We all know about dates that historians consider turning points in history; 1914, 1789, etc.  I’d like to add 1978 to the list.  Maybe it’s just because I was a young adult in 1978.  Things seem very important when we are young.  (Do NOT ever talk to a baby-boomer about 60s pop music.)

It seems like almost everything that crosses my desk reminds me of 1978.  Three items in just the last week.  I’ll discuss those three, and a fourth from a bit further back.

Part 1.  This quotation from Joan Robinson did not seem insane in 1977

From the Economist:

Before the last Korean war in 1950, the North was home to most of the country’s heavy industry. As late as 1975, its income per head still exceeded the South’s, according to Eui-Gak Hwang of Korea University in Seoul. “Obviously, sooner or later the country must be reunited,” wrote Joan Robinson, a Cambridge economist, in 1977, “by absorbing the South into socialism.”

Within about 5 years a comment like that would have seemed far-fetched, and today it would seem completely loony.  I’m not saying I necessarily would have agreed with her in 1977, but North and South Korea were about equally developed at that time.  North Vietnam had just taking over the South.  No communist country had ever gone non-communist.  And even non-communist countries seemed to be getting more statist every day.

Part 2:  How’s this for an event study:

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That’s what happened after they deregulated America’s railroads.  (Transport deregulation began with the airlines—in 1978.)

I think the best way to approach this issue is to use Rorty’s maxim “truth is what your colleagues let you get away with.”  Truth is socially constructed.  So imagine a timeline with a bell-shaped distribution above it.  The distribution shows the point in time when each economist thinks China has surpassed the US.  At the left end in 2010 is me, a China booster who (shamelessly) wants to get credit for being first to notice that America’s more than 100 year reign as number one is over.  The mode occurs when the World Bank says that China has achieved what Italians call “Il Sorpasso.”  And at the far right of the distribution, well into the 22nd century is Lester Thurow.  The mode occurs around 2016.  Mark your calendars.

I should have stayed with that prediction, but forecasters always like to push the date forward if their predictions don’t seem to be coming true.

Arpit Gupta sent me an article by Arvind Subramanian that suggests China did pass the US at some point in 2010.  I find his argument quite plausible, although I certainly wouldn’t claim it is “True,” as there is no fact of the matter.  The US and China produce a vastly different set of goods.  China produces much more “stuff” and we produce much better “stuff” (on average.)  Who produces more RGDP?  That depends on how one defines RGDP, and I’ve never seen an even half-way plausible definition.  Have you?

What does this have to do with 1978?  A little village in Anhui province started the most momentous economic reforms in world history in December 1978, without official permission and at great personal risk.  That’s why the US is about to be overtaken for the first time in more than 100 years.

Part 4:  Let’s make a deal.

Jeremy Horpedahl sent me this Heritage Economic Freedom data, which shows that Denmark has finally surpassed the US in the race to be the most capitalistic economy on Earth.  If you look at the table, you will see just how impressive Denmark’s achievement really is.  They did this despite scoring relatively “low” on the fiscal freedom and size of government components of the survey.  Because the Heritage Foundation is a right wing think tank, they believe big government implies a lack of economic freedom, and thus is “bad.”  Think of the US as the Usain Bolt of capitalist nations.  The archetype, the quintessential free market economy.  Little Denmark approaches the starting line and is suddenly asked to strap a 5 pound weight onto each leg.  And they still beat Bolt in the 100 meter dash!  (Time for a drug test.)

OK, we know life is never like a fairy tale.  It’s boring, there’s always some “reasonable” explanation.  Denmark is more neoliberal than the US in most of the other dimensions of economic freedom; and as Statsguy pointed out a few months back, some of those seem suspiciously more like “good governance” than freedom.

Still it’s the Heritage Foundation’s survey, so I’d like to treat it as if it’s true; or more precisely as if the people at Heritage think it’s true.  Here’s one possible implication; why not have the US adopt Denmark’s economic model?  After all, Heritage says it would be an improvement, and I don’t think the Paul Krugman’s of the world would object.

Now progressives would argue that conservatives merely pretend to care about all sorts of issues, whereas in reality they only care about tax cuts for the rich.  The conservatives would never agree to the deal.  So here’s a compromise.  Have the US adopt Canada’s tax and government spending model (which Heritage says is much better than the US model), and in all other respects adopt Danish policies.  I still say the progressives would do that deal in a heartbeat.  I did some calculations and the US score would soar to 85.5, putting us into 3rd place, far ahead of Australia.  Since many people argue Hong Kong and Singapore are just “city-states” and hence not real countries, you could even argue that the US would become the most capitalist country on Earth.  I’d think the people at Heritage would be thrilled, after all this is their survey, their method.

Obama and Boehner; there’s a deal that will put you both in the history books.  A win-win.  Git er done!

Back on planet Earth, there are a few problems with my pleasant dream:

1.  Conservatives would never agree to Canadian-level defense spending.  Ditto for prisons.  But even allowing for an extra 3% on GDP on the military and 1% on prisons, we could probably move up quite sharply in the rankings.  (BTW, I favor much lower defense spending.)

2.  Denmark is much more decentralized.  The same sort of policies adopted in Denmark would work less well in the US, because we are much more centralized, and hence far less democratic (if you define democracy properly, where people can affect their government.)  Denmark has nothing like the LA school system or the McAllen, Texas, Medicare system.

3.  Denmark is much more civic-minded that the US.  That’s not to say we aren’t civic-minded, we are near the top.  But Denmark is simply off the charts.  Yet even they recently found it necessary to cut unemployment benefits from 4 years to 2, because too many Danes were taking advantage of the system.  (Something rotten . . . )  With our somewhat less honest culture, the Danish/Canadian economic model would work less well.

I don’t see any of these problems as deal-breakers, it’s just that things would be more messy that what I have sketched out.  Obviously what I propose won’t happen.  But it’s an interesting way of thinking about the problem, and illustrates how politics can be a positive sum game.

What does this have to do with 1978?  In 1978 a large black slab was placed on the moon.  It began emitting signals than made earthlings more favorably inclined toward free market reforms.  Those countries that were most under-performing (like China and Britain) and most idealistic (like Denmark) reformed the most.  Denmark went from being far more socialistic than the US in 1978, to slightly more capitalistic in 2011.  Indeed a study showed that the speed at which the 32 developed countries adopted market reforms is highly correlated with how civic-minded they are.  Only New Zealand reformed faster than Denmark among the developed economies.  Which developed country is least civic-minded?  Greece.  And which developed country is least capitalistic?  Greece.

1978:  Disco, big hair, and a mysterious transformation of the zeitgeist that will shape the 21st century.

PS.  Why December?  That’s when it started in China, and it’s roughly midway between the US airline deregulation and Thatcher’s election in Britain.  And of course it was the month chosen by Virginia Woolf.

In a not so recent post Tyler Cowen made the following argument:

Matt Yglesias suggests the notion is implausible, but I am surprised to read those words.  Keep in mind, we have had a recovery in output, but not in employment.  That means a smaller number of laborers are working, but we are producing as much as before.  As a simple first cut, how should we measure the marginal product of those now laid-off workers?  I would start with the number zero.  If a restored level of output wouldn’t count as evidence for the zero marginal product hypothesis, what would?  If I ran a business, fired ten people, and output didn’t go down, might I start by asking whether those people produced anything useful?

It is true that the ceteris are not paribus,  But the observed changes if anything favor the hypothesis of zero marginal product. There has been no major technological breakthrough in the meantime.  If anything, there has been bad monetary policy and a dose of regulatory uncertainty.  And yet again we can produce just as much without those workers.  Think of “labor hoarding” yet without…the hoarding.

I don’t normally comment on old posts, but I was asked what I thought of this idea, which still seems to be attracting attention.  My initial reaction is skepticism. Why wouldn’t companies just lay off more workers?  But Tyler Cowen refers to the labor hoarding hypothesis, which might be able to explain that seemingly irrational behavior.

So I think we need see how the theory matches the data.  This post by Stephen Gordon shows US employment in 2010:3 falling about 5% below its 2008:1 peak, while output seems to have declined only about 0.7%.  This is what Cowen finds puzzling.

But I don’t see any puzzle at all.  If employment didn’t change, I’d expect US output to grow at about 2% a year, which is the trend rate of productivity growth.  Because we are looking at a two and a half year period, you’d expect output to grow roughly 5% with stable employment.  Now assume that employment actually fell 5%.  If the workers who lost jobs were similar to those who remained employed, I’d expect output to be flat over that 2.5 year period.  Because output fell slightly, it seems like the workers who lost jobs were slightly more productive than those who remain employed.

Do I believe this?  No, for several reasons I think they were less skilled than those who remained employed.  Labor productivity growth (assuming we were at full employment) probably slowed in the most recent 2.5 years, as investment in new capital declined.  Measured productivity continued to rise briskly, partly because technological progress continues in good times and bad, and partly because those workers still employed are somewhat higher skilled, or perhaps are trying harder in fear of losing their own jobs.  So Tyler is probably right that those workers who lost their jobs have a lower than average marginal product.  I just don’t see why zero is the natural starting point for consideration of the issue, as you only get that number by making some fairly extreme assumptions about technological progress coming to a screeching halt after 2008:1.

I’m certainly open to alternative views here.  My baseline assumption is not consistent with Okun’s Law, for instance.  And the three most recent recessions have seen slower recovery in employment than earlier recessions, although I think people often underestimate how much of that difference is because monetary stimulus has been much weaker during those recoveries (compared to a recession like 1981-82.)

There’s no question that Arnold Kling’s recalculation view is more intellectually appealing than the messy arguments about wage stickiness used by us “GDP factory” proponents:

Regular readers know that I am trying to nudge them toward a different paradigm in macroeconomics. I want to get away from thinking of economic activity as spending, and instead move toward thinking of it as patterns of sustainable specialization and trade. Even if there is only a small chance that this alternative paradigm is useful, I think it is a worthwhile exercise.

One reason for wanting to change the paradigm is that I believe that trying to describe economic activity using an aggregate production function is a mistake. When I use the derisive expression GDP factory, I am referring to the aggregate production function.

Yes, macroeconomics should be all about specialization and trade.  Except business cycle theory, which needs a special ad hoc sticky wage/price model.  Why?  Because the evidence simply doesn’t fit any other approach.  Here’s Kling on the construction bust:

I want to suggest that the output that is “lost” is output that people do not want. In 2008 and 2009, Americans do not want 2 million houses to be built. So I do not think that it is right to speak of a shortfall in output. Instead, we should say that the people who were building houses have not found a pattern of trade in which they can produce something that people want.

Yes, housing output was low in 2009 and unemployment was high.  But is there a causal relationship?  I say no.  Housing starts peaked in January 2006, and then fell steadily for years:

January 2006 — housing starts = 2.303 million, unemployment = 4.7%

April 2008 — housing starts = 1.008 million, unemployment = 4.9%

October 2009 — housing starts = 527,000, unemployment = 10.1%

So housing starts fall by 1.3 million over 27 months, and unemployment hardly changes.  Looks like those construction workers found other jobs, which is what is supposed to happen if the Fed keeps NGDP growing at a slow but steady rate.  Then NGDP plummeted, and housing fell another 480,000.  Is this because people didn’t “want” those houses?  No.  They didn’t want 2.2 million new houses a year; that really was a societal screw-up (with many possible villains.)  Kling’s completely right about that.  But they probably do want about a million new houses a year as our population grows by 3 million per year and families average about 3.  The reason housing fell far below normal is because the severe fall in NGDP created a deep recession.  Unemployed factory and service workers aren’t going to buy new houses.

Most importantly, the huge run-up in unemployment did not occur when the big fall in housing construction occurred, but much later, when output in manufacturing and services also plummeted.

Here is Kling on the Great Depression:

I think that technological change can drive the marginal product of many workers close to zero (When I mention ZMP, I always feel I owe Tyler Cowen a footnote.) I suspect that this happened in agriculture in the U.S. in the late 1920’s and early 1930’s, dumping a lot of manual laborers into unemployment.

I don’t agree with this.  There had been a very long term secular decline in farm jobs going back for decades before the Depression.  Those workers gradually moved to the cities and were absorbed by growing manufacturing and service industries.  So what changed between the booming late 1920s when unemployment was about 3%, and the early 1930s when it rose to 25%?  The answer is manufacturing collapsed, as industrial production fell by roughly 50%.  It was factory workers losing jobs that explains the Great Contraction, not farm workers.  Yes, farm workers continued losing jobs, but there was no longer any place in the cities for them to find jobs.  Why not?  Because NGDP fell in half between mid 1929 and early 1933.

Here’s Kling on oil prices:

Could “pumping up demand” help in such a situation? Perhaps. But if the recalculation story is right, the higher demand could end up not doing much for employment. Instead, it might only do a lot to raise oil prices.

Of course more demand could raise nominal oil prices by boosting inflation.  But with CPI inflation running around 1% it’s more likely that Kling is referring to an increase in real, or relative, oil prices.  Could monetary stimulus boost real oil prices?  Absolutely.  But if and only if it raised expected levels of output and employment.  In other words, if and only if it was expected to work.

In my next post I’ll address Tyler Cowen’s ZMP workers argument.

A few weeks back I linked to a Louis Woodhill article that showed stocks fell very sharply after the Fed announced interest on reserves, and also fell very sharply the two times the Fed raised the IOR in late October and early November.  Given the unusual size of the stock market declines, it is extremely unlikely these changes could all have been due to chance.  Now Cameron Blank has graciously allowed me to reprint an entire blog post where he fully documents just how powerfully monetary policy news seemed to impact US stock prices during late 2008.

Many of my critics, even some sympathetic to my overall argument, have found it hard to believe that monetary policy was the problem in late 2008.  It seems (so they argue) that the financial crisis was the focus of everyone’s attention.  I agree that economists were not paying attention to monetary policy, but there’s no doubt in my mind that markets were.

BTW, the TIPS spreads for December 1st that he reports are distorted by a change in the type of TIPS being used, so he is right to be skeptical of that observation.

Everything that follows this sentence is from Cameron’s blog; for ease of presentation I do not indent as is usually done with quotations:

“More Evidence that Monetary Policy was Important in late 2008.

The selloff seems like exactly the type of reaction one might expect if markets thought the Fed would do what was necessary to prevent NGDP from falling the 13th, only to realize it was hopelessly focused on the financial crisis (and not aggregate demand) two days later. And why would a Fed Chairman ever say continued weakness was certain? If that was the case shouldn’t they ease policy?

October 20, 2008

October 22, 2008.

October 28, 2008

October 30, 2008
A smaller, but similar market reaction as October 28th.

This article noted expectations had increased for the Bank of Japan, the ECB and the Bank of England to ease policy as well.

November 4, 2008

November 5, 2008
Again a day when the Fed raised the interest paid on reserves. A bad ISM services report also came out that day, but markets didn’t seem to clearly be reacting to that. Note also that fed funds futures actually increased slightly despite a sharp fall in stocks, nominal yields and oil prices (down 8% according to the NYT article).

November 7, 2008
Another rally with seemingly no explanation, except for easier money.

A trader remarked “The lesson people have to learn is they can no longer look for rational reasons for why short-term moves are happening,”

Hmm. Maybe, but I like my explanation better.

(Something bizarre seems to have been going on with TIPS yields data that day but 5 year inflation swaps show a more plausible decline in 5 year inflation expectations)

December 16, 2008

In the next few days I will write a short paper on NGDP targeting in the UK.  I’d be very interested in knowing why inflation remains fairly high.  It looks to me like RGDP growth was about 2.35% from 2000:2 to 2008:2, and NGDP growth was about 5.15%, meaning inflation was about 2.7%.  Since 2008, NGDP has been rising about 0.2%, and RGDP has fallen at about 2.2%, implying about 2.4% inflation.  That’s not much of a slowdown in inflation.

Perhaps more of the UK recession is real and less is nominal than in the US.  I know that London is a big international banking center.  Has the financial crisis hurt the UK more than the US?  I’d be curious as to whether the fall in UK RGDP is more concentrated in finance than in the US.  I notice jobs have fallen much less than in the US, but that’s true most places in Europe.

Update:  I forgot to mention, I’d also be interested in knowing 2, 5, or 10 year TIPS spreads in the UK.

On another topic, my critics often say that central bankers are wedded to inflation targeting; you can’t expect them to suddenly switch over to NGDP targeting.  I thought of those criticisms when I read this interesting article from the Financial Times, sent to me by Ashwin:

Very subtly, Bank insiders, including members of the monetary policy committee, are beginning to complain that the criticism is overblown and the Bank should not be in the line of fire for specific price rises about which it can do little. Would it be better to bring down inflation quickly with a large immediate tightening of monetary policy and ignore the consequence on jobs and growth, some insiders ask in rhetorical asides. Others are open that the Bank is really targeting nominal gross domestic product growth of about 5 per cent a year regardless that this is not consistent with the Bank’s strict 2 per cent inflation target objective.

Secret Sumnerians?  Have you noticed that every day the world seems to get a bit more “quasi-monetarist” (to use Krugman’s term for our small band of NGDP proponents.)  And this article also fits with another theme I’ve been emphasizing, the illogical discussion of monetary and fiscal stimulus.  There is currently a fierce debate in the UK over the coalition government’s plans for fiscal austerity.  Many argue it will lead to high unemployment.  But if that’s the case, then the criticism of the BOE for being too easy is borderline schizophrenic.  People can’t have it both ways.  If the UK has an AD problem, then, ipso facto, high inflation is not a problem.  Indeed it needs to be even higher.  (Draw an AS/AD diagram if you don’t believe me.  QED.)  If they don’t have an AD problem, then there are no valid grounds for criticizing Cameron’s fiscal austerity.  So which is it?  And for those Brits who do worry about inflation, why aren’t you demanding even greater fiscal austerity?  Why blame the BOE?

And while I’m pathetically trying to claim credit for powerful trends in the world economy, why stop now.  Here’s something Liberal Roman put in the comment section of the previous post:

I am still amazed that after the events of the past few months (which vindicated Scott in my eyes once and for all and made me a tidy investment profit) that no one and I mean NO ONE!!! is making the connection between QE and the improved economic performance the past few months.

Be they right or left, the pundits still throw out the SAME lines when it comes to monetary policy (Pushing on a string, banks not lending despite Fed printing, etc., etc., etc.).

I blame Krugman and DeLong almost as much as I do the right wingers. They are STILL apathetic towards monetary policy. Still, pining for fiscal stimulus. UNREAL!

Of course I’m far too modest to take credit for enriching my commenters, but not too modest to quote others.  Seriously, there is one flaw in Roman’s argument; I claim to have no forecasting ability, because I believe in the EMH.  But let’s entertain an alternative hypothesis.  Suppose I am right about monetary policy and wrong about the EMH.  A few months back when bloggers were listing what they had been wrong about, I mentioned the effect of QE1 on the bond markets.  I would have expected the announcement to raise long term bond yields (due to the income and inflation effects) as often occurs with unexpected monetary stimulus.  But yields fell sharply on the announcement.  I also pointed out that yields then turned right around and rose strongly as the economy seemed to recovery a bit in mid-2009.  As if markets started reading my blog.

This time around the yields fell on rumors of QE2, as it was widely anticipated by the time it was adopted.  And what has happened since?  Exactly the same as QE1, yields started rising rapidly almost immediately after the formal announcement, as inflation and real growth expectations rose.  I presume this is where Roman made his money.

I’m guessing that my teaching income is tiny by the standards of investment banking.  Surely there must be an investment bank or bond fund out there who would love to have my insights on monetary policy before they go into my blog.  I don’t mind enriching my readers, but I also have to think about my family.  (BTW, when businessmen use the line about “taking care of their family,” they are about as sincere as when politicians say they want to “spend more time with their family.”)