Acemoglu on Growth and Innovation

Posted by: Michael Mandel on January 14

Daron Acemoglu, whom I identified here as one of the leaders of innovation economics, has written a paper titled The Crisis of 2008: Structural Lessons for and From Economics. It's being widely quoted and criticized. Mark Thoma has a post titled Acemoglu: The Models are Broken. Arnold Kling likes Acemoglu's essay, calling it "highly recommended". But Yves Smith calls the analysis in the essay "shallow and profession serving".

I'm going to focus on a different part of the Acemoglu essay than these commentators. I'm going to focus on his analysis of growth and innovation, as it relates to the crisis. Acemoglu writes:

Barring a complete meltdown of the global system, even with the ferocious severity of the global crisis, the possible loss of GDP for most countries is in the range of a couple of percentage points, and most of this might have been unavoidable given the overexpansion of the economy in the prior years. In contrast, modest changes in economic growth will accumulate to much larger numbers within one decade or two. Thus, from a policy and welfare perspective, it should be self-evident that sacrificing economic growth to deal with the current crisis is a bad option.

followed by

Recent events have not shed doubt on the importance of innovation. On the contrary, we have enjoyed prosperity over the past two decades because of rapid innovations quite independent from financial bubbles and troubles. We witnessed a breakneck pace of new innovations in software, hardware, telecommunications, pharmaceuticals, biotechnology, entertainment, and retail and wholesale trade. These innovations are responsible for the bulk of the increases in aggregate productivity we enjoyed over the past two decades. Even the financial innovations, which are somewhat tainted in the recent crisis, are in most cases socially valuable and have contributed to growth. Complex securities were misused to take risks with the downside being borne by unsuspecting parties. But when properly regulated, they also enable more sophisticated strategies for risk sharing and diversification. They have enabled and will ultimately again enable…firms to reduce the cost of capital. Technological ingenuity is the key to the prosperity and success of the capitalist economy. New innovations and their implementation and marketing will play a central role in renewed economic growth in the aftermath of the crisis.

I think this point is being dramatically overlooked in the rush of today's crisis. Innovation is essential, and probably the only way out of the mess in the long run.

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Retail Sales Plummet: The Consumer Crunch Arrives

Posted by: Michael Mandel on January 14

I haven't been tooting my own horn very much, because like almost everyone else I missed the magnitude of the downturn.

However, I did expect the collapse in retail sales that was reported today (down 5.6% over the past year, even leaving out gasoline stations). Back in November 2007, I wrote a cover story entitled "The Coming Consumer Crunch. " Back then I wrote:

It's been a glorious run for the consumer. In the past 25 years, Americans have kept shopping through good times and bad. In every quarter except one since 1981, consumer spending rose over the previous year, adjusted for inflation. The exception was the first quarter of 1991, and even then the decrease was a mild 0.4% dip.

The main fuel for the spending was easy access to credit. Banks and other financial institutions were willing to lend households ever increasing amounts of money. Any particular individual might default, but in the aggregate, loans to consumers were viewed as low-risk and profitable.

The subprime crisis, however, marks the beginning of the end for the long consumer borrow-and-buy boom. The financial sector, wrestling with hundreds of billions in losses, can no longer treat consumers as a safe bet. Already, standards for real estate lending have been raised, including those for jumbo mortgages for high-end houses. Credit cards are still widely available, but it may only be a matter of time before issuers get tougher.

What comes next could be scary—the largest pullback in consumer spending in decades, perhaps as much as $200 billion to $300 billion, or 2%-3% of personal income. Reduced access to credit will combine with falling real estate values to hit poor and rich alike. "We're in uncharted territory," says David Rosenberg, chief North American economist at Merrill Lynch (MER ), who's forecasting a mild drop in consumer spending in the first half of 2008. "It's pretty rare we go through such a pronounced tightening in credit standards."

Don't expect the spending to come to a screeching halt, however. Remember the stock market peak in early 2000? It wasn't until a year later that tech spending fell off the cliff and the sector didn't hit bottom until 2003. The same delayed impact holds true here. The latest retail sales numbers, which showed a soft 0.2% gain in October, suggest that spending may hold up through this holiday season.

Next year, though, will be much tougher. The consumer slump may be deep and long-lasting, and the political implications could be enormous.

Consumer spending is *not* going to come back anytime soon.

We now return you to our regularly scheduled programming.

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American Recession, Chinese Depression? Parallels to 1929

Posted by: Michael Mandel on January 12

Is China today like the U.S. in 1929?

This morning brings reports that U.S. imports plummeted in November.Since August non-petroleum imports, adjusted for inflation, are down 10% with no sign yet of a bottom.

At the same time, Chinese exports are starting to fall. According to this morning's report,

Exports were down 9 percent from a year earlier in yuan — a jolting deceleration for a country where exports were still growing at an annual rate of nearly 30 percent in the summer of 2007.

The odds are that this decline in Chinese exports will continue. What does this mean for China's economy?

Here's one clue. If we look back at the Great Depression, we see that the U.S. was hit harder than virtually any other European or Asian country. For example, between 1929 and 1932, industrial production plunged by 45% in the U.S., compared to 41% in Germany, 26% in France, and 11% in Britain (see table 1 here )

Measures of real GDP shows an even bigger disparity between the U.S. and other countries in the Great Depression.

The plunge in U.S. real GDP from 1929 to 1933 was far bigger than comparable countries, at least according to data from Angus Maddison.

Why the disparity? There’s all sorts of reasons, relating to monetary policy and other factors. But in part, the U.S. was hit harder because it was a ‘trade surplus’ country—that is, a net exporter of goods. By contrast, Great Britain (for example) was running a sizable merchandise trade deficit in 1929, so cutbacks in spending would be felt more outside of Britain.

The question now is whether China, and more generally the trade surplus countries of East Asia, are going to play the role of the U.S., as acted out in 1929 and the years that followed. Already Korean and Taiwan exports have been collapsing (see Brad Setser here)

Michael Pettis, a professor at Peking University’s Guanghua School of Management, has been arguing the position that trade surplus countries such as China are going to be hit hard. He writes here:

We are now in the second stage of the crisis, in which trade-surplus countries must adjust after the forced adjustment in trade deficit countries. However, the US is so much larger than China, and it is adjusting so rapidly, there’s a real risk that the Chinese economy will be overwhelmed. Policymakers, especially in the US and China, must ensure that this adjustment takes place in the least disruptive way possible. This requires that as the major trade deficit and trade surplus countries, the US and China must coordinate fiscal and monetary policy so as to slow the process down.

I think there's a very good chance that by this time next year, the economic damage in China will be worse than in the U.S.

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Why Big Tax Cuts Are Essential

Posted by: Michael Mandel on January 10

Let’s get this straight right away. I’m not a dogmatic supply-sider, who believes that tax cuts are the solution to all economic ills.

But I believe that Obama's $300 billion tax cut is essential to ‘recapitalize’ the American consumer, just like the banks are being recapitalized.

Think about it this way. This economic crisis consists of three parts:

--Mountains of bad loans, which are weighing down banks and other financial institutions
--Rapid retrenchment by businesses, which is causing them to cut jobs and investment
--Trillions of dollars in excess consumer debt, which is forcing households to cut back on spending.

These three factors together are feeding on each other. Because banks are lending less, it's harder for businesses and consumers to spend. Because businesses are cutting workers so quickly, loan defaults are rising and it's harder for consumers to pay back debt. And because consumer debt has risen from 96% of disposable income in 2000 to 130% of disposable income today, Americans are completely maxed out. As a result, any job cuts immediately mean more loan defaults.

All three of these problems need to be addressed in order to keep the economy afloat. First, the purpose of the $700 billion in TARP money was to help ‘recapitalize’ the financial system, through injection of money directly into banks and other financial institutions. That must continue until it’s clear that defaults have peaked, which may not be until 2010.

Second, the rising unemployment rate can be directly addressed by government spending programs which create or preserve jobs. Giving money to hard-pressed state and local governments can avoid unnecessary job cuts in education and health care. Infrastructure programs can add construction jobs. And the variety of energy programs that Obama is proposing can goose up an essential sector.

That leaves the consumer. The conventional economic wisdom these days seems to be that tax cuts or tax credits are bad because people save the money, rather than spending it. For example, an article in today's New York Times says:

But economists said the tax credit could have drawbacks as an economic stimulus measure, mainly because people usually save part of the money or use it to pay down debt. That makes good sense from an individual’s standpoint but does nothing to increase economic activity.

But this conventional argument misses the whole point. Consumers have a massive hole in their balance sheets these days. Home prices are plunging, incomes are slowing, and many families have huge debts. Americans are staggering.

From this perspective, the main purpose of the tax cuts and tax credits is to help repair consumer balance sheets, just like the TARP is helping repair bank balance sheets. I don't want consumers to spend the tax cuts--I want them to save the money, as much as possible, and get their debt back to reasonable levels. That’s the only to ensure that consumers will be on solid ground when the recession is finally over.

Edmund Phelps, the Nobel Prize winner, made a similar point at his talk at the recent economics meeting in San Francisco. He said:

Stimulating household consumption is not the best remedy for the fallout of the financial crisis...Weren't we all saying that households are overconsuming?

So the three prongs of the stimulus package serve distinctly different purposes. The TARP recapitalizes the banks, with $700 billion. The tax cut, at $300 billion, recapitalizes the consumer. And the government spending program--say, $500 billion--provides the missing demand and jobs.

Now, all of these numbers, though huge, are probably just a downpayment. My best guess is that we'll have to do it at least one more time. But in any event, a tax cut--even if it is saved--is an essential part of any recovery package.

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The Financial Crisis at the Economics Convention

Posted by: Michael Mandel on January 04

I'm at the annual economics conference in San Francisco. I've been going to these things, on and off, since I was a grad student in the early 1980s. Because of the combination of the financial crisis and the new president, there's a sense of urgency here which I don't recall from the past, even during previous downturns.

So far, the star of the first day of the conference has been Ken Rogoff of Harvard, with a paper in the morning, being the featured speaker at lunch, and then participating in the afternoon on a panel on the crisis. His message is a gloomy one: There's a lot further down to go.

He compared the U.S. crisis to the big financial disasters in the past, and suggested that we are following much the same path. In each of these, the devastation was enormous.

Here's some historical data he showed at lunch, taken from his new paper with Carmen M. Reinhart, entitled "The Aftermath of Financial Crises." (I copied the data from his slide, and then checked it against his paper). The data represents the average from a large number of historical financial crises.

Rogoff made particular note of the enormous rise in government debt in a crisis. Historically, government debt balloons not just because of the cost of bailouts,but because of the fall in tax revenues and rise in government spending.

A couple more Rogoff points: At lunch he predicted "what we will see next is a wave of sovereign defaults." At the afternoon panel, he added "We'll be seeing second and third bailouts of the big banks."

Finally, Rogoff observed at lunch that "A depression is to economists like a plague is to morticians." I'm not quite sure what that means, but it doesn't sound good.

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