Archive for May 2012


Two overrated problems and two underrated problems

Karl Smith has a post on the recovery in the Las Vegas housing market.  I noticed there were a few suspicious statistics—for instance housing starts were up sharply, but from a very low base.   So I decided to check it out by googling stories on the Phoenix housing market, and immediately found similar stories:

In another sign that metro Phoenix’s housing market is slowly recovering, hundreds of homes across the region sold by banks after foreclosure or through short sales are being flipped by investors for almost double the price they paid just a few months earlier.

With metro Phoenix’s median home price steadily climbing this year, speculators have seized on an opportunity to make fast profits and are selling houses across the region at prices not seen since the beginning of the housing boom in 2003-04.

Home prices have climbed as the supply of houses for sale has shrunk. The number of homes for sale in the Phoenix area is half of what it was last May, and the median price is up by an astonishing 30 percent since then.

.   .   .

An east Phoenix home bought through a short sale for $218,000 in September sold in late February for $560,000. The home was completely remodeled, but the price was still an eye-popping 156 percent more than the investor paid.

A home in Chandler, built in 2005, sold through a short sale in November for $255,000 and was then flipped by an investor for $410,000 in March — a 61 percent profit in five months.

A former foreclosure home in central Glendale was bought for $131,000 in January and flipped in mid-April for $243,000, an 85 percent jump. The investor added stainless-steel appliances and replastered the swimming pool at the ranch-style home.

In Goodyear, a 2,000-square-foot home in the Estrella Vista community was purchased from the lender for $88,000 in January. The investor repainted the home, put in new carpet and resold it for $188,000 in mid-April for a 113 percent gain.

“There are hundreds of recent examples of foreclosure or short-sale homes that have sold to investors who have been able to resell them quickly for much higher prices,” said Tom Ruff, managing director of AZ Bidder, a Phoenix-based online foreclosure-auction firm.

.   .   .

It’s now clear metro Phoenix’s housing market hit bottom last fall, according to the experts.

Another article mentioned that Phoenix housing starts are up sharply, although the level remains well below the boom years. So it looks like Karl is right; the US housing market has found a sort of equilibrium.

I’d like to make four claims:

1.  The misinvestment in the housing boom was far smaller than widely believed.

2.  The cost of bailing out the big banks was much smaller than widely believed.

3.  The cost of bailing out small bank depositors was much bigger than widely believed.

4.  The 2008 policy errors of the Fed were the “real problem.”

The US population grows by almost 3 million per years.  The 2003-06 housing fiasco can be summed up as follows.  We allocated too many resources into housing construction, which meant we built a few million houses a few years too early.  How costly is that?  Well houses often last for 100 years.  I frequently visit a completely typical and fairly new house in Arizona, worth about $200,000.  It’s obvious this house will last well over 100 years.  If that sort of house is built a few years early, there is economic waste–but not as much as many people suppose.  One mistake is to look at the big fall in housing values.  Much of that is actually a fall in land values, which doesn’t represent resource misallocation.  The actual price of houses fell by much less.  The flow of wasted housing services is substantial, but trivial compared to the waste caused by mass unemployment.

The second overrated problem is the big bank bailout.  Like housing over-investment it is a big problem in absolute terms, but vastly overrated in relative terms.  The big banks are repaying the loans, which is rather amazing given this was a once in 100 year banking fiasco.  If they are able to repay their loans in this situation, what sort of disaster would be required for them to actually cost the taxpayers money?  Perhaps a once in a 1000 year fiasco.

In contrast, the small bank fiasco is vastly under-rated.  Just as in the 1980s, the smaller banks lent vast sums to risky development projects, and lost big when the Great Recession hit.  The cost to taxpayers will be well over $83,322,000,000.  BTW, contrary to widespread opinion, payments made by FDIC represent taxpayers money.  The FDIC fees paid by banks are simply a cost of doing business, and are passed on just as oil companies pass on most of the gas tax to consumers.

The most underrated problem of all is the Fed policy fiasco of 2008.  You’d expect a fierce Bernanke critic and supporter of higher inflation like Paul Krugman to be all over the Fed.  Their tight money policy of 2008 drove the economy into deflation by early 2009.  And by the fall of 2008 the TIPS markets told us this was happening.  So what does Krugman say about Fed policy during the crisis?

But surely, I argue, the Fed did deliver negative real interest rates by cutting rates quickly and avoiding deflation. This prods Krugman into rare praise: “I have actually very few complaints about monetary policy here through some point in 2009. I thought that Ben [Bernanke] responded aggressively and forcefully, which was the right thing to do. He stepped in with the original QE [quantitative easing] and stabilised the economy.

“The question is, what did he do as we started to look more and more like Japan? At that point the logic says you have to find a way to get some traction. Fiscal policy might be great. But if you’re not getting it you should be doing something on the Fed side and I think that logic becomes stronger and stronger as the years go by. And it’s sad to see that the Fed has largely washed its hands of responsibility for getting us out of the slump.

This quotation just blew me away.  And it made me realize just how big the gap is between market monetarists and mainstream Keynesians.  Recall that the big crash in both NGDP and RGDP occurred between June and December 2008.  At no time during this crash were we at the zero rate bound.  The Fed even refused to cuts rates after Lehman failed in September 2008, even though 5 year TIPS spreads had fallen to 1.23%, and it was obvious we were going into a recession.  Let me say that again, they had a meeting 2 days after Lehman failed and didn’t cut rates below 2%.  Rates didn’t get to zero until mid-December 2008 when the great GDP crash was nearly over. It was too late to prevent the Great Recession by that point.  How many more smoking guns do we need?

It seems like Krugman doesn’t take a “target the forecast” perspective.  He doesn’t seem to share Svensson’s belief that the Fed should always set interest rates at a level expected to hit the dual mandate.  After all, by October 2008 we were clearly going to fall far short of the mandate, and rates were still 1.5%.

Or maybe Krugman does agree with me, and like 99.9% of economists he was totally focused on the banking crisis in the fall of 2008, and never realized that Fed policy was far off course.  Perhaps some readers can dig up old Krugman posts from that period to see what he was saying about monetary policy.

I think it’s the age old problem of “the seen and the unseen.”  The housing fiasco and the big bank bailouts were headline news.  The news media didn’t spend much time on the massive bailout of small bank depositors, and provided zero coverage of the Fed’s ultra-tight money policy in 2008.  Still, one would hope that (nearly 200 years after Bastiat) economists weren’t still taking their lead from newspaper stories.

PS.  Here’s a graph showing NGDP at monthly frequencies:

The mysterious Japanese economy

There’s been a lot of talk recently about how the debate over European economic problems is mostly playing out in the US blogosphere.  But if you really want to see an example of a country cut off from the econ blogosphere, go to Japan.  Let’s not forget that until recently Japan was the second largest economy in the world.  In this post I’d like to claim that Westerners don’t have a clue as to what is going on in Japan.  And I don’t mean “what’s going on” in the sense of why policy is conducted the way it is, we don’t even know the stylized facts about how Japan is doing.  I’ll present two hypotheses:

For the optimistic scenario, let’s start with a Martin Wolf interview of Paul Krugman:

We have already gone straight into the issues.  The conversation turns to the Japanese crisis of the 1990s. In retrospect, I suggest, the Japanese seem to have managed the aftermath of their crisis quite well.

He agrees. “What we thought was that Japan was a cautionary tale. It has turned into Japan as almost a role model. They never had as big a slump as we have had. They managed to have growing per capita income through most of what we call their ‘lost decade’. My running joke is that the group of us who were worried about Japan a dozen years ago ought to go to Tokyo and apologise to the emperor. We’ve done worse than they ever did. When people ask: might we become Japan? I say: I wish we could become Japan.”

This is interesting, as Japan has had the most contractionary demand-side policy of any country in modern history.  Aggregate demand hasn’t just risen slowly; it’s been falling for two decades.  All of their growth comes from the supply side—it’s a sort of anti-Keynesian story.  Even worse for the Keynesians, they’ve had lots of spending on infrastructure, and big deficits, but it hasn’t boosted AD by a single yen.

I see two powerful data points that support Krugman; Japan has low unemployment, and their real GDP rose 15% between 1993 and 2011 (or 13% per capita.)  That’s not fast GDP growth, but then other countries aren’t doing much better, and of course have much worse unemployment (Japan averages around 4% to 5%.)

But I think there’s an equally strong argument for the pessimistic case.  I’ve always been a bit skeptical about the optimists, as I watch lots of Japanese films and occasionally read their novels.  I definitely get a sense that the economy has done poorly since 1993.  One film depicts a middle-aged man too proud to admit to his family that he’d lost his job, so he dresses in a suit and pretends to go to work each day.

Because of my blog I’ve had the opportunity to talk to two very well-educated Westerners who have spent lots of time living in Japan.  The most recent conversation was with someone extremely pessimistic–he suggested that Japan is very much a nation in decline, by all sorts of social and economic metrics.  When I mentioned the film, he said that sort of thing is very common, and was also skeptical of the official unemployment data.  Both said that when you get outside of Tokyo you really see a nation in decline. The young people often have no real opportunity at all, and just live with their parents.  Of course that’s also a recent trend in the West, my point is that it seems to have been going on much longer in Japan.

But that’s all anecdotal, is there any evidence to back it up?

I see one very powerful piece of evidence, the fall in NGDP.  The Japanese NGDP has fallen 4.6% between 1993 and 2011, indeed by 6.7% in per capita terms.  Just think about that, after 18 years the average person in Japan is making 6.7% less income than in 1993, even in nominal terms!  Of course people will immediately point to the fact that RGDP has done much better.  Yes, but recall that NGDP is much easier to measure than RGDP (which requires that one estimate a price index.)  So we can’t be confident about the change in RGDP/person, but we can be pretty confident that NGDP has been falling.

And here’s why that’s so worrisome–the CPI is almost unchanged since 1993 (down a total of 0.4%, to be precise.)  So the Japanese people are making considerably less money in nominal terms, and their cost of living (according to the official consumer price index computed by the Japanese  government), is basically unchanged.  If the CPI is even close to being correct, then living standards in Japan are falling significantly.

Because I speak English, I feel I have a pretty good understanding of how the economy is doing in Australia, Canada, and Britain.  I don’t speak Japanese, and despite my interest in Japanese culture, I don’t really have any sense of how the Japanese economy is doing.  I’d guess the pessimistic case is closer to the truth, but not just because of low aggregate demand, I suspect there are also structural rigidities.

I think it’s interesting that everyone talks about our global economy, and yet if I’m right most Western economists are like me, we don’t have a clue as to what’s really going on in the Japanese economy.  My sense is that you’d have to have lived there, and traveled around a bit, to really understand.  Maybe you’d have to know how to speak Japanese.  For the rest of us, Japan might as well be on the dark side of the moon.

PS.  Just to be clear, I realize my “pessimistic case” wasn’t exactly in opposition to Krugman’s point.  If you just take the last 4 years, then yes, it’s possible to argue we are doing even worse—so far.  But I expect our NGDP/person to rise faster than the CPI over the next 14 years.  Some people argue Japan has been doing as well as the US for several decades.  That’s completely conditional on the Japanese GDP deflator being right, and their CPI being wrong.  Those two indices are about 20% apart since 1993.

All’s well that ends well

I like magazine articles with interesting endings.  Here are a couple examples:

1.  The Economist brings together Julio Cortázar and Tyler Cowen:

IN “The Night Face Up”””a 1956 short story by Julio Cortázar, an Argentine master of magical realism””a young man lies in a hospital at night, one injured arm held aloft by weights and pulleys. He is tormented by a recurring nightmare in which he is being hunted by Aztec warriors. The dreams are vivid, from the cling and reek of the jungle swamp in which he is captured to the chill of a dungeon floor and the hands dragging him up stone steps to an altar slick with human blood. The gore is mostly hinted at. The story’s menace turns on the man’s repeated struggles to wake and return to his darkened ward.

Across the rich world and above all in western Europe, lots of voters know just how that young patient feels. They yearn to hear that today’s unhappy realities””of austerity and spending cuts, debt, intermittent growth and relative decline””are a nightmare from which they can wake. They long to return to the “normality” of the boom years ended by the credit crunch of 2007.

.   .   .

Cortázar’s story ends with a twist: the man realises that he is, in reality, an Aztec prisoner. Modern life, the hospital, his motorcycle like “an enormous metal insect, whirring away between his legs”, was the absurd dream, falling away as he awaits death.

Britons and other Europeans need to go through a similarly vertiginous moment. For decades workers, faced with exploding global competition, were compensated by governments with cheap goods, early retirement and welfare on credit: a dream of affluence for life to replace jobs for life. Now the competition is as intense as ever, societies are ageing and their nations are poorer than they thought only a few years ago. The boom years were the dream. Hard work and tighter belts are the new reality.

If only “hard work” was new new reality.  Actually, mass unemployment is the new reality.

2.  Reason magazine has Thaddeus Russell review The Other America:

Harrington saw nothing of value in black culture, but he was not a racist—he saw nothing of value in anything produced by poor people of any color.  What he found in Appalachian towns populated by white hillbillies, for example, was “a sort of loose, defeated gaiety about the place, the casualness of a people who expected little . . . In some ways they resembled the stereotype of the happy-go-lucky Negro, and the truth of the description is about the same for both.”  And as with blacks, Harrington could see not only into their souls, but also into their futures: “It was relatively easy to guess which boys might end up in a penitentiary, which girls would become pregnant before they were out of grade school.”

His argument that the poor suffer from a comprehensive degradation leads Harrington to prescribe a totalizing project: the elimination of “the cultures of the poor,” the “abolition of the neighborhoods” in which they live, and “the establishment of new communities” for them.  Of course, according to Harrington, there is “only one institution in the society capable” of carrying out such a project: “That is the Federal Government.”

.   .   .

In fact, Lyndon Johnson’s “war on poverty” deployed legions of social workers, armed not only with the power to extort proper behavior from the poor with welfare payments but also with the prevailing idea that their subjects should be treated as children, with restrictions imposed on their sex lives, leisure time, diet, spending habits, clothing, and grooming styles.  In 1996 the welfare regime tightened its grip with the enactment of the Personal Responsibility and Work Opportunity Reconciliation Act (PRWORA), signed into law by another Democrat, Bill Clinton.

.   .   .

Welfare recipients are now instructed in how to improve their attitudes and demeaner so as to be more employable.  In Michigan, Florida, Georgia, and Utah, they are subject to drug testing as a condition of their benefits.  Bills are now before 23 state legislatures that would require testing for people who apply not just for welfare but also in some cases for food stamps, public housing, job training, and even some home heating assistance.

Although few of its left-wing supporters or right-wing detractors know it, our welfare state represents the unity of their cultural values.  It is the dream of Republicans, justified by the ideas of a socialist and enacted by armies of progressive do-gooders, of eliminating not just “the other America” but any other America.

He really nailed it with that final sentence.

Jonathan Portes on fiscal and monetary stimulus

Britmouse directed me to a recent post by Jonathan Portes:

There is at least some economic theory behind the first prescription; indeed, I used to believe it myself, as I set out here.  But this is a purist approach, which simply hasn’t survived contact with reality, as Chris’ own articles show. If monetary policy alone was indeed enough in practice, we wouldn’t be where we are now, with unemployment in the UK a million higher than the official estimate of the natural rate, and no prospect of it coming down in the immediate future. Any demand management policy that delivers that outcome is not one that policymakers should regard as remotely adequate.

I’ll bet most people read this and nod their heads in approval.  But suppose you replaced the phrase “if monetary policy was indeed enough in practice” with “if fiscal policy was indeed enough in practice.”  Would that not be equally true?  I’d say so.  On the other hand I’m pretty sure Portes would disagree.  But why?  Here’s where I’ll try a bit of mind-reading.  I’ll bet Portes would say; “we (in Britain) have tried monetary stimulus, but not fiscal stimulus.  Hence the demand shortfall is best explained by a lack of fiscal stimulus.”  Even if I’ve misread his mind, I don’t doubt that plenty of Keynesians think that way.  But as we’ll see, there’s really no reason for doing so.  First let’s consider what we mean by monetary and fiscal stimulus:

Naive, man-on-the-street view:

Monetary stimulus is low interest rates and/or a rapid increase in the money supply.  Fiscal stimulus is huge budget deficits.

By that definition Britain’s had plenty of monetary and fiscal stimulus; its interest rates are very low and its budget deficits over the past few years have been among the world’s largest.

Now let’s consider the more sophisticated view:

Bernanke says you can’t judge the stance of monetary policy by looking at interest rates or the money supply, only indicators of nominal demand growth are reliable.  Paul Krugman says you can’t judge fiscal stimulus by the budget deficit, you need to look at the full employment deficit, at the tax/expenditure mix, at the change in the deficit.

Money obviously hasn’t been expansionary by the more sophisticated perspective, and Keynesians claim fiscal policy hasn’t been expansionary (I have my doubts, but I’ll take their word for it here.)

[Update 5/26/12: I’ve corresponded with Portes by email, and he emphasized that he was thinking in terms of the effects of the fiscal tightening of the new government, which took office in mid-2010.  It’s probably better to view this post as a critique of broad trends in Keynesian ideas, rather that Portes’ specific views.]

No one can claim that Britain has done easy money and tight fiscal policy, regardless of whether they use the naive or the sophisticated policy definition.  Indeed you’d have to use the naive view of monetary policy and combine it with the sophisticated view of fiscal stimulus, to be able to claim Britain has done easy money and tight fiscal policy.

The bottom line is that either fiscal policy has been tried and failed (my view),  or neither fiscal nor monetary stimulus has been tried (the sophisticated Keynesian view.)  Let’s say I’m wrong and the sophisticated Keynesians are right.  Then what?

Then Cameron should choose the optimal policy.  He could either:

1.  Call on the BOE to hit a higher NGDP target.


2.  Do a big fiscal stimulus, and continue to insist that the BOE adhere to a 2% inflation target, which forces the BOE to cut back on unconventional monetary stimulus every time the fiscal stimulus boosts NGDP and inflation.  That’s obviously nuts.  The Japanese have gone down that road for 20 years and have a countryside paved over with bridges to nowhere, and zero NGDP growth since 1993.

The current British policy is not working—I agree with Portes on that point.  The question is where do we go from here?  I see lots of good arguments for setting a higher NGDP target.  I see no good arguments for relying of fiscal stimulus.

But suppose I’m wrong.  Suppose it’s politically impossible for Cameron to tell the BOE to switch away from a 2% inflation target.  What then?  Well then you’d instruct the fiscal authorities to target inflation at a higher level, and fight it out with the BOE.  Just imagine Cameron announced:  “The BOE is instructed to keep shooting for 2% inflation, but we fiscal authorities will set a 4% inflation target because that’s what it will take in an economy that had its a supply-side weakened by Gordon Brown’s big government policies.  Thus we plan to fight it out with the BOE, and see who is stronger.”

Cameron would instantly be the laughing stock of the global economy.  But that’s essentially what Keynesians are asking him to do; they simply want him to be quiet about it.  They know that the idea of the fiscal authority targeting a higher rate of inflation is absurd, indeed laughable.  And why is it crazy?  Because it would require the fiscal authorities to be able to control aggregate demand, i.e. total nominal expenditure.  Oh wait . . . Keynesians do believe that.

PS.  Last Friday Karl Smith came up with the phrase “the Sumner Critique.”  Within three days the phrase had spread to Matt Yglesias at Slate, Ryan Avent at The Economist, Josh Hendrickson, and across the ocean to Britmouse.  Someone better find a antidote quickly, before the virus spreads even further.

PPS.  Speaking of Karl Smith, at his new Forbes home he has a wonderful graph showing data relevant to the “re-calculation argument.”  It seems that the share of our economy devoted to information technology is plunging, whereas the share devoted to primary metals production is soaring.  In 2000 IT was 2 1/2 times larger than primary metals.  Now primary metals is far bigger.  We desperately need to retrain Silicon Valley engineers on how to dig up copper in the Arizona desert; otherwise Silicon Valley will soon look like Detroit.

The debate our Fed ought to be having

Stefan Elfwing sent me the minutes of the latest Riksbank meeting, and as usual Lars Svensson completely outclasses the competition.  Here he discusses the forecast for the economy contingent on various paths of the policy interest rate (the repo rate.)

Svensson then makes the eminently logical suggestion that the Riksbank ought to choose the target path that best meets the mandate they’ve been given (which is 2% inflation and high employment–interpreted as the natural rate of unemployment equalling 6.5%)  Svensson points out that the actual decision (keeping rates at 1.5%) produces an inferior outcome to the alternative lower interest rate path.

He prefaced his analysis by pointing to the basic “principle” of monetary policy.  First predict the path of the economy under alternative policy scenarios, and then choose the path that best fulfills your mandate.  It would be an understatement to suggest that other members were annoyed at Svensson pointing out the obvious:

Mr Jansson then commented on Mr Svensson’s contribution to the discussion regarding issues of principle. Mr Jansson said that he did not really understand the point of taking up these issues at the monetary policy meeting. These are questions that can be discussed at length, but there is not enough time available at a meeting of this nature. Mr Jansson said that Mr Svensson makes it sound as though the Executive Board has never discussed these issues before, which he considers to be totally misleading. These questions have often come up for lively discussion in recent years, and several of them have also led to concrete projects in the departments’ business plans. It is important that those outside the Riksbank are not given the impression that the Riksbank never talks about these issues.

Just imagine if the Fed presented not just its forecast for the economy, but also an alternative forecast for inflation and unemployment, conditional on a different amount of QE or a longer promise to hold rates at zero.  “Yes, we could have done that, but chose not to.”  I give the Riksbank a lot of credit for clearly explaining the alternatives to the path actually chosen.

Mr. Jansson also seemed perturbed that Svensson pointed out that the Riksbank had been significantly undershooting their inflation target, ever since the policy was adopted in the 1990s:

Mr Jansson considered that the new calculations presented by Mr Svensson rely on a number of assumptions that are rather difficult to digest. Firstly, it is assumed that the Riksbank for some reason should want to deliberately and systematically aim to attain a different inflation rate than the one it has chosen to introduce as a target. Disregarding the fact that this would appear to lack logic, it is something that Mr Jansson does not recognise at all from his almost 15 years of working at the Riksbank.

My goodness!  What would make people believe that the Riksbank is intentionally undershooting their inflation target?  Perhaps the fact that their own forecasts suggest that, given current policy settings, they are likely to miss their target.  Of course the same is true of the Fed.  Pity we don’t have someone like Svensson at the Fed; someone to shine a bright light on that policy failure.