Archive for June 2010


Russ Roberts on regulation

Russ Roberts has a new post where he takes more of a “glass half empty” perspective.

But even on the level of the simplest of narratives, it’s not clear what the stylized facts are. Let’s look at the United States since 1980. Is the glass half-full or half-empty? Scott points to falling marginal tax rates, and deregulation. When I pressed him on how much deregulation had occurred, he pointed to transportation, communications (the breakup of AT&T) and financial deregulation such as the elimination of regulation Q.

My response was that yes, marginal tax rates are lower. The total tax burden is higher. In the last decade, much higher. On deregulation, how important are the changes in trucking, airlines, phone service and financial competition? Pretty important. On the other side you have an enormous increase in government’s role in health care. You have a large increase in government’s role, especially at the federal level, in education. There is more environmental regulation not less. I would guess that in most places it is harder to start a business than before. The tax code is more complicated. The nanny state has expanded. The government has intervened significantly in the tobacco market. Local zoning has become much more discretionary and interventionist.

In financial markets, you have the repeal of Regulation Q, the repeal of Glass-Steagall and probably a few other changes I’m not thinking of. But you have the relentless subsidization of lending through creditor rescue that increased leverage in the financial sector.

Those are good points, but here’s how I would respond:

1.  We have also seen deregulation of prices in important industries like energy (oil and gas.)

2.  I live close to Cambridge, a city that has been transformed by the elimination of rent controls.

3.  Welfare reform dramatically increased labor force participation of poor women in the late 1990s, and the gains continued during the 2001 recession.

4.  Trade is somewhat freer

5.  There is a bit more competition in education.

6.  I’m not sure taxes actually are much higher.  At the federal level they have remained around 18-19% of GDP.  Perhaps state taxes have risen a bit.  But there are huge gains from moving away from 70% MTRs (which, unfortunately, we are gradually reversing.)

7.  Some environmental regulations (that overcome externalities) are arguably market-friendly.

8.  Conrail, some highways, and some public services have been privatized.

9.  Stock trading has been deregulated.

All this is not to say that Russ is wrong, maybe on balance things have gotten worse.  But it’s hard to convey the full sweep of changes in a brief talk, so I wanted to add this list.  I would add that my main interest is the comparative effects of neoliberal reforms across different countries.  I don’t have strong feelings about whether the American glass is half full or half empty.  It might have been 60% full in 2000, and 45% full today.  I do strongly believe that neoliberal reforms have made the world as a whole much more market-friendly than in 1980, and much better off.  I imagine that Russ and I would find greater agreement outside of the US.

Good news out of China

But why is it good news?  In March I had this to say about China’s yuan peg:

Deflation was my fear for China in late 2008 and 2009, but I agree that that danger is now past.  The Balassa-Samuelson effect would allow China to appreciate the real yuan, and even maintain a large CA surplus.  Indeed I predict they will allow some appreciation later this year.

Yes, I know it’s in bad taste to quote oneself.  And no, I’m not trying to say “I told you so.”  (Many people predicted that yuan appreciation would resume sometime this year.)  Rather I wanted to emphasize the right reasons for letting the yuan appreciate.

Some have argued (and by “some” I obviously mean Paul Krugman) that the weak yuan was hurting the US economy by reducing aggregate demand.  I have argued against that view, instead suggesting that China should adjust the yuan as necessary to meet their domestic macroeconomic goals, which include keeping inflation low.  Inflation in China has recently been rising, and the Chinese government has resorted to administrative controls to slow things down.  These controls seemed to hurt Chinese stocks, which have done poorly this year.

Here is an AP new report on the market reaction to the Chinese announcement:

Beijing’s announcement on Saturday affects markets because China currently keeps the yuan artificially low to boost exports. That helps China sells products to the U.S. and Europe on the cheap, but also makes it difficult for its own consumers to buy foreign goods.

An appreciation in the yuan would help balance out growth across China’s economy and is considered a boost for U.S. and European manufacturers and exporters. The main market impact — a weakening of the dollar — could also help make the U.S. economy more competitive.

Finally, by letting the currency rise, the threat of inflation to China should be reduced, easing investors’ worries that interest rates could be hiked to cool off the economy.

“Market players saw the announcement as a sign that Chinese authorities are confident in China’s economic growth,” said Kazuhiro Takahashi, equity strategist at Daiwa SMBC Securities Co. Ltd.

However, experts also noted that any reform to China’s currency policy would be gradual.

This announcement discusses several reasons why markets appear to have responded positively to the Chinese announcement.  The first part of the quotation describes what might be termed the “terms of trade” argument.  Trade is (supposedly) a zero sum game and thus if the yuan goes up then the US and other countries gain business and China loses business.  The second part of the quotation is more in line with the “macroeconomic stability” argument that I alluded to earlier.  I suggested that China should appreciate the yuan if and only if it was in China’s interest to do so.  How can we tell who’s right?  One approach would be to look at the various market reactions:

In Asia, Japan’s benchmark Nikkei 225 stock index ended 242.99 points, or 2.4 percent, higher at 10,238.01 — a one-month high close. South Korea’s Kospi rose 1.6 percent to 1,739.68, and Australia’s S&P/ASX 200 added 1.3 percent to 4,612.60.

Hong Kong’s Hang Seng index climbed 3.1 percent to 20,905.91, while China’s Shanghai Composite Index added 2.8 percent to 2,583.91. Benchmarks in Singapore and Taiwan also advanced.

Of the 11 Asia/Pacific markets listed in, only Hong Kong rose by more than the Chinese stock market.  Many Hong Kong companies have invested heavily in China, and those investments will become more valuable in HK$ terms as the yuan appreciates.  But the big gainers were the Chinese stock investors.  A higher yuan will restrain inflation and reduce pressure on the Chinese government to use crude monetary tools to crack down on real estate speculation.  But shouldn’t the Chinese government crack down on their wildly overheated investment sector?  As Zhou Enlai might have said “It’s too soon to tell.”

I’ll do a post on Chinese real estate in the near future.  (For those who don’t know, the Zhou comment was in response to a questioner who asked him about the impact of the French Revolution.)

Economic freedom and GDP per capita

I recently did an EconTalk podcast with Russ Roberts.  We discussed economic reforms and growth.  In this post I have included a graph that I discussed on the podcast.

The graph shows the relationship between a country’s per capita GDP in 2008 (PPP) and their economic freedom ranking in the Heritage index.  I only had time to do developed countries (defined as income above $23,000/year, i.e. Portugal and higher.)  But these are more representative in any case, as some developing countries obviously have economic models that will allow them to get much richer in the near future (e.g. China.)  In contrast, most developing countries have settled down into a slow rate of growth.

I excluded countries that get a large share of GDP from oil exports, and also excluded Luxembourg because it wouldn’t fit on the graph.  Luxembourg has a fairly average Heritage ranking 75.2, but a GDP/person of nearly $79,000.  Obviously the Luxembourgers must be cheating somehow.  Someone should really go investigate that country. Wikipedia says Kim Il Jung Kim Jung Il has $4 billion dollars stashed away there, which is almost $10,000 for every resident of Luxembourg.

The local students are taught in Luxembourgish for the first three years, then German, and then French in high school.  They cannot graduate without being proficient in all three languages.  Apparently only half do graduate (or at least only half receive a “certified qualification.”)  It almost sounds like a tiny principality full of high school dropouts got together and named their country ‘Luxembourg,’ hoping the rest of the world would think they are rich and want to deposit a lot of money there.  I hope they scam Kim out of his $4 billion.

As you can see there is one noticeable outlier; New Zealand.  The Kiwis have a fairly low per capita income, despite having done a lot of neoliberal reforms.  Why does New Zealand violate the otherwise close relationships between economic freedom and income?  I don’t know.  Perhaps they have been hamstrung by having a strong comparative advantage in agriculture, only to see other countries undercut them with huge farm subsidies.  Or maybe they are just too remote to benefit from multinational investment aimed at the major markets (in contrast to another English-speaking island of 4 million people that also pursued neoliberal reforms.)

I’d appreciate any thoughts on why New Zealand has struggled.  (And please,  no jokes from my Aussie readers.)

As you can see from the list below, the ranking is basically as follows:  Former British colonies, then Nordic countries, then continental Europe, then Mediterranean countries.  The Nordic countries are pretty neoliberal, but held back by size of government.  The Mediterranean countries are held back by statist policies.  For cultural reasons, Holland is usually included in the Nordic group.  The chart suggests that going from an economic freedom ranking of 60 (Greece) to 90 (Hong Kong) will raise income by about $20,000 per person.  In fact, as of 2008 HK was only about about $14,600 ahead of Greece.  Any guesses as to whether that gap is now widening or narrowing?

Note; I excluded Luxembourg and oil-rich Norway from the list.  In 2009 Norway’s nominal GDP surpassed Sweden’s despite having barely half the population.  I  thought the oil wealth distorted Norway’s income too much for it to be useful.  If you include Norway on the graph, the trend line flattens slightly, and the predicted change in income if one moves from a ranking of 60 to 90 falls to about $18,500.

As with any graph, correlation does not prove causation.  In addition, the term ‘economic freedom’ should not be equated with “conservative” or “small government.”  As Statsguy recently pointed out these rankings are heavily influenced by “good government” components, and hence countries with large governments (such as Denmark) often score quite high.

Country EcFree2008 Income
Australia 82 38784
Austria 70 37912
Belgium 71.5 35238
Canada 80.2 39078
Cyprus 71.3 26919
Czech 68.5 24643
Denmark 79.2 36845
Finland 74.8 36195
France 65.4 33058
Germany 71.2 35374
Greece 60.1 29356
HK 90.3 43957
Iceland 76.5 36902
Ireland 82.4 41850
Israel 66.1 27905
Italy 62.5 31283
Japan 72.5 34129
Korea 67.9 27658
Luxembourg*          75.2    78922
Malta 66 23500
New Zealand 80.2 27260
Holland 76.8 40961
Norway* 69 58714
Portugal 64.3 23254
Singapore 87.4 49321
Slovenia 60.6 27860
Spain 69.5 31674
Sweden 70.4 36961
Switzerland 79.7 42415
Taiwan 71 29500
UK 79.5 35468
USA 80.6 46356

In my EconTalk I mentioned a study that examined the relationship between cultural attitudes and the speed of economic reforms.  As the following regression shows, there is a strongly positive correlation between civic-minded (or “liberal”) attitudes and economic reform during the period from 1980-2005 (using the fraser index of economic freedom.)  I’ll try to link to the paper later today.

Table 3.1  The Relationship Between Cultural Values and Changes in Economic Policy

 In this regression the dependent variable was the percentage by which statism fell between 1980 and 2005 in the Fraser Institute Index (with size of government consumption and transfers removed from the index.)  There were 28 observations in the regression.  The results were as follows:

Indep. Variables        Coefficient                 T-Statistic            Adj. R-squared


Constant                         79.82                            5.48                              .375

Values                             .459                              3.53

FraserIndex                    -9.33                            -3.78

I seem to recall that Adam Smith once remarked that while China was richer than Britain, the English were more thriving (which might mean a higher income, or faster growth.)  Of course the fast growth eventually made Britain much richer than China.

When I was young the US and Europe were much richer than Asia.  Singapore was a “developing country.”  But Asia was growing much faster.  As this article suggests, the high Asian savings rates are beginning to overturn traditional notions of who’s rich and who’s poor:

The 2010 Global Wealth Report by The Boston Consulting Group says there were 11.2 million millionaire households in the world at the end of 2009, a 14% jump from 2008. That puts the millionaire count about where it was in the good old days before the global financial crisis.

The U.S. had especially strong growth, with the number of millionaire households rising to 4.7 million — still the largest number of millionaire households in the world. That means that roughly 4% of American households are millionaire households. (Singapore had the highest “millionaire density” with 11% of all households being millionaires)

I also found this article, which suggested Hong Kong was second and Switzerland was third.  I’d expect the number of millionaires in Singapore to soar over the next few decades, as the current group of older residents (who grew up in a much poorer country) gradually die off.

Two mules pulling in opposite directions: Why independent central banks fail

During the 1990s the concept of an “independent central bank” became much more fashionable.  We were all trying to insulate central banks from political pressure, so that we could achieve German-style inflation.  In one sense it worked.  The Fed, BOJ and ECB have delivered German-style inflation.  But nonetheless the experiment has been a failure.  It failed in Japan, and is now failing in America.  It’s useful to consider why.

The Achilles heel of independent central banks is that the fiscal authority believes, rightly or wrongly, that fiscal policy also affects the inflation rate.  Thus when you have a disagreement between the fiscal and monetary authorities as to the appropriate rate of inflation, the two will end up pulling in opposite directions, producing massive economic waste in the form of higher than necessary marginal tax rates to pay for wasteful deficit spending.

We all saw this (two mules) problem in Japan during the 1990s and early 2000s, but somehow assumed (or at least I did, Krugman didn’t) that our policymakers were more sensible.  I also think most economists missed this problem because they don’t think of the fiscal authority as influencing the inflation rate.  For some reason even those economists who look at stabilization policy in the old-fashioned two-pronged way (use of both fiscal and monetary stimulus) tend to think that monetary policy affects inflation whereas fiscal stimulus affects real growth.  I have talked about this issue quite a bit, but still haven’t heard any good explanations for the ubiquity of this strange way of framing stabilization policy.  After all, both fiscal and monetary stimulus impact AD, and hence both influence output and prices.

So we go into a severe recession.  The central bank decides “inflation is not a problem” and thus keeps monetary policy unchanged.  The fiscal authority decides “real growth is too low” and thus adopts fiscal stimulus.  Yet few people see the inconsistency here.  I’ll bet you could find plenty of Congressman in Washington who support fiscal stimulus, and who favor more aggregate demand, but would oppose any Fed attempts to raise inflation.  It makes no sense, but that’s the crazy world we live in.  The mules in Congress don’t even know that someone else in pulling in the opposite direction.

My suggestion is that we end the independence of central banks, but replace it with something else–an explicit, legal, central bank target.  Let’s suppose the Congress instructed the Fed to target 2% inflation.  Now assume Congress wants more growth because we are in a recession, but because inflation is currently 2% the Fed doesn’t want to ease.  The fiscal authorities could instruct the central bank to aim for 2% inflation in the long run, but allow a bit more inflation during the current recession, at the expense of a bit less that 2% inflation during the subsequent years.  In other words the Fed would still have some discretion, even though their long-run mandate would be 2% inflation.  They would have the legal authority to tell the fiscal authorities “OK, we’ll provide a bit more inflation right now, as long as you understand that it is being “borrowed” from future inflation.  We intend to run below 2% inflation during the next boom.”  This would allow for some fruitful policy coordination, while still protecting the central bank from pressure to alter its long run inflation target.

You might be thinking; “Lower than average inflation during booms and higher than average inflation during recessions.  What a great idea for macroeconomic stabilization.  How can we formulate that into a simple and easy to understand nominal target?”

Seriously, Congress needs to decide on some sort of explicit policy goal for aggregate demand.  Whether it be inflation, the price level, or NGDP, the point is to have clearly spelled out goals so that they and the Fed are pulling in the same direction.  Indeed if the goals are spelled out, there is no reason why Congress should ever have to do any pulling.

And that brings me to the final point.  Even if this doesn’t improve monetary policy at all, at least I will be spared from annoying arguments with Keynesians who say; “Well yes, monetary policy could work in theory, but since the Fed is being so conservative we have to rely on fiscal stimulus.  With the Fed no longer independent, there would no longer be any excuses for policy failures.  The voters already blame Bush and Obama for the high unemployment; wouldn’t it be nice if the voters were correct?

Mixed messages

Keynesians face a dilemma.  If they go to Congress and say the following:

The best way out of the recession is to boost AD.  The Fed can do that best, even at the zero bound.  They simply need a higher target for whatever nominal aggregate they are targeting, or they can do level targeting.  But the Fed won’t do those things because they don’t think we need more AD.  They interpret their mandate differently than you guys do.  So instead you guys need to create more AD and inflation the hard way, through spending hundreds of billions of dollars and imposing large future tax burdens on our economy.

I think it’s fair to say the message wouldn’t go over very well.  So instead they say to Congress that we need fiscal stimulus because monetary policy is out of ammunition.   But if they are debating with economists, or at least the dwindling number of economists who understand how monetary policy operates at the zero bound, they won’t be taken seriously propounding that sort of crude 1938 Keynesianism.  Sometimes they play around with “expectations trap” models, although as I discussed here, those are even more applicable to fiscal policy.  In any case, the expectations trap is a bit far-fetched, so the normal argument is; “Yes, the stubborn conservatives at the Fed, ECB and BOJ could do a lot more, but they refuse to set higher inflation targets and thus we need fiscal stimulus.”

I think this two-faced approach has really hurt their credibility.  It helps explain why they aren’t being taken seriously in policy-making circles.  But I don’t have any good alternatives.  The economics profession is split in so many ways that almost any suggestion (including my own argument for monetary stimulus) is not going to get support from enough economists to convince the skeptics.

BTW, I also think this explains why smaller countries seem even less receptive to the fiscal stimulus argument than larger countries.  The zero bound isn’t much of a problem for small countries that want to inflate—they can always depreciate their currencies.  So why would they even consider fiscal stimulus?  Of course small countries that don’t want to inflate (Switzerland) don’t have this option, but if they don’t want more inflation then their problem is not a lack of AD.

I got thinking about all this while reading some posts by DeLong, Cowen and Kling.  Here is Tyler Cowen expressing skepticism about fiscal stimulus:

1. The monetary authority moves last anyway.

Brad DeLong responds:

Yes, the central bank can neutralize any additional fiscal stimulus by raising interest rates. (It is not clear that it can undo any fiscal contraction by some combination of lowering interest rates and quantitative easing: it may be able to.) What is clear is that the U.S. Federal Reserve and the Bank of England are right now definitely not in a place where they would neutralize any additional fiscal stimulus by raising interest rates. And my bet is that the ECB is also not in such a place–although it is much harder to figure out what they think and what they will do. That the central bank moves last is important and relevant, but not determinative when you are in the neighborhood of the zero lower bound on interest rates.

I can’t make heads or tails of this, but perhaps you commenters can set me straight as to what I am missing.  As I read DeLong, he seems to concede that the Fed “may” be able to offset fiscal restraint, presumably with some unconventional policy like QE or higher inflation targets.  I don’t want to put words into DeLong’s mouth, but as the Fed obviously can’t take the conventional step of cutting rates once they have fallen to zero, I don’t see any other interpretation.  So let’s assume DeLong is alluding to unconventional monetary stimulus.  Note that there is no zero bound for unconventional monetary stimulus.  Perhaps it wouldn’t work, but it would fail for reasons other than the zero bound.

But in that case I have no idea what DeLong means by the “What is clear . . .” sentence.  The argument that fiscal policy can be offset with monetary policy is not based on moving interest rates, as indeed (I believe) DeLong implicitly admitted in the previous sentence.  Just as nobody thinks the Fed would respond to fiscal contraction by cutting rates to minus 1%, nobody thinks they’d raise rates to 1% the day after Congress passed a fiscal stimulus.  But they don’t have to.  The way monetary policy works at the zero bound is by changing inflation expectations.  If the expected amount of inflation over the next 5 years doesn’t change after fiscal stimulus is announced, then the fiscal stimulus is expected to fail.

Why might it be expected to fail if the Fed didn’t raise rates right after the stimulus was passed?  Simple; the Fed’s exit strategy would be adjusted.  If you think this possibility is far-fetched then you haven’t been paying attention.  A couple months ago all the chatter out of the Fed was about how the economy was recovering strongly, and that before too long we needed to be contemplating an exit from stimulus.  (Yes, they believe they are actually being stimulative, as they haven’t read their Milton Friedman recently.)  Now just two months later all the chatter is about how the exit will be delayed in 2012.  What’s happened in between?  The Greek and Spanish crises, the strong dollar, higher than expected unemployment claims, lower than expected private job creation, low core CPI inflation, etc, etc.  In other words, the Fed most definitely does respond to signals about AD.

I know that Congress doesn’t think of stimulus in terms of inflation, but let’s suppose that the amount of stimulus Congress wants would lead to 12% (total) expected inflation over 5 years and the Fed wants to do a policy that will lead to 7% inflation over 5 years.  If the Congress uses fiscal stimulus to bump up the expected inflation rate, the Fed can offset that without raising current interest rates.  All they need to do is continue hinting that if AD rises to X level, they will exit their zero interest rate policy.

Now I am not saying this will definitely happen.  I can think of several alternative scenarios.  The Fed might be intimidated by Congress’s action, and move toward a more accommodative policy stance.  Or the fiscal deficits might raise expected inflation by increasing fears that the debt will eventually be monetized.  But what I don’t understand is how DeLong’s argument addresses Cowen’s observation that the central bank moves last.

The left likes to claim the fiscal stimulus “worked.”  The right likes to point out that growth was less than predicted by Obama.  The left responds that “other bad things” happened in late 2008 and early 2009, which explain the disappointing growth.  My view is that the “other bad things” were mostly an excessively tight monetary policy in late 2008 and early 2009, which was due to Fed passivity in the face of expectations that fiscal stimulus would carry the load.

Arnold Kling also has an interesting take on this issue:

So the argument for using fiscal expansion instead of monetary expansion needs to be pretty compelling. Consider two arguments:

1. We should be happy about a larger public sector and a smaller private sector.

2. At low interest rates fiscal policy is very effective (no crowding out) and monetary policy may be ineffective (liquidity trap).

When Tyler says that (2) is a “red herring,” he is implying that it is a stalking horse for (1).

That probably plays into conservatives favoring tax cuts during recessions and liberals favoring spending increases.