John Taylor Unleashed

John Taylor is not bashful about criticizing mistakes made by U.S. economic policy makers. He recently had this interesting paper where he concludes as follows:

In this paper I have provided empirical evidence that government actions and interventions caused, prolonged, and worsened the financial crisis. They caused it by deviating from historical precedents and principles for setting interest rates, which had worked well for 20 years. They prolonged it by misdiagnosing the problems in the bank credit markets and thereby responding inappropriately by focusing on liquidity rather than risk. They made it worse by providing support for certain financial institutions and their creditors but not others in an ad hoc way without a clear and understandable framework. While other factors were certainly at play, these government actions should be first on the list of answers to the question of what went wrong.

I love seeing Taylor unleashed like this--no U.S. Treasury position holding him back now. (Note to critics: in the last sentence above he acknowledges other "factors were at play", he never denied this point) Taylor continues his assault on poorly designed and executed U.S. macroeconomic policy in an interview with Tom Keene of Bloomberg. Listen to the interview here.

Update: John Taylor continues his critique of Fed policy at the AEA meeetings while Josh Hendrickson provides a nice overview of Taylor's paper.

The Hangover Debate

Do certain economic booms inevitably require economic busts? Are recessions sometimes the painful but necessary way to correct the buildup of past economic imbalances? Paul Krugman says no to this line of reasoning and calls it the "hangover theory" of the business cycle. Steven Randy Waldman replies that while not every business cycle fits the "hangover theory", some of them do. Consequently, he believes the hangover theory should not be so easily dismissed. Mike Shedlock also replies by showing in great detail how the past housing boom-bust cycle fits quite well the hangover theory. Finally, Justin Fox weighs in on the matter, but ultimately decides to ride the fence on this question.

My own view is similar to Waldman's--some but not all boom-bust cycles fit the hangover theory. I think this view can be best illustrated by the double-dip recessions of Paul Volker in the early 1980s that are now credited with (1) eliminating double digit inflation and, in turn, (2) laying the foundation for the subsequent 20+ years relative macroeconomic stability.

What Happened to the 1,911,000 Lost Jobs?

Mark Thoma directs us to a stunning claim made by Casey Mulligan in the New York Times:

[T]he decreased employment is explained more by reductions in the supply of labor (the willingness of people to work) and less by the demand for labor (the number of workers that employers need to hire).

If true, this claim means most of the 1,911,000 jobs lost since December 2007 are the result of voluntary choices made by employees. This interpretation probably strikes most observers as ridiculous, but before we dismiss it out of hand let's take a look at the employment data. The place for data on this question is the BLS's Job Opportunity and Labor Turnover Survey (JOLTS). This survey provides data on job openings, hires, and separations, and goes back to December 2000.

Let's first take a look at the JOLTS data on "quits" and "layoffs & discharges". The quits category is defined as "employees who left voluntarily" and does not include retirees or transfers to other locations. The layoffs and discharges category is self explanatory, but here is the JOLTS definition if you are interested. I have graphed these two series below through the last data point available, October 2008 (click on figure to enlarge):



Note that the number of voluntary quits has actually declined over the past two years, indicating workers are not leaving their jobs en masse as suggested by Mulligan. So much for the labor supply contraction. Layoffs & discharges, on the other hand, show a upward trend over the past two years. The increase in layoffs & discharges, however, is quite modest and that may be surprising to some observers given the large number of lost jobs this year. The modest increase in layoffs & discharges, though, is more than made up for with the lack of new job openings and hires (definitions here) as can be seen in the figure below (click on figure to enlarge):


This last graph highlights an interesting point raised by Robert Hall: employment typically falls during a recession not because of a huge increase in job losses, but because new jobs are harder to find. Either way, weakened labor demand is the source of the employment reduction. The JOLTS data show this to be the case for the current U.S. recession.

Fiscal Policy Stimulus Smackdown

The usually reserved Tyler Cowen comes out swinging in this rebuttal to Paul Krugman and other fiscal policy stimulus proponents. He provides a number of good critiques, but this one I think is key:

Note that under standard theory neither monetary nor fiscal policy will set right the basic problems from negative real shocks and indeed the U.S. economy is undergoing a series of massive sectoral shifts. That includes a move out of construction, a move out of finance, a move out of debt-financed consumption, a move out of luxury goods, the collapse of GM, and a move out of industries which cannot compete with the internet (newspapers, Borders, etc.)

I've never seen a stimulus proponent deny this point about real shocks but I don't see them emphasizing it either. It should be the starting point for any analysis of fiscal policy but so far it is being swept under the proverbial rug.

Josh Hendrickson makes a similar point here in his discussion of what macroeconomic theory has to say about this crisis. My belief is that macroeconomic policy should aim to stabilize nominal spending while these negative real shocks are being worked out. This can be most easily accomplished through the existing policies of (1) shoring up the financial sector and (2) quantitative easing by the Fed. Note that it was the equivalent of these two policies in the 1930s the ended the Great Depression, not fiscal policy stimulus.

Saint Nick Brings Good Economic Cheer This Holiday Season

Okay, it was not really Saint Nick but Nick Rowe who gave me some economic cheer this holiday season. He did so by addressing, in part, my concern about the deterioration of the Fed's balance sheet over at Econbrowser. There, Nick reassures me that this deterioration is nothing to fear, but is the equivalent of the now-needed helicopter money drop:

Let's compare the Fed's "gamble" with helicopter money.

With a "helicopter" increase in the money supply, the Fed's balance sheet shows a new liability, and no new asset.

That is equivalent to the Fed buying an asset, with newly-printed money, and then the asset turning out to be worthless.

In other words, if you believe that a "helicopter" increase in the money supply is what is needed to get the economy out of a liquidity trap, then the destruction of the Fed's balance sheet net worth is exactly what the Fed is trying to achieve.

The only difference between helicopter money and the Fed's buying a worthless asset is in who gets the money: the person who picks it up off the ground (i.e. the one who receives the government transfer payment); or the person who sold the fed the worthless asset.

Let me put it another way: if it lost the gamble, the Fed would be forced to print money to make the same monthly transfer to Treasury, and this would be inflationary. But the expectation of future inflation is exactly what the Fed needs to create now, to escape the liquidity trap. This is a gamble the Fed wants to "lose".

This is a very interesting take on the changes in the Fed's balance sheet, one that Nick Rowe further elaborates on over at the Worthwhile Canadian Initiative. He is beginning to give me hope that maybe there is a well-thought out plan behind the deterioration of the Fed's balance sheet. What would fully bring me peace is if Nick Rowe could also explain what the Fed will do once the recovery is secured and inflationary pressures loom.

Update: See the comment section for Nick's answer to my question on inflationary pressures.

Misery Loves Company: Recession Edition

Justin Wolfers recently reported poll data that shows the current recession is taking a steep toll on self-reported measures of well being. His posting confirms what other related studies indicate will happen over this recession: happiness will see a marked decline. But wait, Sonja Lyubomirsky writing in the NY Times tells us that happiness has not declined as much as it could and, as a result, we are still relatively happy. (ht Mark Thoma) Why? Lyubomirsky says it is because relative rather than absolute economic status that matters:

Research in psychology and economics suggests that when only your salary is cut, or when only you make a foolish investment, or when only you lose your job, you become considerably less satisfied with your life. But when everyone from autoworkers to Wall Street financiers becomes worse off, your life satisfaction remains pretty much the same.

Indeed, humans are remarkably attuned to relative position and status. As the economists David Hemenway and Sara Solnick demonstrated in a study at Harvard, many people would prefer to receive an annual salary of $50,000 when others are making $25,000 than to earn $100,000 a year when others are making $200,000.

Similarly, Daniel Zizzo and Andrew Oswald, economists in Britain, conducted a study that showed that people would give up money if doing so would cause someone else to give up a slightly larger sum. That is, we will make ourselves poorer in order to make someone else poorer, too.

Findings like these reveal an all-too-human truth. We care more about social comparison, status and rank than about the absolute value of our bank accounts or reputations.

[...]

So in a world in which just about all of us have seen our retirement savings and home values plummet, it’s no wonder that we all feel surprisingly O.K.

So while we are not happy as we were at the peak of the housing boom, we are not as miserable as we should be giving our absolute economic condition. While this interpretations seems plausible to me, I assume it only applies within certain bounds. (e.g. Would most people really prefer dire poverty for everyone just to eliminate a some variance in the standard of living?) For now, though, it provides a silver lining amidst the economic distress.

Macroeconomic Insights on the Current Crisis

Josh Hendrickson reviews modern macroeconomic theory and explains what it has to say about our current economic situation.