It’s October 1931

We are now more than two years into the Great Recession, which began in December 2007.  In the Great Depression, this was the point where the Fed decided to raise interest rates to keep the dollar from depreciating (after Britain left the gold standard.) 

Mr.  Bullard of the St. Louis Fed wants to see “at least one month of positive jobs growth” before raising rates.  Maybe it will come out tomorrow, but stocks fell sharply today on worries that the recovery is sputtering out:

NEW YORK (AP) — Stocks buckled Thursday under the growing belief that the global economy is weaker than many investors expected and is likely to stop the U.S. labor market from rebounding in the coming months.

.   .   .

The drop was similar to stumbles the market began having in mid-January. Stocks fell then in response to China’s attempts to curb its overheated growth. Those moves raised fears that the other world economies could suffer as a result. The pullback in stocks worsened as leaders in Washington said they would impose tighter regulations on U.S. banks.

So stocks crashed because investors are worried about Chinese moves to curb demand, and tighter regulation of the banking system.  Interestingly, Krugman has recently been calling for a higher value of the yuan (which is a deflationary policy for China) as well as tighter regulation of the banking system.  He also favors tariffs on big carbon emitters (i.e. China.)

I still think we will avoid an outright double dip (or perhaps I should say that I infer that the markets think this will be avoided, as I don’t do witchcraft.)  But I am increasingly worried about the Japanese scenario (which to his credit, Krugman has repeatedly warned about.)  The CBO just put out an estimate of 2.8% NGDP growth in 2011.  There is no way to overstate how depressing that number is.  During the recovery from the 1981-82 recession we had roughly 10% nominal growth for much of 1983 and 1984.  The normal NGDP growth rate has been just over 5% in recent decades.  In this recession we fell about 8% below that trend, and could now use some rapid catch-up.  Instead, we may fall even farther behind trend. 

Why does any of this matter?  Consider the following from a study of the Great Depression:

We find that, once we have controlled for lagged output and banking panics, the effects on output of shocks to nominal wages and shocks to prices are roughly equal and opposite.  If price effects operating through nonwage channels were important, we would expect to find the effect on output of a change in prices (given wages) to be greater than the effect of a change in nominal wages (given prices).  As we find roughly equal effects, our evidence favors the view that sticky wages were the dominant source of nonneutrality.

Let me explain what Steve Silver and I did when we studied the Great Depression.  We regressed (differences of logs of) monthly industrial production on monthly wholesale prices and nominal hourly wages.  We found higher prices had a positive effective, and higher nominal wages had a negative effect of a similar magnitude.  So it looks like real wages were the problem.  You can get higher real wages through deflation (for a given nominal wage) or through higher nominal wages (for a given price level.)  Either way you get high unemployment.

Actually I tricked you.  The quotation above does not come from the time series paper with Steve Silver that I just described, but rather from a different paper that looked at cross-sectional data for many different countries during the Depression.  Isn’t it interesting that they got almost the same findings, using a completely different technique.  BTW, the authors of the paper I quoted were Kevin Carey, and . . . some fellow named Ben Bernanke.

Late last year I expressed a lot of concern about how difficult it was going to be to get all workers to accept pay cuts that put them 8% below their previous trend line, assuming that NGDP doesn’t fully recover but rather starts a new 5% growth rate from this point forward.  I pointed out that NYC teachers, for instance, were about to get a 4% raise negotiated way back in 2005.  Little did I imagine that even 8% adjustments wouldn’t be enough.  Faster than 5% NGDP growth would allow us to get back to a reasonable unemployment level without painful and prolonged wage cuts.  Instead they’re estimating only 2.8% NGDP growth in 2011.  So after a painful round of wage cuts workers can look forward to  . . .  even more painful wage cuts.

I’m not a leftist, but if I was a conspiratorial leftist I would attribute today’s stock crash to investors waking up to the fact that the pain was spreading beyond the labor markets.  Here’s what a left-wing Sumner would assume was going through the mind of investors :

“For a while we had the economy in a sweet spot.  It was depressed enough to keep labor and other inputs really cheap, but at least we could look forward to steady 5% NGDP growth going forward.  Yeah, workers were suffering, but corporate profits were doing alright.  But now the hawks at the Fed and ECB and BOJ have gone too far.  If NGDP growth slows further, it won’t just be workers suffering; there won’t even be enough revenue to underpin higher corporate profits.  And now the Chinese are even tightening.  China; the one bright spot in the world economy during 2009!  And I just read that the ‘Davos men’ are pressuring China to adopt the Hoover/Mellon strong currency policies.  If the China recovery sputters out, who’s going to be the engine of the world economy?  I’m all for conservative policies, but not so conservative we end up in a depression.”

I’m not saying that’s what happened on Wall Street recently; just saying a left-wing version of me would entertain that hypothesis.

Part 2. Krugman wants a stronger yuan

Paul Krugman is again attacking the weak yuan policy, using a zero sum exchange rate model that takes no account of how the policy impacts world aggregate demand.  But Krugman is not a vulgar protectionist.  In the past he carefully noted that the weak yuan would not hurt the US if interest rates weren’t stuck at zero.  Normally, the Fed could ease policy to offset any negative effects on AD.  Instead, he only seems like a vulgar populist because he has a special “depression economics” model that allows for all sorts of unsavory policy advice once rates hit the zero bound.  Unfortunately, he is still wrong for three different reasons. 

1.  Start with his assumption that currency adjustments are a zero-sum game.  If that were true, and it’s not, then the weak yuan should help China and hurt the US.  Yes, some other poor countries might also be hurt, but they could offset the effect via devaluation.  In contrast, the US and Europe cannot easily devalue without triggering all sorts of international tensions.  But even if this view is right, his advice to the Chinese is wrong.  China has 1.35 billion mostly poor people.  The US has 310 million mostly affluent people.  A good liberal like Krugman should argue for a weak yuan, as the Chinese need the money much more than we do.

2.  The second thing wrong with Krugman’s argument is that (unless he has become a vulgar protectionist in the last few weeks) he himself notes that it only applies to a situation where the Fed is powerless to boost AD.  But even Krugman admits that they aren’t powerless right now.  They could set a higher inflation target.  They simply don’t want to.  So now he wants to impose hardship on millions of poor Chinese workers in export industries because our own Fed (and ECB) are too lazy to lift a finger to boost NGDP growth in the US.  Indeed they are just itching to tighten policy further.  So even if Krugman isn’t a utilitarian liberal like me, even if (unlike me) he doesn’t care more about the poor in China than the middle class in America, it’s still a bad argument, as the solution isn’t a higher yuan, it’s unconventional monetary stimulus in the US.

3.  But it’s even worse than that.  Because even if Krugman doesn’t care about the Chinese, and even if you assume the Fed is powerless, a stronger yuan is still a bad policy.  Why?  Because money isn’t a zero-sum game.  Currency policies are also monetary policies.  A stronger yuan is a deflationary monetary policy.  A weaker yuan is expansionary.  Krugman has spoken highly of FDR’s bold expansionary policies undertaken when he took office, even citing a 2008 AER paper by Eggertsson.  But the FDR policy that was far and away the most influential at boosting inflation expectations was dollar devaluation.  That’s right; he praises his hero FDR for pursuing exactly the sort of “beggar thy neighbor” policy that he wants the Chinese to stop doing.  Just to be clear, I understand that China has begun growing briskly again and that at some point they will need to start appreciating the yuan again to prevent overheating.  But Krugman was certainly wrong about the yuan in 2009, when China experienced deflation.  And the recent stock plunges all over the world, which seemed to follow the Chinese decision to tighten policy in January, should be a shot across the bow of those who want to tighten prematurely.  Krugman quite rightly points to the errors of 1937, when the US tightened policy during a period of rapid growth, but also a period when neither the US nor world economy was yet out of depression.  Let’s not make the same mistake again.  There’s plenty of time to tighten policy when things get a bit better.  If the Chinese recovery is real then by late 2010 a higher yuan will probably be appropriate.  But it is too soon to tighten now.

If China slows, our recovery will also be threatened, regardless of the fact that US exports to China are relatively modest.  China affects the entire world economy.  It has a huge effect on East Asia, on Australia, even on capital goods producers in Germany.  If the entire world economy slows, it will affect the US. 

And the effects are not just from exports, that’s more zero-sum thinking.  It will lower the world Wicksellian real interest rate, and that will drag central banks deeper into a Japanese-style liquidity morass.

I hope I am just overreacting to the stock market tonight (it fell 3.1%), and that we get a “strong” jobs number tomorrow.  (These days ‘strong’ would mean 10% unemployment, and a few hundred jobs gained after 8 million lost.)  But please, let’s err on the side of recovery.  I haven’t even talked about all the other problems with slow NGDP growth—more banking problems, debt crises in Southern Europe, and lots more.  Those who have studied the Great Depression know about all the ugly side effects.  And how about this Gideon Rachman’s description of the “best and the brightest” who represent us at Davos:

With the Americans and the Europeans experiencing a crisis of confidence, Davos man was keen to learn from China this year. American businessmen could be heard ruefully contrasting their own “dysfunctional” political system and flaky politicians with China’s decisive and meritocratic leadership.

Oh yes, China has strong leaders who can make the high speed trains get built on time.  Wish we had a leader like that here.  Our businessmen made many similar comments during the 1930s, but not about China.


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51 Responses to “It’s October 1931”

  1. Gravatar of Joe Calhoun Joe Calhoun
    4. February 2010 at 20:48

    Scott,

    The action in the dollar and gold (especially gold today) spooked the hell out of me. Things need to stabilize soon or we are headed right back for deflation and more pain.

    I’ve been thinking about the recovery from the 82 recession recently too because Volcker is so much in the news lately. It is humorous to me that Volcker is given so much credit for guiding the economy through that time because I think he basically stumbled on the correct policy by accident. That recession was caused by deflationary monetary policy too. Volcker knocked gold from $850 to $310 and he would have kept at it if the Mexicans hadn’t defaulted. He eased in August of ’82 because he had to; kind of like Bernanke last year. Easier monetary policy and Reagan’s supply side policies kicked off the boom and the great bull market.
    Frankly, I don’t think Volcker had a clue how to run monetary policy and can’t understand why he is so lionized.

    Volcker made a mistake that policy makers have been making for a very long time:

    People labored under the delusion that the evils caused by inflation could be cured by a subsequent deflation…But the statesmen who were responsible for the deflationary policy were not aware of the import of their action.

    They failed to see the consequences which were, even in their own eyes, undesirable, and if they had recognized them in time, they would not have known how to avoid them. Ludwig von Mises

    That was in reference to England going back to gold after the first world war but it seems apt here too. We never learn.

  2. Gravatar of Mike Sandifer Mike Sandifer
    4. February 2010 at 22:13

    Great post. It’s very thought-provoking and counter-intuitive in some ways, at least for me.

  3. Gravatar of cucaracha cucaracha
    4. February 2010 at 23:12

    “Our businessmen made many similar comments during the 1930s, but not about China.”

    ” In the 1928 German elections, less than 3% of the people voted for the Nazi Party…”

    ” By 1930 the German economy was beset with mass unemployment and widespread business failures. The SPD and the KPD parties were bitterly divided and unable to formulate an effective solution; this gave the Nazis their opportunity, and Hitler’s message, blaming the crisis on the Jewish financiers and the Bolsheviks resonated with wide sections of the electorate ”

    History repeats itself, indeed.

  4. Gravatar of Lorenzo from Oz Lorenzo from Oz
    5. February 2010 at 00:11

    Why is monetary stimulus so scary? Why does the BOJ and the Fed look at the world and say: we have to keep the value of the currency up? Is it some sense that that is the “last leg” and if you knock that over, it’s all gone? The abyss opens?

  5. Gravatar of Lorenzo from Oz Lorenzo from Oz
    5. February 2010 at 00:16

    Or, to put it another way, a sense that monetary stimulus means “losing control”?

    But this a very informative and clear post, even more than usual, thank you.

  6. Gravatar of Kevin Donoghue Kevin Donoghue
    5. February 2010 at 02:21

    “A good liberal like Krugman should argue for a weak yuan, as the Chinese need the money much more than we do.”

    As Arvind Subramanian points out, it’s mostly poor countries who suffer from China’s exchange rate policy.

  7. Gravatar of frankl frankl
    5. February 2010 at 04:13

    you say it started in dec07 but i recall it started coming apart (markets that is, vs mainstreet economy) when BNP (thru no fault of their own, specifically) froze some of their moneymarket funds due to inability to price some of the holdings (don’t recall which ones but likely cdo/clo stuff eh?) and this is when the wheels really started coming off – some date it to june07 when the BearStearns mortgage hedgefunds imploded – btw, dec07 is around the time when it was seen that the moneycenter usa banks in NYC stopped being lenders into the market (collectors of yield) and started borrowing…..

  8. Gravatar of OGT OGT
    5. February 2010 at 04:25

    Prof. Sumner- A couple of points, as Donoghue mentions, it is mostly poor countries that pay for China’s capital control regime. It’s no accident that India, Indonesia and Vietnam have all made moves toward imposing trade sanctions on China this year. (Three countries that are in the aggregate more populous and poorer than China).

    And since, we are taxing your family to pay for benefits for poorer families elsewhere is never a popular policy (Ask Scott Brown), anyone who cares about the long term viability of free trade should be interested in China relenting.

    Further, you’re plainly confusing the monetary/currency issue (too be provocative?), as China has just shown by tightening and leaving the peg/capital control regime in place. Giving us the worst of both worlds.

  9. Gravatar of dlr dlr
    5. February 2010 at 07:42

    So it looks like real wages were the problem.

    So how does this affect your favored monetary target in times like this, when there was an initial negative surprise in NGDP expectations, but there has not been a constant string of disappointments. For example, NGDP expectations today are probably not way off from where they were a year ago. So presumably there has been time for some degree of wage adjustment off of the initial (pre-September 2008) path. Bill Woolsey seems to favor returning to the initial path anyway. Do you, or is there some middle ground and some way to measure what it should be in advance (assuming we were price level targeting)? Is it a matter of also looking at whether nominal wages veered of their path? Finally, does this mean that you find the effect of a negative NGDP surprise on explicit rigidities like debt and other fixed contracts mostly unimportant?

  10. Gravatar of Atlas Sound Money Project » Blog Archive » It’s October 1931 Atlas Sound Money Project » Blog Archive » It’s October 1931
    5. February 2010 at 08:00

    [...] “We are now more than two years into the Great Recession, which began in December 2007. In the Great Depression, this was the point where the Fed decided to raise interest rates to keep the dollar from depreciating (after Britain left the gold standard.) Mr. Bullard of the St. Louis Fed wants to see “at least one month of positive jobs growth” before raising rates. Maybe it will come out tomorrow, but stocks fell sharply today on worries that the recovery is sputtering out…” Read more. [...]

  11. Gravatar of Rafael Rafael
    5. February 2010 at 10:35

    Hey Scott,

    This one is provocative:

    http://www.nber.org/papers/w15710

  12. Gravatar of Philo Philo
    5. February 2010 at 10:48

    Kevin Donoghue points to Arvind Subramanian’s claim that “it’s mostly poor countries who suffer from China’s exchange rate policy.” So why don’t these poor countries devalue their own currencies, to obtain the (alleged) benefits of a weak currency? Subramanian writes: “[W]ith capital pouring into emerging market countries, their ability to respond to the threat of asset bubbles and overheating is undermined [by the Chinese policy]. Emerging market countries such as Brazil, India and South Korea are loath to allow their currencies to appreciate – to damp overheating – when that of a major trade rival is pegged to the dollar.” This is incoherent; how can the economies of these emerging market countries be in danger of “overheating,” with all the damage that Chinese exchange-rate policy is doing to them?

  13. Gravatar of scott sumner scott sumner
    5. February 2010 at 12:48

    Joe, I agree.

    Thanks Mike.

    cucaracha. Let em emphasize that it won’t get nearly that bad this time, but I found the comments chilling.

    Thanks Lorenzo, So we’re back to my original hypothesis that the Aussies are less uptight than us Puritans.

    Kevin, Krugman wouldn’t agree with that view, as he claims beggar thy neighbor policies are only a problem when you are stuck in a liquidity trap. But poor developing countries never get stuck in liquidity traps as they can always devalue. The article you linked to didn’t make much sense. He implied South Korea is a competitor to China. Actually it has a complimentary relationship, and has benefited hugely from the Chinese boom.

    frankl, I mostly agree. I’d say a very mild recession started in late 2007, perhaps before December, and it became severe in August 2008.

    OGT, Kevin is wrong, even according to Krugman’s view (check out my reply to him.) I don’t think Krugman has much interest in free trade, as he wants tariffs on Chinese goods for lots of reasons. BTW, we also need to go after Germany if big trade surpluses are a problem, theirs is nearly as big as China’s.

    And even if you are right, it is all a moot point as the proper policy is a weaker dollar (against goods and services, not the yuan), not tariffs against China. Even Krugman’s own model implies that is the solution.

    I might be wrong about one of the three points I raised (although I doubt it) but I am not wrong about all three. And Krugman needs me to be wrong about all three.

    dlr, You raise a good question. But if people knew how bad things were going to get in late 2008 and early 2009, why were wages still going up? If NGDP grows 2.8% in 2011, we will need far deeper wage cuts than we have had so far. Consider the NYT teacher example I gave.

    Don’t get me wrong, wage stickiness is a bit of a mystery. My sense is the problem is not any one thing, but a combination. Money illusion, lack of wage coordination (which occurs in places like Austria), both real and nominal stickiness, etc. No one factor gives a plausible explanation, but all I can say is look at the data . . . wages are very sticky, for whatever reason. I don’t know a single person who has stayed in the exact same job, and seen their nominal hourly wage fall 8% below trend. We had a pay freeze last year (4% below trend) and will get 2.5% this year (another 1.5% below trend.) That will leave our wages 2.5% too high even if NGDP starts growing at 5%, but it looks like it won’t be growing that fast.

    On the bright side, the unemployment number today was better than I expected.

    Rafael, Thanks, their conclusions sound plausible to me.

    Philo, Yes, I didn’t read that part, but I did mention the devaluation option in my responses above. But your other point is also excellent.

  14. Gravatar of ca ca
    5. February 2010 at 13:11

    It is refreshing to see someone routinely take on Krugman, and have the intellectual capacity to match their passion.

  15. Gravatar of TGGP TGGP
    5. February 2010 at 14:17

    I’m a bit confused. A little while back you said that a worker wants everyone’s wages (not just his/her own) to be dynamic, so that the especially sticky wages of public employees is causing unemployment in the private sector. I don’t quite get how this works. Public employee pay rates fail to fall during a recession, either some get laid off (unlikely) or the government goes into debt to keep them on. How does this hurt the private sector worker? They have to pay the taxes (either now or in the future), which leaves them with lower take-home pay, but shouldn’t cause unemployment. If there was no stickiness in the private sector (which I know isn’t true, but I’m just analyzing one thing here) I don’t see how unemployment is produced in the private sector rather than just lower real wages. Actual stats show that unemployment is lowest right now in government, education and healthcare sectors so the private sector is taking most of the hit.

    Your post on the EMH and bubbles was critiqued at Modeled Behavior. I gave an argument for what I thought your response would be, but it would be best to hear the real McCoy.

  16. Gravatar of StatsGuy StatsGuy
    5. February 2010 at 15:27

    Holy cow, that’s the math? You have to be kidding me…

    “We regressed (differences of logs of) monthly industrial production on monthly wholesale prices and nominal hourly wages. We found higher prices had a positive effective, and higher nominal wages had a negative effect of a similar magnitude. So it looks like real wages were the problem.”

    How did they factor in forward expectations of demand? (No, differencing doesn’t net that out.) Also, I’ve mentioned inventory stocking/destocking, and wage gaming that could overestimate the impact. And the fact that when new employees are hired back after a cyclical downturn, average wage GOES DOWN EVEN AS EMPLOYMENT GOES UP. Meaning that you could easily have reverse causation, such that increases in production mean you are hiring (cheaply paid) labor back onto the production line which brings the overall average down.

    Why, again, are macro-economists allowed to use regression models?

  17. Gravatar of StatsGuy StatsGuy
    5. February 2010 at 15:43

    Free trade – what are your views on policy-equalizing tariffs?

    In other words, let’s say (leaving aside the idea of artificial volcanoes and the notion that acidification of oceans etc. destroys fish that currently are a major source of protien) we get a US carbon tax. Would you be in favor of a carbon-equalizing tax on imports from countries without a carbon tax?

    Also, what are your views on the Chanos China bubble narrative? There’s an interesting argument that Chinese currency action has harmed itself, although one could just as well argue that US lack of currency action has harmed China. Why they keep building an economic structure that is dependent on exports to a debt ridden US to buy their raw materials imports is beyond me.

    And I have to wonder, do the benefits of “free trade” take into account the financial market instability caused by a _possible_ default of Greece, which represents 1/2% of world total GDP? Wow.

  18. Gravatar of Mark A. Sadowski Mark A. Sadowski
    5. February 2010 at 16:17

    We’ve had an unusual pattern for post WW II recessions in that real wages have held up better than usual. But this recession has not had any unusual factors that suggest greater than normal wage stickiness. This suggests to me an unusually steep reduction in AD. Sounds like 1931.

  19. Gravatar of RN RN
    5. February 2010 at 16:59

    Krugman is right about China, and Sumner is nothing more than a fame-monger trying to achieve notoriety by attacking Krugman at all times.

    Pathetic.

  20. Gravatar of ssumner ssumner
    5. February 2010 at 18:09

    ca, Thanks

    TGGF, Yes, I did a reply to that EMH post already.

    Suppose NGDP is one half public and one half private sector. Assume both wages and employment are held steady in the public sector. Now assume monetary policy reduces NGDP by 25%. Private sector wages must fall 50% for private sector workers to keep their jobs. That’s just not going to happen.

    Statsguy. Yes, I realize that real wage regressions don’t prove anything about causation. But you should look at the paper, there is much more to the argument than I indicated. We were basically comparing wage cyclicality in the 1920s and 1930s. The big shift is that nominal wages became highly countercyclial after 1933, in other words after FDR starting moving nominal wages artificially. Before that they were acyclical, because there are affected by shifts in both the supply and demand for labor. I’m not saying the paper’s perfect, but it’s not as naive as that paragraph makes it seem.

    People that know China say Chanos knows nothing about the country, and just grabbed a bit of data. That’s not to say there aren’t “bubbles.” Whenever asset prices rise fast, there will be some nasty dropoffs in the future. But I wouldn’t rely on his model. China ain’t Enron.

    Mark, Yes the big problem is AD, although wages might be a bit stickier than usual due to the 73 week benefit extension, and the 40% jump in minimum wages.

    RN, Darn, I was hoping nobody would notice.

  21. Gravatar of Lorenzo from Oz Lorenzo from Oz
    5. February 2010 at 20:08

    Aussies, I am sure, generally believe we are less uptight/more laid back than Yanks and Japs.

    (I am tempted to add: but isn’t anyone? Then I though of Swiss and Germans …)

    I don’t know that national stereoptypes (sorry, culturally-specific characteristics) are much use as an explanatory variable for monetary policy.

  22. Gravatar of OGT OGT
    5. February 2010 at 20:29

    Sumner- Actually a very large percentage of Germany’s trade surplus is within the Euro zone, which of course does have an unnaturally fixed exchange rate. If anyone should be complaining about Germanic monetary policy and currency policy, it should their fellow Euro members.

    I don’t know how many points Krugman needs you to be wrong about. I’d grant that last year any change in the yuan could have been contractionary so on cyclical basis there was a defense for stopping appreciation last year. However, now they are clearly making moves to tighten credit and monetary policy, but keeping the peg in place. As I wrote above this is the worst of both worlds, smoot-hawley II. And the affect on secular trading patterns could be similar.

  23. Gravatar of StatsGuy StatsGuy
    5. February 2010 at 20:45

    ssumner:

    “The big shift is that nominal wages became highly countercyclial after 1933, in other words after FDR starting moving nominal wages artificially.”

    That’s a different and stronger argument – the natural experiment approach. Still not perfect, but better than a first differenced _monthly_ regression.

    Right now, the Euro is proving a pretty serious problem – Krugman (and OGT) have that very right. Germany doesn’t want to ease because it doesn’t want to “bailout” the “PIIGS” – they are like creditors who made bad loans who intend to see that their blood money is repaid in full. But they scream when the US takes monetary action. The US then screams when China takes monetary action.

    FYI, I’m guessing that the Fed takes no action until on/after next wednesday, when the bond auctions for the month (the first after wind down of Fed liquidity programs) is completed. They need bid/cover to be very strong to set a precedent of support for the deficits they are financing this year. Right now, they perceive the shortage of dollars to be to their advantage. Put yourself in their shoes – FOMC is terrified of having poor coverage for the auction. More so than some “temporary” damage to the economy caused by 3 weeks of market panic. And this week’s the superbowl – nice distraction.

    If the Fed increases QE, they will try to stage the announcement from a position of strength, when the markets seem to be indicating there is no need for QE. If they announce QE from a position of weakness, we’ll get a dollar run.

  24. Gravatar of Kevin Donoghue Kevin Donoghue
    6. February 2010 at 02:33

    Scott/Philo,

    “They can always devalue” is a response on a par with “let them eat cake.”

    There are good reasons why some of the Asian economies don’t want to follow the Chinese path of tight capital controls and an undervalued currency. I’m a bit stuck for time and I won’t be online for a few days so I’m not going to go into that in more detail. But Scott, if you read Krugman’s work from the days when he didn’t believe a liquidity trap could be generated in a “respectable” economic model, I think you’ll find that even back then he considered beggar-thy-neighbour policies to be harmful.

  25. Gravatar of ssumner ssumner
    6. February 2010 at 11:36

    Lorenzo, I’m tempted to add comments, but then I recall that I have readers from all over the world.

    OGT, regarding Germany, if there is one thing that almost all economists agree on, even those who worry about trade deficits and surpluses being problems, it is that bilateral deficits are completely meaningless. It is well known that much of what we buy from China are products actually made in Japan, Korea, Taiwan, etc. Thus our former big deficits with those countries just migrated to China. But not much changed. The value-added still goes to the rich countries. But China gets blamed bacause they do the final assembly.

    You said;

    “As I wrote above this is the worst of both worlds, smoot-hawley II. And the affect on secular trading patterns could be similar.”

    There is no similarity between tariffs and “undervalued” currencies. None. And to answer your other question I’d have to be wrong on all three points for Krugman to be right. And I still haven’t heard any good arguments against any of the three points.

    Statsguy, You said;

    “That’s a different and stronger argument – the natural experiment approach. Still not perfect, but better than a first differenced _monthly_ regression.”

    It’s not an either or, you have to do the regression to get the data required for the natural experiment.

    I’m not one of those economists who thinks regressions test models. They are descriptive statistics in my view. They show correlations, like a graph. They are the beginning of the analysis, not the end.

    I half agree with Krugman on the euro. He emphasizes the loss of monetary independence, I emphasize the overly tight money. Perhaps the difference is merely nuance, as I’m sure he thinks the lack of independence is a problem precisely because money is too tight everywhere in Europe.

    I thought the Fed hoped nobody would buy our debt. Then we’d be out of the liquidity trap, and they could again boost AD with conventional policy. (Yes, I’m being sarcastic here. My point is they are inconsistent.)

    As far as a dollar run–please don’t get my hopes up.

    Kevin, It has nothing to do with capital controls. Any small country can devalue with or without capital controls. Just target the exchange rate and the money suplly becomes endogenous. As far as beggar thy neighbor, Krugman specifically indicated recently that China’s low yuan policy was a problem because we couldn’t cut interest rates. He may have other reasons, but I don’t know what they are.

    By the way. I understand there may be other objections to beggar-thy neighbor policies, such as the desire in Europe to avoid harmful exchange rate competition. But those other reasons don’t apply to a US response to the weak Chinese yuan. We should not be not worried about hurting their feelings with a weak dollar.

  26. Gravatar of vimothy vimothy
    6. February 2010 at 11:45

    China is to the US what Germany is to the EMU (esp. the med. EMU). It’s the same problem of the surplus that can’t be adjusted for because of the exchange rate peg. The ECB are pretty crazy hawkish too, which doesn’t help.

  27. Gravatar of Doc Merlin Doc Merlin
    6. February 2010 at 23:06

    @ lorenzo
    “Why is monetary stimulus so scary?”

    Money for fiscal stimulus requires either deficit borrowing or taxing, or deficit borrowing and a tax cut/rebate. All three cause problems.

    1. Government borrowing competes with everyone else’s borrowing at a time when private borrowing is needed to end the recession. This raises the interest rates higher than they should be.

    2. Business taxing increases supply costs, which makes businesses cut production. Personal taxing tends to decrease consumption and savings and thus hurts recovery that way.

    3. Financing a tax cut type stimulus through deficit borrowing, will give us an immediate boost, but will prolong the recession (because it decreases private investment).

  28. Gravatar of Mandos Mandos
    7. February 2010 at 00:22

    1. Start with his assumption that currency adjustments are a zero-sum game. If that were true, and it’s not, then the weak yuan should help China and hurt the US. Yes, some other poor countries might also be hurt, but they could offset the effect via devaluation. In contrast, the US and Europe cannot easily devalue without triggering all sorts of international tensions. But even if this view is right, his advice to the Chinese is wrong. China has 1.35 billion mostly poor people. The US has 310 million mostly affluent people. A good liberal like Krugman should argue for a weak yuan, as the Chinese need the money much more than we do.

    OMG. This attitude is a recipe for extremist right-wing populism to arise in the USA. The US middle and working classes are worried about sending their kids to college, not Chinese kids.

  29. Gravatar of Doc Merlin Doc Merlin
    7. February 2010 at 05:26

    I seem to have completely misread your question, Lorenzo. I read that as “fiscal stimulus.”

    Monetary stimulus is only scary when coupled with large increase in government pending. The seventies are an example of this. By itself its not nearly as scary, but can still cause problems due to the ignorance of policy makers.

  30. Gravatar of vimothy vimothy
    7. February 2010 at 07:09

    Doc,

    The government’s deficit is the difference between what it spends and what it taxes.

    In a closed economy, after netting intra-sector transactions, the government’s liabilities are the public’s assets. Symmetrically, the public’s liabilities are government assets. Government spending (i.e. borrowing) does not prevent private sector saving (i.e. lending). It enables it. The BOP complicates matters somewhat but the logic remains the same.

    Thus (still closed economy model) if the private sector wants to net save, without deficit spending there are no addition funds for investment because total income (AD) will fall. Only net spending from another sector can increase the aggregate pool of savings available for investment for that sector. As long as AD is going to an asset class that does not mobilise labour in its production, the economy will remain below capacity. In the model we need to satisfy the sectoral desire for net paper assets by supplying them (i.e. the government deficit holds output constant allowing savings to rise), and offsetting the drag on AD.

    Well, in the real world, the Chinese already said no (meaning: a continual foreign sector drag on AD). So that leaves the private sector balance sheet moving away from a net savings position back into the red or government. There is nowhere else for the money to come from. If you divide the economy into three sectors, public, private and foreign, the recovery in AD has to come from increased net spending in one of these sectors, by definition.

  31. Gravatar of ssumner ssumner
    7. February 2010 at 10:40

    Vimothy, I don’t see it as a “problem” at all. Why is it a problem?

    Mandos, China’s surpluses don’t hurt the US, so it’s a moot point.

  32. Gravatar of vimothy vimothy
    7. February 2010 at 10:56

    It’s only problem if there’s no off-setting cross-sectoral flow maintaining AD and thus total income.

  33. Gravatar of vimothy vimothy
    7. February 2010 at 11:17

    All I’ve done there is rearrange an accounting identity. Total income is equal to total expenditure in the economy. If we restrict the system to the US and China the difference between total spending and total income in the US economy *is* the CAD with China. That balance relative to total spending is the proportion of US AD going straight out of the economy (into China). Another way to say this is that the US CAD allows total income to exceed total spending in China. We can also look at this relationship in terms of the capital account, which takes us back to Keynes’ liquidity trap:

    “… the export of T-bills is different from the export of cars or computers or almost anything else: it does not create jobs. That is why countries whose currency is being used as a reserve, and exporting T-bills rather than goods, often face an insufficiency of aggregate demand.”

    –Stiglitz

  34. Gravatar of Nathanael Nathanael
    7. February 2010 at 19:28

    In 1930, Hitler *was* running the economy better than FDR. It’s no wonder he was admired by businessmen.

    The economy isn’t everything; it isn’t even the most important thing, and that’s why the US was a better place to live in than Germany — we weren’t about to invade Poland, and we weren’t sending around thugs to kill people of certain religions!

    The US, so far, is not harvesting organs from prisoners, making US government better than Chinese government, and our courts are still more honest.

    Unfortunately the US is degenerating fast on rule-of-law issues, and on torture, and we seem to have the warmongering down pat….

  35. Gravatar of scott sumner scott sumner
    8. February 2010 at 07:22

    Vimothy, Stiglitz is wrong, he needs to read some Krugman. Countries need to target NGDP or the price level, regardless of what is happening to their current account. There is no correlation between CAs and unemployment.

    The accounting identity does not suggest that a bigger CA deficit will reduce AD, rather that it will boost I (for an given S). In any case, the accounting identity is not a useful way of thinking about what is funamentally a monetary problem.

    And of course so-called ‘liquidity traps’ do not prevent price level or NGDP targeting.

    Nathanael, Neither Hitler nor FDR was in power in 1930, but I agree if you are talking about the late 1930s. Of course in the end our economy did far better, as we both agree.

    I also share your concern about the US going a bit downhill right now. China has far worse governance, but at least an upward trajectory since the horrors of Mao. But I also think the US goes in cycles, and we may recovery for this malaise.

  36. Gravatar of vimothy vimothy
    8. February 2010 at 09:03

    The US CAD represents the amount of total spending in America that does not contribute to total income. Therefore, in a two country macroeconomy, consisting of just China and America, America’s CAD with China relative to total spending is the proportion of AD not contributing to US output. Symmetrically, that ratio represents the proportion of US GDP that the Chinese economy receives as a net stimulus to aggregate demand, so that on net China earns more than it spends and America spends more than it earns.

  37. Gravatar of vimothy vimothy
    8. February 2010 at 11:28

    “The accounting identity does not suggest that a bigger CA deficit will reduce AD, rather that it will boost I (for an given S).”

    You are still letting the ex post identity drive causality in the model! There is a logical fallacy in your statement. If (and only if) C falls while Y remains constant, then of course the additional spending must have come from one of the other sectors in the identity. If G and NX do not rise then it must be from I—this is simply circular reasoning.

    However, you cannot hold output constant: it is the dependent variable, the determinate of the other variables in the identity. Aggregate savings do not increase as C falls. This paradox is hard to grasp, but let me give it a shot.

    Consider a closed economy at T0 with potential output of $100 and a stock of money equal to the same. If at T1 AD is $100 the economy is at potential. But what happens when the economy as a whole saves 5% of its wealth. At T2 total spending equals $95 and so total income equals $95. GDP is now $95—output has fallen. The stock of paper wealth did not increase so there are no additional funds available to boost investment spending—all we have is the same $100 we started with.

    There can never be an aggregate increase in paper wealth from within this closed system. It has to come from somewhere else—a cross sectoral deficit flow.

  38. Gravatar of vimothy vimothy
    8. February 2010 at 12:03

    Sorry, should read,

    “But what happens when the economy as a whole saves 5% of its income?

  39. Gravatar of Dan Dan
    8. February 2010 at 15:12

    It looks to me like Yglesias, Cohen and Delong are ready to join you and Eichengreen in calling for a competitive devaluation solution:

    ‘DeLong suggested that the Obama administration can begin to fix this dilemma by appointing “competent economists” to the Federal Reserve Board to reduce and eliminate global imbalances that trap the United States and China in financial terror.

    “Ninety-eight percent of economists think a weaker dollar will help the economy,” but it is a difficult sentiment to express without being seen as treasonous, Cohen explained.’

    http://yglesias.thinkprogress.org/archives/2010/02/stepping-on-the-monetary-gas-pedal.php

    Oh, and don’t leave out Salmon and Mosler:

    “the European Central Bank should simply print 1 trillion euros, and hand it out, on a pro-rated basis, to all the Eurozone states.”

    http://blogs.reuters.com/felix-salmon/2010/02/08/can-europe-print-money-to-get-out-of-its-fiscal-hole/?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+felix-all+%28Felix+Salmon+-+All%29

    The question really is why the people in power make up the majority of the big names that seem to disagree. Or rather, in Bernanke’s case at least, why they suddenly disagree when they are put into power. I have a feeling that the final verdict on the failures in responding to this crisis might be more about institutional design than about disagreement over macro policy.

  40. Gravatar of thruth thruth
    8. February 2010 at 16:03

    vimothy said ““But what happens when the economy as a whole saves 5% of its income?“”

    lets start with the glib closed economy answer: in normal times, it invests it. Y unchanged.

    ok, that hasn’t happened because we are in liquidity trap dynamics (i.e. at the zero interest rate lower bound, when the optimal nominal rate is negative). People are clinging to money and money subsitutes because that’s the only thing they trust, but they are a nonproductive store of wealth. What’s the easiest way to get them to spend or invest in productive real stuff? Debase the (current and/or expected future) money supply sufficiently to make real spending or investments a better alternative. Now that we have a ZIRP, the Fed obviously needs to do something other than conventional OMOs to achieve that. Take your pick… Don’t forget that intentions matter too when it comes to setting inflation expectations.

    “However, you cannot hold output constant: it is the dependent variable, the determinate of the other variables in the identity. Aggregate savings do not increase as C falls. This paradox is hard to grasp, but let me give it a shot.”

    It is equally wrong to hold everything else constant, such as prices. This is a jointly determined system.

    “Well, in the real world, the Chinese already said no (meaning: a continual foreign sector drag on AD). So that leaves the private sector balance sheet moving away from a net savings position back into the red or government.”

    So what? “private net savings in the red” can mean a variety of things: consuming beyond your means, or investing more than saving (putting that foreign capital to productive use). Current account deficits are not inherently evil.

  41. Gravatar of vimothy vimothy
    8. February 2010 at 16:23

    “lets start with the glib closed economy answer: in normal times, it invests it. Y unchanged.”

    ONLY IF output is constant and spending in one sector decreases does spending in another sector increase. But output is the dependent variable. You are committing the exact same fallacy as Scott. There is no increase in *aggregate* savings to fund additional investment spending. Output must fall. Go back to my toy economy and look again.

  42. Gravatar of vimothy vimothy
    8. February 2010 at 16:44

    Thruth,

    Remember that C & I represent the same sector!

  43. Gravatar of vimothy vimothy
    8. February 2010 at 16:47

    “private net savings in the red” can mean a variety of things

    “Private net savings in the red” means that, in the sector in question, total spending is greater than total income.

  44. Gravatar of Doc Merlin Doc Merlin
    8. February 2010 at 20:06

    @vimothy responding to me, and trying to explain the ‘paradox of thrift’:
    “But what happens when the economy as a whole saves 5% of its wealth. At T2 total spending equals $95 and so total income equals $95. GDP is now $95—output has fallen. The stock of paper wealth did not increase so there are no additional funds available to boost investment spending—all we have is the same $100 we started with.”

    Not at all, the 5 dollars of savings go to a bank and the bank multiplies it via the mechanism of their reserve rate, and now we have more than $100 (nominal) paper wealth in the economy. This isn’t really the only reason I don’t believe in the paradox of thrift, really Hayek and many others made better arguments against it than I, but this is one reason I don’t.

    @vimothy responding to other people:
    “ONLY IF output is constant and spending in one sector decreases does spending in another sector increase. But output is the dependent variable.”

    No, no, no.
    That is zero sum game nonsense. And output isn’t the dependent variable, that ignores the entire supply side of the economy.

    ‘“Private net savings in the red” means that, in the sector in question, total spending is greater than total income.’

    Not always, it can also mean that investment is being funded with new money instead of with saved money.
    The old-school hydraulic
    Yd=C+S is somewhat meaningless, when money creation is taken into account. If your sector is getting new money first, then you can have spending > Income without having “private net savings in the red.”

    And at the same time, if banks are getting the new money so they are holding interest rates lower than they would sans money creation, then you have “Private net savings in the red” but you don’t have spending greater than income

  45. Gravatar of vimothy vimothy
    9. February 2010 at 01:42

    Not at all, the 5 dollars of savings go to a bank and the bank multiplies it via the mechanism of their reserve rate, and now we have more than $100 (nominal) paper wealth in the economy

    Well in that case ALL of the $100 goes to the bank regardless of the level of total spending. The fact that total spending is below capacity does not add to that initial $100, it just reduces total income for that period.

    So it obviously doesn’t matter if you add a banking system at T3: double entry bookkeeping is such that after netting out assets against liabilities we are still back to the same initial $100–even if the loanable funds and money multiplier type stories are assumed to be true. There will *never* be a net increase in invest-able funds from within the system. Spending or not spending does not alter the number of net financial assets within the toy economy, just their distribution. It will always be $100–unless there is a across-sectoral deficit flow from another toy model/sector.

    “No, no, no.
    That is zero sum game nonsense”

    No, no, no–this is logical and stock-flow consistency. I know it seems counter-intuitive, but that’s why macro is hard. Everything going somewhere has to have come from somewhere else. Total spending *is* total income.

    Not always, it can also mean that investment is being funded with new money instead of with saved money… If your sector is getting new money first, then you can have spending > Income without having “private net savings in the red.”

    I’m afraid it always means that. That’s what a negative net saving flow is. New credit-money simply pairs new assets on one side with new liabilities on the other–balances sum to zero for no new net money in the system.

  46. Gravatar of vimothy vimothy
    9. February 2010 at 03:27

    Just to expand on that last point slightly, the flow of saving in a period is equal to the flow of income less the flow of expenditure. Negative net savings (flow) means that spending exceeds income, by definition.

  47. Gravatar of Scott Sumner Scott Sumner
    9. February 2010 at 06:21

    Vimothy, You said;

    “The US CAD represents the amount of total spending in America that does not contribute to total income. Therefore, in a two country macroeconomy, consisting of just China and America, America’s CAD with China relative to total spending is the proportion of AD not contributing to US output. Symmetrically, that ratio represents the proportion of US GDP that the Chinese economy receives as a net stimulus to aggregate demand, so that on net China earns more than it spends and America spends more than it earns.”

    But you forget that the flip side of the CAD is a capital account surplus, which is Chinese money invested in the US. That boost our investment, ceteris paribus.

    You said;

    “However, you cannot hold output constant: it is the dependent variable, the determinate of the other variables in the identity. Aggregate savings do not increase as C falls. This paradox is hard to grasp, but let me give it a shot.”

    First of all, I’ve been teaching macro for 30 years, I assure you that I don’t find hydraulic Keynesian models “difficult to grasp”, I find them unconvincing. There’s a reason the paradox of thrift fell into disrepute after 1982, it’s not because elite macroeconomists at Ivy League schools suddenly couldn’t grasp the paradox of thrift. I mentioned the accounting identity in response to your mention of it. Of course it doesn’t prove anything.

    Here is one of my posts criticizing attempts to reason from the C+I+G identity.

    http://s84684.gridserver.com/?p=274

    In your model, what determines the LEVEL of NGDP?

    Dan, Thanks, it’s good to see these ideas catching on.

  48. Gravatar of thruth thruth
    9. February 2010 at 06:34

    vimothy “No, no, no–this is logical and stock-flow consistency. I know it seems counter-intuitive, but that’s why macro is hard. Everything going somewhere has to have come from somewhere else. Total spending *is* total income.”

    Here is the problem. You claim you have a “model”, but all you have is an accounting identity. Where are the prices? If savings rise due to some shock, that income has to go somewhere. Lets assume that in a liquidity trap it sits in bank vaults instead of being put to productive use resulting in a shortfall AD. Why is it sitting in a bank vault? Well, according to the liquidity trap story, with interest rates at the lower bound money and bonds are now equally attractive, and much more attractive than real goods and investment at their pre-shock prices. If those wages or goods prices are sufficiently sticky, then the AD shortfall lowers incomes with investment crashing. Increasing G is one way to solve the AD shortfall (but over the longer term G is a very poor substitute for I). So where does the money for increasing G come from? The bank vaults. So the real problem is we need to get money out of the bank vaults. Clearly another way out is to change the relative prices of bonds and cash by creating inflation. Whether the Fed has the necessary tools to do that is a separate issue.

    Just to reiterate. Increasing savings isn’t the problem. The problem is those savings being held in cash instead of invested.

  49. Gravatar of vimothy vimothy
    9. February 2010 at 07:06

    It doesn’t matter if the money is spent. If the toy economy includes a banking sector, it is already invested. The only thing that changes is total spending, total income and thus total output.

  50. Gravatar of vimothy vimothy
    9. February 2010 at 07:08

    Scott,

    Thanks a lot!

  51. Gravatar of Doc Merlin Doc Merlin
    9. February 2010 at 18:31

    Me: “Not always, it can also mean that investment is being funded with new money instead of with saved money… If your sector is getting new money first, then you can have spending > Income without having “private net savings in the red.”

    Vimothy: “I’m afraid it always means that. That’s what a negative net saving flow is. New credit-money simply pairs new assets on one side with new liabilities on the other–balances sum to zero for no new net money in the system.”

    Response:
    1) I didn’t say new “credit” I said new money.
    2) Also if the fed can create new credit at below the market rate, this doesn’t balance out. It creates new nominal assets greater than new nominal discounted liabilities.

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