Archive for April 2010


The self-correcting mechanism

Those who teach the AS/AD model may do the example of the big drop in AD after 1929.  Then you are supposed to show two alternatives; either the Keynesian policy of boosting AD to try to speed up the recovery, or merely waiting for the AS curve to shift right as wages and prices adjust downward.

After unemployment hit 10.8% in late 1982, Volcker opted for fast NGDP growth and we got a fast recovery.  This morning the BEA announced that NGDP grew a bit over 4% in the first quarter.  While the rate for the year will probably be somewhat higher, it is clear that the Fed has decided to rely on the self-correcting mechanism this time, and just wait for the long and painful adjustment in wages and prices to play itself out.  If this is the strategy, then it would have been better not to have recently boosted minimum wage rates by 40%, quadrupled the duration of UI, passed a health care tax increase, and cracked down on immigration. 

Let’s hope the euro crisis doesn’t trigger another drop in AD.  (I’m cautiously optimistic it won’t, but we are in uncharted waters.)

Any thoughts on Zipf’s Law?

I don’t have time to do posts on what I’d really like to talk about, the new Krugman and Wells article or Russ Roberts’ piece on banking.  So I’ll defer those until after my trip to Oxford, and instead do a short fun piece on Zipf’s Law.  Well, fun for nerds like me, who find descriptive statistics to be endlessly fascinating.  (Not the other kind of statistics.)

Mankiw recently linked to an Edward Glaeser article on Zipf’s Law, which reminded me of a table of skyscraper statistics.  It may be that everything I say is already widely known, and fully explained.  If so I can count on my very smart commenters to point that out.  For those who don’t know, Zipf’s Law says that in a ranking of entities by size, the second on the list will be about 1/2 the size of the first, the third will be 1/3 the size of the first, the 10th largest will be one tenth the size of the first, etc.  A good example is the population of US cities:

Rank↓  City↓  State↓  Population↓
1  New York  New York  8,363,710
2  Los Angeles  California  3,833,995
3  Chicago  Illinois  2,853,114
4  Houston  Texas          2,242,193
5  Phoenix  Arizona  1,567,924
6  Philadelphia   Pennsylvania  1,540,351
7  San Antonio  Texas          1,351,305
8  Dallas  Texas                  1,279,910
9  San Diego  California  1,279,329
10  San Jose  California  948,279

I find this kind of spooky, as these cities grew spontaneously.  Note that if you look at this Wikipedia list you will find that the big cities are actually a bit too small when compared to cities ranked, 20, 30, etc.  The Glaeser article shows that metro populations have the same problem–big cities are a bit too small.
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Reader requests

I have had several requests to comment on the euro crisis.  One person suggested discussing this post by Megan McArdle:

The Great Depression was composed of two separate panics.  As you can see from contemporary accounts–and I highly recommend that anyone who is interested in the Great Depression read the archives of that blog along with Benjamin Roth’s diary of the Great Depression–in 1930 people thought they’d seen the worst of things.

Unfortunately, the economic conditions created by the first panic were now eating away at the foundations of financial institutions and governments, notably the failure of Creditanstalt in Austria.  The Austrian government, mired in its own problems, couldn’t forestall bankruptcy; though the bank was ultimately bought by a Norwegian bank, the contagion had already spread.  To Germany.  Which was one of the reasons that the Nazis came to power.  It’s also, ultimately, one of the reasons that we had our second banking crisis, which pushed America to the bottom of the Great Depression, and brought FDR to power here.

Not that I think we’re going to get another Third Reich out of this, or even another Great Depression.  But it means we should be wary of the infamous “double dip” that a lot of economists have been expecting.  The United States is in comparatively good shape, but the euro is in crisis, and already-weak European banks seem to be massively exposed to Greece’s huge debt load.  They’re even more exposed to the debt of the other PIIGS, which is far too large for it all to be bailed out.  The size of the rescue package that Greece needs is already going to take a fairly substantial chunk of the IMF’s war chest.

I also found it hard to avoid comparisons to 1931.  I wish I could tell you the precise lessons of 1931, but it is surprisingly difficult.  The first question we need to consider is why some bad news from tiny Portugal seemed to knock 2.4% 0ff the S&P yesterday.  I always look at other markets for insights, and I noticed that the fall in stock prices was accompanied by lower 5 year inflation expectations, and a stronger dollar.  That looks like a contractionary monetary shock. 
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In Good Company

I am having trouble getting my brain up and running after 5 days in Miami and 5 more at DisneyWorld.  I didn’t see much evidence of recession in Orlando, as lots of people were paying $70 for the privilege of waiting 30 minutes in line for a 2 minute ride on a malfunctioning elevator (AKA “Tower of Terror.”)  Speaking of elevators, did anyone see this video of Mundell?  Sean Rushton summarizes the key argument:

Part Two of Mundell’s analysis is the most intriguing and least understood aspect. He argues that, as the real-estate bubble burst, large quantities of fresh liquidity were demanded by the public and banks. In summer 2007, the world’s central banks supplied it and no liquidity crunch developed. But by summer 2008, spooked by rising inflation, the U.S. Federal Reserve failed to provide adequate cash, leading to dollar scarcity. Four key symptoms of tight money appeared within months: the dollar rose 30 percent against the euro; gold fell 30 percent; oil fell 80 percent; and the inflation rate dropped from 5.5 percent to negative levels. As a result, Mundell believes, Lehman Brothers collapsed, the stock marketwent into free fall, and a near-panic ensued. This phase was entirely preventable and constitutes one of the worst mistakes in Fed history, Mundell says. The crisis eased in early 2009, as the Fed upped the money supply, but the damage was done.

Arnold Kling did a post on this quotation entitled “Mundell as Sumnerian?”   When I first read the title I thought I was receiving an undeserved honor.  Mundell is a Nobel Prize winner and I’m just an economist from a small university that is often confused with an over-stuffed British luxury automobile.  But then I noticed that Kling wasn’t honoring me, but rather dissing Mundell:

Anyway, he seems to espouse a view that tight money caused the severe financial and economic downturn, which puts his elevator on the same floor as that of Scott Sumner.

This refers to Nobel Laureate Robert Mundell. Back when I was in grad school, Mundell was treated by the MIT faculty as: (a) a mythic figure in open-economy macroeconomics; (b) someone to whom Rudi Dornbusch owed a huge intellectual debt; and (c) someone whose elevator no longer went to the top floor.

In any case, I’m still honored to be compared to a Mundell that has slipped a few floors.  But shouldn’t the title of the post have been “Is Sumner a Mundellian?”
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What shall we call changes in nominal gross domestic product?

I’ve constantly complained that there is no word in the English language for nominal shocks, i.e. unexpected increases and decreases in NGDP.  (Or even expected changes, for that matter.)  In contrast, there are simple words for rising and falling price levels; inflation and deflation.  Interestingly, this language failure is mirrored by an analytical failure; when economists discuss Fed policy and nominal shocks they speak in terms of inflation and deflation, not rising and falling NGDP. 
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