A bigger China shock?

I have a new piece at The Hill.  Here’s an excerpt:

The biggest puzzle is what the Trump administration is trying to achieve with its trade war. Is it a move to pressure the Chinese to open up their economy, thus reducing barriers to U.S. trade and investment? Maybe, but it was precisely the opening of the Chinese economy that first created the “China shock.”

Indeed, China was no threat at all to U.S. firms when its economy was closed under the leadership of Chairman Mao. An even more open China would create an even bigger shock, resulting in even more economic dislocation in the Rust Belt. Presumably, Ohio manufacturing workers who supported candidate Trump were not hoping China would buy more Hollywood films and computer software, so that America could buy more auto parts from China.

Read the whole thing.

PS.  A recent NBER paper by Zhi Wang, Shang-Jin Wei, Xinding Yu, and Kunfu Zhu reversed the finding of the famous Autor, Dorn and Hanson paper on the “China shock”.  Here is the abstract:

The United States imports intermediate inputs from China, helping downstream US firms to expand employment. Using a cross-regional reduced-form specification but differing from the existing literature, this paper (a) incorporates a supply chain perspective, (b) uses intermediate input imports rather than total imports in computing the downstream exposure, and (c) uses exporter-specific information to allocate imported inputs across US sectors. We find robust evidence that the total impact of trading with China is a positive boost to local employment and real wages. The most important factor is employment stimulation outside the manufacturing sector through the downstream channel. This overturns the received wisdom from the reduced-form literature and provides statistical support for a key mechanism hypothesized in general equilibrium spatial models.

I don’t “believe” either result.  The science of economics has not advanced to the point where it’s possible to have a high level of confidence in these sorts of empirical studies.

PPS.  Off topic, this made me smile:

Trump has moaned to donors that Powell didn’t turn out to be the cheap-money Fed guy he wanted. The president repeated the effort this week in an interview with Reuters, adding the ridiculous claim that the euro is manipulated and the more credible notion that China is massaging the yuan. (The European Central Bank rarely intervenes directly in currency markets; when the ECB does, it’s usually with the Fed.)

Where to begin:

1. Trump had a choice between Yellen and Powell.  I suggested Yellen, as she had done a very good job.  Trump’s advisors said he shouldn’t pick Yellen because she’s not a Republican.  So Trump picked Powell, even though he was slightly more hawkish than Yellen.  Trump is tribal and assumes everyone else in the world is just as corrupt as he is.  He thought Powell would be “better” because he’d want to help a Republican president.  And now Trump is shocked to find out that Powell is not his lapdog.  (Actually it’s too soon to know for sure, as Trump also wrongly assumes that higher interest rates mean tighter money.  But we can cut him some slack, as lots of other people make the same mistake.)

2. I also smiled at the notion that the ECB doesn’t intervene in the currency market.  Of course they have a 100% monopoly on the entire supply side of the euro currency market.  Yes, I understand the reporter meant “foreign exchange market” when he said “currency”.  But even that’s a bit misleading, as ECB policy does affect the forex value of the euro, and there have been ECB actions in recent years that were clearly aimed at depreciating the euro.  Ditto for the Fed and the Chinese central bank.  Still, the reporter is correct in claiming that Trump has no grounds to complain about ECB policy; I wish he had made the same point about China.

PPPS.  Another day, another two convictions of close Trump advisors.  In one case it was for for a crime that Trump ordered him to commit.  Trump’s now as deeply enmeshed in scandal as Nixon was back in 1974.  The good news for Trump is that none of this matters.  Trump’s support is in the low 40s and it will not decline at all.  There was no Nixon cult—his supporters abandoned him in droves.  But the Trump cult would support him if he murdered someone in the middle of Times Square, at least that’s what Trump himself claims.  As long as those 40% of voters stick with Trump, frightened GOP Congressmen will do the same.  Trump is safe.

Still, it will be fun watching the scandal play out—lots more to come!

Screen Shot 2018-08-21 at 6.53.56 PMPPPPS.  Focus on the blue line, as the yellow line partly reflected the worsening economy.

Teaching money/macro in 90 minutes

A few weeks ago I gave a 90-minute talk to some high school and college students in a summer internship program at UC Irvine.  Most (but not all) had taken basic intro to economics.  I need to boil everything down to 90 minutes, including money, prices, business cycles, interest rates, the Great Recession, how the Fed screwed up in 2008, and why the Fed screwed up in 2008.  Not sure if that’s possible, but here’s the outline I prepared:

1.  The value of money (15 minutes)

2.  Money and prices  (20 minutes)

3.  Money and business cycles (25 minutes)

4.  Money and interest rates (15 minutes)

5.  Q&A (15 minutes)

Intro

Inflation is currently running at about 2%.  It’s averaged 2% since 1990.  That’s not a coincidence, the Fed targets inflation at 2%.  But it’s also not normal.  Inflation was much higher in the 1980s, and still higher in the 1970s.  In the 1800s, inflation averaged zero and there were years like 1921 and 1930-32 where it was more like negative 10%!

We need to figure out how the Fed has succeeded in targeting inflation at 2%, then why this was the wrong target, and finally how this mistake (as well as a couple freshman-level errors) led to the Great Recession.

1. Value of Money  

Like any other product, the real value of money changes over time.

But . . . the nominal price of money stays constant, a dollar always costs $1

Value of money = 1/P (where P is price level (CPI, etc.))

Thus if price level doubles, value of a dollar falls in half.

Analogy:

Year      Height    Unit of measure   Real height

1980      1 yard           1.0                1 yard

2018      6 feet            1/3               2 yards

Switching from yards to feet makes the average size of things look three times larger.  This is “size inflation”.  But this boy’s measured height increased 6-fold, which means he even grew (2 times) taller in real terms.

Year      Income    Price level  Value of money   Real Income

1980     $30,000        1.0               1.0               $30,000

2018    $180,000       3.0               1/3               $60,000

The dollar lost 2/3rds of its purchasing power between 1980 and 2018, as the average thing costs three times as much.  This is “price inflation”.  But some nominal values increase by more than three times, such as this person’s income, which means the income doubled in real terms, or in purchasing power.

Punch line:  Don’t try to explain inflation by picking out items that increased in price especially fast, say rents or gas prices, rather think of inflation as a change in the value of money.  Focus on what determines the value of money . . .

2.  Money and the Price Level

. . . which, in a competitive market is supply and demand:

Screen Shot 2018-08-02 at 7.11.51 PM

Demand for Money: How much cash people prefer to hold.

Who determines how much money you carry in your wallet?  You?  Are you sure?  Is that true for everyone?

Who determines the average cash holding of everyone in the economy?  The Fed.

How can we reconcile these two perceptions?  They are both correct, in a sense.

Helicopter drop example:  Double money supply from $200 to $400/capita

==> Excess cash balances

==>attempts to get rid of cash => spending rises => AD rises => P rises

==>eventually prices double.  Back in equilibrium.

Now it takes $400 to buy what $200 used to buy.  You determine real cash holdings (the purchasing power in your wallet), while the Fed determines average nominal cash holdings (number of dollars).

Punch line:  Fed can control the price level (value of money), by controlling the money supply.

What if money demand changes?  No problem, adjust money supply to offset the change.

Fed has used this power to keep inflation close to 2% since 1991.  Before they tried, inflation was all over the map.  After they tried, they succeeded in keeping the average rate close to 2%.  That success would have been impossible if Fed did not control price level.

But, inflation targeting is not optimal:

3.  Money and business cycles

Suppose I do a study and find that on average, 40 people go to the movies when prices are $8, and 120 people attend on average when prices are $12.  Is this consistent with the laws of supply and demand?  Yes, completely consistent. But many students have trouble seeing this.

Explanation:  When the demand for movies rises, theaters respond with higher prices.  The two data points lie along a single upward-sloping supply curve.

Implication:  Never reason from a price change.  A rise in prices doesn’t tell us what’s happening in a market.  It could be more demand or less supply.  The same is true of the overall price level.  Higher inflation might indicate an overheating economy (too much AD), or a negative supply shock:

Screen Shot 2018-08-02 at 7.26.42 PM

In mid-2008, the Fed saw inflation rise sharply and worried the economy was overheating.  It was reasoning from a price change. In fact, prices rose rapidly because aggregate supply was declining.  It should have focused on total spending, aka “aggregate demand”, for evidence of overheating:

M*V = P*Y = AD = NGDP

This represents total spending on goods and services.  Unstable NGDP causes business cycles.

Example: mid-2008 to mid-2009, when NGDP fell 3%:Screen Shot 2018-08-02 at 7.43.04 PM

Here we assume that nominal GDP was $20 trillion in 2008, and then fell in 2009, causing a deep recession and high unemployment.

Musical chairs model:  NGDP is the total revenue available to businesses to pay wages and salaries.  Because wages are “sticky”, or slow to adjust, a fall in NGDP leads to fewer jobs, at least until wages can adjust.  This is a recession.

It’s like the game of musical chairs.  If you take away a couple chairs, then when the music stops several contestants will end up sitting on the floor.

The Fed needs to keep NGDP growing about 4%/year, by adjusting M to offset any changes in V (velocity of circulation).

Punch line:  Don’t focus in inflation, NGDP growth is the key to the business cycle

Why did the Fed mess up in 2008? Two episodes of reasoning from a price change:

1.  The 2008 supply shock inflation was wrongly viewed as an overheating economy.

2.  Low interest rates were wrongly viewed as easy money.

4.  Money and Interest Rates

Below is the short and long run effects of an increase in the money supply, and then a decrease in the money supply.  Notice that easy money causes rates to initially fall, then rise much higher.  Vice versa for a tight money policy.

Screen Shot 2018-08-02 at 7.26.56 PMWhen the money supply increases, rates initially decline due to the liquidity effect. The opposite occurs when the money supply is reduced.

Screen Shot 2018-08-02 at 7.43.15 PMHowever, in the long run, interest rates go the opposite way due to the income and Fisher effects:

Income effect: Expansionary monetary policy leads to higher growth in the economy, more demand for credit, and higher interest rates.

Fisher effect:  Expansionary monetary policy leads to higher inflation, which causes lenders to demand higher interest rates.

In 2008, the Fed thought lower rates represented the liquidity effect from an easy money policy.

Actually, during 2008 we were seeing the income and Fisher effects from a previous tight money policy.

Don’t assume that short run means “right now” and long run means “later”.  What’s happening right now is usually the long run effect of monetary policies adopted earlier.

Punchline:  Don’t assume low rates are easy money and vice versa.  Focus on NGDP growth to determine stance of monetary policy.  That’s what matters.

(I actually ended up covering about 90% of what I intended to cover, skipping the yardstick metaphor.)

Paraguay politics

Let’s consider Paraguay, a country that has traditionally been dominated by two parties, the Colorados and the Liberals.  I’ll make up a hypothetical set of facts, and you tell me the most plausible way to interpret this imaginary scenario:

1.  Manuel Suarez of the Colorado Party is elected president.

2.  Almost all Liberals view Suarez as a dishonest, vindictive demagogue.

3.  The leading Colorado intellectuals and pundits view Suarez as a dishonest, vindictive demagogue.

4.  Roughly 80% of former leaders of the Colorado party (who are now retired from politics) view Suarez as a dishonest, vindictive demagogue.

5.  Roughly 10% of current Colorado politicians criticize Suarez as if he were a dishonest, vindictive demagogue.

6.  In private, most Colorado politicians view Suarez as a dishonest, vindictive demagogue, even while supporting him publicly in order to please their constituents.

7.  Most Colorado voters do not view Suarez as a dishonest, vindictive demagogue.  These voters support Suarez on virtually all issues, regardless of whether his views represent traditional Colorado positions.

Suppose you were a French, Australian or Egyptian political scientist, examining the political situation in Paraguay.  You have no emotional tie to either the Colorados or the Liberals.  You are examining the situation as dispassionately as one might study an ant farm.  Which hypothesis would you regard as most plausible:

A.  Suarez is a dishonest, vindictive demagogue.

B.  Suarez is not a dishonest, vindictive demagogue.  Rather he’s very much misunderstood by the elites in Asuncion, of both parties, who follow him most closely.  Only his cult-like following among ordinary voters of one political party see him for what he is.

Screen Shot 2018-08-19 at 12.44.58 PM

PS.  AP had a good piece on how GOP politicians view the Trump cult.  I almost broke out laughing when I read the concluding paragraph:

“The Trump phenomenon is going to end at some point in time. That might be six years, that might be two years, that might be sooner. No one knows,” the former Ohio GOP chairman said. “When it does end, it’s the job of a lot of us … to make sure that the party is still populated by good, honest, decent candidates and officeholders who we can continue to be proud of.”

“still”?

Reveal, depress, destroy: Three types of contagion

The term ‘contagion’ is used quite a bit in the financial press, but what does it actually mean?  There are at least three very different types of contagion, each with its own policy implications:

1.  An economic crisis in one country might reveal a weakness that was not previously apparent to the international investment community.  Thus in the late 1990s, the gradual rise of China and the strengthening US dollar was slowly weakening the position of export-oriented nations in Southeast Asia, which had fixed their currencies to the US dollar and also accumulated dollar-denominated debts.  When Thailand got into trouble in mid-1997, investors looked around and noticed similarities in places like Malaysia and Indonesia.  It wasn’t so much that Thailand directly caused problems in those countries (in the way a US recession might directly cause problems for Canada); rather it revealed weaknesses that were already there.

2.  A financial crisis in a big country might depress the global Wicksellian equilibrium real interest rate.  For example, the US housing bust and banking crisis of 2007-08 triggered a global recession.  By itself, this doesn’t necessarily cause problems in other countries.  But if the foreign country is already at the zero bound (Japan), or if the foreign central bank is too slow to cut interest rates (ECB), then a lower global equilibrium interest rate might lead to tighter money in other countries.  Here I would say that the US triggered the Great Recession, but the Fed, ECB and BOJ jointly caused the Great Recession.

Similarly, under an international gold standard, the hoarding of gold in one country can depress nominal spending in other countries.  Indeed gold hoarding by the US and France was a principal cause of the Great Depression.

3.  A financial crisis in one country can affect other nations if they are linked via a fixed exchange rate regime or a single currency.  Consider Greece, which comprises less than 2% of eurozone GDP.  Fears that Greece might have to leave the eurozone caused significant stress in other Mediterranean nations.  If one country were to exit, investors might expect this to lead to an eventual breakup of the entire eurozone.  That would trigger a banking crisis, and would also lead major debtor nations such as Italy to default on their huge public debts.  This is why a small country like Greece could have such a big impact on eurozone asset markets; investors feared that a Grexit would destroy the eurozone.

So far, Turkey looks like it fits the “reveal” template best.  The greater the extent to which Turkey is viewed as a special case reflecting local conditions, the smaller the contagion effect.  If Turkey becomes seen as emblematic of much of the developing world, then contagion is more likely.

Trump derangement syndrome

It’s now enough to simply present the words of Trump and his associates.  First, John Kelly shows prosecutorial discretion:

On the recording, Mr. Kelly says Ms. Manigault Newman could be facing “pretty significant legal issues” over what he alleged was misuse of a government car. She denied misusing it.

“I’d like to see this be a friendly departure,” Mr. Kelly says on the tape. “There are pretty significant legal issues that we hope don’t develop into something that, that’ll make it ugly for you.”

“But I think it’s important to understand,” he adds, “that if we make this a friendly departure, we can all be, you know, you can look at, look at your time here in, in the White House as a year of service to the nation. And then you can go on without any type of difficulty in the future relative to your reputation.”

Then Trump explains the qualities he looks for in White House officials:

Screen Shot 2018-08-13 at 11.41.30 AMNow I understand what Trump meant by hiring the best people—he meant the people who a best at praising him.