Category: Economics

From the comments, Garett Jones writes:

Here’s a simple neoclassical explanation for the high G (government purchases)–>Low Y (GDP) relationship: 

More high-paying government jobs–>
More people waiting in line for those good jobs–>
Less private-sector employment. 

Queuing for good Davis-Bacon jobs is what creates the problem. 

It’s a new twist on the Cole and Ohanian story of high wages worsening the Depression, and Quadrini and Trigari told it in the Scandinavian Journal of Economics as well as here…

There is more at the first link.  I am pleased to report that I have the honor of sharing a corridor with Garett Jones.

He quotes Blanchard and Perrotti, neither of whom is a follower of Milton Friedman:

…we
find that both increases in taxes and increases in government spending
have a strong negative effect on private investment spending. This
effect is consistent with a neoclassical model with distortionary
taxes, but more difficult to reconcile with Keynesian theory: while
agnostic about the sign, Keynesian theory predicts opposite effects of
tax and spending increases on private investment. This does not appear
to be the case.

There is much more here and do read the whole thing.  The bottom line is that the evidence for the Keynesian effects of fiscal policy is far from overwhelming.  Keynesian results cannot be ruled out but we simply don’t understand the short-run dynamics of cycles very well.  So why should we be so convinced it is time to spend $1 trillion or more? 

Addendum: On this post comments seem to be working.  Sorry again for the troubles.

It’s not just Social Security and Medicare which are underfunded.  State governments have vastly underfunded public pensions.  Here is the abstract to a new NBER paper, The Intergenerational Transfer of Public Pension Promises by Novy-Marx and Rauh. 

The value of pension promises already made by US state governments will
grow to approximately $7.9 trillion in 15 years. We study investment
strategies of state pension plans and estimate the distribution of
future funding outcomes. We conservatively predict a 50% chance of
aggregate underfunding greater than $750 billion and a 25% chance of at
least $1.75 trillion (in 2005 dollars). Adjusting for risk, the true
intergenerational transfer is substantially larger. Insuring both
taxpayers against funding deficits and plan participants against
benefit reductions would cost almost $2 trillion today, even though
governments portray state pensions as almost fully funded.

It began (pdf) in December 2007.

The monetary regime has changed and, as a result, many people are misinterpreting the recent increase in the monetary base.  Paul Krugman, for example, posts the picture at right.  His interpretation is that the tremendous increase in the base shows that the Fed is trying to expand the money supply like crazy but nothing is happening, i.e. a massive liquidity trap.  (Krugman is not alone in this interpretation, see e.g. this post by Bob Higgs).  Thus, Krugman concludes, Friedman was wrong both about monetary history and monetary theory. 

Krugman’s interpretation, however, neglects the fact that the monetary regime changed when the Fed began to pay interest on reserves.  Previously, holding reserves was costly to banks so they held as few as possible.  Since Oct 9, 2008, however, the Fed has paid interest on reserves so there is no longer an opportunity cost to holding reserves.  The jump in reserves occurred primarily at this time and is entirely under the Fed’s control.  The jump in reserves does not represent a massive attempt to increase the broader money supply.

Here’s a bit more background.  When no interest was paid on reserves banks tried to hold as few as possible.  But during the day the banks needed reserves – of which there were only $40 billion or so – to fund trillions of dollars worth of intraday payments.  As
a result, there was typically a daily shortage of reserves which the Fed made up for by extending hundreds of billions of dollars worth of daylight credit.  Thus, in essence, the banks used to inhale credit during the day – puffing up like a bullfrog – only to exhale at night.  (But note that our stats on the monetary base only measured the bullfrog at night.) 

Today, the banks are no longer in bullfrog mode.  The Fed is paying interest on reserves and they are paying at a rate which is high enough so that the banks have plenty of reserves on hand during the day and they keep those reserves at night.  Thus, all that has really happened – as far as the monetary base statistic is concerned – is that we have replaced daylight credit with excess reserves held around the clock.  The change does not represent a massive injection of liquidity and the increase in reserves should not be interpreted as evidence of a liquidity trap.

Addendum: (For the truly wonkish.)  If you want more, see my earlier post on excess reserves, posts by Jim Hamilton, and David Altig, and especially two very useful Fed articles, Keister, Martin, and McAndrews (n.b. the last section) and Ennis and Weinberg.

Kevin Drum comments, here is Brad DeLong, and Matt Yglesias, and Arnold Kling; they make good points all around.  There aren’t nearly as many Cassandras as you think, once you require more of a person than "having called" the housing bubble.  A simple question is what financial stocks a person had shorted as of, say, November 2007, or for that matter July 2007, and no "my wife wouldn’t let me" is not an adequate comeback.  And if you’re afraid of an unhedged position or margin call just buy some puts.

I plead fully guilty to not having been a Cassandra.  Oddly, I published an entire book in the late 1990s — Risk and Business Cycles(cheaper on Kindle)  — on how excess risk and correlated errors could cause an economy to explode; I’ll tell you more about that soon.   But if anything when it came to running commentary (on this blog, most of all) I was an anti-Cassandra.  First, I was too influenced by the relatively mild housing bubble collapse of the late 1980s.  Second, I did not understand how much fragility the extant degree of leverage implied.

Cassandra’s gift was in fact the source of continual pain and frustration.  That’s one reason why not so many people are Cassandras.

Fischer Black insisted in the mid-90s that the law of large numbers did
not apply to individual economic forecasts of sectoral shifts and thus such errors could not be expected to "cancel out" in the aggregate.  Not so many
people believed him and in retrospect the failure of people to take
Black seriously on this point is further evidence that the point is
indeed correct in many situations.

Addendum: The end of this Kevin Drum post nails it.

I very much agree with this sentiment of Mark Thoma’s:

There has been much debate about whether the financial crisis is driven
by lack of liquidity or from fears about lack of adequate capital and
solvency, but I’m starting to think a third component is important as
well, the complete breakdown of traditional information flows, and a
loss of confidence in the models used to evaluate that information.
Markets need information to work properly, and the information
financial markets need is not available.

Here is more.  I do not wish to suggest that we abolish currency and T-Bills, but the deeper (and less stable) the private demand for these assets the harder it is to generate socially useful information from the trade in other assets.  Maybe today we’re in a world where the 1980 Grossman-Stiglitz paradox of information partly holds.  It’s not that the status quo price is already efficient, but rather no one gathering information feels they could benefit from swapping with the noise traders and so in turn not enough information is gathered.

No rational regulator concerned with substantive transparency would
approve of common stock, if it were a novel investment vehicle. It
guarantees no cash flows whatever, its "control rights" are so weak for
most purchasers that representations thereof should be viewed as
fraudulent. Empirically common stock behavior is very weakly coupled to
the performance and health of the firms that stocks fund. The only
instrument in wide use more substantatively opaque than common stock is
fiat money.

Here is more, interesting throughout.

Markets on whether InTrade will continue to exist.  The numbers are here.

These markets are run by…InTrade.

I’ve been looking for markets in the probability of an India-Pakistan nuclear exchange (did the probability of a detonation just go up?) but I have to find one.

I thank Blake Johnson for the pointer.

Mark Thoma runs through some numbers.  Of course the plan has not been announced, so I don’t have a good sense of it.  There is talk of five million new jobs, however, and that figure makes me suspicious.  There is very often a trade-off between spending the stimulus money well and spending the money to create new jobs.  For instance the better "Green Energy" ideas mostly involve hiring or reallocating skilled people who already have jobs.  Many of the recently unemployed seem to be coming from construction, retail, finance, and, soon, manufacturing.  If we spend to build up mass transit, can we cobble together a team from these people?  And do they live in the right regions, have the right skills, and have the right willingness to lay some extra Metro track?  Don’t accept the rosy scenario numbers until you see at least partial answers to these questions. 

The New Deal put many people to work in the physical construction of infrastructure; at that time the skills of labor were more homogeneous, people were more desperate for work, and it was more expected that "labor" meant physical labor for able-bodied men.

Addendum: Arnold Kling makes a similar point.

On YouTube, find it here.  The taping was about an hour long but the video is six minutes long.  The full talk started with a discussion of capitalism and morality but it ended up focusing on the financial crisis; since I don’t watch myself who knows what made this cut?

Sometimes I try to be "chatty," but that’s not really my temperament.  This time I tried to flood the interviewer with as much content as possible.

Here is a Big Think forum, with Lawrence Summers, George Soros, Peter Thiel, and Robert Merton.  There is more of Summers here.  (Why does he talk slower now?  What happened to the beloved fire hose?  Did someone give him media training and teach him to be chatty?)  Here is Thomas Cooley on whether we should change how economics is taught?

Via Greg Mankiw.  She understands the Great Depression very well.  Here are previous MR entries on Christina Romer, mostly touching on macroeconomics.  I can’t vouch for her managerial or political abilities one way or the other, but intellectually this is a very good pick.  Here is one report on the announcement.

Here is the National Journal on the work of Christina and David Romer on fiscal policy:

At the same time that Obama is calling for higher income taxes on people making $250,000 or more, the Romers have found that tax increases are generally bad for economic growth and that they primarily discourage investment — the supply-side argument that conservatives use to justify tax cuts for the rich. On the other hand, the Romers have shredded the conservative premise that tax cuts eventually force spending reductions (‘starving the beast’). Instead, they concluded that tax reductions lead only to one thing — offsetting tax increases to recover lost revenue.

Here is the MR entry on that paper, please do read it again to receive a dose of good news.  Here is Romer’s home page.  Here is her soon to be longer Wikipedia page.

I feel like I am repeating myself, but since the topic is so much in the news, let’s give it another go.  A massive fiscal policy could:

1. Generate some investments which are worthwhile on their own terms.  LaGuardia really does need another runway.

2. If the broader monetary aggregates are falling, because of either a credit crunch or a liquidity trap, a fiscal boost can keep aggregate demand from deteriorating.  Note that this is distinct from bringing about a recovery; it is limiting further downside.

3. A fiscal boost can provide a beneficial "sunspot" in a multiple equilibrium model, thereby moving everyone to the higher output equilibrium.

4. If spending needs to fall, a fiscal boost can postpone this fall.  Postponing this fall may be a good idea to prevent immediate economic destruction.  But then the fiscal policy is not really bringing about recovery.  In fact the fiscal policy is (optimally, perhaps) hindering the pace of adjustment and recovery.  Fiscal policy makes the downturn less severe but it also prolongs the adjustment process.

You’ll note that only under #3 does a massive fiscal boost in fact bring about an economic recovery.  But I do not believe that #3 is better for anything than a few good days in the stock market nor do most people rely on #3 in making the case for fiscal policy.

You might also try #5:

5. The economy needs a boost to aggregate demand and since monetary policy isn’t working any more, fiscal policy has to step in.  This is usually followed by drawing a graph with two or three curves on it.

This makes sense if it is reworded to be more precise and to be some combination of #2 and #4.  But still, a huge fiscal boost will not bring recovery because a big chunk of the problem requires real economic adjustments (the simple graph obscures this).  The economy needs to adjust out of housing, out of so much consumption, and out of various classes of associated risky assets.  Those are some pretty massive adjustments and along the way lots of major banks become zombie banks.  A massive fiscal boost won’t get us over those problems.

Just to recap: Because of #1 and #2, you might think that a massive fiscal boost is a good idea, compared to the alternatives.  But you should not argue that a massive fiscal boost will bring about or drive an economic recovery.  It is tempting to cite #5 to justify the fiscal boost but the bottom line is some mix of #2 and #4.