditors to debtors, either through defaults, financial repression, or inflation.

Rogoff and Carmen Reinhart (R & R), along with others such as economic historian Harold James, emphasize that economic growth built upon too rapid a credit build-up cannot be sustained with expansionary monetary and fiscal policy. It requires de-leveraging (perhaps, you prefer credit build down), a process that cannot be accomplished quickly and offers little positive in the short run that can be gained to soften the blows. The only solutions require that the real level of debt must be reduced to a sustainable level.  As noted in the Rogoff quotation above, somehow creditors must bear some of the burden (a “haircut” in Wall Street parlance.)  The dynamics of this process lead R & R to deem our most recent period as “The Second Great Contraction.”

Rogoff’s suggests that inflation might be the least costly way to address problem – one might argue it is THE “time honored” policy of choice when governmental commitments exceed its ability to meet them.  Of course, this suggestion is not met with great enthusiasm (see “Kids Prefer Cheese” which argues that Rogoff proposes “theft, pure and simple.”)  Is it the least bad approach?  The answer depends upon one’s view of the functionally of our governance structure.  Let’s just say that “dysfunctional” would not egregiously mis-characterize U.S. governance at present.

Recognition of the right problem and a useful framework for policy discussion must come first.  As Rogoff puts it in the article linked above,

The big rush to jump on the “Great Recession” bandwagon happened because most analysts and policymakers simply had the wrong framework in mind. Unfortunately, by now it is far too clear how wrong they were.

Acknowledging that we have been using the wrong framework is the first step toward finding a solution. History suggests that recessions are often renamed when the smoke clears. Perhaps today the smoke will clear a bit faster if we dump the “Great Recession” label immediately and replace it with something more apt, like “Great Contraction.” It is too late to undo the bad forecasts and mistaken policies that have marked the aftermath of the financial crisis, but it is not too late to do better.

The Debt Ceiling Is At Best Superfluous

In today’s New York Times Economix column, former advisor to presidents Ronald Reagan and George H. W. Bush Bruce Bartlett argues persuasively that the debt ceiling and debate about it accomplishes nothing constructive that is not already contained in the Congressional Budget and Impoundment Control Act of 1974.  Former Fed Chair Alan Greenspan made this point emphatically in his 2003 testimony to Congress.

In the Congress’s review of the mechanisms governing the budget process, you may want to reconsider whether the statutory limit on the public debt is a useful device. As a matter of arithmetic, the debt ceiling is either redundant or inconsistent with the paths of revenues and outlays you specify when you legislate a budget.

Current Fed Chair Bernanke put it even more starkly when he noted that the debt ceiling legislation is equivalent to using a credit card to buy things and then refusing to pay the bill when it arrives.

Innovation and Entrepreneurship Ride to the Rescue

Although there is some disagreement amongst economists, many argue that traditional monetary and fiscal policy will not take the US economy from its current relatively stagnant state to the robust growth needed to employ many of the 8 million who were unemployed during the recent recession as well as the new entrants into the labor force.  As those in Intermediate Macroeconomics learned, since we add roughly 1.5 million people to the work force each year, we need about that number of jobs just to keep  unemployment from worsening.

As several studies from the Kauffman Foundation have shown, the vast majority of new jobs created in the United States come from new firms (that is firms that are five years old or younger),  not from large firms or small firms and not from governments.  In recent years, fewer new firms have been created than  in the past, and each of these firms has generated fewer jobs than in the past.  The Kauffman Foundation has put together a non-partisan “Startup Act Proposal” to jump start the economy.  It is entitled “Access to Capital: Fostering Job Creation and Innovation Though High-Growth Startups.”   The four key provisions are as follows:

1.  Provide a permanent capital gains exemption to investment in startups held for at least five years.

2.  Reduce the corporate tax burden for new companies in the first three years they have taxable income. (This may be already doable under subchapter S of the corporate tax code.)

3.  Reduce Sarbanes-Oxley requirements for firms with less than  $1 billion in market capitalization.

4.  Subject federal regulation to 10 year sunset.

Carl Schramm and Robert Litan, on behalf of the Kauffman Foundation also argue for removing the caps on skilled immigrants and immigrant driven entrepreneurial ventures.

These are intriguing ideas.  They should encourage Lawrence students to sample our Innovation and Entrepreneurship courses.  Check out Schramm and Litan’s presentation last week to the National Press Club.

Alan Greenspan on Excessive Risk Avoidance

In today’s Financial Times, former U.S. Federal Reserve Chair Alan Greenspan opines that we can carry risk aversion too far.   Greenspan’s discussion parallels that posted by Professor Gerard related to the interview of Vernon Smith.  In particular, Greenspan argues persuasively that the more we set aside to protect against once in 50 year or once in 100 year adverse events, the less capital we have to devote to productive activities.  He cites bank reserves in excess of $1.5 trillion as excessive private risk aversion.  Regarding public policy, he argues as follows:

What is not conjectural, however, is that American policymakers, in recent years, faced with the choice to assist a major company or risk negative economic fallout, have regrettably almost always chosen to intervene. Failure to act would have evoked little praise, even if no problems subsequently arose; but scorn, and worse from Congress, if inaction was followed by severe economic repercussions. Regulatory policy, as a consequence, has become highly skewed towards maximising short-term bail-out assistance at a cost to long-term prosperity.

This bias leads to an excess of buffers at the expense of our standards of living. Public policy needs to address such concerns in a far more visible manner than we have tried to date. I suspect it will ultimately become part of the current debate over the proper role of government in influencing economic activity.

Why didn’t the fiscal stimulus have large effects on employment?

As noted previously,  cheap capital and expensive labor tend to lead to the substitution of capital for labor – after all capital is often called “labor saving devices” for a reason.  Now, we have solid evidence that the total cost (wages or salary and benefits) of labor has risen markedly while equipment and software costs have fallen since 2009.

For the rest of the story, see Catharine Rampall’s NY Times Economix blog last Friday entitled “Man vs. Machine.”   To put it most starkly, if your job can be replaced by an algorithm, it probably will be.  As those who took Econ 320 should know, if you attempt to implement  macroeconomic stabilization policy without understanding the microeconomics of labor markets, you may not be blessed with success.

Trade Agreements and Transitional Costs for Workers

As with many aspects of economic policy, political leadership – such as it is – often snatches defeat from the jaws of victory.  Presently, the United States has the opportunity to sign trade agreements with Columbia, South Korea, and Panama that will provide great opportunities for U.S. exporters without having to offer special privileges or changes in domestic markets related to products from these countries.

Why might Columbia, South Korea, and Panama want to sign these apparently one-sided agreements?  One answer is their economies would benefit greatly from better access to goods from the U.S.  Why have we resisted signing these agreements?  Many advocates in these country believe that trade hurts domestic workers.   This certainly is true in the short run for workers whose jobs end because the products they produce no longer are competitive with imports.  It’s also true when capital investment, often spurred by low interest rates, encourages the substitution of capital for labor.  Neither of these concerns, however, are pertinent for the trade policy opportunities before us.

Passage of the aforementioned trade deals seems to be based on support for expanded trade assistance, a policy that provides specific benefits to some who can prove that they have lost jobs as a consequence of import competition.  Matthew Slaughter and Robert Lawrence in today’s Opinion Pages of the New York Times argue that both more trade and more aid make sense, but the aid should not be specifically focused on those who allegedly lost jobs as a result of imports.  They propose an innovative program that combines the existing trade adjustment policy with unemployment compensation benefits to create a new, more efficient safety net that, among other things,  helps workers retool for different jobs and provides funds for health insurance in the interim.

I hope, but am not too optimistic, that our Congressional leaders, will recognize the equity and efficiency improvements offered by both the trade deals and the Slaughter-Lawrence proposal, pass the trade agreements for the aforementioned countries, and craft a new, improved safety net designed to help with labor market and structural unemployment transitions.