Wednesday, January 30, 2008

The Challenges Ahead for the Fed

This Bloomberg article highlights some of the challenges the Fed faces as it pushes real interest rates back into negative territory:

``The Fed is going to have to keep slashing rates, probably below inflation,'' said Robert Shiller, the Yale University economist who co-founded an index of house prices. ``We are starting to see a change in consumer psychology"... So-called negative real interest rates represent an emergency strategy by Chairman Ben S. Bernanke and are fraught with risks. The central bank would be skewing incentives toward spending, away from saving, typically leading to asset booms and busts that have to be dealt with later.

Negative real rates are ``a substantial danger zone to be in,'' said Marvin Goodfriend, a former senior policy adviser at the Richmond Fed bank. ``The Fed's mistakes have been erring too much on the side of ease, creating circumstances where you had either excessive inflation, or a situation where there is an excessive boom that goes on too long.''

Read the whole thing

Real GDP Per Capita Shows Contraction, Not Slow Growth

Today we learn the U.S. economy weakened to 0.6% growth in the fourth quarter, a lower than expected growth rate according to CNBC and Bloomberg. What is not being reported, though, is that on a more meaningful per capita basis the U.S. economy outright contracted in the fourth quarter at a -0.4% rate. So as a public service, I am posting the below graph that shows the annualized growth rate of real GDP and real GDP per capita. The data comes from the BEA (I used their quarterly population data from the personal income tables).

To make sense of this decline in real GDP, I point you to the BEA table below which provides a nice decomposition of the real GDP growth rate. Here, each expenditure category's contribution to overall real GDP growth is reported. All the categories contributions sum to the real GDP growth rate.

Unsurprisingly, residential investment (circled in red) has been a drag all year. Another non-surprise given the decline of the dollar, is that net exports (also circled in red) have provided a net boost to real GDP since the second quarter. However, the contribution from net exports declined dramatically in the fourth quarter. Is this development of weakening global aggregate demand? The other interesting development to note in this table is the huge drag inventories had on real GDP in the fourth quarter.

Finally, below is the same table on an annual basis for the years 2004-2007. Here, you can see residential investment began to drag on the U.S. economy in 2006. Also, this table reveals that the boost from net exports appear to have come more from a decline in imports than from significant gains in exports.

Sunday, January 27, 2008

Economic Cartoon Idea

Based on the discussion in my previous posting, I was thinking it would be great if some artist would draw a cartoon where Uncle Sam is in a cowboy hat pulling his two pistols out to shoot the recession outlaw. One pistol is labeled fiscal policy and the other one is labeled monetary policy. However, as Uncle Sam pulls the triggers he realizes he is out of ammunition in both guns. On the ground we see some empty shells with 'Bush budget deficits' and '2002-2005 low interest rate policy' written on them. You see panic set in on Uncle Sam's face as he realizes he is out of ammunition. I am hoping that some artist out there reads this request and draws up the cartoon. The artist can take full credit for the cartoon too. Just get me the picture so I can post it on my blog.

Marmico in the comments sections points us to a hilarious cartoon that captures the spirit of my above posting:

Saturday, January 26, 2008

Why Monetary Policy Has Already Used Up its Ammunition

The reality of a new fiscal stimulus package has led to much discussion about the proper type of fiscal stimulus during a recession (See here, here, and here). A key concern raised in this debate by some observers is that the past budget deficits under the Bush administration have used up of much of the ammunition fiscal policy would otherwise have had during a recession. Now The Economist makes a similar argument for why monetary policy stimulus may not be as effective this time around: it has used up much of its ammunition (i.e. monetary policy transmission channels) from being too loose and accommodative over the same time period.

"Faith in the Federal Reserve is not what it used to be. Since September the Fed has cut its policy rate by 1.75 percentage points, to 3.5%. It still has plenty of firepower left—rates are some way above the 1% level reached in 2003—but few seem willing to rely on monetary policy alone to save the day...

What lies behind this loss of faith? One cause is the feeling that overly loose monetary policy got the economy into this mess. Repeated cuts in interest rates during the last downturn, in 2001-03, fuelled the housing and credit bubbles that are now bursting to such damaging effect. The legacies of that boom—falling asset prices, high consumer debt and bank losses—may now hamper the ability of central banks to prop up spending."

Nicely put. Read the whole thing.

The Fed Apologist

One of the top monetary economists in the nation is seemingly bent on being a Fed apologist. Over at the WSJ Real Time Ecomics blog, Mark Gertler is defending the Fed's surprise interest cut last Tuesday. This is too bad, but not altogether surprising given his defense of the Fed's extremely loose monetary policy during the 2003-2005 period. Here is what he says regarding Tuesday's rate cut:

"... plans for significant easing was in the works before Tuesday. The global asset price decline certainly influenced the timing of the cuts, but I don’t believe it’s going to affect the medium term path of the Funds rate, which is going to be governed by events in the real economy."

So he admits global asset prices influenced the timing of the decision to cut rates. Does he not find this troubling? Since when is it in the Fed's mandate to respond to stock market movements? The only way to wiggle through that question is to reply (a) the stock market is harbinger of things to come in the real economy or (b) that the stock market decline itself will create real economic problems. He opts for the later:

"... [G]iven the weakened state of financial institutions, a sharp asset price contraction had the potential to significantly disrupt credit flows and thus do significant harm to the real economy. The Fed action offset this potentially disruptive chain of events."

Even if he is correct in this assessment, I see several new problems the Fed has created by this action. First, it sets a precedent for a 'Bernanke Put', similar to the 'Greenspan Put'. The market now knows that in the mind of the Fed it is too important to fail because of the potential real economic harm it may cause. Second, although Mark Gertler says the 'medium term path' of the fed funds rate has not changed because of this move I am less certain. The Fed's move last Tuesday set in play a whole new dynamic, as market expectations have now changed. How can Mark be so confident the 'medium term path' will now be the same
? This is not a static world. Third, the Fed just used up a large chunk of their valuable ammunition on an uncertain outcome. Given the liquidity trap rumblings we now hear, this rate cut may be costly down the road. I may be wrong in my assessment, but for now the rate cut still appears to me as a panicked Fed responding to market volatility.

Friday, January 25, 2008

A New International Economics Book

I just received my copy of the new International Economics textbook by Robert Feenstra and Alan Taylor. My initial thoughts are that this book has the user friendly feel of introductory economic textbook but the substance of the Krugman & Obstfeld text. Most of my students in my international economics class are non-econ majors and they find the Krugman and Obstfeld text too dense. I am going to give this text a try in the Fall.

You can buy the book from Worth publishers either whole or broken down into its international trade and international macro sections. My dream is one day to have a international trade and an international macro course here instead of cramming them both into an one semester course. Should that day come, this text would be ideal.

Thursday, January 24, 2008

The Economist and Benign Deflation

I had the privilege today of meeting Zanny Minton Beddoes, the economics editor for The Economist magazine. She was a presenter at at a regional economic outlook conference held in nearby Austin, Texas. Her part of the program was to deliver an assessment of the national economy. She did a great job describing the major shocks that have recently hit the U.S. economy--high oil prices, frozen credit markets, housing market bust--and the potential outcomes of these shocks. After her talk, I was able to chat with her for a few minutes. Among other things, I complemented her and The Economist for taking seriously the implications of benign deflation for the U.S. economy during the 2003-2005 period. As I have argued before, the Fed's misreading of the 2003 deflationary pressures as being malign when in fact they were benign led to an overly accommodative monetary policy at that time. As a consequence, interest rates were pushed far beneath their neutral level and the stage was set for the biggest housing boom-bust cycle in U.S. history. The Economist recognized this was happening and was one of the few observers sounding the alarm over this development (Andy Xie was another, see here). Only now are other observers (here, here) beginning to see how prescient The Economist was in its calls to reign in monetary policy during this time. It was a real treat, then, for me to meet Zanny, and briefly discuss these issues with her.

In case you missed The Economist's coverage of benign deflation and its implications for the U.S. economy during the 2003-2004 period, I have posted below an edited version of an article that appeared in 2004.

From The Economist print edition

A new paper questions whether inflation will really turn out to be America's main economic problem... Most commentators have cheered Alan Greenspan and his colleagues at the Fed for being so aggressive in warding off the deflationary threat caused by huge corporate debts and the popping of the stockmarket bubble... Mr King is not among those cheerleaders. He argues that the Fed was wrong to cut interest rates so much, because much of the deflationary pressure was of an altogether more benign sort: a reduction in overall prices caused by rapid technological change, improvements in the terms of trade and other factors. Britain had long periods of “good” deflation in the late 18th and 19th centuries, when nominal interest rates and growth were both strong. In recent years, argues Mr King, there has again been deflation of just that sort, and for similar reasons. Technological change and the integration of China, and increasingly India, into the global economy have pushed down the price of traded goods in America, thus pushing up real incomes. “And, because of these real gains, any rise in real debt levels will not be a source of potential ongoing instability,” writes Mr King. Alas, because the Fed's perceptions of deflation have been coloured by the experiences of America in the Depression and Japan in its lost decade, it reacted by reducing interest rates sharply, a response that is more likely to bring about the debt deflation it most feared.

High real growth—so long as deflation is of the good sort—requires high real interest rates. If rates are too low, people borrow too much and spend it badly: what Mr King calls “happy investment rather than good investment”. For a given level of nominal interest rates, a fall in prices will deliver the appropriate level of real interest rates. But by cutting nominal rates to prevent deflation, the Fed has reduced the real rate of interest too much.

Evidence that this has been the case comes in two forms. The first is that borrowing has ballooned in America in recent years. Any reduction in the indebtedness of American firms (under immense pressure from the capital markets) has been more than matched by borrowing by consumers and the government...

[T]he second piece of evidence [can be seen in] what Americans spend their money on. If money is too cheap, then rates of return will fall, companies will tend to use capital rather than labour, and people will spend money on riskier assets; on things that have little to do with underlying economic growth; and on things that are in short supply. As it happens, this is a decent description of America in the past few years. Companies have been slow to hire workers even as the economy has bounded along; and workers' share of national income is very low. The low cost of capital has, moreover, encouraged speculation in risky assets, such as emerging markets, or—closer to home, as it were—property. And, yes, with all that money sloshing about, it has also pushed up inflation a bit...

There is thus a distinct danger that by pushing real interest rates back to where they should have been in the first place, monetary tightening will reveal the economic recovery to have been more fragile than most think—and threaten a hard landing and the malign sort of deflation that the Fed was so keen to avoid.

If you want more, see Unnaturally low.

Wednesday, January 23, 2008

A Great Martin Wolf Column

Even though I think Martin Wolf has drunk too much 'saving glut' kool aid, I enjoyed this article by him. He makes the point that the different perspectives on the causes of the recent financial turmoil each have a unique perspective on the matter and should not be dismissed out of hand. I agree and hope Martin will follow this thinking in his future discussions of global economic imbalances.

The Financial Turmoil is Like an Elephant in a Dark Room
Financial Times

Tuesday, January 22, 2008

Today's Surprise Fed Funds Rate Cut

I find today's fed funds rate cut troubling. Since when does the Fed's mandate cover activity in global stock markets? And no, I do not buy the argument that the fall in global stock markets somehow represents brand new information--that did not exist a few days ago--about the possibility of a U.S. recession. The market sell off was pure panic driven and the irregular timing of this rate cut makes the Fed look panic driven too.

I really like Ben Bernanke, but this response blows my mind away. The only reasonable justification for such action is that the Fed knows something the markets do not know. If so, then the markets have even more reason to panic and sell off.

So how does Wall Street feel about this move? CNBC did a quick survey today and found,

"Nearly 75 percent of Wall Street pros responding to the CNBC Trillion Dollar Snap Survey think the Federal Reserve did the right thing by cutting interest rates by three-quarters of a point, to 3.5%, this morning."

Surprise, surprise. Stepping away from Wall Street, where the intoxicating influence of liquidityholics like Jim Cramer is hard to avoid, one can find more thoughtful observers. For example, Willem Buiter of the London School of Economics writes in Financial Times the following:

"It is bad news when the markets panic. It is worse news when one of the world's key monetary policy making institutions panics. Today the Fed cut the target for the Federal Funds Rate by 75 basis points, from 4.25 percent to 3.50 percent. The announcement was made outside normal hours and between normal scheduled FOMC meetings.

This extraordinary action was excessive and smells of fear. It is the clearest example of monetary policy panic football I have witnessed in more than thirty years as a professional economist. Because the action is so disproportionate, it is likely to further unsettle markets. Even the symptoms of malaise that appear to have triggered the Fed's irresponsible rate cut, the collapse of stock markets in Asia and Europe and the clear message from the futures markets that the US stock markets would follow (a 500 point decline of the Dow was indicated), are unlikely to be improved by this measure and may well be adversely affected.

In the absence of any other dramatic news that the sky is falling, I can only infer from the Fed's action that one or both of the following two propositions must be true.

(1) The Fed cares intrinsically about the stock market; specifically, it will use the instruments at its disposal to limit to the best of its ability any sudden decline in the stock market.

(2) The Fed believes that the global and (anticipate) domestic decline in stock prices either will have such a strong negative impact on the real economy or provides new information about future economic weakness from other sources, that its triple mandate (maximum employment, stable prices and moderate long-term interest rates) is best served by an out-of-sequence, out-of-hours rate cut of 75 basis points.

The first proposition would mean that the Fed violates its mandate. The second is bad economics."

Another example comes from Felix Salmon:

"There's nothing in there to justify a huge rate cut in the week before a regularly-scheduled meeting. Tighter credit for some households? Come on. There's one reason and one reason only that the Fed took this move, and it's the plunge in global stock markets on Monday, along with indications that the US markets were set to follow suit.

Now the Fed is charged with keeping employment high and inflation low; it's not charged with protecting the capital of investors in the stock market. So this action smells a bit like panic to me, and it might also have prevented the kind of stomach-lurching selling which could conceivably have marked a market bottom. I have to say I don't like it."


Monday, January 21, 2008

The 'Great Moderation' and the Income Volatility Question

Over at the CBO Director's Blog we read that based on the CBO's own research "household income is much less volatile than individual worker’s earnings, and that household income volatility has not increased over time — and perhaps even declined slightly." The period being studied here is from the early 1980s to the present. These results run contrary to the work of Jacob Hacker of Yale University who finds that the volatility of family income doubled between 1973 and 2004. Professor Hacker's response to the CBO Directors Blog can be found here.

A question: what role does the 'Great Moderation' play in this debate? A well documented fact is that there has been less volatility in aggregate economic activity since the early 1980s and this development is called the 'Great Moderation.' One study has found real economic activity volatility has fallen 50% over this time. Would not some of this decline in aggregate economic volatility be felt at the household or individual level? Is not the low U.S. household saving rates one indication of this development?

Some observers may look at the low U.S. saving rate and say it is the result of the global saving glut or the U.S. asset price booms. I am not convinced, though, these answers can provide the full explanation for the sustained downward trend in U.S. household savings. A more complete answer has to account for the possibility of improved household expectations arising from the long economic expansions of the past two decades that were interrupted by only mild economic downturns (i.e. the 'Great Moderation'). Any thoughts?

Sunday, January 20, 2008

Cyclically-Adjusted Tax Revenues Under Different U.S. Presidents

Paul Krugman is attempting to provide "straight talk on taxes" at his blog. He shows real federal revenue per capita from the early 1990s to the present. While his approach is insightful, I like to look at the cyclically-adjusted federal revenues as a percent of GDP. This approach makes similar adjustments as does Paul's measure--it accounts for the size of the economy and inflation--but it also adjusts for the influence the business cycle has on federal revenues. This latter adjustment is important because both the Reagan and Bush tax cuts were during economic downturns. (The data is also easily available from the Congressional Budget Office at this site; look for the "standardized budget revenue".)

I downloaded down the data and created the following graph (click here for larger picutre), where the dashed lines mark off each presidency:

This graph is not what I expected. I will let it speak for itself. Mabye Paul Krugman will have a word to say on it.

To be clear, and repeating what I stated when I discussed cyclically-adjusted budget balances, I still find the nuanced Laffer curve view--if I can call it that--of Justin Fox, Brad DeLong, and Greg Mankiw a reasonable position to hold.

My above post did not make clear why it is important to correct for cyclical influences on tax revenues. Both the Reagan and Bush II tax cuts occurred during economic downturns. This timing means that even if there had been no tax cuts tax revenues probably still would have declined during the recessions. Similarly, even if Clinton had not increased taxes there probably still would been higher tax revenues given the booming economy of the mid-to-late 1990s. Consequently, one needs to also account for these business cycle influences when assessing the tax revenue evidence. The data I use above makes this adjustment.

Friday, January 18, 2008

Are Real Wages Countercyclical, Procyclical, or Acyclical?

Eric Swanson of the San Francisco Fed provides an interesting, nuanced answer to this question using data from the Panel Study of Income Dynamics. From his abstract:

Although real wages were procyclical across the entire distribution of workers from 1967 to 1991, the wages of lower-income, younger, and less-educated workers exhibited greater procyclicality. However, workers’ straight-time hourly pay rates have been acyclical, suggesting that more variable pay margins such as bonuses, overtime, late shift premia, and commissions have played a substantial if not primary role in generating procyclicality.

Here is a link to the paper.

Wednesday, January 16, 2008

The Fed Smackdown by the High Priestess of US Monetarism.

In a Telegraph interview, the legendary Anna J. Schwartz does a smackdwon on Greenspan's Fed (hat tip Greg Mankiw):

The high priestess of US monetarism - a revered figure at the Fed - says the central bank is itself the chief cause of the credit bubble, and now seems stunned as the consequences of its own actions engulf the financial system. "The new group at the Fed is not equal to the problem that faces it," she says...

According to Schwartz the original sin of the Bernanke-Greenspan Fed was to hold rates at 1 per cent from 2003 to June 2004, long after the dotcom bubble was over. "It is clear that monetary policy was too accommodative. Rates of 1 per cent were bound to encourage all kinds of risky behaviour," says Schwartz.

She is scornful of Greenspan's campaign to clear his name by blaming the bubble on an Asian saving glut, which purportedly created stimulus beyond the control of the Fed by driving down global bond rates. "This attempt to exculpate himself is not convincing. The Fed failed to confront something that was evident. It can't be blamed on global events," she says.

Her critique fits in nicely with some of my views. This Fed smackdwon seems to be catching on among big name economists.
By the way, this is not Anna J. Schwartz first smackdown. See her paper with Edward Nelson where she leaves Paul Krguman smacked up and dazed.

Recession Humor

Monday, January 14, 2008

What the U.S. Trade Deficit with China Means for You and Me.

James Fallows tells us in his Atlantic Monthly article, "The $1.4 Trillion Question" (hat tip Brad Setser):

"In effect, every person in the (rich) United States has over the past 10 years or so borrowed about $4,000 from someone in the (poor) People’s Republic of China."

How long can this arrangement last?

"Like so many imbalances in economics, this one can’t go on indefinitely, and therefore won’t. But the way it ends—suddenly versus gradually, for predictable reasons versus during a panic—will make an enormous difference to the U.S. and Chinese economies over the next few years, to say nothing of bystanders in Europe and elsewhere."

Read the rest.

Friday, January 11, 2008

Recession Index

From the Economist:

"ALMOST six out of ten Americans believe that the country is already in a recession. Although most forecasters still expect a formal recession will be avoided (typically putting the odds at around 40%), not everyone agrees. The Economist’s informal R-word index is also sounding alarms. Our simple formula pinpointed the start of recession in 1981 and 1990 and 2001. Although the number of stories is still lower than before previous recessions, the recent jump—if sustained for a quarter—is similar to that which preceded the 2001 downturn."

Another Advocate for the Cleansing Effects of a U.S. Recession

The idea that a recession may actually be good for the U.S. economy has been discussed before in this blog (here, here, and here). Now Willem Buiter of the London School of Economics provides further thoughts on the cleansing effects of recessions in the Financial Times:

Why the US May Well Need a Recession

"... A significant slowdown in the US, perhaps even a recession, is necessary to restore a sustainable desirable level of the national saving rate. There can be further beneficial longer-run effects from a recession, because recessions are quite efficient mechanisms for purging, through defaults, insolvences and financial and real restructuring, the distortions, inefficiencies and misallocation of resources that were created by the financial excesses in the US economy during these past five years. When it has to happen, why wait?"

Read all of it.

Thursday, January 10, 2008

Greenspan's Reputation is Under Fire for Past Monetary Profligacy...

So says a Bloomberg article.

"Hailed as perhaps the greatest central banker who ever lived when he left the Federal Reserve in 2006, Greenspan is under attack from critics ranging from the New York Times to economists at the American Enterprise Institute for his handling of the 2000-2005 housing boom... Critics blame his aversion to regulation and reluctance to use interest rates to puncture asset bubbles for the boom in mortgage lending and house prices that has since gone bust, threatening to throw the economy into recession...

Some economists, including [Alan] Blinder, also fault Greenspan for fostering the housing bubble by keeping interest rates too low for too long. The Fed cut its benchmark rate to a 45-year low of 1 percent in June 2003, held it there for a year, then raised it only gradually, in quarter-percentage-point increments... A simulation by Stanford University professor John Taylor suggested that much of the housing boom could have been avoided if the Fed hadn't cut rates so deeply and had raised them back up more quickly. [Alan]Meltzer said that while Greenspan was a ``great Fed chairman,'' he erred in ignoring warnings about the risks of keeping rates low. ``I think he lets himself off much too easy,'' Meltzer said, adding that he told Greenspan at the time that he was exaggerating the danger of deflation and thus making a mistake in cutting interest rates to 1 percent."

If this all sounds familiar then you may be a regular reader of this blog (see here, here, here, and here). The Bloomberg article reminds me of the great song "The Bubble Man" by Scott Peterson.

Wednesday, January 9, 2008

What Does the Recession Mean for Religiosity?

I have received some inquiries about my research that looks at the relationship between the business cycle and religiosity. I have posted previously about it, but given the increased interest and the fact that the U.S. appears to be going into--if not already in--a recession I am reposting the abstract and the link to the paper.

Praying for a Recession: The Business Cycle and Protestant Church Growth in the United States (link)

Some observers believe the business cycle influences religiosity. This possibility is empirically explored in this paper by examining the relationship between macroeconomic conditions and Protestant religiosity in the United States. The findings of this paper suggest there is a strong countercyclical component to religiosity for evangelical Protestants while for mainline Protestants there is both a weak countercyclical component and a strong procyclical component.

Tuesday, January 8, 2008

Why I like Stephen Roach

I used to look forward to reading Stephen Roach's commentaries every Monday and Friday at the Morgan Stanley Global Economic Forum. He had much to say about global economic imbalances and was one of the few thoughtful observes who took the 'liquidity glut' view seriously. (See his critique of the 'saving glut' view here.) Some of his classics form the Global Economic Forum include "Original Sin" and "The Great Unraveling." Unfortunately, he stopped writing for this outlet when he took on new responsibilities with Morgan Stanley. His commentaries have been missed. I was delighted, therefore, to run across this Op-Ed of his in the Financial Times yesterday.

America’s inflated asset prices must fall

By Stephen Roach

The US has been the main culprit behind the destabilising global imbalances of recent years. America’s massive current account deficit absorbs about 75 per cent of the world’s surplus saving. Most believe that a weaker US dollar is the best cure for these imbalances. Yet a broad measure of the US dollar has dropped 23 per cent since February 2002 in real terms, with only minimal impact on America’s gaping external imbalance. Dollar bears argue that more currency depreciation is needed. Protectionists insist that China – which has the largest bilateral trade imbalance with the US – should bear a disproportionate share of the next downleg in the US dollar.

There is good reason to doubt this view. America’s current account deficit is due more to bubbles in asset prices than to a misaligned dollar. A resolution will require more of a correction in asset prices than a further depreciation of the dollar. At the core of the problem is one of the most insidious characteristics of an asset-dependent economy – a chronic shortfall in domestic saving. With America’s net national saving averaging a mere 1.4 per cent of national income over the past five years, the US has had to import surplus saving from abroad to keep growing. That means it must run massive current account and trade deficits to attract the foreign capital.

America’s aversion toward saving did not appear out of thin air. Waves of asset appreciation – first equities and, more recently, residential property – convinced citizens that a new era was at hand. Reinforced by a monstrous bubble of cheap credit, there was little perceived need to save the old-fashioned way – out of income. Assets became the preferred vehicle of choice.

With one bubble begetting another, America’s imbalances rose to epic proportions. Despite generally subpar income generation, private consumption soared to a record 72 per cent of real gross domestic product in 2007. Household debt hit a record 133 per cent of disposable personal income. And income-based measures of personal saving moved back into negative territory in late 2007.

None of these trends is sustainable. It is only a question of when they give way and what it takes to spark a long overdue rebalancing. A sharp decline in asset prices is necessary to rebalance the US economy. It is the only realistic hope to shift the mix of saving away from asset appreciation back to that supported by income generation. That could entail as much as a 20-30 per cent decline in overall US housing prices and a related deflating of the bubble of cheap and easy credit.

Should Fiscal Policy be Used as a Stabilization Tool?

We already know Greg Mankiw's answer to this question. We now know Alex Tabarrok's answer as well: no. His reasons--which are similar to some of the points I raised earlier--are as follows:

"First, the money for any new spending or tax cuts has got to come from somewhere, right? Thus there is usually substantial crowding out of any stimulus.

Second, by the time the new spending or tax cut gets through the political process the economy has moved on and the stimulus is no longer relevant except by accident.

Third, there just isn't that much discretionary spending to play with and even a large increase in spending, say tens of billions, is too small to make much of a difference in a 13 trillion dollar economy.

Fourth, in their desperation to "do something" politicians will often do something foolish. If a spending increase or tax cut isn't worthwhile on its own merits then it's highly unlikely to be worthwhile once we add in the benefits of "stimulus." Thus, it's one thing to argue for extending unemployment benefits as a matter of welfare it's quite another to think that an increase in unemployment benefits will so increase spending as to reduce unemployment! (The implicit view of Larry Summers.)"

Since Greg Mankiw is crafty at naming new clubs (e.g. Pigou Club), maybe he should find a clever name for the "no fiscal policy" club he and Alex are forming. I suspect Larry Summers will not be joining anytime soon.

See this relevant post by Mark Thoma

Monday, January 7, 2008


Another Look at The Cleansing Effects of Recessions

There have been rumblings in the blogosphere and elsewhere that a recession may be needed to purge out economic imbalances in the U.S. economy (see my postings here and here on this idea). Yoonsoo Lee and Toshihiko Mukoyama have an article that helps shed light on this discussion:
Yoonsoo Lee, Toshihiko Mukoyama, 8 January 2008
It is commonly believed that business cycles ‘cleanse’ industry with waves of creative destruction. New research shows that entry is higher in booms than busts, but exit rates and the type of exiting firms, are steady over the cycle. Plants entering during recessions, however, are larger and more productive –‘creative entry’ rather than ‘creative destruction’.

Fair Tax Links and a Question

Here is a compilation of links to individuals and their writings on the Fair Tax. It appears to me many economists are skeptical of the plan (though more supportive in general of consumption taxes relative to income taxes for efficiency reasons). I have been able to find a few prominent economist, though, supportive of the plan.

One question I have not seen answered is this: what would happen to fiscal policy as a tool for macroeconomic stabilization under this plan in its purest form? Given all the recent talk about using fiscal policy (here, here) to fight off the almost certain recession now facing the U.S. economy, I would think someone out there would have explored this question.

Arnold Kling
Bruce Bartlett (abbreviated version)
Tyler Cowen
Megan McArdle
Brad DeLong
William Gale

Laurence Kotlikoff
Vernon Smith

Other Sources
Justin Fox
Fair Tax Official Page
NY Times Piece
Fair Tax Wikipedia
Fair Tax Blog
Tax Foundation (Article Round Up)

Holiday Reading

Following the recommendations of David Leonhardt and Arnold Kling, I read Shannon Brownlee's book "Overtreated" over the holidays. It was a fascinating read about (1) how there is a large amount of unnecessary health care and spending on it in the USA and (2) how this unnecessary care actually does more harm than good. I learned a lot reading this book, but probably the most fascinating thing I found is how much of medicine is an art and not a science. Many doctors simply fail to keep up with the literature in their field and even when they do, the literature is often inconclusive or not scientifically robust. Next time a doctor recommends an invasive procedure for me I will be sure to quiz him/her on the literature.

The broader point of "Overtreated"should not be too surprising, though, given that 86 cents of every dollar expended on health care comes from a third party--there is very little incentive to be conscious of costs by both consumer and providers when someone else is footing the bill. Michael Cannon and Michael Tanner also make the case in their book "Healthy Competition" that since Medicare accounts for 1/2 of the all health care expenditures and influences choices made by private insurers, there are going to be distortions in the health care industry.

Does My Apartment Manager Understand Externalities?

I have been out of Texas for a couple of weeks and returned yesterday. Upon my return, I got a surprise notice from my apartment manager. Before I tell you what was in that notice, let me give you some background.

As noted before in this blog, I moved my family this past summer from Michigan to Texas. We moved into an apartment while we waited to sell our home in Michigan. Our home finally sold so now we are waiting out our one-year apartment lease and getting to know the area better. (I am also hopping the Nouriel Roubinis of the world are right when they say the housing recession has yet to hit bottom--I am ready to pick up a home at a bargain price this summer.) I am currently in a nice apartment complex that allows pets. The complex has pet waste collection stations place throughout the complex. There are also warning signs about being fined for not collecting and properly disposing of your pet's poop. Unfortunately, many pet owners are negligent in this area. As a result, most of the grassy areas in the complex are often not safe for walking. This development has become particularly frustrating for me since I have children who inevitably find their way into the grassy areas. The management has sent out many notices, but to no avail. Apparently, the marginal cost of collecting and disposing of pet waste exceeds any marginal benefit for many pet owners here.

In economics, the standard solution for correcting a negative externality like this is to somehow force the pet owners to internalize the cost they are imposing on me and other tenants. My solution for management was as follows:

(1) Every month, at some unannounced time, count the amount of poop. If it is too costly to go over the entire complex, then randomly pick representative locations throughout the complex.
(2) If the poop count exceeds a certain threshold--one must allow for the occasional pet pooping without the owner knowing--then all of the pet owners should be charged a higher rent. The greater the poop count the greater the excess rent.

I had been meaning to submit my idea to the complex, but never got around to it. The surprise notice I got upon my return, however, stated that going forward into 2008 pet owners will now be charged extra when there are excessive amounts of poop. The excess poop charge is probably not large enough, but management is on the right track and effectively forcing the pet owners to internalize the external costs they are creating. It is as if my apartment manager understood the concept of externalities.

A bigger point I take away from this experience is that best place to experience market failure is in your own backyard.