Archive for November 2010


Comment on Murphy and Thaler

Bob Murphy thinks he has an argument that blows away my critique of income:

A few weeks ago I promised to “eviscerate” Scott Sumner’s blog post, in which he claimed that income was a “meaningless, misleading and pernicious” concept. It is now ready for your inspection. Flowers and condolences can be sent to Scott Sumner’s widow, c/o Bentley University.

Not so fast there partner, I’m not dead yet.  Here’s a comment from his essay:

In the comments section of his first post, I asked Sumner if he had a problem with the standard definition of income. I reminded him that it is the amount of consumption that one could afford, without reducing the value of capital. Sumner replied, “I do not object to your definition. … I guess ‘meaningless’ was a bit strong, but what possible use is there for a concept that measures how much consumption one could do [without] impairing one’s wealth?”

This reply actually flummoxed me; it’s akin to asking what possible use there is for the concept of profit. Specifically, a household needs to calculate its income, in order to know if it is “living beyond its means.” We can make the analysis more esoteric if we wish. For example, one of the key issues in Austrian business-cycle theory is that people during the boom period enjoy a false prosperity “” a high standard of living “” because they are unwittingly consuming their capital. These crucial issues are dependent on the basic definition that Sumner finds useless.

I hate it when people quote my comments; often my brain is fried by the time I answer my 100th comment in a day.  But I’ll stick by this one.  Profit is useful because it tells firms whether to enter or exit an industry.  Positive economic profit suggests you should enter, and negative economic profit is a signal to exit.  But income is a signal for  . . .  what?  Surely not for consumption.  Yes, it tells you how much you can consume without digging into capital, but why would you want to consume that much?  I had negative income in 2008, but I didn’t decide to do negative consumption.  I dug into my capital—which Bob suggests is violating the recommendation of Austrian business cycle theory.  Entschuldigen sie bitte!  (That’s ‘sorry’ in Austrian.)

Bob also finds an inconsistency in my critique of income taxes.

By the same token, I could challenge Sumner’s own argument for a tax on consumption. Imagine two identical people who could each hold a $100,000-per-year job. Person A goes to work, and spends his entire income on goodies each year. Because the government imposes a Scott-Sumner-approved 11 percent tax on consumption, this man pays $10,000 to the government, and actually only consumes $90,000 worth of goodies.

On the other hand, person B decides to be a drifter. He only works occasionally at odd jobs; he spends most of his days hitchhiking, watching the sunset, and working on his great American novel. He doesn’t cheat on his taxes, though: out of the $10,000 in annual income that he earns, he saves none of it, sends $1,000 to the government, and consumes the remaining $9,000 in goodies.

I could very easily condemn this hypothetical consumption tax, and along Sumnerian lines. After all, the two men had equal abilities at the start of their adulthood. Person B could have chosen to work in the office and earn enough money to spend $90,000 each year on consumption. But instead, person B chose a different path. So why in the world should the government tax him far less than it is taxing the “equivalent” person A?

So far, so good. I am showing that the (immoral and inefficient) consumption tax cannot hold up to scrutiny; it isn’t really true that people who “consume” more are necessarily “richer” and therefore able to pay more, as Scott Sumner and other advocates of the consumption tax seem to think.

But what if I went further? Suppose I went on to argue, “Indeed, the very concept of labor income is meaningless, misleading, and pernicious. In our example, person A earned ten times as much ‘labor income’ as person B, but there is no reason to suppose that person A somehow has a better life, since person B could have made the same choices. Indeed, ‘labor income’ is really just forfeited leisure. The drifter could have devoted his hours to office work, but instead he chose to ‘purchase’ $90,000 worth of his time from himself. Therefore, to count ‘labor income’ as a form of freebie flow of wealth is to count the same hours twice.”

Now, regardless of how one feels about the validity of a consumption tax, does anyone want to go so far as to say that a paycheck isn’t really a form of income after all? I submit that Sumner made an analogous mistake in his own analysis. Just because we can imagine scenarios in which an income tax (that includes interest and capital gains) is patently unfair, does not mean that interest income therefore isn’t “really” income. Rather, it simply means that the conventional calls for progressive income taxes are misguided.

OK, whenever I lose an argument on logical grounds, I fall back on pragmatism.  I agree that consumption doesn’t really measure the theoretically relevant concept.  People get utility from goods, services, and leisure.  In practice it’s hard to tax leisure, or even measure leisure, so we tend to estimate living standards based on consumption, and we tend to tax consumption despite the fact that it distorts the labor/leisure choice.  We could avoid the distortion with a head tax, but that is probably too regressive.  On the other hand a land tax just might work.

Of course Bob will say the tax discussion is off-topic (I always use sleight of hand when losing); he showed that my argument against income could just as easily apply to consumption on purely logical grounds.  And I admit that my critique was more about specific uses of income (taxes, Gini coefficients, etc) than the concept itself.  Consumption is also less than perfect, as a tax base and as a way of judging living standards.  But I still think it’s much better than income.  So income is truly evil, and consumption is just a little bit naughty.

Oh, and my wife says she’d prefer red roses.

Part 2:  Richard Thaler tries to defend the indefensible

First, it is incorrect to say the estate tax amounts to double taxation. The wealth in many large estates has never been taxed because it is largely in the form of unrealized “” therefore untaxed “” capital gains. A 2000 study found that for estates worth more than $10 million, unrealized capital gains represented 56 percent of assets. For estates with active farms and businesses, the percentage is much higher. If no estate tax is imposed, capital gains taxes can be avoided indefinitely.

In fact, any tax on capital income is double taxation of labor income.  That’s why a consumption tax is best.  What Thaler should have said is that the estate tax is not necessarily triple taxation.  Triple taxation would occur if you earned some labor income, paid taxes, saved some of the remainder, earned capital gains on the saving, paid capital gains tax, and then was taxed when you died and left the remainder to your niece.  We need to abolish the estate tax and replace it with a progressive consumption tax (i.e. payroll tax.)

Greg Mankiw replies to Thaler, and has much better arguments.

More evidence the recession was not caused by the financial crisis

Last night I criticized a new Robert Hall article in the JEP, which argued that the financial crises of 1929 and late 2008 caused the Great Depression and the Great Recession.  I pointed out that there was no financial crisis in 1929, and that it was the Depression that caused the later banking panics.  I pointed out that the 2008 recession was well advanced before the banking crisis of late 2008 occurred.  Undoubtedly those crises worsened each slump by further depressing AD, but they weren’t the cause—tight money was.

Soon after I read a new article by Lee Ohanian from the same journal that supported my argument regarding the Great Depression, and provided lots of new evidence for the current recession.  Here he points out that the Great Depression could not have been caused by the financial crisis:

For example, many cite the fact that the number of U.S. banks declined by about 40 percent between 1929 and 1933 as a central reason why the Great Depression was “Great,” and draw inferences from this fact for the potential effect of financial crises more generically (for example, Reinhart and Rogoff, 2009). But most of the Depression-era banks that closed were either very small or merged, which indicates that the decline in banking capacity resulting from bank closings during the Depression was small. In fact, the share of deposits in banks that either closed or temporarily suspended operations for the four years from years 1930-1933 was 1.7 percent, 4.3 percent, 2 percent, and 11 percent, respectively (Cole and Ohanian, 2001).

Moreover, the Depression was indeed “Great” before any of the monetary contraction or banking crises identified by Friedman and Schwartz (1963) occurred.  Figure 2 shows that industrial hours worked had declined by 29 percent between January 1929 and October 1930, which is not only before the first Friedman and Schwartz-identified banking crisis (November 1930 to January 1931), but is also before the money stock fell.

I agree with Friedman and Schwartz that the 1930s banking crises were important, but only because they led to the hoarding of base money, not for Bernankean disintermediation reasons.  Indeed Ohanian misses his strongest argument here—the 1933 crisis was worse than all the others put together, yet 1933 was the first year of recovery, seeing brisk growth in industrial production and prices.  You might argue; “But that’s because dollar devaluation pushed up AD in 1933.”  Bingo—it’s all about AD, not disintermediation.  Then Ohanian turns his attention to the current crisis:

The corporate sector typically has nearly as much cash as they invest in plant and equipment, and cash is relatively high during the last few years.

One possible issue with Figure 3, however, is that perhaps the cash reserves displayed in the figure are only being held in certain sectors while other sectors have little or no cash. To address this issue, Chari and Kehoe (2009, in progress) examine firm-level data from Compustat to compare firms that use external finance to those that do not. These data indicate that on average about 84 percent of investment is financed internally. Indeed, about two-thirds of investment is undertaken by firms not using external funds, and slightly more than half of the investment undertaken by those using external funds is still financed internally.  .  .  .

Another assertion often made in the financial explanation is that small firms have much less access to capital markets, and thus small firms decline much more than large firms during crises. However, Cravino and Llosa (2010, in progress) show that there is virtually no change at all in the relative sales performance of small versus large firms during the 2007-2009 recession. They compare the share of sales accounted for by small, medium, and large firms during the fourth quarters of 2007, 2008, and 2009. The shares are virtually identical in these periods, indicating that firm sales growth was unrelated to firm size. This fact is thus inconsistent with a central assumption in the financial explanation.

The financial explanation also argues that the 2007-2009 recession became much worse because of a significant contraction of intermediation services. But some measures of intermediation have not declined substantially. .  .  .  bank credit relative to nominal GDP rose at the end of 2008 to an all-time high. And while this declined by the first quarter of 2010, bank credit was still at a higher level at this point than any time before 2008.6 Similarly, flow of funds data show that borrowing levels of households and of the nonfinancial businesses that households own, are virtually unchanged since 2007, and that the composition of those liabilities across mortgages and other liabilities are also unchanged. These data suggest that aggregate quantities of intermediation volumes have not declined markedly.  But perhaps the most challenging issue regarding the financial explanation is why economic weakness continued for so long after the worst of the financial crisis passed, which was around November 2008

I’ve consistently argued that if the AD was there then firms would have supplied the output, and I think most business people would tell you the same thing.  Many have pointed to a Rogoff-Reinhart study that shows financial crises are usually followed by severe recessions.  I have responded by asking “how many of those financial crises were associated with a sharp currency appreciation?”   I believe the answer is “damn few,” and I often cite the US in the early 1930s, Argentina in 1998-2002, and the US in the last half of 2008.  Note that in all three cases the financial crisis was caused by tight money, and in the first two cases rapid growth resumed almost immediately after the currency was devalued.  Here’s how Ohanian addresses the evidence:

From the perspective of the financial explanation, the continuation of recession long after the worst of the crisis passed raises an important puzzle about why employment did not recover sooner. This question is not resolved simply by noting that economies often remain below trend for years following a significant financial crisis (Cerra and Saxena, 2008; Blanchard, 2009). In many of these cases, output remains below trend because productivity is far below trend (Ho, McGrattan, and Ohanian, 2010, in progress). But as documented above, the productivity deviation during the 2007-2009 U.S. recession was very small, which means that low productivity is not the reason why U.S. macroeconomic weakness continued.

Ohanian explores whether the Great Recession can be explained in a “neoclassical” (i.e. real business cycle) framework.  He argues that the data on hours worked, productivity, etc, indicate that the marginal rate of substitution between labor and leisure had fallen far below the marginal productivity of labor.  He speculates that various government policies might have created an implicit tax wedge in the labor market that discouraged employment.  In my view this explanation suffers from some of the same problems as the financial disintermediation story—it doesn’t explain the sharp fall in NGDP and RGDP after June 2008.  But in making his argument he keeps scoring points that indirectly support my alternative wage/price stickiness story.  It’s like some alternative universe version of TheMoneyIllusion.  We both agree that the standard story is wrong.  We both agree on why it is wrong.  But we disagree on which alternative story is better.  I believe Ohanian has a very persuasive critique of the disintermediation story, and I very much want Ohanian to win in his attempt to discredit the mainstream story.  Then the dispute will be between my sticky wage/price transmission mechanism for falling AD, and his tax wedge argument that relies on the sort of explanation put forth by people like Casey Mulligan:

A policy explanation for the 2007-2009 recession is that economic policies, including the 2008 tax rebate, the Troubled Asset Relief Program (TARP), the American Recovery and Reinvestment Act (ARRA), Cash for Clunkers, Treasury mortgage modififi cation programs, and other policies signififi cantly contributed to the recession. The common argument here is that these policies distorted incentives through their deficient design and also increased uncertainty about the underlying economic environment. . . .

For example, Mulligan (2010a) studies the possible effect of U.S. Treasury mortgage modification programs on the low employment rate by evaluating how the eligibility requirements for these programs implicitly raised income tax rates on some households to levels of more than 100 percent.

I think I know which alternative explanation will win out among mainstream economists.   🙂

PS.  I did find one flaw in the Ohanian article.  He seems to assume that US productivity did much better than German productivity during the recession.  But this may be because he was only able to find employment data for Germany (which did not decline) whereas hours worked data in Germany (which did decline) might have told a different story

Sweden threatens the global economy

Doing Bastiat-style reductio ad absurdum arguments seems to get more difficult each day.  A few week ago I tried to satirize the view that China was the Great Satan of international imbalances, pointing out that the combined current account surpluses of tiny Switzerland and Norway (population 13 million)  is nearly half as large as China’s $289 billion CA surplus (population 1.35 billion.)  Indeed a relatively small block of countries lying between Switzerland to the south and Norway to the north have a combined CA surplus of $397 billion, and a population of only 125 million.

So I was quite startled to see an article in the Swedish press with the following headline:

Sweden ‘threatens the global economy’: study

An American think tank has criticised Sweden for maintaining a constant current account surplus and urged the country to undertake measures to stimulate domestic demand.

“Sweden has not taken sufficient measures to reduce its current account surplus,” non-profit New America Foundation, a non-profit, non-partisan US-based think tank, wrote in a statement on Thursday.

“Its fiscal policy should be more expansionary; it should encourage currency appreciation; and it should open its domestic market to foreign goods.”

I’m worried to death that I have made some sort of terrible mistake.  I know that I have a few Swedish readers; please tell me I haven’t accidentally cited a Swedish version of The Onion, so I can quickly erase this post.

Seriously, I actually respect the New American Foundation much more than the neo-mercantilists who obsess over China.  At least they have the courage of their convictions, and at least they’ve bothered to look at the data.  However I’m not quite sure about the charge that Sweden doesn’t have an open domestic market; doesn’t Sweden have relatively low trade barriers?

A serious error by Robert Hall and the JEP

The Journal of Economic Perspectives is a widely read journal that provides economists with relatively accessible (i.e. non-mathematical) articles on important issues.  The new issue focuses on the current crisis, with articles by famous economists such as Hall, Woodford and Ohanian.  The lead-off article by Robert Hall begins as follows:

The worst financial crisis in the history of the United States and many other countries started in 1929. The Great Depression followed. The second-worst struck in the fall of 2008 and the Great Recession followed. Commentators have dwelt endlessly on the causes of these and other deep financial collapses.  Less conspicuous has been the macroeconomists’ concern about why output and employment collapse after a financial crisis and remain at low levels for several or many years after the crisis.

If you’ve followed my blog you know that I don’t think those assertions are correct.  Indeed I don’t think they are even defensible.  Let’s start with the first two sentences.  The US did not suffer any sort of financial crisis in 1929.  Rather, the Great Depression began in August 1929, and the first crisis occurred at the end of 1930 (and was itself quite mild.)  A severe banking crisis did occur after Britain left gold in September 1931, by which time the US was already deep in depression.  Note how Hall’s intro leads the reader to assume causation ran from financial crisis to economic depression, when in fact the causation ran in exactly the opposite direction.  It is doubtful the US would have experienced any financial crisis during the early 1930s, if we had not seen NGDP fall in half.

I re-read the passage several times, trying to imagine what Hall could have had in mind.  Perhaps he was thinking of the 1929 stock market crash.  But there are two problems with that view.  First, a stock market crash is not a financial crisis.  And second, the 1987 stock crash was almost identical to the 1929 crash, and yet did not cause even a tiny ripple in the economy.  So no one would start a paper arguing that big stock market crashes cause recessions.  And if stock market crashes really were “crises,” then 1987 should be considered one of the great financial crises in US history, and I think almost everyone would regard that assertion as crazy.  So I’m completely perplexed by what Hall (and the JEP editors who approved his manuscript) were thinking.  And remember that Hall is right up there with McCallum as one of my favorite macroeconomists.

The second pair of sentences are hardly any better.  The Great Recession (also the name I use) started in December 2007, long before the severe crisis of late 2008.  In fairness, the recession was not at all severe during the early months.  But if you look at the monthly GDP series from Macroeconomics Advisers, you’ll notice that the severe plunge took place between June and December 2008. The financial crisis occurred half way through that severe plunge in GDP (real and nominal.)

Why am I being so picky?  After all, we all know that intros are just flowery window dressing before economists get to the meat and potatoes of the paper.  To see why, consider the title of the paper:

Why Does the Economy Fall to Pieces after a Financial Crisis?

Hall has written a paper to explain stylized facts “we all know are true,” that in fact are completely false.  The paper should be entitled:

Why are Financial Crises Preceded by the Economy Falling to Pieces?

And the intro should read:

The worst depression in the history of the United States and many other countries started in 1929. The Great Banking Panics followed.  The worst recession since the 1930s struck in December 2007, and dramatically worsened in July 2008.  The Great Financial crisis of the fall of 2008 followed. Commentators have dwelt endlessly on the causes of these and other deep financial collapses.  Less conspicuous has been the macroeconomists’ concern about why output and employment collapse before a financial crisis and remain at low levels for several or many years after the crisis.

We know that severe declines in NGDP are likely to cause severe declines in RGDP.  The reasons are murky, although I believe sticky wages are an important transmission mechanism.  There is more controversy about what causes NGDP to plunge.  But given the recession began in December 2007, and given the severe plunge in NGDP occurred between June and December 2008, it seems a bit hard to believe that the financial crisis of the fall of 2008 was the cause.

I was also a bit disappointed by the final paragraph of Hall’s paper:

In the category of blue-sky thinking, a few macroeconomists, including this writer when he has nothing better to do, think about how to work around the zero lower bound on interest rates. The key policy move to eliminate the bound is for the Fed to drop its unlimited willingness to issue currency, given that currency is, in effect, a way that the federal government borrows from the public at above-market interest rates. If the Fed stopped accommodating the swelling demand for currency, the existing stock of currency would appreciate””a $20 bill would buy more than $20 worth of merchandise, just as a British pound buys more than a dollar today. We are still pondering how the public would react to this departure from a century and a half of government currency issuance.

I’d rather see brilliant economists like Hall focus on pragmatic solutions for our AD shortfall, such as my “cocktail” policy of NGDP targeting (level targeting), negative IOR, and QE.  People are used to using currency as a medium of account—indeed its great convenience comes from the fact that its nominal price is fixed, making it extremely easy to use in transactions.  Suppose we did increase its value by ceasing to issue new currency, and suppose it remained a medium of account; where would we be then?  (Hint: the answer starts with the letter “d”.)

Calling 123

I’ve frequently argued that the interest on reserve policy was a huge mistake, comparable to the 1936-37 decision to double reserve requirements in the midst of the Great Depression.  I pointed out that both policies sharply increased the demand for base money, and the implementation of IOR was associated with a big stock market crash during the first 10 days of October, 2008.  I don’t know exactly when the stock market understood what was going on, but I read that the decision was made on October 3rd, announced on the 6th, and implemented on the 8th.  Whatever the exact dates, it’s clear that the story became understood at some point during the famous crash.

The title of the post refers to frequent commenter (and blogger) 123, who knows more about the IOR program than I do, and disagrees with my view that it was contractionary.  Indeed he argues it was beneficial.  I’m wondering how he will react to this Louis Woodhill piece from RealClearPolitics:

The available data indicates that it was the Fed’s IOR program, not the collapse of Lehman Brothers on September 15, 2008, that crashed the real economy and sent unemployment skyrocketing. Because the two events were only three weeks apart, many people believe that it was the Lehman bankruptcy that precipitated the worst economic downturn since the Great Depression. However, the market data from that period suggests strongly that the real cause was IOR.

A valid way to gauge whether events are “good” or “bad” for the economy is to look at the stock market’s reaction to them. The day that Lehman Brothers collapsed, the S&P 500 went down 4.71%. Three days later (i.e., at the fourth market close after the event), the S&P 500 was down by a total of 3.61% from its pre-Lehman close.

At the time of the Fed’s IOR announcement, the S&P 500 was down by a total of 12.18% from its pre-Lehman close, 15 trading days earlier. However, the day that the Fed announced IOR, the S&P 500 fell by 3.85%, and it was down by a total of 17.22% three days later.

On October 22, 2008, the Fed announced that it would increase the interest rate that it paid on reserves. The S&P 500 fell by 6.10% that day, and it was down by a total of 11.11% three days later. On November 5, 2008, the Fed announced another increase in the IOR interest rate. The S&P 500 fell by 5.27% that day, and it was down by a total of 8.60% three days later.

I’ve always thought the timing of the implementation of IOR was an interesting coincidence, but hardly definitive.  But for some reason I never got around to closely investigating the program in detail.  I had no idea that the two subsequent IOR rate increases were also associated with mini-crashes.  Again, the evidence is hardly definitive.  But crashes this size are quite rare.  To have all three contractionary IOR decisions (and the only contractionary IOR decisions in all of American history!) each be associated with a once-in-a-blue-moon market plunge, is certainly suspicious.  I’m surprised others haven’t made a big deal of this pattern—people have spun elaborate economic theories based on much flimsier empirical evidence.  And remember, economic theory predicts the decision should have been contractionary.

Over to you, 123.

PS.  There’s an easy way to test this theory.  If Bernanke finds QE2 doesn’t produce the effects he’s looking for, he should try lowering the IOR to 0.15%.  No need to worry about those annoying regional Fed presidents; the Board determines the IOR.  And you won’t have Sarah Palin looking over your shoulder—I can’t imagine the Tea Party would get up in arms over a Fed decision to slightly reduce the Fed’s subsidy to big banks.

Here’s a prediction–the Dow rises 10 points for each 1 basis point reduction in the IOR.

HT:  JimP

Update 11/12/10:  123 has responded on his (or her?) blog.  As I indicated, he knows more about this that I do.  Part of our dispute has been over the “other things equal” assumption.  I look at the IOR issue holding the size of the base constant, he tends to assume that the increase in the base was facilitated by having the IOR program.  He also discusses the problem of increased uncertainty over future fed funds rates, something I know little about.  I do have one question, however.  123 says:

As October 2008 FOMC minutes put it, “In the overnight federal funds market, financial institutions became more selective about the counterparties with whom they were willing to trade.”

Is the implication that IOR solved the counterparty risk problem?  If so, how?  And why is the uncertainty about fed funds rates a big problem, when the level of rates was low thoughout this period, and extremely low if you recall that these are overnight loans.  How much risk did ffr instability actually produce?

PS.  I love that George Bush quotation at the end of his post.