Archive for November 2011


Giving thanks to commenters

Today’s a good day to thank my commenters.   (For overseas readers, today is Thanksgiving in America.)

Comments like this recent one by Integral make it all worthwhile:

I continue to be amazed that you find the time to read and respond to every comment. Not many bloggers do that and I commend you for your dedication to the comment section.

With regards to your point, I think you’re right. Most economists look at Debt/Price level but Debt/NGDP would be a more appropriate variable.

I think it was Lucas who said “once you start thinking about economic growth, it’s difficult to think about anything else.” I’d add an addendum: when you start thinking about monetary policy in terms of NGDP, it’s difficult to think about it any other way. The key breakthrough for me was identifying NGDP with AD. Once I accepted that, literally everything else fell into place.

The same thing happened to me.  Monetary policy is supposed to address AD.  Which best measures AD; NGDP or the price level?  And remember the criticism of old monetarism; the argument that “velocity might change?”  OK, if that’s the problem then shouldn’t we offset velocity shocks, keeping M*V on target? And how about the “dual mandate?”  The advantage of a dual mandate is that we care about both prices and output.  The complaint is that we can only target one aggregate at a time.  So does NGDP or P better fulfill the dual mandate?  Everywhere you look NGDP just makes more sense.

I’m increasingly inclined to believe that most average economists/forecasters/pundits/business reporters/bankers/etc, simple don’t “get” macroeconomics, and never have.  I blame the old Keynesian model, which taught many mediocre economists to think in terms of sectors.  How people could not see that tight money and sharply falling eurozone NGDP growth expectations are absolutely central to the euro crisis is beyond my comprehension.  Yet JPIrving just sent me the following comment, which supports my recent post on the NABE poll:

Baffling. I sat through a two hour meeting on the European outlook today and was the only one who mentioned money might be tight and inflation expectations in the toilet. Everyone else is hung up on the side effects of tight money trying to come up with just so stories to implicitly explain falling V.

Right after Integral, Lorenzo made an excellent observation about Australia:

Down here in Australia, we already ran the experiment of monetary policy operating “surreptitiously”. It worked very badly and we now have 18 years (since 1993) of experience in why explicit targets are good. You would think being the country where the “Great Moderation” never ended would get some attention. (Indeed, not only never ended but operated better than elsewhere when everyone was experiencing it even though our terms of trade were still on their long term downhill slide and mining is about 9% of GDP and extremely volatile.) Apparently not.

I sometimes point to Australia as an example of the virtues of maintaining positive NGDP growth.  One push-back I get is that they benefited from the recent commodities boom.  But that cuts both ways.  Commodity industries are much more volatile than other industries, yet Australia missed both the 2001 and 2008 recessions; their last recession was in 1991.  And note that there have been huge swings in commodity markets over those two decades.  They’ve had to “reallocate” labor into mining industries but somehow avoided high unemployment, perhaps by keeping NGDP growth positive.

Today Rob left an interesting remark that referred to my recent Dr. Strangelove post:

Jim, it’s my favourite movie too. I actually used the “keeping it a secret” line in a recent comment on the Bank of England’s alleged secret NGDP targeting.

He’s referring to the fact that the Soviet doomsday device in Dr. Strangelove was useless unless they US knew about it, which we didn’t.  A very apt comparison.

The “rational” thing for me to do would be to stop answering comments and focus my extra time on twitter.  How do I know that?  Adam Ozimek told me so yesterday . . . in my comment section.

PS.  People!  I’m not seeing many comments today.  Stop spending time with your families and get busy.

The Fed wants banks to be able to survive epic Fed incompetence

A commenter named Steve sent me this puzzling article on stress tests:

The Federal Reserve plans to stress test six large U.S. banks against a hypothetical market shock, including a deterioration of the European debt crisis, as part of an annual review of bank health.

The Fed said it will publish next year the results of the tests for six banks that have large trading operations: Bank of America (BAC.N), Citigroup (C.N), Goldman Sachs (GS.N), JPMorgan Chase (JPM.N), Morgan Stanley (MS.N) and Wells Fargo (WFC.N).

“They are clearly worried about the issue of Europe,” said Nancy Bush, a longtime bank analyst and contributing editor at SNL Financial. “In a time of risk aversion and concern, you need transparency.”

The Fed said its global market shock test for those banks will be generally based on price and rate movements that occurred in the second half of 2008, and also on “potential sharp market price movements in European sovereign and financial sectors.”

In the Fed’s hypothetical stress scenario, unemployment would spike as high as 13 percent while U.S. gross domestic product would fall by as much as 8 percent.

I’d rather the Fed stress test their own policies.  Can they keep US NGDP rising at a 5% rate as Europe goes to pieces?  If not, what sort of policy regime might be able to do that?

The doomsday device

Here’s a scene from Dr.Strangelove:

The Ambassador reveals that his side has installed a doomsday device that will automatically destroy life on Earth if there is a nuclear attack against the Soviet Union. The American President expresses amazement that anyone would build such a device. But Dr. Strangelove (Sellers), a former Nazi and weapons expert, admits that it would be “an effective deterrent… credible and convincing.” However, a recent study by an American think tank had dismissed it as being too dangerous to be practical.

It turns out that the biggest problem is that the machine cannot be deactivated if something goes wrong.  And something did go wrong; a single rogue bomber attacked the Soviet Union at the instructions of General Jack D. Ripper:

From his wheelchair, Strangelove explains the technology behind the Doomsday Machine and why it is essential that not only should it destroy the world in the event of a nuclear attack but also be fully automated and incapable of being deactivated.

Recently I’ve been wondering about the EU’s backup plan if the euro didn’t work out.  One option would be to go back to the previous national currencies.  But that’s easier said than done.  Presumably it would be costly and time consuming, but even that isn’t the main problem.  After all, the countries previously converted to the euro without much problem. It’s not the end of the world.

But there’s a much bigger problem with deactivating the doomsday device euro.  Unlike when it was first set up, some of the new currencies would be introduced at different (lower) exchange rates.  And the expectation of devaluation is extremely destabilizing for financial markets.  That’s how George Soros got rich—he knew that the UK pound was under stress in 1992, and that the only two likely possibilities were a steep devaluation or no change.  He bet on devaluation, and won a billion dollars.  So devaluations are quite destabilizing.  Even so, they’ve been done before; it’s not the end of the world.

Unfortunately, there is no currency to devalue in this case.  So it’s not as easy to do as when a country has its own currency, and decides to suddenly change the par value.  There would probably have to be a decision to call a bank holiday, and impose all sorts of capital controls, to prevent everyone from smuggling euros out of the country into Swiss banks right before the official changeover.  That’s not easy.  But it’s not impossible.  The US did a bank holiday in the 1930s, and other countries have imposed capital controls.  So it’s not the end of the world.

Unfortunately, we are not just dealing with one country.  If it was just Greece, the government could meet in secret and work out an emergency transition plan.  Then suddenly spring it on the public.  But things have gone way beyond just Greece.  We are looking at the possibility of a complete breakup of the eurozone.  So the 17 countries would have to independently reach the conclusion that the euro was done, and then get together and meet in secret, without the meeting leaking out to the press.  And recall that right now these countries are getting along about as well as the US and Soviet Union during the cold war.  Still, it’s not . . .

On second thought, time to cue up Vera Lynn’s “We’ll Meet Again.”

Is it 1936 already?!?!?

Well that didn’t take long.  I have to admit that when I made this prediction eight days ago I didn’t really expect it to happen so fast:

The great irony of the Depression period is that by 1936 things had gotten so bad that even the French had to devalue.  The French had helped cause the Depression by their obsessive hoarding of gold, and their refusal to help out the weaker countries.  In other words, in monetary terms France was the Germany of the 1930s.  When you see doubts raised about countries like Finland and Austria, you really have to wonder if even the German debt is truly safe.

I still think the policy elite are slightly less pigheaded than in the 1930s, so I doubt things will go that far.  But it would be a lot simpler if they recognized reality right now, instead of dragging out the pain.

First a bit of background.  In the late 1920s and the early 1930s the Bank of France hoarded vast quantities of gold.  This raised the value of gold, which meant deflation (once the US and Britain stopped offsetting the French hoarding after October 1929.)  An international financial crisis ensued, with one country after another leaving the gold standard.  Britain in 1931, the US in 1933, etc.  At first France got off lightly, as their currency had been undervalued on the eve of the Depression.  But by 1936 the deflation in France was so bad that even they had to devalue.  In each case countries didn’t begin recovering until they had left the gold standard.

In the modern world things seem to move much faster than during the long agonizing 1931-36 collapse of the gold standard.  Today German bonds were hit hard:

The debt crisis that began more than two years ago now risks engulfing Germany. The Markit iTraxx SovX Western Europe Index of credit-default swaps on 15 governments rose to an all- time high as Germany failed to find buyers for 35 percent of the bonds offered at an auction.

Germany is of course the France of the 21st century.

It’s now quite possible that the Fed may have to move toward NGDP targeting before they would have liked.  The Fed cannot allow another collapse of NGDP like we saw in 2009.  The cost in terms of banking distress, worsening public finances, international discord and mass unemployment is simply too great to contemplate.  I have no doubt that Ben Bernanke of all people understands this.

Perhaps the Europeans will come together and do something dramatic in the next few days.  But if not, the Fed must be prepared to hold an emergency meeting and do whatever it takes.  To quote David Beckworth:

Also, if a nominal GDP level target is explicit and widely understood it would actually serve to mitigate the effects of financial shocks.  If the public understood the Fed would always close return nominal GDP to its trend path, public expectations would be better anchored and thus be less susceptible to wide swings.  That means velocity (i.e. real money demand) would be more stable.  For these reasons, it is reasonable to conclude that had the Fed been targeting nominal GDP during the 2008-2009 financial crisis, the outcome would have been far milder.  And for the same reasons, the Fed should be targeting nominal GDP now given the looming financial threat coming from the Eurozone crisis.

It’s Bernanke’s moment of truth.

PS.  Also check out Beckworth’s post showing the non-German NGDP in the eurozone.  And people wonder why the eurozone is having a sovereign debt crisis.

HT:  Joe2

Saez and Diamond explain taxes in the Journal of Economic Propaganda

Oops, I meant the Journal of Economic Perspectives, a prestigious publication that is supposed to provide survey articles about what is going on in various specialized fields, for those of us outside of those fields.

In a recent article Peter Diamond and Emmanuel Saez argue that we should impose much higher taxes on high incomes.  Note that I don’t say much higher taxes on “the rich.”  It would not put higher taxes on Warren Buffett, as the tax won’t come out of his consumption, it will come out of the investments that he no longer makes, and the charities to which he no longer contributes.  Ditto for Bill Gates.  A point Saez and Diamond somehow overlooked.

Their entire article skillfully toggles back and forth between pragmatic real world arguments and pie-in-the-sky theoretical arguments.  The only common thread is that the approach used to make each point is the one that just happens to favor higher MTRs on high incomes.  For instance, consider the argument they make for taxes on capital.  The traditional view is that the tax on capital should be zero, because a higher rate would impose higher taxes on future consumption than current consumption, and hence lead to a sub-optimal level of savings and investment.  In response, they point out that our current tax system often allows people to take advantage of gimmicks that result in labor income being falsely reported as capital income:

The existence of tax differentials between labor and capital also creates pressure to extend the most favorable tax treatment to a wider set of incomes. For example, in the United States, compensation of private equity and hedge fund managers in the form of a share of profits generated on behalf of clients is considered realized capital gains, although it is conceptually labor income.

Isn’t the obvious solution to make hedge fund managers treat their earnings as labor income?  Obviously yes.  I presume S-D would say that’s unrealistic, that the political process inevitably results in these sorts of loopholes.  Fair enough, but then let’s see what happens when those pragmatic arguments cut the other way.  Paul Krugman recently trumpeted the S-D conclusion that the optimal tax rate on high incomes is over 70%:

Using parameters based on the literature, D&S suggest that the optimal tax rate on the highest earners is in the vicinity of 70%.

That presumably comes from this statement by S-D:

As an illustration using the different elasticity estimates of Gruber and Saez (2002) for high-income earners mentioned above, the optimal top tax rate using the current taxable income base (and ignoring tax externalities) would be τ * = 1/(1 + 1.5 × 0.57) = 54 percent, while the optimal top tax rate using a broader income base with no deductions would be τ * = 1/(1 + 1.5 × 0.17) = 80 percent. Taking as fixed state and payroll tax rates, such rates correspond to top federal income tax rates equal to 48 and 76 percent, respectively.

I believe Krugman was referring to the 76% rate, which assumes a theoretically ideal tax system with no loopholes.  And S-D also seem to lean toward the “assume a can opener” school of policy analysis:

In the current tax system with many tax avoidance opportunities at the higher end, as discussed above, the elasticity e is likely to be higher for top earners than for middle incomes, possibly leading to decreasing marginal tax rates at the top (Gruber and Saez, 2002). However, the natural policy response should be to close tax avoidance opportunities, in which case the assumption of constant elasticities might be a reasonable benchmark.

So there you are.  It’s just too much to ask of our policymakers to actually make hedge fund managers pay labor taxes on their labor income, but S-D have no problem waving a magic wand and assuming away all tax loopholes.  Notice how both assumptions favor higher MTRs on higher incomes.

If the gap between labor and capital taxes was a potential source of cheating, I wonder why we wouldn’t want to shrink the gap with lower top rates on labor income, rather than higher top rates on capital income (which discourage saving and investment.)  To be fair, S-D mention that possibility, but merely as a throwaway observation that 99% or readers would skim right over:

Does the presence of capital income mean that earnings should be taxed significantly differently? When we discuss taxation of capital income in a later section, we note that the ability to convert some labor income into capital income is a reason for limiting the difference between tax rates on the two types of income””that is, an argument for taxing capital income. Plausibly, it is also an argument for a somewhat lower labor income tax, assuming that labor income should be taxed more heavily than capital income.

This is mentioned before the long discussion of capital income, which is entirely focused on (pragmatic) arguments in favor of taxes on capital—against the usual presumption of a zero optimal MTR.  Thus readers would have forgotten this point long before they finished the paper.  It might be important to actually investigate the implications of this alternative approach before we rush back into top MTRs that even the Scandinavian countries have found to be counterproductive (and which they abandoned many years ago.)

The S-D results rely on short run estimates of labor elasticities, and they admit that these ignore possible long run effects:

It is conceivable that a more progressive tax system could reduce incentives to accumulate human capital in the first place. The logic of the equity-efficiency tradeoff would still carry through, but the elasticity e should reflect not only short-run labor supply responses but also long-run responses through education and career choices. While there is a sizable multiperiod optimal tax literature using life-cycle models and generating insights, we unfortunately have little compelling empirical evidence to assess whether taxes affect earnings through those long-run channels.

Little compelling evidence?  That might be technically true, but it’s highly misleading.  Both common sense and the empirical evidence we do have suggests that high MTRs have much bigger incentive effects in the long run.  First consider the intuition.  Suppose you have 76% tax rates on the rich.  Now consider how that would affect hours worked in brain surgery of the following two groups:

1.  People who have already become brain surgeons.

2.  People considering becoming a brain surgeon.

For the first group, I doubt the effect would be all that large.  Their education is a sunk cost, and even after-taxes their income from brain surgery will exceed any likely alternative.  On the other hand the person considering undertaking the long and arduous process of becoming a brain surgeon might be deterred by the smaller expected after-tax income.  This would reduce surgeon supply until after-tax wages rose high enough to make medical school just worthwhile for the marginal student.

The best empirical evidence for long run effects comes from cross-sectional studies.  Those may not be “compelling” because it’s hard to hold everything constant.  But the evidence we do have (from Prescott and others) suggests that countries with high taxes tend to see fewer hours worked.  As a result (back in 2007) the Germans only collected about as much tax revenue per capita as the US, despite the fact that taxes are 40% of GDP in Germany vs. 29% in the US.  I pick Germany because it would be pretty hard to argue that German workers are in any sense “inferior” to American workers.  They just work a lot less, presumably because they have much less incentive to work.

S-D might argue that this evidence isn’t compelling.  But would we really want to make a great leap into the unknown on the assumption that both common sense and the empirical evidence that we do have is wrong?  What’s their model of European hours worked?  In addition, back when we did have 90% top MTRs, the wives of high paid men tended not to work.  Do S-D want us to go back to the 1950s, when women stayed home?

Krugman also points out that S-D analysis relies on the assumption that workers are paid their marginal product:

Yet textbook economics says that in a competitive economy, the contribution any individual (or for that matter any factor of production) makes to the economy at the margin is what that individual earns “” period. What a worker contributes to GDP with an additional hour of work is that worker’s hourly wage, whether that hourly wage is $6 or $60,000 an hour. This in turn means that the effect on everyone else’s income if a worker chooses to work one hour less is precisely zero. If a hedge fund manager gets $60,000 an hour, and he works one hour less, he reduces GDP by $60,000 “” but he also reduces his pay by $60,000, so the net effect on other peoples’ incomes is zip.

Conservatives do often assume that workers are paid their MPs.  But I think it’s also fair to say that those at the top may well contribute more than their marginal product.  Here’s Adam Ozimek:

Consider, for instance, that if we suddenly kicked out the top 10% of high IQ people (or 10% most productive people, or 10% most creative people, or whatever) in the U.S.. It strikes me as fairly likely that the total output of the remaining 90% would go down. Krugman seems to argue that this would not be the case. But even if you disagree with me in the short run, in the long-run the productivity increasing innovations these people would have made won’t show up, and the rest of us would have lower productivity as a result.

Travis Allison emailed me the Krugman post, and made this comment:

Suppose that an inventor creates new product X and patents it. He reaps the benefits from the patent for 15 years or whatever the time period is and then it goes into the public domain. Consequently, he contributes a lot more to GDP than what he was able to earn.

Let’s consider the biotech industry, which many believe will be the most important industry of the 21st century.  Investments in biotech tend to be all or nothing.  So your decision to invest in a biotech company will be very sensitive to the after-tax expected gain in the state-of-the-world where your company invents a cure for cancer.  Obviously a very high tax rate on the rich will tend to reduce that gain much more sharply than say the return from investing in MBSs (on which you’d pay a lower tax rate.)  So very high taxes on the super rich will tend to shift capital away from companies trying to find cures for cancer, and toward home construction.  That could easily delay a cure for cancer by 5 or 10 years.  (Just imagine where the world would be today without US high tech firms.)  Now maybe that’s a trade-off that S-D are comfortable making.  After all, we don’t know for sure whether the biotech industry will be able to cure cancer, heart disease, or diabetes, nor do we know the degree to which the speed and likelihood of a cure is sensitive to different rates of investment in biotech.  But at a minimum, I’d think we’d want to think long and hard before taking that gamble.

PS.  I can assure you that people in biotech are highly motivated by possible capital gains.  My wife works in a small biotech firm that is working on a vaccine that would prevent all types of flu.  How nice would that be next time there’s a pandemic like 1919?