I’ve wondered about this for years, here is a neat but to me unconvincing result:

Aggregate consumption growth risk explains why low interest rate currencies
do not appreciate as much as the interest rate differential and why high interest rate currencies do not depreciate as much as the interest rate differential. Domestic investors earn negative excess returns on low interest rate currency portfolios and positive excess returns on high interest rate currency portfolios. Because high interest rate currencies depreciate on average when domestic consumption growth is low and low interest rate currencies appreciate under the same conditions, low interest rate currencies provide domestic investors with a hedge against domestic aggregate consumption growth risk.

That is from The American Economic Review, March 2007.  Here is an earlier version of the paper. 

If you are investing lots of money in foreign currencies in the first place, how much consumption risk do you really face these days?  (And does this mean that philosophical Stoics, who can make do with whatever, should load up on the Kiwi dollar?)  I tend to think there are now enough marginal investors who are in any case set for life in terms of consumption risk or rather the lack thereof.

Simple home bias, and the fear of looking like a fool, may be better explanations for the persistence of high nominal interest rate currencies which do not on average depreciate very much.  Yes it sounds a little lame to postulate those loose millions, but a) it’s only in expected value terms, and b) it is consistent with the fact that investors don’t optimally diversify across borders either.

Bubbles leave behind an economic infrastructure that spurs later growth.  The telegraph and railroad bubbles of the 19th century gave birth to modern communications and transportation.  The fiber-optic bubble of the 90s paved the way for YouTube and MySpace.  Might we need a "green bubble" to solve current energy problems?  So argues Daniel Gross, Slate.com and NYT columnist, and also blogger.

I can think of two mechanisms:

1. The bubbly asset price spurs overoptimistic innovators, thus counteracting the tendency to underinvest in new ideas (which are public goods to some extent)

2. The bubbly asset price spurs clusters of production, which help overcome the fixed costs of innovating with a new technology.  I am reminded of Andrei Shleifer’s seminal work on implementation cycles.

Of course Gross is smart enough not to defend all bubbles.  Perhaps bubbles are best when an economy has the potential for breaking through to a new high-growth mode; that would cover today and the mid- to late 19th century.  I am less convinced by his treatment of the 1920s bubble, which he cites as beneficial in paving the way for the New Deal.  I see a smoother economic path as having brought the better parts of the New Deal without so many of the overreactions.

Gross argues that government should support many bubbles instead of choking them off.  At the very least, bubbles are underrated.  This is a stimulating book, worth your time and money. 

I am of course interested in the cross-sectional cultural contrasts.  Paintings are resold for profit, and they are possibly bubbly assets, but CDs are not.  Does that make the artistic market more supportive of innovation than the music market?  Are bubbles beneficial in the auctions for book contracts?  Was this book the result of a bubble?

Here is an FT review.

The limited impact of Kyoto is evinced by the fact that carbon permits are now selling in the range of a negligible one euro a ton.

Here is much more, all excellent, via Brad DeLong.

It’s possible that sluggish business investment reflects lack of confidence in the economic outlook –… that’s understandable given the bursting of the housing bubble…But…there is a more disturbing possibility.  Instead of investing in physical capital, many companies are using profits to buy back their own stock.

Here are longer excerpts.  Of course stock buy-backs do not take away resources for subsequent investment.  The money used to buy shares can still be funneled into the purchase of capital goods, as no real opportunities have been taken off the table. 

That said, cash "in the firm" is more likely to be invested than "cash in the hands of investors," for reasons of credit rationing and other institutional rigidities (for instance borrowing money brings more outside scrutiny).  Given the size and profitability of these firms, however, I do not expect that the credit rationing effect is a large one.  The causes of the sluggishness of investment are thus to be found elsewhere than through this financial mechanism.

Here is my earlier post on the Junker fallacy.  I believe this sort of argument was first criticized by Fritz Machlup in his book on the stock market.  Of course if you wish to save the claim through various second best arguments, comments are open…

Over at Mark Thoma’s house, incluidng responses from Paul Krugman and Dani Rodrik.  Here is Rodrik responding to me.

Jacob Hacker writes:

I have received many questions about the Congressional Budget Office’s (CBO) recent report that finds that individual earnings volatility, while extremely high, has not risen since the 1980s.  Although this new research significantly expands what we know about individual earnings volatility, it does not challenge my contention that family income volatility has grown, nor is it at odds with my larger argument that the level of economic risk that families face has risen dramatically.

Do read his entire response, and ask exactly how many of the paragraphs speak to the point at hand.  The CBO data appear perfectly good, and point in an overwhelmingly consistent direction across different measures; in contrast Hacker’s measure of volatility is extremely complicated and non-intuitive.  In his response, Hacker never challenges the claim that individual volatility of income doesn’t seem to be rising.

His response focuses on the difference between individual and family income, but this comparison should not in general favor him.  Note that a) divorce rates generally are falling, b) on net families provide income and wealth insurance, c) volatility swings in the upward direction are good rather than bad, and d) if a woman darts in and out of the workforce, for optimizing reasons, this will boost family income volatility but that is fine.  Try telling any of the standard Hackeresque stories — "we are now more buffeted by the winds of change" — and making it consistent with an essentially unchanged level of individual income volatility.  That is very hard to do in a convincing manner.

Go again to Hacker’s calculations.  His volatility index is especially high today and especially low for 1974-1982.  Those were the days of double-digit unemployment, rampant inflation, prime rates of 20 percent, oil price spikes, and universal feelings of volatility and decline, not to mention lower transfer payments from government.  That doesn’t pass the "huh?" test.

You’ll notice other funny features of his measure; for instance 1993 is about "twice as volatile" by Hacker’s pre-tax metric as 1991.  Was America getting so much shakier over those two years, otherwise considered economically healthy?  For purposes of contrast, the difference between 1974 (the first year in the series) and 2000 (the next to last year) is also by a factor of two.

Here is the CBO report, do paw through those graphs (sadly I can’t get them to reproduce on this page but they are crystal clear).

See what Hacker is pinning his hopes on:

Unlike earnings volatility, family income volatility hinges on (1) the joint labor supply decisions of workers in the family; (2) family formation, expansion, contraction, and dissolution; (3) the earnings and losses of family-owned businesses and capital holdings; and (4) government taxes and benefits. Each of these could cause individual earnings volatility and family income volatility to follow different paths.

Factor 1) works against him, given the families diversify risk to some extent.  On 2) he doesn’t mention falling divorce rates but rather stays vague, 3) might help him but if the family owns a business or great deal of capital it is probably not a public policy problem, noting that much of this volatility may be in the upward direction, and 4) government benefits should provide insurance on net.  His last sentence in that paragraph — "Each of these could cause individual earnings volatility and family income volatility to follow different paths" — simply isn’t very potent.

Also recall that Hacker’s original estimates try to convert family income into individual income by a mathematical operating involving the division by the square root of family size.  That is admittedly an imperfect conversion but how does it square with his claim #2 that varying family size will help his argument?  He claimed his attempted conversion to an individual level measure as a virtue of his original method, but now that we have a direct measure of individual volatility he is moving back in the direction of claiming the family estimate is on his side.

It can plausibly be argued that unemployment duration has increased, and that this class of losers is simply stuck in a bad state without necessarily seeing much income volatility.  This is a) far weaker than Hacker’s thesis, b) does not affect the population as a whole, and c) unemployment rates are generally low even if many spells of unemployment are longer.

Here is my first post on Hacker’s book, which criticizes some of his non-income volatility claims. 

Dani Rodrik says not really:

Advocates of globalization love to argue
that free trade lowers prices, and the argument seems sensible enough.
Think of all the cheap goods from China that we can buy at Wal-Mart.  But anyone who understands comparative advantage knows that free trade affects relative prices, not the price level (the latter being the province of macro and monetary factors).  When
a country opens up to trade (or liberalizes its trade), it is the
relative price of imports that comes down; by necessity, the relative
prices of its exports must go up!  Consumers are
better off to the extent that their consumption basket is weighted
towards importables, but we cannot always rely on this to be the case.

The intuition is this: if my household suddenly trades with the outside world, bread is cheaper but my wife has superior opportunities than before.  It might be harder for me to bid for her time and I will have no one to play tennis with.  If I enjoy tennis enough, I might be worse off.  If you want a real world example, American
ethanol use is bidding up the price of Mexican corn; not every
campesino is better off.

Greg Mankiw responds, and Rodrik in turn, then Mankiw again.  I would put it as such.  The real gain from trade is the additional output; it should not be surprising if the pecuniary externalities (higher and lower prices) should prove a wash rather than an additional net gain.  In fact a wash of the pecuniary externalities helps ensure that the output effect dominates the welfare calculus. 

More empirically, having your export prices bid up is a wonderful driver of growth more than it is a distributional or efficiency nightmare.  The net externalities of that process are usually positive rather than negative, even without firm- or industry-level increasing returns in the traditional sense.  The exports help build a middle class and in the long run make democracy and rule of law possible.  The dynamic effects are the key to the benefits of trade, and neither the Ricardian nor the Heckscher-Ohlin model is satisfactory.  The best simple (ha!) model has trade bringing more innovation, new goods with high consumer surplus, greater reason to work hard and get ahead, greater domestic inequality, a growing middle class, and new and usually more liberal political coalitions.

Empirically, the troubled cases of trade typically involve exports of oil or diamonds and subsequent corruption.  The relevant problem with trade is not higher prices for home consumption, in fact home consumption of those commodities is usually quite low.  How much oil does Guinea-Bisseau use?  We’re left with Mexico and corn prices as a possible example, but note that Mexico would have much lower corn prices with free trade in corn.  And it is U.S. government subsidy, not the market, bidding up the price of corn in the first place.

Maybe we’re left with this as the relevant real world example: outsourcing in India drives up wages and makes life harder for people who want lots of servants.

My Inner Misesian is uncomfortable with Rodrik’s strong distinction between relative prices and the absolute price level.  Productivity shocks (which are in critical regards analogous to an expansion of trade) can and do lower most of the prices we face, albeit not all of them.

I don’t disagree with Rodrik’s claims about positive economics, although they don’t quite "shade" as I might wish.  I would have liked to have seen the sentence: "The early 20th century trade theorists discussed by Jacob Viner and Gottfried Haberler knew about these problems, but they also realized they did not, when viewed in a realistic context, weaken the case for free trade."

Addendum: Read this survey paper on trade.