Category: Economics

It comes not from a professional economist but from Warren Buffet, here goes:

Sadly, that's about as scientific as we've been able to get.

Matt Yglesias has a very good post on Robert Barro's latest.  Brad DeLong seems to agree with Matt.  Paul Krugman uses the word "boneheaded" to describe the Barro piece.

This exchange is a good micro-cosm of how the stimulus debate has proceeded.  A highly respected anti-stimulus economist puts up some anti-stimulus evidence in a highly imperfect test (in Barro's defense, he did cover more than just WWII).  The anti-stimulus economist is attacked by pro-stimulus economists.  But the pro-stimulus proponents are focused on attack.  They are not putting up comparable empirical evidence of their own for the efficacy of fiscal policy and there is a reason for that, namely that the evidence isn't really there.

I fully admit that I don't trust the oft-cited evidence that tax cuts are 4x better stimulus than government spending boosts; I think the result is a mirage from underspecified models.  Overall we simply don't know how well the proposed stimulus will work — if at all (is aggregate demand always the relevant war?).  It's a kind of Hail Mary pass, an enduring belief in aggregate demand macroeconomics at the theoretical level, even in light of broken banks, sectoral shifts, and nasty, failing expectations, all mixed in with hard to spend well, slow to come on line, monies.  Yes it could work but our agnosticism should be strong rather than just perfunctory. 

Writing polemics against market-oriented economists, no matter what the failings of such economists (and I am one of them, and I have failings), doesn't get us out of that box.

I'll say it again to the pro-stimulus forces: a stimulus is going to happen, so I'd love to be cheered up by your evidence.  Put it on the table.

I also am confused by Krugman's view of the relevance of WWII.  On his blog, at the end of a discussion of how the historical example of WWII doesn't much apply, he writes:

I can’t quite imagine the mindset that leads someone to forget all
this, and think that you can use World War II to estimate the
multiplier that might prevail in an underemployed, rationing-free
economy.

And he is upset at Barro for thinking that the WWII experience does apply.  Fair enough, but a) the War didn't start at full employment, and b) is it possible that Barro received this impression from reading Krugman himself?  In Rolling Stone last week Krugman wrote:

It
took the giant public works project known as World War II – a
project that finally silenced the penny pinchers – to bring
the Depression to an end.

The lesson from FDR's limited success on the employment front,
then, is that you have to be really bold in your job-creation
plans. Basically, businesses and consumers are cutting way back on
spending, leaving the economy with a huge shortfall in demand,
which will lead to a huge fall in employment – unless you
stop it. To stop it, however, you have to spend enough to fill the
hole left by the private sector's retrenchment.

If you read both Krugman passages closely, there is not actually a literal contradiction.  But still, a fundamental decision has to be made on whether to run away from the WWII evidence or not.  I say the WWII evidence does not apply and so I am closer to Krugman as he writes on his blog.

Either way you cut it, there aren't any boneheads in the room.

Here are a few key graphs from Time Magazine's cover story.  Read them carefully.

Did the last line give it away?  The article is describing the recession of 1991, an unusually mild recession that preceeded one of the biggest expansions in American history.

Thanks to Roger Congleton for the link.

You'll find the link here; I believe that Megan McArdle has a role in managing the site.

And who do I choose to link to but myself.  Here is my guest post on bank nationalization.  I could have stressed further that bank nationalization works best in small countries with a small number of banks.  The more banks a country has, the greater the danger that nationalizing a few of them will make the rest much harder to recapitalize, thereby leading to a kind of contagious need for nationalization.

But enough of me (can any blogger say that with a straight face?).  Here is a good post on the perils of Medicare reform.

You'll find them here.  They are all excellent but I thought Kevin Murphy was the most to the point.  

The issue is here, I was sent this summary of the articles:

Are the most capable women and the most
capable men equally capable? Previously, Garett Jones, John
Johnson, and Catherine Hakim questioned Christina Jonung's and
Ann-Charlotte Ståhlberg's call for more women in economics. Now
Jonung and StÃ¥hlberg respond. 

Banks don't function well at low levels of capitalization, so there is a strong and understandable tendency to want to "do something."  Everyone says nationalization is not intended as a long-term solution but the question is whether government ownership will succeed in building up a greater capital cushion for the banks.  If the environment for banking is not favorable, it won't and banks will have to stay nationalized.

How many years of profits are needed to create the cushion of capital which is required for re-privatization?  And how many years of government ownership will be needed to generate that many years of profits?  Will banks owned by the government be allowed to pursue profits, rather than lending to troubled industries in the districts of influential Congressmen?  Or will government just stick money in the bank and hope they have thereby created a sound enterprise?

You might take the line: "Government is bad at running bail-outs, but it sure is good at running banks," but of course that's a tough sell.

Those are the questions you should be asking.  Admittedly the alternatives to nationalization don't currently look so great either.

Kevin Drum adds some good points.  Felix Salmon offers ongoing coverage.

The liquidity trap is often cited as the reason why fiscal policy is required to get us out of the downturn. 

My view is this: the short-run nominal interest rate is different than is
socially optimal but that doesn't mean the economy is in a trap.  Liquidity trap proponents have lots of good evidence for the former proposition but much less evidence for the latter notion of a true trap.

I think of liquidity trap arguments as stressing the extreme importance of a single market price, namely the relative price between cash and T-Bills.  In general I am suspicious of macroeconomic arguments which place so much weight on a single price being out of whack.  You can put the Austrians into this camp (the loan rate of interest is wrong) and you can put the supply-siders into this camp (the tax rates on labor or perhaps capital are too high).  Even though I think the short-run interest rate is "wrong," from the point of view of social optimality, that is not a driving fact of central macroeconomic importance.  This doesn't have to be a "pro market" argument: in fact one can think that many different prices and quantities have comparably important degrees of "wrongness."

Here's a short list of economists who have expressed (varying degrees of) skepticism about liquidity trap arguments: D.H. Robertson, Jacob Viner, Milton Friedman, Philip Cagan, Don Patinkin, Auerbach and Obstfeld, Robert H. Lucas, Greg Mankiw, and, I might add, Bernanke and Blinder.  You can make a case for adding Franco Modigliani to the list, although his article is cryptic in some regards.  Leo Svensson has many interesting papers critical of the idea of a liquidity trap as a binding constraint. 

It is possible that of these people are wrong but they do all understand Keynes's theory of interest and they do all understand how the liquidity trap is supposed to work.  Nor are they merely citing "the real balance effect" as it is usually dismissed.  These economists just don't think that so much in an economy can revolve around a single incorrect price.  Many or all of them believe that monetary policy can work on other prices as well and through other channels.

There is also some good evidence that maybe the Great Depression wasn't a liquidity trap either.  Here is some evidence against Japan having been in a liquidity trap in the 1990s.  Neither of those papers is definitive; my point is that people who are skeptical of the liquidity trap argument aren't simply being pigheaded or ideological.

The overall point is that this talk of a liquidity trap — as a true trap (and not just another screwy price) — is a speculative hypothesis, not an obvious truth.

And unless you regard "the liquidity trap" as a true trap, you needn't favor such a large fiscal stimulus.

Linda Bilmes presented an interesting paper (not online) at the AEAs looking at the fiscal stimulus in light of Katrina, Iraq and the Big Dig.  Here are some key grafs:

Bilmes is the co-author with Joseph Stiglitz of The Three Trillion Dollar War.

Paul Krugman has some questions:

Financial
institutions that want to “get bad assets off their balance sheets” can
do that any time they like, by writing those assets down to zero – or
by selling them at whatever price they can. If we create a new
institution to take over those assets, the $700 billion question is, at what price? And I still haven’t seen anything that explains how the price will be determined.

I suspect, though I’m not certain, that policymakers are once more
coming around to the view that mortgage-backed securities are being
systematically underpriced. But do we really know this? And how are we
going to ensure that this doesn’t end up being a huge giveaway to
financial firms?

Here is more detail on various plans.  I see it so:  If the assets are undervalued by the market, buying them up is an OK deal.  Presumably the price would be determined by a reverse auction, with hard-to-track asset heterogeneity introducing some arbitrariness into the resulting prices.  If these assets are not undervalued by the market, and indeed they really are worth so little, our government wishes to find a not-fully-transparent way to give financial firms greater value, also known as "huge giveaway."

Right now it seems to boil down to the original TARP idea or nationalization, take your pick.  You are more likely to favor nationalization if you think that governments can run things well, if you feel there is justice in government having "upside" on the deal, and if you are keen to spend the TARP money on other programs instead.

Here is one source:

Here is another:

One Calculated Risk commentator states:

Addendum: Do note that is the gross flow of cash from the government, not the net financial cost or the net social cost.

That's Paul Volcker's idea, namely that the way to prevent "too big to fail" is to prevent "too big."  Details are sketchy but Matt Yglesias offers some comments. 

Is there a precedent for this kind of plan working?  We have antitrust law but antitrust law doesn't actually prevent big firms from becoming big; we've had General Motors, Microsoft, Google, and others, all very large relative to their sectors.

You could imagine an absolute cap on the size of bank assets, so that above the size limit would-be loans and deposits are sent to a rival institution elsewhere by mandate.  One implication is that banks won't have to treat their customers very well, since in a growing economy (we'll get one again, sooner or later) a lot of banks will be at the cap and will be turning away extra business.  If different banks were perfect substitutes for each other, you wouldn't be seeing large banks in the first place.

A second question is whether ten little banks are safer than one larger, 10x bank.  For sure they are if the problem is one bonehead manager at the bigger bank, but what if it's systemic asset price risk?  The smaller banks could well be less safe.  In a financial crisis, would you rather be a larger country or a smaller country?

I believe the plan would require very tight restrictions on off-balance sheet activity.  Something like this may be coming anyway, and its rationale is understandable, but it is easier said than done.  We would be requiring regulators to estimate the net "size" (it's debatable whether that word even applies; what is the "size" of a naked put?) of a bank financial position when banks themselves haven't been very good at doing that.  A simple approach would be to ban all bank trading in derivatives but I believe that would increase bank risk more than decrease it, at least at this point.

By the way the 1927 McFadden Act banned interstate branch banking, in part to keep banks small, and economic historians usually consider that policy to have been a disaster which contributed to the severity of the Great Depression.

Here is a summary of where some of the debate on bank policy is at right now.

Is there a way out?

Buiter's argument — which applies just as much to the US as it does to the UK – is that the only way to get banks lending again is to nationalize them.  Otherwise, they'll simply hoard liquidity in a desperate attempt to avoid being nationalized.

That's Felix Salmon.  

It is a common shibboleth that saved funds mean a decline in aggregate demand but this doesn't have to be true.  Savings often fund investment, which boosts aggregate demand and creates jobs.

Admittedly, savings don't fund investment when the banking system is malfunctioning.  Or it may take so long to translate savings into investment that incomes are falling in the meantime and S and I follow them on the way down (Keynes's scenario).  Still, you shouldn't assume that savings translate into a collapse of aggregate demand.

Michael Mandel adds:

I believe that Obama’s $300 billion tax cut is essential to
‘recapitalize’ the American consumer, just like the banks are being
recapitalized.

With that as background, consider the tax cuts in Obama's stimulus plan.  If the money is spent, you get a boost to aggregate demand.  That was the goal.  If the money is not spent, it is a wash.  The government borrows for people (at a low rate) and people save it.  Since savings has gone up, the borrowing is sustainable and it doesn't even have to crowd out additional government spending, if that is what you want. 

Furthermore these people would have done some borrowing anyway, so their ability to implicitly borrow at a lower interest rate creates a small, positive wealth effect.  The savings also means you have supplied those people with some form of implicit insurance, and at very low risk of moral hazard.

I wouldn't expect a whole lot of recovery from these scenarios, but there's nothing problematic about having some tax cuts in the stimulus package.  If you're looking for another opinion, here is Joseph Stiglitz.

From Terry Fitzgerald at the Minneapolis Fed.

You are correct that the "mildest, median, and harshest" recession lines do
not represent single recessions. Please allow me to try to justify our
procedure. We spent considerable time weighing alternative approaches.

In drawing our timeline "length of recessions" graphs, we wanted to
illustrate where the current recession lies relative to past recessions at
each month of the recession. So for each month (or quarter), the lines
would tell you what had been the largest, median, and smallest decline in
any recession to that point.

The median line would indicate that one-half of the past recessions had
experienced larger declines, and one-half had experienced smaller declines
to that point. Similarly, no recession had a larger decline to date than
the "harshest" line. (And similarly for the mildest line.)

One feature of this approach is that the mildest, median, and harshest lines do not shift over time. So we can update just the "current" line in our graphs without all the lines shifting.

…I knew that insightful readers might wonder about this point, and I hoped that the note would at least explain what we did.

We are not trying to do anything deceptive or misleading with these charts.
Our aim is only to provide some empirical context to the current recession.