Archive for August 2010

 
 

France never recovered from the 1974/1981 recessions. Will we recover from this one?

Probably.  Nevertheless it’s worth thinking about the implications of this Robert Barro piece:

To get a rough quantitative estimate of the implications for the unemployment rate, suppose that the expansion of unemployment-insurance coverage to 99 weeks had not occurred and—I assume—the share of long-term unemployment had equaled the peak value of 24.5% observed in July 1983. Then, if the number of unemployed 26 weeks or less in June 2010 had still equaled the observed value of 7.9 million, the total number of unemployed would have been 10.4 million rather than 14.6 million. If the labor force still equaled the observed value (153.7 million), the unemployment rate would have been 6.8% rather than 9.5%.

In contrast, his son Josh Barro points out that most studies suggest extended UI boosted the unemployment rate by only about 0.4% or 0.7%, and then goes on to argue that even those figures may be too high.

…The incentive effects of UI extension must also be weighed against the stimulative effects of paying UI benefits. For some reason it’s become almost taboo to note this on the Right, but UI recipients tend to be highly inclined to spend funds they receive immediately, meaning that more UI payments are likely to increase aggregate demand. UI extension also helps to avoid events like foreclosure, eviction and bankruptcy, which in addition to being personal disasters are also destructive of economic value.

I’d like to sit in on one of those family dinners!

Count me as being somewhere between the two Barros, but closer to Josh.  I think the main difference between 1983 and today is that NGDP growth was nearly three times faster in the initial recovery of 1983-84.  If that’s all I knew about this recession–nothing about the banking/housing fundamentals that triggered it, and nothing about 99 week UI extensions, I’d still predict a very slow recovery, albeit perhaps a tad faster than we are getting.  Robert Barro contrasts the slow recovery to 1983, but better comparisons might be 1992 and 2002, when unemployment actually rose for more than a year after the end of the contraction.

However, I wouldn’t go as far as Josh Barro, who concedes a small adverse effect on the economy’s supply side, but then argues that the program boosts AD.  If extended UI benefits make the labor market more rigid (which seems likely), then it may reduce the equilibrium real rate of interest.  In that case monetary policy will become effectively tighter, even if the Fed continues to target nominal rates at 0.25%.  Many economists overlook the way supply and demand shocks become entangled.  There is a reason why negative demand shocks often follow closely on the heels of negative supply shocks (1974, 2008, etc.)

And although I think it unlikely we end up never recovering, the French experience should teach us some humility.  Recall that in the 1960s most European economies had much lower unemployment than the US, typically around 2% or 3%.  By the 1980s many were stuck with rates close to 10%.  France never really recovered from the 1981 recession, with unemployment fluctuating between 7% and 11% over the past 30 years.  And in 1972 no one in Europe saw this coming.

Why did it happen?  Who knows.  Initially people came up with all sorts of explanations.  Here’s an example from a 1993 paper:

A flow model is used to identify the causes for rising unemployment in France between 1978 and 1990. Two flow equations are estimated as functions of exogenous factors such as aggregate demand, factor costs, structural shifts and long-term factors and then used in simulations for the level of unemployment. It is shown that the main reason for high unemployment in France is a slow down in the demand for labour due to high labour and energy costs in the early 1980s and to tight aggregate demand over the whole period.  Change in the labour supply have had an increasing impact in recent years.

Today it seems silly to cite AD and energy prices, but it’s hard not to sympathize with the author (Dominique Gross).  If the cause was structural (as most now believe) it begs the question of why the natural rate of unemployment suddenly rose from 2% to 9%.  And which structural problem?  For ever suspect, you can find some small European country that has that policy, and yet maintains only 5% unemployment.  Perhaps it is labor market policies interacting with differences in culture and comparative advantage. 

An optimist like me would argue that we aren’t about to copy the French statist model; dramatically higher minimum wages, generous UI benefits, national health care, higher taxes, etc.  Oh wait . . .  Seriously, as bad as it looks to conservatives, there is a lot of ruin in a nation.  So I still think there is only a 10% or 20% chance we will experience French-style “ hysteresis” (which refers to a sticky unemployment rate that refuses to fall during “recoveries.”)

One thing that has always annoyed me is economists who do a lot of moral grandstanding, accusing people they disagree with of being evil.  For instance, this is how Robert Reich recently entitled his attack piece on Robert Barro:

A record number of Americans is unemployed for a record length of time. This is a national tragedy. It is to the nation’s credit that many are receiving unemployment benefits. This is good not only for them and their families but also for the economy as a whole, because it allows them to spend and thereby keep others in jobs. That a noted professor would argue against this is obscene.

Regarding obscenity, a Supreme Court justice once said “I know it when I see it.”  With all due respect to Reich, I don’t see it.  Here’s the Barro article he responds to:

The unemployment-insurance program involves a balance between compassion—providing for persons temporarily without work—and efficiency. The loss in efficiency results partly because the program subsidizes unemployment, causing insufficient job-search, job-acceptance and levels of employment. A further inefficiency concerns the distortions from the increases in taxes required to pay for the program.

In a recession, it is more likely that individual unemployment reflects weak economic conditions, rather than individual decisions to choose leisure over work. Therefore, it is reasonable during a recession to adopt a more generous unemployment-insurance program. In the past, this change entailed extensions to perhaps 39 weeks of eligibility from 26 weeks, though sometimes a bit more and typically conditioned on the employment situation in a person’s state of residence. However, we have never experienced anything close to the blanket extension of eligibility to nearly two years. We have shifted toward a welfare program that resembles those in many Western European countries.

Didn’t Reich just say Barro opposed unemployment insurance?  Not only does he favor it, but he favors extended benefits during recessions. 

Perhaps he thinks it’s obscene to accuse the unemployed of being lazy.  But then I found this in Reich’s article:

In theory, Barro is correct. If people who lose their jobs receive generous unemployment benefits they might stay unemployed longer than if they got nothing.

So I guess somewhere between the 99 weeks recommended by the virtuous Robert Reich, and the 39 weeks recommended by the evil Robert Barro (and implemented by Bill Clinton), UI extension proposals become obscene.  It all reminds me of the old Winston Churchill joke:

Churchill: “Madam, would you sleep with me for five million pounds?”

Socialite: “My goodness, Mr. Churchill… Well, I suppose… we would have to discuss terms, of course…”

Churchill: “Would you sleep with me for five pounds?”

Socialite: “Mr. Churchill, what kind of woman do you think I am?!”

Churchill: “Madam, we’ve already established that. Now we are haggling about the price.”

PS.  Robert Barro is one of my favorite supply-side economists.  No one is more deserving of a Nobel Prize in Economics.  But I think he has a bit of a blind spot about AD shocks, as do many on the right.

HT: Alex Tabarrok, Mark Thoma

Long and Variable LEADS

In the previous post I explained why the commonly held notion of long and variable lags is a myth.  I didn’t mention the reason for this myth.  It results from economists trying to cover up the fact that the monetary policy indicators they have fallen in love with (interest rates, the money supply, etc) don’t actually identify changes in the stance of monetary policy.  Recent work by Woodford and others shows that it is changes in future expected monetary policy that drive current AD.  Krugman also did important work in this area, and used this basic idea a few weeks back when he argued hawkish statements by Fed officials were already slowing the economy.

And in fairness to Mr. Bernanke, discord among senior officials also makes it difficult for policy to change expectations: it would be hard to credibly commit to higher inflation if this commitment were constantly being undercut by speeches out of the Richmond or Dallas Feds. In fact, I’d argue that loose talk by some Fed officials is already having a negative economic impact.

Suppose Fisher, Plosser, and Hoenig make a bunch of scary sounding statements about exit strategies, and that causes people to expect tighter money next year.  Why would that cause the economy to slow right now?  There are many reasons, but the easiest explanation involves a simple example using a perfectly competitive industry.  Suppose tighter money is expected next year.  Economic theory predicts this will reduce AD next year, and also depress commodity prices.  But if future expected commodity prices decline, then inter-temporal arbitrage also causes current prices to fall.  If wages are sticky, then lower current commodity prices will cause lower output of commodities like zinc. 

Those more comfortable with Keynesian explanations might look at the process through interest rates.  Tighter expected money next year will raise expected future real short term interest rates.  This will raise current real long term interest rates.  And this might slow housing.  I personally don’t like using this mechanism, because if tight money leads to slower expected growth, it might actually depress longer term rates.  Even so, it would contract current output by lowering the current price of houses.

Here’s what I find interesting about these expectations stories.  Suppose you think of monetary policy in the way most people do—as open market operations that change the money supply.  In that case, there may actually be LEADS in monetary policy, i.e. the effect may occur before the cause.  A future money supply change may cause a current change in demand and output. 

Those who are philosophically inclined may be a bit uncomfortable with the thought of effects occurring before causes.  “Wait” (I can just hear you saying) “it isn’t the future money supply change that causes a current change in spending, it is the CURRENT EXPECTATION of a change in future monetary policy, and future AD.”  OK, I’m willing to go along with that.  We should not describe changes in monetary policy in terms of current changes in the money supply, but rather expected future changes in the money supply.  And of course we also know that it isn’t just the money supply that matters, velocity is equally important.  So what really matters is changes in the expected future level of M*V, or NGDP.  It is changes in expected future NGDP that best characterizes changes in monetary policy, at least if we don’t want effects to occur before causes.  Of course that’s exactly what I have been arguing in my blog for 18 months. 

And by the way, if we define monetary policy changes in terms of changes in expected future M*V (as we should), and if the fiscal multiplier is estimated under the assumption that monetary policy is held constant, then it is a truism that the expected fiscal multiplier is always precisely zero.  

Don’t like that result?  Then give me your definition of “monetary policy changes” where:

1.   Cause doesn’t follow effect

2.  The definition does not imply money was “easy” in the Great Depression (when rates were low and the monetary base soared.)

Having trouble?

How the Greek crisis helped Germany

A few days ago Tyler Cowen did a post discussing the 8.8% RGDP growth rate in Germany in the 2nd quarter.  Because I had previously expressed skepticism about the robustness of the Germany recovery, let me congratulate Tyler for being correct.  Nevertheless, in my never-ending struggle to turn sow’s ears into silk purses, I tried to make the best of it with this essay over at The Economist.  Yes, I was wrong about the recovery (which I still think was less than robust until the second quarter) but the blowout number for German growth shows I was right about something far more important.  I know what you are thinking, “How convenient, he can make up ad hoc theories for his past mistakes.”  Bear with me; this is what I said in May:

“So stocks in the heart of the eurozone, the area with many banks that are highly exposed to Greek and Spanish debts, are actually down a bit less (on average) than the US.  Perhaps the strong dollar is part of the reason.  Perhaps monetary policy has become tighter in the US than Europe.”

Now I certainly did not expect 8.8% growth in Germany, but I did point out that the Greek crisis might have been hurting the US more than Germany.  Recall that it sharply appreciated the US dollar against the euro, and that those gains were closely linked to news stories about the Greek crisis.  So I think it is reasonable to infer that worries about the “PIIGS” led to an increased demand for dollars, which caused the dollar to appreciate.  In principle, the Fed could have prevented this by increasing the supply of dollars, but they are reluctant to do unconventional QE.

I’d also like to mention a few ideas not in The Economist essay.  Let’s start with the slowdown in US growth.  David Beckworth has a post that shows May and June were the key months, when growth in US NGDP began to slow sharply.  But can we really link this to tighter money?  After all, doesn’t monetary policy work with long and variable lags?”   Actually no. 

Monetary policy affects the economy almost immediately.  It is very hard to identify monetary shocks with postwar data, because policy is so endogenous.  But in the interwar period there were some large monetary shocks that were easily identifiable, and in each case they led almost immediately to a sharply change in:

1.  Stock prices

2.  Commodity prices

3.  The WPI

4.  Industrial production

Those who want to argue long and variable lags have a problem.  It isn’t just the empirical evidence I cite, on theoretical grounds the impact on stock and commodity prices must be immediate (unless there are a lot of $100 bills lying around on the ground.)  But the movement in stocks and commodities is closely correlated with broader price indices and monthly industrial production.  So whatever caused the prices of assets to change was also probably driving industrial production. 

And of course we see the same thing in modern times.  The great fall in industrial production in late 2008 occurred at the same time stock and commodity prices were collapsing.  We know the Greek crisis sharply depressed US stock and commodity prices in May 2010.  Now that we get the GDP report, we also know that it depressed NGDP, especially in May and June.  In Germany, the effect was positive, as the weaker euro gave a big boost to the already robust German export machine, which is a big part of the German economy. 

So what can we learn from all this?  Here are some lessons:

1.  Krugman was wrong in suggesting that the slowdown this spring was entirely predictable from the planned phase-out of stimulus.  The slowdown was associated with a sharp drop in stock prices, which was obviously unforecastable.

2.  Krugman was wrong for another reason; the slowdown in the US was not due to less spending, but rather less output growth, as the trade deficit worsened dramatically.  And German output soared with strong exports.

3.  There are no long and variable lags, the economy responds almost immediately to monetary shocks.

4.  Monetary shocks (changes in the supply and demand for dollars) are often much more important than real shocks (banking problems.)  The Greek crisis put the German and French banks under a great deal of stress.  Yet the German economy grew fast, as the weaker euro was like an easing of monetary policy.

5.  I do share one trait with Krugman.  We both have an almost shameless ability to turn failed predictions into claims of “See, I was right all along!” 

[Krugman fans:  Just kidding, he actually does have a pretty good track record at forecasting. But he can be a bit hard to pin down at times.]

Next post:  long and variable LEADS.

Why I am so repetitious

God save the Brits.  When I studied the Great Depression it often seemed like the British (both economists and journalists) were the only ones who understood that money was too tight.  Recall that they were the first (Europeans) to bail on the gold standard, and had the good sense to stay out of the euro.  It still seems they are ahead of us, at least at The Economist’s Free Exchange and the Financial Times.  Here is Ryan Avent:

Britain’s economy will be watched closely given the government’s relatively aggressive plans for fiscal consolidation. Can the Bank of England offset the contractionary impact?

That is exactly the question.  (The answer is yes, at least if we are to believe Paul Krugman when he explains away past austerity successes by pointing to easy money policies such as currency depreciation that were pursued concurrently.)  But note how rarely American reporters understand this policy interrelationship.

Here is Clive Crook at the FT:

As the monetary economist Scott Sumner has pointed out, Milton Friedman – name me a less reconstructed monetarist – talked of “the fallacy of identifying tight money with high interest rates and easy money with low interest rates”. When long-term nominal interest rates are very low, and inflation expectations are therefore also very low, money is tight in the sense that matters. When money is loose, inflation expectations rise, and so do long-term interest rates. Unreconstructed monetarists ought therefore to agree with Mr Magnus’s main point: under current circumstances, better to print money and be damned.

Admittedly, once that strategic issue is settled, difficult tactical questions arise. For instance, which assets should the Fed buy? As Alan Blinder, a former vice-chairman of the Fed, has noted, the recent policy of replacing maturing mortgage-backed securities on the Fed’s balance sheet with government debt has a secondary effect of reducing downward pressure on risk spreads, which is a pity.

I first did a post on that Friedman quotation back more than a year ago, and have done a dozen since using the exact same quotation.  But only in the past few weeks has it started to resonate.  Brad DeLong just linked to it a few days ago.   As far as Blinder is concerned, he recommended negative rates on excess reserves a few days ago in the Wall Street Journal.  Once again, I had to repeat the idea many times before the message broke through. 

I apologize to longtime readers for my repetitiveness.  But there is a reason; ideas don’t get accepted unless they are repeated over and over again.  It is only in the past few months that I have seen other bloggers picking up on the NGDP targeting idea, which David Beckworth, Bill Woolsey and I have been pushing for years.

Next post:  “Why I am so egotistical”  (Doing a post that pretends to justify repetitiousness, while actually reveling in my ideas get airplay.  Time for a post on my biggest mistakes?)

HT:  Marcus

Faulty arguments for the marriage penalty

I was surprised that a number of commenters actually defended the marriage penalty in the comment section of my recent tirade.  I thought it worth driving a nail into the coffin of one particularly popular but fallacious argument.

Some commenters argued something to the effect that “two can live almost as cheaply as one” (or more specifically at less than double the cost of one.)  First let’s consider someone born with the love of the sea.  It leads him to buy a sailboat as an adult. As a result, he has less income to spend on food, clothing, and shelter than the typical guy.  Should he pay a lower income tax rate, to compensate for his unusually high living expenses?

Now consider six young professional women.  Three are picky misanthropes who don’t like sharing bathrooms and kitchen counterspace with other women.  The other three women share a three bedroom apartment, thus having lower per person shelter costs.  How should we think about this situation?

Most people would say that the three women living alone are free to share an apartment with others if they wish, and thus must derive lots of utility of having their own private place.  I can certainly understand that, I was a picky misanthrope who lived alone for more than 15 years.  I can’t image anyone saying there should be different tax forms for the three women sharing an apartment, and that they should pay a higher tax rate than the other three.  Indeed, I don’t think people would want that to occur even if the government could costlessly ascertain who is living alone and who is not.  So why all the arguments for the marriage penalty based on the notion that it is cheaper to share an apartment with others?  I don’t get it.