Economist's View

A Counter Example to the 'Tragedy of the Commons'

Running late -- have a dissertation proposal defense to get to, then a final to give to my Ph.D. students -- so a quick one:

A Counter Example to the "Tragedy of the Commons", by Matthew Kahn: ...This OP-ED by Andrew Kahrl is actually quite interesting. ... For at least 20 years, I have lectured on the "tragedy of the commons" that takes place both in cities and in the oceans. Consider a smoker in a city...[numerical example]. This is a simple example of the tragedy of the commons --- this smoker unintentionally degraded the commons as he pursued his privately optimal action. The same logic applies to over-fishing in common oceans. One "solution" to this property rights issue is to privatize the commons and the owner would charge a price to allow the smoker to smoke and the smoker would only smoke if he is willing to pay this fee.

We can now evaluate Professor Kahrl's claims. He argues that the privatization of beaches in the Northeast is the reason that Hurricane Sandy caused so much damage.

He writes; "By increasing the value of shoreline property and encouraging rampant development, the trend toward privatizing formerly public space has contributed in no small measure to the damage storms like Hurricane Sandy inflict. Tidal lands that soaked up floodwaters were drained and developed. Jetties, bulkheads and sea walls were erected, hastening erosion. And sand dunes — which block rising waters but also profitable ocean views — were bulldozed." ...

Kahrl is saying that capitalism and the pursuit of aesthetic beauty nudged us to drop our guard and destroy Mother Nature's coastal defense system. .... For this claim to be true, he must assume that the tragedy of the commons would not have degraded such natural capital. This may be true.

Mother Nature is now engaging in a takings as she tries to seize coastal property from incumbent owners. I say let her win. These place based stakeholders want to use your tax dollars as funds to build a wall around them. A compromise would be for the state government to buy these properties and knock them down and revitalize the natural capital adaptation strategies that the author lists. ...

Miracles Can Happen, But Probably Won't

Antonio Fatas reacts to the Republican counterproposal on the budget:

Planning for (fiscal) miracles, by Antonio Fatas: The debate in the US about how to deal with the "fiscal cliff" has produced a counterproposal by the Republicans on how to avert a crisis. The proposal is criticized by many because of its lack of details (see here, here, here and here). The way the proposal avoids dealing with the real issues and suggests solutions that do not impose a cost on anyone reminds me of some of the debates in Europe about finding a plan to deal with Greek government debt or the capitalization of Spanish banks. In all these cases you hear proposals that seem to generate resources without anyone having to pay for them. Republicans in the US want to raise revenues without increasing tax rates, cutting spending without really cutting it. And the Spanish government will bailout banks without imposing any cost on taxpayers. In some cases these proposal have no logic in others there is some logic but a lot of wishful thinking that generates economic miracles. ...

Fed Watch: Monetary Policy to Become Easier Next Week?

Tim Duy:

Monetary Policy to Become Easier Next Week?, by Tim Duy: There are two important issues to be discussed at next week's FOMC meeting. One is the issue of specific thresholds as future policy guides. The second is the replacement for Operation Twist. Clearly, support is building for specific thresholds, and I believe policymakers will work out the details within the next meeting or two. Also, I think the general sense is that the Fed will continue to purchase long-term Treasuries after Operation Twist is complete. But will they continue to purchase the full $45 billion a month? That seems like it should be an open question, but it looks like momentum is building in that direction.

St. Louis Federal Reserve President James Bullard offered his thoughts on both these topics yesterday. On the first point, he offers support for replacing the forward guidance with a set of thresholds. I don't find this to be surprising. Bullard has never been a huge fan of the time commitment implied in the current statement. Not only does it send a pessimistic signal about the economy, in theory it should respond more flexibly to evolving economic events. But in practice, the Fed is only willing to alter the date in the event of a substantial shift in the economic outlook.

Bullard cites the 6.5/2.5 unemployment/inflation thresholds recently described by Chicago Federal Reserve President Charles Evans. I am not sure that Bullard specifically endorses these figures, but he may sense the political wind is blowing in that direction. He nicely describes six challenges to a threshold regime:

1. The Fed needs to make clear that in the long-run the Fed cannot target unemployment.
2. He believes the threshold should be on actual outcomes, not forecasts.
3. The Fed needs to communicate that policy is about more than just two variables. For example, he suggests the possibility of raising interest rates to limit asset price bubbles.
4. Unemployment is not the only measure of the labor market. The Fed takes a broader view of labor markets into consideration.
5. Unemployment can remain high, such as in Europe (I think this is really just a restatement of point one).
6. Beware that thresholds will be viewed as triggers, which they are not.

I think these are valid concerns the Fed needs to address as the communication strategy evolves. Bullard then shifts gears to Operation Twist. Currently, large scale asset purchases come in two flavors. One is $40 billion a month in outright mortgage purchases (QE3), the other a monthly swap of $45 billion in short-term Treasuries for an equal amount of long-term Treasuries (Operation Twist). The former is open-ended, the latter concludes this month. Should it be fully converted to an outright asset purchase program? San Francisco Federal Reserve President John Williams gave his opinion last month:

Meeting with reporters following a speech at the University of San Francisco, MNI asked Williams whether he thinks the FOMC should replace the Operation Twist Treasury purchases dollar for dollar upon their expiration Dec. 31. He answered strongly in the affirmative.

"My view is based on the expectation that we won't see substantial improvement in the labor market" for awhile, Williams said, adding that therefore "my view is that we should continue with purchases of long-term Treasuries after December into next year."

Williams said he favors "just purely buying long-term Treasuries at the rate we're buying."

Asked to clarify, Williams said he favors buying MBS and Treasuries "at the same rate we're doing now" -- $85 billion per month.

Boston Federal Reserve President Eric Rosengren agreed yesterday. Operation Twist changes the composition of the balance sheet, not its size. If the Fed converts to an outright asset purchase program, they will more than double the pace of net purchases. In my opinion, this appears to be a substantial easing of policy. Bullard feels similarly:

...on balance I think it is reasonable to think that an outright purchase program has more impact on inflation and inflation expectations than a twist program....

...Replacing the expiring twist program one-for-one with outright purchases of longer-dated Treasuries is likely more dovish than current policy.

I think that is correct; the conversion of Operation Twist should be considered a more aggressive policy. Yet inflation expectations (with the usual caveats about TIPS based expectations) continue to wane:

Perhaps financial market participants do not expect the Fed to commit to the full $85 billion in purchases. But this does not seem to be the case. There has been more than enough Fedspeak to suggest that additional easing is coming. Which leads me again to wonder if monetary policy is now at full throttle? $40, $50, or $85 billion a month. Does it make a difference? Or is the expectation of additional easing simply offsetting expectations of tighter fiscal policy?

Bottom Line: The Fed is gearing up to convert Operation Twist to an outright purchase program. A complete conversion should be considered a more aggressive policy stance. If the Fed wants to hold policy constant, then we would expect a less than one-for-one conversion. There are reasons to expect the Fed would go the full monty. Notably, the fiscal cliff drama already appears to be affecting the economy, even though it is more risk than reality. But why are inflation expectations sliding? And what does that imply about the effectiveness of additional easing at this juncture? Important but as of yet unanswered questions.

Links for 12-05-2012

• 11 shocking facts about Simpson-Bowles - Ezra Klein
• Unionizing at the Low End of the Pay Scale - NYTimes.com
• The midlife crisis in humans and other apes - Andrew Oswald
• Psychodrama Queens, Revisited - Paul Krugman
• How to Get a Budget Deal Instead of the Cliff - Alan Blinder
• The Importance of Unemployment Insurance - Brookings Institution
• The allies who moulded the welfare state - FT.com
• Climate Change Strategies (Including Mangroves) - Tim Taylor
• The Debtor Prisoner’s Dilemma - Harold James
• Industry Structure and Systemic Risk Regulation - FRB - Tarullo
• Degree Inflation? Jobs That Newly Require B.A.'s - NYTimes.com
• The IMF and Capital Controls - Paul Krugman
• Three-Card Budget Monte - Paul Krugman
• Fiscal Slope Negotiations - Menzie Chinn
• Against the Coupon State - Next New Deal

Rogoff: Innovation Crisis or Financial Crisis?

Kenneth Rogoff says our troubles may last awhile but thye aren't permanent:

Innovation Crisis or Financial Crisis?, by Kenneth Rogoff, Commentary, Project Syndicate: As one year of sluggish growth spills into the next, there is growing debate about what to expect over the coming decades. Was the global financial crisis a harsh but transitory setback to advanced-country growth, or did it expose a deeper long-term malaise?

Recently, a few writers, including internet entrepreneur Peter Thiel and political activist and former world chess champion Garry Kasparov, have espoused a fairly radical interpretation of the slowdown. In a forthcoming book, they argue that the collapse of advanced-country growth is not merely a result of the financial crisis; at its root, they argue, these countries’ weakness reflects secular stagnation in technology and innovation. As such, they are unlikely to see any sustained pickup in productivity growth without radical changes in innovation policy.

Economist Robert Gordon takes this idea even further. ...

These are very interesting ideas, but the evidence still seems overwhelming that the drag on the global economy mainly reflects the aftermath of a deep systemic financial crisis, not a long-term secular innovation crisis. ...

Attributing the ongoing slowdown to the financial crisis does not imply the absence of long-term secular effects, some of which are rooted in the crisis itself. ... Taken together, these factors make it easy to imagine trend GDP growth being one percentage point below normal for another decade, possibly even longer. ..

So, is the main cause of the recent slowdown an innovation crisis or a financial crisis? Perhaps some of both, but surely the economic trauma of the last few years reflects, first and foremost, a financial meltdown...

This Heritage Has No Foundation

pgl highlights the Heritage Foundation's response to the Republican budget proposal (though I fear calling it a proposal gives it more credit than it deserves:

Heritage Foundation on the Republican Offer on the Fiscal Cliff: ...let’s turn to Alison Acosta Fraser and J.D. Foster of the Heritage Foundation:

To be fair, the details of the Republican proposal are extraordinarily vague. Nor is much clarity or comfort gained from the three-page accompanying letter sent to the President and signed by Speaker John Boehner (R-OH), Majority Leader Eric Cantor (R-VA), House Budget Committee Chairman Paul Ryan (R-WI), and three other senior members of the House Republican leadership.

...notice that the folks at the Heritage Foundation fear that the Republicans are engaged in “categorical, pre-emptive capitulation”. After all, they prefer that we slash and burn Social Security, Medicare, and Medicaid so as to avoid raising taxes on the very well to do. Not that I agree with their agenda in the slightest – but at least the folks at the Heritage Foundation are a lot clearer about the Republican agenda than is the Speaker of the House.

[On another note, reinforcing the message in my column today on why republicans won't admit supply-side economics has failed, here's the title of a column by Diana Furchtgott-Roth of the Manhattan Institute: Cut Tax Rates, Boost Tax Revenues. It says "Republicans ... want lower tax rates, which, they predict, will lead eventually to higher revenues." They just can't give this up.]

Why the GOP Won't Admit That Supply-Side Economics Has Failed

The Bush tax cuts have not delivered the economic growth and widely shared prosperity that were promised, and if the Republican Party was really the party of business it would end our bad investment in supply-side economics:

    Why the GOP Won't Admit That Supply-Side Economics Has Failed - Mark Thoma

But maybe the tax cuts were about something else?

Links for 12-04-2012

• Forget the Cliff, Fix the U.S. Tax System - Stevenson and Wolfers
• Few of us show a consistent approach to financial risk - MIT News
• High-Speed Trades Hurt Investors, a Study Says - NYTimes.com
• Volcker Rule: “Market Making” and the SEC - Economics of Contempt
• Fed’s Rosengren Supports Bond Buying Into 2013 - WSJ
• External Shocks and China’s Monetary Policy - FRBSF Economic Letter
• It's Health Care Costs, Stupid - Paul Krugman
• Free Market Fairness - O’Neill and Williamson
• The Daily’s Demise - Digitopoly
• Just what is a recession? - The Economist
• Greedy Geezers, Reconsidered - Robert Kuttner
• Can the States Sabotage Obamacare? - Greg Anrig
• Europe’s Economic War of Attrition - Mohamed A. El-Erian
• The Debt Limit Is the Real Fiscal Cliff - Bruce Bartlett
• More Nonsense from Robert Samuelson - Barkley Rosser
• Entitlements Scare Tactics - Baseline Scenario
• 26 Economists You Should Be Following On Twitter - Huffington Post
• David Beckworth might be very wrong about the multiplier - Noahpinion
• Why (or Why Not) Keep Paying Interest on Excess Reserves? - Liberty Street
• Is There a Case for Optimism About the Eurozone? - naked capitalism
• Focal Points and the Short Run Phillips Curve - Nick Rowe
• Inflation: Not so great expectations - The Economist
• The Poverty Line in Low-Income Countries - Tim Taylor

Fed Watch: Apples and Oranges in the Manufacturing Data?

One more from Tim Duy:

Apples and Oranges in the Manufacturing Data?, by Tim Duy: Reporting on today's spate of manufacturing numbers, Neil Irwin at the Washington Post writes:

Just a few months ago, the global economy seemed to be stuck in a precarious state. Huge swaths of the world economy were either slowing down or contracting outright, and it wasn’t at all clear whether global economic policymakers would have enough gas left in their stimulus tanks to stop things from spiraling into a bad place.

But the latest data in a wave of reports on the manufacturing sectors in nations around the world overnight and Monday morning suggest that the world has avoided that fate. The same cannot be said of the United States, however.

I appreciate Irwin's point - many of the global manufacturing reports were better than expected, although I would say only marginally so. And I think this is accurate:

But put it all together, and the portrait painted by the manufacturing reports is of a world economy that isn’t going off the rails. China’s slowdown over the summer was not, so far at least, the start of any broader economic collapse. Europe’s recession is bad, but major European economies aren’t in free-fall. Mario Draghi, president of the European Central Bank, said in an interview with Europe 1 radio Friday that a euro-zone recovery “would start probably in the second half of 2013.” The new numbers Monday seem to fit that forecast; contraction remains underway for now, but the pace of that contraction is slowing.

The European Central Bank has so far prevented a free fall on the continent; whether or not recovery is at hand or the region is faced with a long, grinding period of zero growth remains a subject of debate. Europe's fate will be decided, I suspect, by a lack of fiscal stimulus. As far as the persistence of the recent uptick is concerned, take quick look at the Markit Eurozone PMI:

Notice the upswing in 2011 that was subsequently reversed. Perhaps the same dynamic will happen this time as well?

Where Irwin trips me up is here:

All of which brings us to the United States. The Institute for Supply Management’s purchasing managers’ index fell sharply, to 49.5, from 51.7 in October. The details of the number were simply terrible. The actual level of production activity at American factories actually rose, but new orders fell 3.9 percent, which bodes ill for the future. The employment component of the survey fell to its lowest level since September 2009, which is hardly an optimistic sign for the November jobs numbers due out on Friday.

This is all true, in my opinion, but I am wondering if this is an apples to oranges comparison? Irwin shifts from the Markit PMIs to the ISM PMI data. What was the Markit PMI for US manufacturing? Up, not down as the ISM reported:

What about the underlying details?

In many ways this is almost the mirror image of the ISM report! What's down is up! Headline, new orders, new export orders, and employment all move in opposite directions. Which leads one to wonder which is correct, the ISM or Markit PMI? If ISM is correct, then is Markit also overestimating the strength of manufacturing elsewhere? Honestly, I don't know, but it makes me hesitant to compare the Eurozone Markit PMI to the ISM US PMI to argue that the US is deteriorating relative to Europe.

Bottom Line: The ISM report on manufacturing is widely followed in the US. It is a natural starting point to understand current trends in US manufacturing. It's what I would do. But should we compare it to the Markit PMI reports of other nations? Yes, but with an important caveat - we shouldn't ignore the Markit US PMI data when making such comparisons, especially when it stands at odds with the ISM data.

Fed Watch: Struggling to Gain Traction in Manufacturing

Tim Duy:

Struggling to Gain Traction in Manufacturing, by Tim Duy: The US manufacturing sector is not collapsing. But it is struggling to gain traction, and in doing so throwing up a number of signals that, in the past, have been consistent with recession. I don't think they are telling that story this time, at least not yet. But the end of the year is looking a little more fragile than we would like it to be - and while a good part of that fragility is a consequence of the international sector, it is hard to ignore the role of fiscal policy uncertainty as a depressing force on economic activity.

Last week's advanced manufacturing report was hardly inspiring despite the ever so slight rise in core manufacturing orders:

Compared to a year ago, this data still has a recessionary feeling:

The same holds for shipments as well, although to a lesser extent:

Today's ISM release confirms the softness across the manufacturing sector, with the headline number dipping below the expansion/contraction line:

While the production component rose, new orders fell, only part of which can be attributed to the international situation:

Somewhat disconcerting is the ongoing weakness in import orders, a sign of weak domestic demand:

And, of course, the employment component was soft as well:

Let's hope the employment weakness is not spreading far beyond manufacturing. Note also that the softness in recent manufacturing data is carrying forward from broader third quarter trends, notably the decline in the equipment and software component of GDP:

So while the international sector is clearly a drag, the same is increasingly true of the domestic side of the equation. This seems to be confirmed by some of the anecdotal evidence in the ISM survey, for example:

"The principle business conditions that will affect the company over the next three or four quarters will be the U.S. federal government tax and budgetary policies; the impact of those policies is not yet clear." (Petroleum & Coal Products)

"The fiscal cliff is the big worry right now. We will not look toward any type of expansion until this is addressed; if the program that is put in place is more taxes and big spending cuts — which will push us toward recession — forget it." (Fabricated Metal Products)

The fiscal drama playing out in Washington is clearly impacting decision makers. When will this uncertainty be lifted? Calculated Risk is looking for a deal early next year, but that still leaves firms sitting on the sidelines for at least another six weeks. And note that "compromise" certainly means additional austerity. We are talking about the degree of austerity. In other words, fiscal policy will continue to be a drag into 2013. Also, Bruce Bartlett points out that the fiscal cliff is a fake problem while the real threat is the debt ceiling - read his latest on the topic and some thoughts about the implications for the president. Recall that it was the debt ceiling debate that roiled markets in the summer of 2011.

Altogether, the US economy is ending the year on a weak note, with the externally-derived weakness being compounded by expectations of further fiscal austerity and fears of severe fiscal austerity. These factors are taking the wind out of the sails of the momentum provided by improvement in the housing market:

Also note that car sales bounced back strongly in November (See Calculated Risk), a sign that the negative household spending impact of Hurricane Sandy was temporary. Unlike businesses, households have been resilient to the fiscal cliff drama; I doubt that will change unless the fears became reality and the job market turns south.

Bottom Line: 2013 is shaping up to be another slow year for the US economy. The manufacturing slowdown is real, and is being compounded by fiscal policy concerns, both real and imagined. This, of course, should be no surprise. When at the zero bound, austerity is always and everywhere an economic drag. However, it would be unusual for the US economy to slip into a recession in the midst of a housing recovery. I think the path to recession in 2013 is through the unlikely event that the worst fiscal cliff nightmares are indeed realized. That said, continuing slow growth itself would make 2013 yet another disappointing year in the recovery.

'Lessons from a Half Century of Federal Individual Income Tax Changes'

Owen Zidar:

... I find that heterogeneity is quite important, that almost all of the stimulative effect of tax cuts results from tax cuts for the bottom 90%, and that there is no substantial link between tax cuts for the top 10% and subsequent job creation. The notion that raising top rates slightly leads to substantially lower job creation and economic growth has no empirical support from the last half century...

If only evidence mattered. He also has an interesting chart:

Negative entries are tax cuts, and positive entries are tax increases (as he notes, this is federal income tax only, payroll tax changes follow a different pattern). The light blue line is the top 20%.

'Where Most Cuts Should be Coming From'

Michael Froomkin on debt negotiations:

both sides have taken the Pentagon’s budget off the table even though that is where most cuts should be coming from

Robert Reich:

You want to cut, cut spending on the military — which now exceeds the military spending of the next 13 largest military spenders in the world combined.

Works for me.

Paul Krugman: The Big Budget Mumble

Exposing the Republican con game on the deficit:

The Big Budget Mumble, by Paul Krugman:, Commentary, NY Times: In the ongoing battle of the budget, President Obama has done something very cruel. Declaring that this time he won’t negotiate with himself, he has refused to lay out a proposal reflecting what he thinks Republicans want. Instead, he has demanded that Republicans themselves say, explicitly, what they want. And guess what: They can’t or won’t do it.

No, really. While there has been a lot of bluster from the G.O.P. about how we should reduce the deficit with spending cuts, not tax increases, no leading figures on the Republican side have been able or willing to specify what, exactly, they want to cut.

And there’s a reason for this reticence. ...Republican posturing on the deficit has always been a con game, a play on the innumeracy of voters and reporters. Now Mr. Obama has demanded that the G.O.P. put up or shut up — and the response is an aggrieved mumble.

Here’s where we are right now: As his opening bid in negotiations, Mr. Obama has proposed raising about $1.6 trillion in additional revenue over the next decade, with the majority coming from letting the high-end Bush tax cuts expire and the rest from measures to limit tax deductions. He would also cut spending by about $400 billion...

Republicans have howled in outrage. ... They say they want to rely mainly on spending cuts instead. Which spending cuts? Ah, that’s a mystery..., when you put Republicans on the spot and demand specifics about how they’re going to make good on their posturing about spending and deficits, they come up empty. There’s no there there.

And there never was. ... Now Republicans find themselves boxed in. With taxes scheduled to rise on Jan. 1 in the absence of an agreement, they can’t play their usual game of just saying no to tax increases and pretending that they have a deficit reduction plan. And the president, by refusing to help them out by proposing G.O.P.-friendly spending cuts, has deprived them of political cover. If Republicans really want to slash popular programs, they will have to propose those cuts themselves.

So while the fiscal cliff — still a bad name for the looming austerity bomb, but I guess we’re stuck with it — is a bad thing from an economic point of view, it has had at least one salutary political effect. For it has finally laid bare the con that has always been at the core of the G.O.P.’s political strategy.

Links for 12-03-2012

• A Symbolic Slaying - Economic Principals
• Data revisions mean more of the same - Econbrowser
• Operation Rolling Tantrum - Paul Krugman
• The wrong benchmark for tax rates - Antonio Fatas
• Some Economists Doubt Dire Effects of Tax Increases - NYT
• Lunch with Warren Buffett - James Surowiecki
• How to try and get more inflation quickly - mainly macro
• Why do Asian Americans vote so heavily Democratic? - Political Animal
• Can Markets Encourage Wildlife Conservation? - Donald Marron
• Fiscal Policy Bait and Switches - EconoSpeak
• The Keynesian Fixation - askblog
• The Full McConnell - Paul Krugman
• Obama's First-Term Eco-Legacy and the Road Ahead - CityEconomist
• Governments Pay High Price to Attract Businesses - NYTimes.com

'I Don’t Like the Stagnant Median Wage Argument'

Jamie Galbraith's view on wage stagnation might surprise you:

Muddling Towards the Next Crisis: I think there is a tendency on the left to underestimate the success of the programs that created and sustained the middle class and the middle class mentality. There’s a tendency to focus on some statistical aspects of what’s happened to wages—median wages in particular—and to focus less on the role played by Medicaid, Medicare, Social Security, the housing programs, public education, and support for higher education, all of which gave us a population that had the attributes of a middle class society.

The story that is often told about what’s happened to factory jobs, and what’s happened to wage rates, is not a good way of getting at the threat to that existence. The typical story is that median wages peaked in 1972 and have been stagnant and falling since then. As a result, it must be the case that people who are working now are much worse off than they were ten, fifteen, twenty years ago. That’s not an accurate story—at least not up until the crisis in 2008—because over that period the labor force became younger, more female, more minority, and more immigrant. All of these groups start at relatively low wages, and they all then tend to have upward trajectories. So there’s no reason to believe that life was getting worse for members of the workforce in general. On the contrary, for most members of the workforce it was still getting better. Plus they had the benefit of technical change and improvement in the other conditions of life.

The real threat to the middle class is not there, it’s in the erosion of the programs I just mentioned. That is to say, it’s in the attack on the public schools, it’s in the squeeze on higher education, it’s in the threat to Social Security. When you look at housing, you have a very large unambiguous loss. Millions of people have been displaced, but many, many more have lost the capital value of their homes. They won’t be able to sell and retire on the proceeds.

So I think there is a threat to the middle class, but if I were talking about it in political terms, I wouldn’t be giving an abstract statistical picture of wages. This doesn’t connect to people’s experiences. If I were designing the boilerplate rhetoric of a popular movement, I would take a blue pencil to these statistical formulations. I don’t like the stagnant median wage argument—I think it obscures what actually happened. And I don’t particularly care for the “one percent” argument. I understand it has a certain power, but one can be much more precise about what it is you want to attack, and what it is you want to preserve and to build. I would cut to the chase: we need to tear down the financial sector and rebuild it from scratch in a very different way. ...

Let's Get Serious about Getting Serious

Jonathan Weiler:

The Republican Party Should Have Zero Credibility on Deficits, by Jonathan Weiler: Speaker Boehner's angry response to the White House's opening gambit in the budget negotiations related to the so-called fiscal cliff provides a useful opportunity to remind folks that the GOP should have zero credibility on deficit reduction. Boehner claims that the Democrats proposal is not serious and is a bad-faith offer. Coming from him, that's rich. We have a three-decades long record to prove definitively that Republicans are themselves unserious about deficits. That has been evident during periods in which they've controlled the presidency, as both Reagan and W. presided over explosions in our national debt. And we have the account of GOP insider after GOP insider revealing the true motives behind GOP fiscal policy. As far back as 1981, Reagan budget director David Stockman admitted that Republicans' professed concern with the impact of deficits and debts on our children and grandchildren was just a ruse to allow Republicans to avoid responsibility for the adverse consequences of lowering taxes on the rich. Bruce Bartlett, a former Reagan treasury official has explained in detail that the right-wing's rhetorical push against deficits over the past thirty years was not the product of a sincere commitment to fiscal prudence. Rather, Bartlett has shown, the goal was to reduce taxes on the rich, which would starve the government of funds, which would require government to cut spending for the less well off. In other words, the concern was never deficits. The desire was to reduce social spending for those deemed undeserving by the Republicans, including poor children, the struggling elderly and other disfavored groups. Deficits were merely the excuse for doing so. And Vice President Dick Cheney stated as emphatically as he could that, when Republicans hold power, "deficits don't matter." ...

He says "Boehner claims that the Democrats proposal is not serious." Paul Krugman explains:

What Defines A Serious Deficit Proposal?, by Paul Krugman: Just a thought: if you follow the pundit discussion of matters fiscal, you get the definite impression that some kinds of deficit reduction are considered “serious”, while others are not. In particular, the Obama administration’s call for higher revenue through increased taxes on high incomes — which actually goes considerably beyond just letting the Bush tax cuts for the top end expire — gets treated with an unmistakable sneer in much political discussion, as if it were a trivial thing, more about staking out a populist position than it is about getting real on red ink.

On the other hand, the idea of raising the age of Medicare eligibility gets very respectful treatment — now that’s serious. So I thought I’d look at the dollars and cents — and even I am somewhat shocked. Those tax hikes would raise $1.6 trillion over the next decade; according to the CBO, raising the Medicare age would save $113 billion in federal funds over the next decade.

So, the non-serious proposal would reduce the deficit 14 times as much as the serious proposal.

I guess we have to understand the definition of serious: a proposal is only serious if it punishes the poor and the middle class.

Here's an example:

On Sunday, during an appearance on Meet the Press, Sen. Bob Corker (R-TN) reiterated his call for restructuring entitlement programs like Medicare, highlighting the “very painful cuts” he has proposed as part of a package to avert the fiscal cliff. ...

Host David Gregory seemed to agree with Corker’s characterization and pressed fellow panelist Sen. Claire McCaskill (D-MO) to accept reforms that will shift health care costs to seniors in order to show that Democrats are “serious” about entitlements:

CORKER: Look, I laid out in great detail very painful cuts to Medicare. ...

GREGORY: Name some specific programs that ought to be cut that would cause pain in terms of the role of our government that Democrats are prepared to support.

McCASKILL: Well,... a lot of us voted for more cuts in the farm program…and defense. I spent a lot of times in the wings of the Pentagon. if you don’t think there’s more money to be cut in contracting at the pentagon, you don’t understand what has happened at the Pentagon. [...]

CORKER: David, as much as I love Claire, those are not the painful cuts that have to happen. We really have to look at much deeper reforms to the entitlements …

Note the "those are not the painful cuts that have to happen." It's not enough that the cuts be "painful." To actually count and be endorsed, the cuts have to be targeted at particular people and programs.

Links for 12-02-2012

• What Defines A Serious Deficit Proposal? - Paul Krugman
• 4 Companies Provided Half of 2012 Earnings Growth - Big Picture
• An Important Step Forward - Robert Stavins
• A post for Steve Keen - Nick Rowe
• Egalitarian airlines - Frances Woolley
• Latour's Invisible Paris - Dan Little
• Against Willful Denseness, The Gods Themselves... - Paul Krugman
• The real reason some colleges make SATs optional - James Choi
• Mandated Employer Health Insurance and Small Business - EconoSpeak

'Europe’s Avoidable Collision Course'

Tyler Cowen on Europe:

... Until a broad solution is enacted, the system remains within the danger zone for a broader crash. ... Unfortunately, the relevant governments — and their citizens — still don’t seem close to accepting the onerous financial burdens they need to face. And when those burdens are unjust to mostly innocent voters, no matter whose particular story you endorse, acceptance becomes that much tougher.

Still, we shouldn’t forget that a solution exists. In essence, the required debt write-down is a large check lying on the table waiting to be picked up. No one knows how costly it is, but estimates have ranged from the hundreds of billions to the trillions of dollars. It need only be decided how to divide the bill. The reality is this: The longer that the major players wait, the larger that bill will grow. That they’ve yet to split the check is the worst news of all.

Should We Extend the Payroll Tax Cut?

Jared Bernstein says we should renew the payroll tax cut:

When You’re Trying to Decide if We Need to Renew the Payroll Tax Break, Picture This. by Jared Bernstein: It’s just a slide…in both senses of the word…of the real earnings—pretax, which is important—of middle-wage workers: blue collar workers in manufacturing and non-managers in services, adjusted for inflation. And it’s not inflation holding back these wage rates—it’s the weak economy. This series starts in 1964, and in nominal terms, it’s never grown more slowly than it has this year.

Source: BLS

So it is to his great credit that the President proposed another round of the payroll tax break, or something like it, as part of his opening bid for the cliff negotiations... With unemployment still way too high, we need to continue to support workers’ paychecks and temporarily offset some of the fiscal contraction from the tax increases and spending cuts that are likely to come out of the cliff negotiations.

I know that adding a spending program to a deficit reduction package may sound counterintuitive, but it’s really countercyclical. And by dint of being temporary—we could even write in the legislation that it expires when unemployment goes (and stays) below 7%–it won’t affect the medium-term deficit. ...

I think the payroll tax should be extended, but as I noted when this first came up, I'd prefer the "optics" to be different:

I see the payroll tax reduction as potentially troublesome... Though the revenue the Social Security system loses due to the tax cut will be backfilled from general revenues, the worry is that the tax cut will not expire as scheduled -- temporary tax cuts have a way of turning permanent. That's especially true in this case since labor markets are very unlikely to recover within the next year and it will be easy to argue against the scheduled "tax increase" for workers. In fact, it will never be a good time to increase taxes on workers and if the tax cut is extended once, as it's likely to be, it will be hard to ever increase it back to where it was. That endangers Social Security funding -- relying on general revenue transfers sets the system up for cuts down the road -- and for that reason I would have preferred that this be enacted in a way that produces the same outcome, but has different political optics. That is, leave the payroll tax at 6% on the books and keep sending the money to Social Security, and fund a 2% tax "rebate" out of general revenues. The rebate would come, technically, as a payment from general revenues rather than through a cut in the payroll tax, but in the end the effect would be identical. But the technicality is important since it preserves the existing funding mechanism for Social Security even if the taxes are permanently extended.

[On the connection between the payroll tax and support for Social Security, see here. As Bruce Bartlett notes while expressing similar worries, "Arch Social Security hater Peter Ferrara once told me that funding it with general revenues was part of his plan to destroy it by converting Social Security into a welfare program, rather than an earned benefit. He was right."]

Links for 12-01-2012

• Notes on Epistemic Closure - Paul Krugman
• Macro-Finance Linkages - Narayana Kocherlakota
• Large-Scale Asset Purchases - FRB: Stein
• Global Manufacturing: A McKinsey View - Tim Taylor
• The East Asian Miracle 2.0 - Otaviano Canuto
• Pulling the OMT Trigger - Luigi Zingales
• Destructive Responsibility - Paul Krugman
• The Aftermath of a Devastating Hurricane . . . in 1938 - Liberty Street
• Banking reform: Do we know what has to be done? - Wouter den Haan

'The Outlook Has Already Improved'

Laura D’Andrea Tyson:

... The single most important factor behind the projected growth in federal spending is the growth in health care spending, driven primarily by the growth in Medicare spending per beneficiary.

The outlook has already improved as a result of significant changes in the delivery and payment of health care services in the Affordable Care Act. As a result of these changes, growth in Medicare spending per enrollee is projected to slow to 3.1 percent a year during the next decade, about the same as the annual growth of nominal G.D.P. per capita and about two percentage points slower than the annual growth of private insurance premiums per beneficiary.

Speeding up the pace of the Affordable Care Act changes along with others, such as reducing subsidies for high-income beneficiaries and drug benefits and introducing small co-pays on home health-care services, would mean even larger Medicare savings.

A “structural reform” popular among Republican deficit hawks like Representative Paul Ryan of Wisconsin to convert Medicare to a premium-support or voucher system would be counterproductive and would drive up both spending per beneficiary and overall costs in the health care system.

The goal of a “go big” plan for deficit reduction should be to ensure the economy’s long-term growth and competitiveness. Yet the debate over spending in Washington is fixated on cutting entitlement spending. Very little is heard about the need to increase federal spending in education and training, research and development and infrastructure, three areas with proven track records in rate of return, job creation, opportunity and growth. ...

The Real Trust Fund Fiction

Kevin Drum explains that the surplus in the Social Security Trust fund allowed taxes on the wealthy to be cut, and that it's only fair that taxes on the wealthy should go back up to repay the money in the Trust Fund that was used to finance lower taxes. If it's not paid back, then it is, plainly and simply, a raid by the wealthy (through tax cuts) on the funds working class households are relying upon, and are counting on -- they held their end of the bargain and paid more into the system that it needed for decades -- for their retirements:

No, the Social Security Trust Fund Isn't a Fiction, by Kevin Drum: Charles Krauthammer is upset that Dick Durbin says Social Security is off the table in the fiscal cliff negotiations because it doesn't add to the deficit...

What Krauthammer means is that as Social Security draws down its trust fund, it sells bonds back to the Treasury. The money it gets for those bonds comes from the general fund, which means that it does indeed have an effect on the deficit. That much is true. But the idea that the trust fund is a "fiction" is absolutely wrong. ...

Starting in 1983, the payroll tax was deliberately set higher than it needed to be to cover payments to retirees. For the next 30 years, this extra money was sent to the Treasury, and this windfall allowed income tax rates to be lower than they otherwise would have been. During this period, people who paid payroll taxes suffered from this arrangement, while people who paid income taxes benefited.

Now things have turned around. As the baby boomers have started to retire, payroll taxes are less than they need to be to cover payments to retirees. To make up this shortfall, the Treasury is paying back the money it got over the past 30 years, and this means that income taxes need to be higher than they otherwise would be. For the next few decades, people who pay payroll taxes will benefit from this arrangement, while people who pay income taxes will suffer.

If payroll taxpayers and income taxpayers were the same people, none of this would matter. The trust fund really would be a fiction. But they aren't. Payroll taxpayers tend to be the poor and the middle class. Income taxpayers tend to be the upper middle class and the rich. ... When wealthy pundits like Krauthammer claim that the trust fund is a fiction, they're trying to renege on a deal halfway through because they don't want to pay back the loans they got.

As it happens, I think this was a dumb deal. But that doesn't matter. It's the deal we made, and the poor and the middle class kept up their end of it for 30 years. Now it's time for the rich to keep up their end of the deal. Unless you think that promises are just so much wastepaper, this is the farthest thing imaginable from fiction. It's as real as taxes.

Paul Krugman: Class Wars of 2012

The class war isn't over:

Class Wars of 2012, by Paul Krugman, Commentary, NY Times: On Election Day ... Logan International Airport in Boston was running short of parking spaces. Not for cars — for private jets. Big donors were flooding into the city to attend Mitt Romney’s victory party.

They were, it turned out, misinformed about political reality. But the disappointed plutocrats weren’t wrong about who was on their side. This was very much an election pitting the interests of the very rich against those of the middle class and the poor.

And the Obama campaign won largely by disregarding the warnings of squeamish “centrists” and ... stressing the class-war aspect of the confrontation. This ensured not only that President Obama won by huge margins among lower-income voters, but that those voters turned out in large numbers, sealing his victory.

The important thing to understand now is that while the election is over, the class war isn’t. The same people who bet big on Mr. Romney, and lost, are now trying to win by stealth — in the name of fiscal responsibility — the ground they failed to gain in an open election. ...

Consider, as a prime example, the push to raise the retirement age, the age of eligibility for Medicare, or both. This is only reasonable, we’re told — after all, life expectancy has risen... In reality,... it would be a hugely regressive policy change...

Or take a subtler example, the insistence that any revenue increases should come from limiting deductions rather than from higher tax rates. The key thing to realize here is that the math just doesn’t work... So any proposal to avoid a rate increase is, whatever its proponents may say, a proposal that we let the 1 percent off the hook and shift the burden, one way or another, to the middle class or the poor.

The point is that the class war is still on, this time with an added dose of deception. And this, in turn, means that you need to look very closely at any proposals coming from the usual suspects, even — or rather especially — if the proposal is being represented as a bipartisan, common-sense solution. ...

So keep your eyes open as the fiscal game of chicken continues. It’s an uncomfortable but real truth that we are not all in this together; America’s top-down class warriors lost big in the election, but now they’re trying to use the pretense of concern about the deficit to snatch victory from the jaws of defeat. Let’s not let them pull it off.

Links for 11-30-2012

• Speculation Regarding Asian-American Voting Patterns - Menzie Chinn
• Most Americans Face Lower Tax Burden Than in the 80s - NYT
• Is it a sin for the central bank to help reduce debt? - mainly macro
• Evidence for Man-Made Climate Change Stronger - Scientific American
• Dropping the Ball on Financial Regulation - Simon Johnson
• Dark Matter: A Quick Revisit - Twenty-Cent Paradigms
• Varieties of Error - Paul Krugman
• A Flood from the Past - Environmental Economics
• The BP Spill: What's the Environmental Damage? - Tim Taylor
• Keep the net beyond the autocrats’ reach - FT.com
• A new paradigm shift for the infant universe - EurekAlert
• Grover Norquist Gets Schelling 101 - Cheap Talk
• The Stunning Cost of Bad Economic Ideas - Matthew O'Brien
• Applying Evidence to Social Programs - NYTimes.com
• The unintended consequences: QE - The Economist
• The Road to Serfdom: Good Hayek or Bad Hayek? - Uneasy Money
• Veblen on universities - UnderstandingSociety
• Payday loans: statism vs libertarianism - Chris Dillow
• The U.S. economy grew 2.7% last quarter - Brad Plumer

'High-Frequency Trading and High Returns'

Have to teach classes in a bit, and running late, so just have time for a quick post -- this is from Ricardo Fernholz, a professor of economics at Claremont McKenna College:

High-Frequency Trading and High Returns, The Baseline Scenario: The rise of high-frequency trading (HFT) in the U.S. and around the world has been rapid and well-documented in the media. According to a report by the Bank of England, by 2010 HFT accounted for 70% of all trading volume in US equities and 30-40% of all trading volume in European equities. This rapid rise in volume has been accompanied by extraordinary performance among some prominent hedge funds that use these trading techniques. A 2010 report from Barron’s, for example, estimates that Renaissance Technology’s Medallion hedge fund – a quantitative HFT fund – achieved a 62.8% annual compound return in the three years prior to the report.

Despite the growing presence of HFT, little is known about how such trading strategies work and why some appear to consistently achieve high returns. The purpose of this post is to shed some light on these questions and discuss some of the possible implications of the rapid spread of HFT. ...

DeLong: America’s Political Recession

Since Brad DeLong is such a shy, wallflower type, I'll take it upon myself to highlight his latest column:

America’s Political Recession, by Brad DeLong, Commentary, Project Syndicate: The odds are now about 36% that the United States will be in a recession next year. The reason is entirely political: partisan polarization has reached levels never before seen, threatening to send the US economy tumbling over the “fiscal cliff”...

Obama broadly follows Ronald Reagan’s (second-term) security policy, George H.W. Bush’s spending policy, Bill Clinton’s tax policy, the bipartisan Squam Lake Group’s financial-regulatory policy, Perry’s immigration policy, John McCain’s climate-change policy, and Mitt Romney’s health-care policy... And yet he has gotten next to no Republicans to support their own policies. ...

There are obvious reasons for this. A large chunk of the Republican base, including many of the party’s largest donors, believes that any Democratic president is an illegitimate enemy of America, so that whatever such an incumbent proposes must be wrong and thus should be thwarted. ... Moreover, ever since Clinton’s election in 1992, those at the head of the Republican Party have believed that creating gridlock whenever a Democrat is in the White House ... is their best path to electoral success.

That was the Republicans’ calculation in 2011-2012. And November’s election did not change the balance of power anywhere in the American government...

Now, it is possible that Republican legislators may rebel against their leaders... It is possible that Republican leaders like Representatives John Boehner and Eric Cantor and Senator Mitch McConnell will conclude that their policy of obstruction has been a failure. ... But don’t count on it. ...

It seems to me that the odds are around 60% that real negotiation will not begin until tax rates go up on January 1. And it seems to me that, if gridlock continues into 2013, the odds are 60% that it will tip the US back into recession. Let us hope that it will be short and shallow.

Nah, the press will do its job, expose the fraud that underlies the Republican's budget and tactics, and they will be forced to fold their hand (are you laughing yet -- that's supposed to be a joke).

'Bring Back Real Competition to the Telecom Industry'

Are you tired of paying too much for low-quality cable, internet, and phone services?:

Bad Connections, by David Cay Johnston, Commentary, NY Times: Since 1974, when the Justice Department sued to break up the Ma Bell phone monopoly, Americans have been told that competition in telecommunications would produce innovation, better service and lower prices.

What we’ve witnessed instead is low-quality service and prices that are higher than a truly competitive market would bring.

After a brief fling with competition, ownership has reconcentrated into a stodgy duopoly of Bell Twins — AT&T and Verizon. ...

The AT&T-DirectTV and Verizon-Bright House-Cox-Comcast-TimeWarner behemoths market what are known as “quad plays”: the phone companies sell mobile services jointly with the “triple play” of Internet, telephone and television connections, which are often provided by supposedly competing cable and satellite companies. And because AT&T’s and Verizon’s own land-based services operate mostly in discrete geographic markets, each cartel rules its domain as a near monopoly.

The result of having such sweeping control of the communications terrain, naturally, is that there is little incentive for either player to lower prices, make improvements to service or significantly invest in new technologies and infrastructure. And that, in turn, leaves American consumers with a major disadvantage compared with their counterparts in the rest of the world. ...

The remedy ... is straightforward: bring back real competition to the telecom industry. The Federal Communications Commission, the Justice Department and lawmakers have long said this is their goal. But absent new rules that promote vigorous competition among telecom companies, it simply won’t happen.

Just as canals and railroads let America grow in the 19th century, and highways and airports did so in the 20th century, the information superhighway is vital for the nation’s economic growth in the 21st. The nation can’t afford to leave its future in the hands of the cartels.

Links for 11-29-2012

• The Different Paths of Greece/Spain to High Unemployment - Liberty Street
• Who killed the CRS report? - Steve Benen
• Exploiting Reciprocation - Cheap Talk
• End Federal Flood Insurance - NYTimes.com
• The Growing Burden of Payroll Taxes - NYTimes.com
• U.S. Treasury vs. Fed: You Say Long, I Say Short - RTE
• Bungee-Jumping Over the Fiscal Cliff - Robert Reich
• Putting a Spotlight on the Arbitration Industry - TripleCrisis
• The Benefits of the Safety Net - Freakonomics
• Social Security and the National Debt - Baseline Scenario
• The Right’s Post-Election Self-examination - askblog
• Monetary policy: First, assume a can-opener - The Economist
• International Capital Flows Slow Down - Tim Taylor
• CBO: Extending unemployment saves 300,000 jobs - Washington Post

'Romney is Wall Street’s Worst Bet Since the Bet on Subprime'

This is from a much longer Ezra Klein interview of Chrystia Freeland:

‘Romney is Wall Street’s worst bet since the bet on subprime’, by Ezra Klein: Ezra Klein: You’ve written about the revolt of the very rich against President Obama, and all the money they spent and time they dedicated to defeating him. So what’s the mood in those circles now that they’ve lost?

Chrystia Freeland: There’s a great joke on Wall Street which is that the bet on Romney is Wall Street’s worst bet since the bet on subprime. But I found the hostility towards Obama astonishing. ... On that Tuesday, the big Romney backers I was talking to were sure he was going to win. They were all flying into Logan Airport for the victory party. There’s this stunned feeling of how could we be so wrong, and a feeling of alienation.

The Romney comments to his donors,... I think they accurately reflected the view of a lot of these money guys. It’s the continuation of this 47 percent idea. They believe that Obama has been shoring up the entitlement society, and if you give enough entitlements to enough people, they’ll vote for you.

EK: Here’s my question about those comments. Romney was promising the very rich either a huge tax cut or, if you believe he would’ve paid for every dime and dollar of his cut, protection from any tax increases. He was promising financiers that he would roll back Dodd-Frank and Sarbanex-Oxley. He was promising current seniors that he wouldn’t touch their benefit. How are these not “gifts”?

CF: Let me be clear that I’m not defending any of them. But I think the way it works — and I think Romney’s comments were very telling in this regard — ...they’re absolutely convinced that they’re not asking for special privileges for themselves. They’re convinced that it just so happens that their self-interest coincides perfectly with the collective interest. That’s where you get this idea of the “job creators”. ... If you’ve developed an ideology that what’s good for you personally also happens to be good for everyone else, that’s quite wonderful because there’s no moral tension. ...

EK: ... From my reporting with the White House, I think the president’s view of the economy is that globalization is here and it’s not going away. The economy rewards high skills more than ever. Automatic and computerization and foreign competition are wiping out many middle class jobs, and while some new ones are created, it’s not at all clear that enough are being created. But in his view, he sees more redistribution as very necessary in this context. He thinks that if the economy is going to grow but the gains won’t be broadly shared, then it’s the government’s role to try and redistribute some, though of course not all, or even most, of those gains.

My experience is that the very rich are open to higher taxes in the context of a deficit deal. ... But they don’t like the idea that their money should be redistributed simply because they have too much of it. They don’t like the idea that, so to speak, they didn’t build all of this, and as such, they need to give back in order to make sure it continues. ... They see it as punishing their success.

CF: I completely agree. ...

Fed Watch: A Little Less Dovish...

Tim Duy:

A Little Less Dovish..., by Tim Duy: In the midst of an internal debate over policy communication, Chicago Federal Reserve President Charles Evans pulled back on his 3 percent inflation threshold in a speech yesterday. Arguably, as the only policymaker suggesting guidance well above the Fed's stated 2 percent target, Evans was the last true dove at the Fed. With Evan's falling in line with his colleagues, it looks like the last sliver of hope that the Fed would tolerate slightly higher inflation to accelerate the reduction of real burden has now been dashed.

There is a lot of interesting material in Evan's speech, but here I focus only on his basic outlook and the implications for policy. Regarding growth:

That said, monetary policymakers must formulate policy for today. In the United States, forecasts by both private analysts and FOMC participants see real GDP growth in 2012 coming in at a bit under 2 percent. Growth is expected to move moderately higher in 2013, but only to a pace that is just somewhat above potential. Such growth would likely generate only a small decline in the unemployment rate.

Of course, he added earlier that this forecast is vulnerable to the possible of an austerity bomb in 2013, but for the moment assume that issue is resolved:

Having said all that, most forecasters are predicting that the pace of growth will pick up as we move through next year and into 2014. Underlying these projections is an assumption that fiscal disaster will be avoided—and with this, that some important uncertainties restraining growth should come off the table. Also, deleveraging will run its course, and as it does, the economy’s more-typical cyclical recovery dynamics will take over. As the FOMC indicated in its policy moves last September, the current highly accommodative stance for monetary policy will be kept in place for some time to come.

He then praises recent policy actions:

Tying the length of time over which our purchases will be made to economic conditions is an important step. Because it clarifies how our policy decisions are conditional on progress made toward our dual mandate goals, markets can be more confident that we will provide the monetary accommodation necessary to close the large resource gaps that currently exist; additionally, markets can be more certain that we will not wait too long to tighten if inflation were to become an important concern.

And then tackles a big question:

The natural question at this point is to ask: What constitutes substantial improvement in labor markets? Personally, I think we would need to see several things. The first would be increases in payrolls of at least 200,000 per month for a period of around six months. We also would need to see a faster pace of GDP growth than we have now — something noticeably above the economy’s potential rate of growth.

From Evan's perspective, these conditions would be sufficient to end the expansion of the balance sheet, although interest rates will remain near zero beyond that point. When should rates rise?

Of course, we will not maintain low rates indefinitely. For some time, I have advocated the use of specific, numerical thresholds to describe the economic conditions that would have to occur before it might be appropriate to begin raising rates.

On the employment mandate:

In the past, I have said we should hold the fed funds rate near zero at least as long as the unemployment rate is above 7 percent and as long as inflation is below 3 percent. I now think the 7 percent threshold is too conservative....This logic is supported by a number of macro-model simulations I have seen, which indicate that we can keep the funds rate near zero until the unemployment rate hits at least 6-1/2 percent and still generate only minimal inflation risks.

So he shifts to a 6.5 percent threshold for unemployment, and later argues that even this might be a bit conservative as his models don't foresee much inflation pressure before 6 percent. See also Federal reserve Janet Yellen's recent speech; Evans' view is consistent with the optimal path forecasts. On one hand this is somewhat of a shift to the dovish side on the inflation forecast, suggesting that inflation will not accelerate as quickly as some might expect. What about the threshold for the rate of inflation itself?

With regard to the inflation safeguard, I have previously discussed how the 3 percent threshold is a symmetric and reasonable treatment of our 2 percent target. This is consistent with the usual fluctuations in inflation and the range of uncertainty over its forecasts. But I am aware that the 3 percent threshold makes many people anxious. The simulations I mentioned earlier suggest that setting a lower inflation safeguard is not likely to impinge too much on the policy stimulus generated by a 6-1/2 percent unemployment rate threshold. Indeed, we’re much more likely to reach the 6-1/2 percent unemployment threshold before inflation begins to approach even a modest number like 2-1/2 percent.

So, given the recent policy actions and analyses I mentioned, I have reassessed my previous 7/3 proposal. I now think a threshold of 6-1/2 percent for the unemployment rate and an inflation safeguard of 2-1/2 percent, measured in terms of the outlook for total PCE (Personal Consumption Expenditures Pride Index) inflation over the next two to three years, would be appropriate.

Notice that he really doesn't have a reason to shift his threshold; he doesn't even expect to hit the inflation threshold before hitting the employment threshold. His reason for essentially is that the 3 percent threshold makes people "anxious." Anxious about what? Anything that is perceived to be a threat to the Fed's credibility.

Does this shift on Evans' part really change anything? Probably not. He was always an outlier among Fed policymakers, with a tolerance for inflation as high as 3 percent making him a true dove. But he was never going to get any additional traction on that front from his colleagues. The 2 percent target is set in stone, and it is too much to expect the Fed will tolerate any meaningful deviations from that target. Of course, it is questionable that 3 percent is a meaningful deviation to begin with, but that is question is almost irrelevant at this point.

Bottom Line: By shifting his threshold on inflation, Evan's concedes to the political realities within the Fed. There was never much support for anything like tolerance for 3 percent inflation; for most policymakers, I suspect anything above 2.25 percent would be considered a threat to credibility. By falling in line with the rest of the FOMC, Evan abandons his role as a true dove, someone willing to tolerate substantially higher inflation. He is a dove now in the modern sense - a policymaker with a lower inflation forecast that allows for a longer period of easier policy.

Hurricane Sandy’s Lesson on Preserving Capitalism

I thought I'd note this column from several weeks ago for two reasons. First, it was widely misinterpreted as supporting laws against price-gouging, but I didn't mean to disavow the price-system. The point was that there is a lesson in the public's reaction to price-gouging: When the public believes the price-allocation mechanism results in unfairness, they won't support it. Market fundamentalists, and those who support capitalism more generally, should worry more than they do about how increasing inequality or the increasing market and political power of those at the top will affect the public's perception of the fairness of the capitalist system. If the belief that the system is unfair crosses the tipping point, who knows what type of system could be adopted in its place. Second, and more to the point, I haven't had much luck finding things to post today, and no time to write something myself (so this is filler):

Hurricane Sandy’s Lesson on Preserving Capitalism: With long gas lines and other shortages putting people on edge in the wake of Hurricane Sandy, the usual post-disaster debate over the economics and ethics of price-gouging is underway. However, while the question of whether it is okay, even desirable, for businesses to raise prices after natural disasters is certainly important, there are larger lessons that can be drawn from this debate.

Economists do not like the term “price-gouging.” They believe that price increases are the best way to allocate scarce goods and services after a natural disaster and, importantly, to encourage additional supply. When people can make a large profit by supplying goods and services to a market, they will work extraordinarily hard to meet the demand.

But if there is such an advantage to allowing the price system to work after an event like Hurricane Sandy, why did producers often choose to stick with pre-disaster prices? Why would they leave profits on the table by maintaining pre-disaster prices and allocating goods through other mechanisms such as first-come, first-serve until supplies run out? One answer is that price-gouging after a natural disaster is illegal in many places. But this just begs the question. Why do so many places choose to prohibit large price increases in response to disaster induced shortages?

Most of the explanations economists have come up with rely upon the idea of fairness. ...[continue]...

Let me add one reference to a study by Daniel Kahneman I didn't know about when I wrote this supporting the notion that perceptions of unfairness undermine support for the price-allocation system:

As far as most economists are concerned, it would be totally reasonable for a grocery store to raise prices the day be for a hurricane. In fact, that's what's supposed to happen. If prices don't go up when demand increases, you wind up with shortages. To an economist, empty shelves at grocery stores are evidence that prices were too low.

In a famous study, the Nobel laureate Daniel Kahneman and his co-authors asked ordinary people lots of questions about pricing and fairness. In one question, a hardware store raised the price of snow shovels from $15 to $20 the morning after a snowstorm.

The higher price sends a signal to the world that says: Send more snow shovels! Someone who runs a hardware store an hour away might be inspired by to put a bunch of shovels in the back of a truck and bring them to town, easing a potential shortage and, perhaps, driving prices back down.

But, not surprisingly, eighty percent of people surveyed said raising the price of snow shovels after a storm would be unfair. Presumably, those people would also say it's unfair for a store to double prices on canned food the day before a hurricane.

People feel so strongly about this that they've passed price-gouging laws in many states, banning merchants from raising prices during hurricanes or other natural disasters.

'Death of a Prediction Market'

Rajiv Sethi on the "death of a prediction market":

Death of a Prediction Market: A couple of days ago Intrade announced that it was closing its doors to US residents in response to "legal and regulatory pressures." American traders are required to close out their positions by December 23rd, and withdraw all remaining funds by the 31st. Liquidity has dried up and spreads have widened considerably since the announcement. There have even been sharp price movements in some markets with no significant news, reflecting a skewed geographic distribution of beliefs regarding the likelihood of certain events.

The company will survive, maybe even thrive, as it adds new contracts on sporting events to cater to it's customers in Europe and elsewhere. But the contracts that made it famous - the US election markets - will dwindle and perhaps even disappear. Even a cursory glance at the Intrade forum reveals the importance of its US customers to these markets. Individuals from all corners of the country with views spanning the ideological spectrum, and detailed knowledge of their own political subcultures, will no longer be able to participate. There will be a rebirth at some point, perhaps launched by a new entrant with regulatory approval, but for the moment there is a vacuum in a once vibrant corner of the political landscape.

The closure was precipitated by a CFTC suit alleging that the company "solicited and permitted" US persons to buy and sell commodity options without being a registered exchange, in violation of US law. But it appears that hostility to prediction markets among regulators runs deeper than that, since an attempt by Nadex to register and offer binary options contracts on political events was previously denied on the grounds that "the contracts involve gaming and are contrary to the public interest."

The CFTC did not specify why exactly such markets are contrary to the public interest, and it's worth asking what the basis for such a position might be.

I can think of two reasons, neither of which are particularly compelling in this context. First, all traders have to post margin equal to their worst-case loss, even though in the aggregate the payouts from all bets will net to zero. This means that cash is tied up as collateral to support speculative bets, when it could be put to more productive uses such as the financing of investment. This is a capital diversion effect. Second, even though the exchange claims to keep this margin in segregated accounts, separate from company funds, there is always the possibility that its deposits are not fully insured and could be lost if the Irish banking system were to collapse. These losses would ultimately be incurred by traders, who would then have very limited legal recourse.

These arguments are not without merit. But if one really wanted to restrain the diversion of capital to support speculative positions, Intrade is hardly the place to start. Vastly greater amounts of collateral are tied up in support of speculation using interest rate and currency swaps, credit derivatives, options, and futures contracts. It is true that such contracts can also be used to reduce risk exposures, but so can prediction markets. Furthermore, the volume of derivatives trading has far exceeded levels needed to accommodate hedging demands for at least a decade. Sheila Bair recently described synthetic CDOs and naked CDSs as "a game of fantasy football" with unbounded stakes. In comparison with the scale of betting in licensed exchanges and over-the-counter swaps, Intrade's capital diversion effect is truly negligible.

The second argument, concerning the segregation and safety of funds, is more relevant. Even if the exchange maintains a strict separation of company funds from posted margin despite the absence of regulatory oversight, there's always the possibility that it's deposits in the Irish banking system are not fully secure. Sophisticated traders are well aware of this risk, which could be substantially mitigated (though clearly not eliminated entirely) by licensing and regulation.

In judging the wisdom of the CFTC action, it's also worth considering the benefits that prediction markets provide. Attempts at manipulation notwithstanding, it's hard to imagine a major election in the US without the prognostications of pundits and pollsters being measured against the markets. They have become part of the fabric of social interaction and conversation around political events.

But from my perspective, the primary benefit of prediction markets has been pedagogical. I've used them frequently in my financial economics course to illustrate basic concepts such as expected return, risk, skewness, margin, short sales, trading algorithms, and arbitrage. Intrade has been generous with its data, allowing public access to order books, charts and spreadsheets, and this information has found its way over the years into slides, problem sets, and exams. All of this could have been done using other sources and methods, but the canonical prediction market contract - a binary option on a visible and familiar public event - is particularly well suited for these purposes.

The first time I wrote about prediction markets on this blog was back in August 2003. Intrade didn't exist at the time but its precursor, Tradesports, was up and running, and the Iowa Electronic Markets had already been active for over a decade. Over the nine years since that early post, I've used data from prediction markets to discuss arbitrage, overreaction, manipulation, self-fulfilling prophecies, algorithmic trading, and the interpretation of prices and order books. Many of these posts have been about broader issues that also arise in more economically significant markets, but can be seen with great clarity in the Intrade laboratory.

It seems to me that the energies of regulators would be better directed elsewhere, at real and significant threats to financial stability, instead of being targeted at a small scale exchange which has become culturally significant and serves an educational purpose. The CFTC action just reinforces the perception that financial sector enforcement in the United States is a random, arbitrary process and that regulators keep on missing the wood for the trees.

Links for 11-28-2012

• Bob Lucas on macro - Noah Smith
• Teaching graduate macro - mainly macro
• The Recession Probability Chart - Calculated Risk
• RIP Marvin Miller - Sports Economist
• Corporate tax is not only for little people - John Kay
• Could Higher Taxes Stimulate Academic Research? - Matthew Kahn
• Fed’s Evans Revises Thresholds for Monetary Policy Change - WSJ
• Monetary Policy in Challenging Times - Charles Evans
• What’s holding back the economy, in 10 charts - Zachary Goldfarb
• Fed: Consumer Deleveraging Continued in Q3... - Calculated Risk
• Will We Go Over The Fiscal Cliff? - Cheap Talk
• Bruce Bartlett Is A Mensch - Paul Krugman
• Inequality is not just about taxes and education - Josh Bivens
• Five Questions on Money Market Mutual Fund Reform - Treasury
• Central Bank Interactions with Financial Markets - Simon Potter
• Marketing Wittgenstein - Dan Little
• Fighting Economic Inequality - NYTimes.com
• The global economy is weakening again - OECD
• Mario on other platforms? - Digitopoly
• Volleyball Scoring - Cheap Talk
• Tax Cuts, Tax Rates and Tax Shares - Bruce Bartlett

Tim Geithner: 'Pragmatic Deal Maker'?

Robert Reich is worried:

Will Tim Geithner Lead Us Over or Around the Fiscal Cliff?, by Robert Reich: I’m trying to remain optimistic that the President and congressional Democrats will hold their ground over the next month as we approach the so-called “fiscal cliff.”

But leading those negotiations for the White House is outgoing Secretary of Treasury Tim Geithner, whom Monday’s Wall Street Journal described as a “pragmatic deal maker” because of “his long relationship with former Treasury Secretary Robert Rubin, for whom balancing the budget was a priority over other Democratic touchstones.” ...

Both Rubin and Geithner are hardworking and decent. But both see the world through the eyes of Wall Street rather than Main Street. I battled Rubin for years in the Clinton administration because of his hawkishness on the budget deficit and his narrow Wall Street view of the world.

During his tenure as Treasury Secretary, Geithner has followed in Rubin’s path — engineering a no-strings Wall Street bailout that didn’t require the Street to help stranded homeowners, didn’t demand the Street agree to a resurrection of the Glass-Steagall Act, and didn’t seek to cap the size of the biggest bank, which in the wake of the bailout have become much bigger.  In an interview with the Journal, Geithner repeats the President’s stated principle that tax rates must rise on the wealthy, but doesn’t rule out changes to Social Security or Medicare. And he notes that in the president’s budget (drawn up before the election), spending on non-defense discretionary items — mostly programs for the poor, and investments in education and infrastructure — are “very low as a share of the economy relative to Clinton.” If “pragmatic deal maker,” as the Journal describes Geithner, means someone who believes any deal with Republicans is better than no deal, and deficit reduction is more important than job creation, we could be in for a difficult December.

Not sure if this will make you feel more confident, but a recent post on the Treasury's blog from Jason Furman asserted that "Increasing Taxes on Middle-Class Families Will Hurt Consumer Spending." Unfortunately, it didn't say much about Social Security and Medicare. I am worried too.

Cyberattacks on Banks Escalating

President of the Atlanta Fed, Dennis Lockhart:

...A real financial stabiliy concern ... is the potential for malicious disruptions to the payments system in the form of broadly targeted cyberattacks. Just in the last few months, the United States has experienced an escalating incidence of distributed denial of service attacks aimed at our largest banks. The attacks came simultaneously or in rapid succession. They appear to have been executed by sophisticated, well-organized hacking groups who flood bank web servers with junk data, allowing the hackers to target certain web applications and disrupt online services. Nearly all the perpetrators are external to the targeted organizations, and they appear to be operating from all over the globe. Their motives are not always clear. Some are in it for money, while others are in it for what you might call ideological or political reasons.

Unlike other cybercrime activity, which aims to steal customer data for the purpose of unauthorized transactions, distributed denial of service attacks do not necessarily result in stolen data. Rather, the intent appears to be to disable essential systems of financial institutions and cause them financial loss and reputational damage. The intent may be mischief on a grand scale, but also retaliation for matters not directly associated with the financial sector.

Banks have been defending themselves against cyberattacks for a while, but the recent attacks involved unprecedented volumes of traffic—up to 20 times more than in previous attacks. Banks and other participants in the payments system will need to reevaluate defense strategies. The increasing incidence and heightened magnitude of attacks suggests to me the need to update our thinking. What was previously classified as an unlikely but very damaging event affecting one or a few institutions should now probably be thought of as a persistent threat with potential systemic implications.

I'm drawing your attention to this area of risk... But I feel the need to be measured about the potential for severe financial instability from this source. In my judgment, cyberattacks on payments systems are not likely to have as deep or long lasting an impact on financial system stability as fiscal crises or bank runs, for example. Nonetheless, there is real justification for a call to action. ...

Even broad adoption of preventive measures may not thwart all attacks. Collaborative efforts should be oriented to building industry resilience. Resilience measures would be similar to those put in place in the banking industry to maintain operations in a natural disaster—multiple backup sites and redundant computer systems, for example.

'By 2035, We Project Oil Imports into the US of Only 3.4 Million Barrels a Day'

Fatih Birol, chief economist of the International Energy Agency and chair of the World Economic Forum’s Energy Advisory Board, discusses his projection that "the United States will become the world’s leading oil producer within a few decades":

Q. The new report has attracted great press attention for its projection that the United States may soon become the world’s leading oil producer. Can you discuss what you see as the greatest implications of this change, in terms of energy security, geopolitics and carbon emissions?

A. The most striking implications concern U.S. oil imports and international oil-trade patterns. The upward trend in production is partly responsible for a sharp fall in U.S. oil imports. By 2035, we project oil imports into the United States of only 3.4 million barrels a day, which implies a substantial (60 percent) reduction in oil-import bills. North America as a whole actually becomes a net oil exporter. In international oil markets, this accelerates the shift in trade patterns toward Asia, raising the geostrategic importance of trade routes between Middle East producers and Asian consumers.

But what should attract equal attention … is the essential role played by energy efficiency. I believe that energy efficiency has been an epic failure by policymakers in almost all countries. Its potential is huge but much of it remains untapped. Compared with today, savings from more rigorous vehicle fuel-economy standards could prompt a 30 percent fall in U.S. oil demand by 2035.

Fed Watch: Meanwhile, in Japan...

Tim Duy:

Meanwhile, in Japan..., by Tim Duy: Back in September, I wrote:

What I expect to happen is this: The Bank of Japan will be forced into outright monetization at some point; a soft default in the form of higher inflation will occur. And dramatically higher inflation, I fear. Japan has not had inflation for two decades. I suspect they will experience all that pent-up inflation in the scope of a couple of years.

Sure enough, the battle begins. Almost lost in the holiday weekend, from Reuters last week:

Japan's main opposition Liberal Democratic Party (LDP) said on Wednesday that on its return to power it would set a 2 percent inflation target with an eye to revising the law governing the Bank of Japan so as to boost cooperation between the government and the central bank...

...In its campaign platform unveiled on Wednesday, the LDP called for bold monetary easing through cooperation between the government and the central bank on debt management, but it made no mention of Abe's calls for the BOJ to buy debt to finance infrastructure projects.

The response from the Bank of Japan was swift:

But BOJ Governor Masaaki Shirakawa dismissed many of Abe's proposals, including the possible revision of the Bank of Japan law, a step critics say is aimed at clipping the central bank's independence and forcing it to print money to finance public debt that is already double the size of Japan's economy.

"Central bank independence is a system created upon bitter lessons learned from the long economic and financial history in Japan and overseas countries," Shirakawa told a news conference....

...Shirakawa was adamant the central bank would not directly underwrite government debt because bond yields would spike and hurt the economy.

"No advanced country has adopted such a policy," he said.

Shirakawa is correct. Modern central banks may have lost some control over inflation at times, but I don't think any has engaged in outright monetization of government debt. Yet despite Shirakawa's insistence to the contrary, I still think that is exactly where Japan is headed. More central bank history in the making.

Links for 11-27-2012

• The Asset Price Meltdown and the Wealth of the Middle Class - NBER
• Household Income Stagnates, Again - NYTimes.com
• What's The Matter With Italy? - Paul Krugman
• Inside America’s Tax Battle - Laura Tyson
• Adam Smith On Exchange - Gavin Kennedy
• The Unhappy Marriage of Capitalism and Conservatism - Nancy Folbre
• Washington Post Wants Social Security Benefits Reduced - Dean Baker
• Why is the White House's CEA Helping the Republicans? - Robert Reich
• When You Come to a Fiscal Cliff, Take It - Andrew Samwick
• Bold Canadian takeover of Threadneedle Street - Gavyn Davies
• Benevolent Paternalists vs. Tough Love - Matthew Kahn
• Hayek, Friedman, And Illusions Of Conservative Economics - Robert Solow
• Republicans Propose to Raise Marginal Rate on "Job Creators" - Dean Baker
• Why Doesn't Someone Undercut Payday Lending? - Tim Taylor
• A Minimum Tax for the Wealthy - Warren Buffett

'The Multiplier is at Least Two'

For infrastructure spending, in particular spending on roads and highways, Sylvain Leduc and Daniel Wilson "find that the multiplier is at least two":

Highway Grants: Roads to Prosperity?, by Sylvain Leduc and Daniel Wilson, FRBSF Economic Letter: Increasing government spending during periods of economic weakness to offset slower private-sector spending has long been an important policy tool. In particular, during the recent recession and slow recovery, federal officials put in place fiscal measures, including increased government spending, to boost economic growth and lower unemployment. One form of government spending that has received a lot of attention is public investment in infrastructure projects. The 2009 American Recovery and Reinvestment Act (ARRA) allocated $40 billion to the Department of Transportation for spending on the nation’s roads and other public infrastructure. Such public infrastructure investment harks back to the Great Depression, when programs such as the Works Progress Administration and the Tennessee Valley Authority were inaugurated.

One criticism of public infrastructure programs is that they take a long time to put in place and therefore are unlikely to be effective quickly enough to alleviate economic downturns. The fact is, though, that surprisingly little empirical information is available about the effect of public infrastructure investment on economic activity over the short and medium term.

This Economic Letter examines new research (Leduc and Wilson, forthcoming) on the dynamic effects of public investment in roads and highways on gross state product (GSP), the total economic output of a state. This research focuses on investment in roads and highways in part because it is the largest component of public infrastructure in the United States. Moreover, the procedures by which federal highway grants are distributed to states help us identify more precisely how transportation spending affects economic activity.

We find that unanticipated increases in highway spending have positive but temporary effects on GSP, both in the short and medium run. The short-run effect is consistent with a traditional Keynesian channel in which output increases because of a rise in aggregate demand, combined with slow-to-adjust prices. In contrast, the positive response of GSP over the medium run is in line with a supply-side effect due to an increase in the economy’s productive capacity.

We also assess how much bang each additional buck of highway spending creates by calculating the multiplier, that is, the magnitude of the effect of each dollar of infrastructure spending on economic activity. We find that the multiplier is at least two. In other words, for each dollar of federal highway grants received by a state, that state’s GSP rises by at least two dollars.

The Federal-Aid Highway Program

The federal government’s involvement in financing road construction goes back to the early part of the past century. Although initially small, this involvement became much more significant in 1956 with the enactment of the Federal-Aid Highway Act, which authorized almost $34 billion in 1956 dollars over 13 years for the construction of the Interstate Highway System. At the time, The New York Times noted that “the highway program will constitute a growing and ever-more-important share of the gross national product … (affecting) every phase of economic life in this country.”

The Interstate Highway System was completed in 1992. Since then, the federal government has continued to provide funding to states mostly through a series of grant programs collectively known as the Federal-Aid Highway Program (FAHP). The FAHP helps fund construction, maintenance, and other improvements on a wide range of public roads beyond the interstate highways. Local roads are often considered federal-aid highways and are eligible for federal funding, depending on how important the federal government judges them to be.

Because road projects typically take a long time to complete, advance knowledge of future funding sources can help smooth planning. Congress designs transportation legislation to minimize uncertainty. First, it enacts legislation that typically extends five to six years. Second, it apportions funds to states according to set formulas. Thus, a typical highway bill will specify an annual national amount for each highway program over the life of the legislation and spell out the formula by which that program’s national amount will be apportioned to states. Importantly, these formulas are based on road-related metrics measured several years earlier. That means that changes to current and future highway funding are not driven by current economic conditions.

Highway bills generally include information that helps states forecast relatively accurately the amount of grants they are likely to receive while the legislation is in effect. For the past two highway bills, the Federal Highway Administration (FHWA) published forecasts of each state’s annual future grants under each program.

Estimating the effects of road spending

We conduct a statistical analysis to estimate the effects of federal highway spending on state economic activity. Specifically, we construct a variable that captures revisions to forecasts of current and future highway grants to the states, based on information from highway bills since 1991. We closely follow, but also expand on, the FHWA’s methodology for forecasting each state’s future grants.

These forecast revisions serve as proxies for changes in expectations about current and future highway spending in a given state. In economic terms, these changes can be regarded as shocks, that is, unanticipated events that affect economic activity.

We study forecast revisions rather than changes in actual highway spending for two reasons. First, actual spending may both affect and be affected by current economic conditions, making it difficult to sort out the true causal effects of the spending.

Second, changes in actual spending are most likely to be anticipated years in advance. For that reason, some of their economic effects may be felt before the spending changes actually take place. For instance, a state government and other important players, such as construction and engineering firms, may decide to spend more today if they expect the state to receive more highway grants in the future. In this way, changes in expectations regarding future grants to the states may be important for current economic activity. Failing to account for changes in expectations may lead to incorrect conclusions about how government spending affects economic activity (see Ramey 2011a).

Figure 1
Average response of state GDPs to unexpected grants

In our analysis of how changes in forecasts of highway grants to the states affect state GSP, we control for lags in state GSP, lags in receipt of highway grants, average state GSP levels, and national movements of gross domestic product (GDP) over the sample period from 1990 to 2010.

In Figure 1, the solid line shows the average percentage change in a state’s GSP following a 1% increase in forecasted future highway grants to the states. The shaded area around the line represents a 90% probability range. The horizontal axis indicates the number of years after the unanticipated change in forecasted highway grants to the states. The figure shows that changes in the forecasts have a significant short-term effect on state output in the first one to two years. This effect fades, but then increases sharply six to eight years after the forecast revisions, before declining again. This pattern holds up well with alternative estimation techniques, the inclusion of different control variables, and with different data samples.

This pattern is consistent with New Keynesian theoretical models in which public infrastructure, such as roads, are used by the private sector in the production of goods and services and take time to be built (see Leduc and Wilson, forthcoming). In this framework, the initial impact is due to a traditional Keynesian effect of an increase in aggregate demand. The medium-term effect on output arises once the public infrastructure is built, thus increasing the economy’s productive capacity.

The highway grant multiplier

One concept often used to assess the effectiveness of government spending is the multiplier. The fiscal multiplier represents the dollar change in economic output for each additional dollar of government spending. Thus, a multiplier of two implies that, when government spending increases by one dollar, output rises by two dollars.

Based on the results shown in Figure 1, we find that multipliers for federal highway spending are large. On initial impact, the multipliers range from 1.5 to 3, depending on the method for calculating the multiplier. In the medium run, the multipliers can be as high as eight. Over a 10-year horizon, our results imply an average highway grants multiplier of about two.

Our estimated multipliers are noticeably larger than those typically found in the literature on the effects of government spending. For instance, in a recent survey, Valerie Ramey reports multipliers between 0.5 and 1.5 (see Ramey 2011b). One possible reason for the wide differences is that we consider a very different form of government spending. Most of the literature concentrates on the multiplier effect of military spending. But such spending is arguably nonproductive in an economic sense. By contrast, government investment in infrastructure, such as roads, can raise the economy’s productive capacity. In that respect, it can have a higher fiscal multiplier. Another difference is that we concentrate on the multiplier effect on GSP, while the literature typically studies the effect on U.S. GDP as a whole.

The American Recovery and Reinvestment Act

The deep recession of 2007–09 led to the enactment of ARRA, which included a large one-time increase of $27.5 billion in federal highway grants to states. ARRA was designed to have strong short-term effects. In general, infrastructure projects are not viewed as effective forms of short-term stimulus because of the long lags between authorization, planning, and implementation. By the time the projects get under way, a recession may be over. The extra spending could ultimately end up feeding an already booming economy. To address this problem, ARRA stipulated that state governments had to fully use their share of federal highway grants by March 2010.

It is conceivable that highway spending during a major downturn, when productive capacity is underutilized, may affect output in a substantially different way than spending during more normal times. To test this, we examined whether unanticipated changes in highway spending in 2009 and 2010 had a different effect on GSP than in other years in our sample. We found that spending in 2009 and 2010 was roughly four times as large as the peak response shown in Figure 1. This suggests that highway spending can be effective during periods of very high economic slack, particularly when spending is structured to reduce the usual implementation lags.

Conclusion

Surprise increases in federal investment in roads and highways appear to have had positive effects on gross state product in both the short and medium run. The short-run impact is akin to the traditional Keynesian effect that stems from an increase in aggregate demand. By contrast, the positive impact on GSP in the medium run is probably due to supply-side effects that boost the economy’s productive capacity. Infrastructure investment gets a good bang for the buck in the sense that fiscal multipliers—the dollar of increased output for each dollar of spending—are large.

References

Leduc, Sylvain, and Daniel J. Wilson. Forthcoming. “Roads to Prosperity or Bridges to Nowhere? Theory and Evidence on the Impact of Public Infrastructure Investment.” NBER Macroeconomics Annual 2012.

Ramey, Valerie A. 2011a. “Identifying Government Spending Shocks: It’s all in the Timing.” Quarterly Journal of Economics 126(1), pp. 1–50.

Ramey, Valerie A. 2011b. “Can Government Purchases Stimulate the Economy?” Journal of Economic Literature 49(3), pp. 673–685.

Household Services Expenditures

Here's a graph of spending on discretionary services from Jonathan McCarthy of the NY Fed:

Household Services Expenditures: An Update, by Jonathan McCarthy, Liberty Street: This post updates and extends my July 2011 blog piece  on household discretionary services expenditures. I examine the most recent data to see what they reveal about the depth of decline in expenditures in the last recession and the extent of the recovery, and find that the expenditures appear to be further below the peak identified earlier. I then compare the pace of recovery for discretionary and nondiscretionary services in this expansion with that of previous expansions, finding that the pace in both cases is well below that of previous cycles. In summary, household spending continues to be constrained by a combination of credit conditions and weak income expectations. ...

The author also looks at the pace of the recovery of spending on both discretionary and non-discretionary services, and finds both to be subpar (see the last two graphs). The conclusion:

The pattern of a similarly sluggish pace of recovery for discretionary and nondiscretionary services expenditures suggests that the fundamentals for consumer spending remain soft. In particular, it appears that households—more than three years after the end of the recession—remain wary about their future income growth and employment prospects even though consumer confidence measures have improved in recent months. In addition, households may still see the need to repair their balance sheets from the damage incurred during the recession, especially if they expect that increases in asset prices will be subdued at best and that credit will continue to be constrained. Consequently, a positive resolution of these issues is likely necessary before a stronger services and overall consumer spending recovery can be sustained.

If households had gotten as much help with their balance sheet problems as banks got, the recovery would be a lot further along.

'Wreaking Havoc on the Environment with Little or No Accountability'

Jeff Sachs says "polluters must pay":

Polluters Must Pay: When BP and its drilling partners caused the Deepwater Horizon oil spill in the Gulf of Mexico in 2010, the United States government demanded that BP finance the cleanup, compensate those who suffered damages, and pay criminal penalties for the violations that led to the disaster. BP has already committed more than $20 billion in remediation and penalties. Based on a settlement last week, BP will now pay the largest criminal penalty in US history – $4.5 billion.

The same standards for environmental cleanup need to be applied to global companies operating in poorer countries, where their power has typically been so great relative to that of governments that many act with impunity, wreaking havoc on the environment with little or no accountability. As we enter a new era of sustainable development, impunity must turn to responsibility. Polluters must pay, whether in rich or poor countries. Major companies need to accept responsibility for their actions. ...

I can't see the companies doing this voluntarily.

Lucas Interview

Stephen Williamson notes an interview of Robert Lucas:

SED Newsletter: Lucas Interview: The November 2012 SED Newsletter has ... an interview with Robert Lucas, which is a gem. Some excerpts:

... Microfoundations:

ED: If the economy is currently in an unusual state, do micro-foundations still have a role to play?

RL: "Micro-foundations"? We know we can write down internally consistent equilibrium models where people have risk aversion parameters of 200 or where a 20% decrease in the monetary base results in a 20% decline in all prices and has no other effects. The "foundations" of these models don't guarantee empirical success or policy usefulness.

What is important---and this is straight out of Kydland and Prescott---is that if a model is formulated so that its parameters are economically-interpretable they will have implications for many different data sets. An aggregate theory of consumption and income movements over time should be consistent with cross-section and panel evidence (Friedman and Modigliani). An estimate of risk aversion should fit the wide variety of situations involving uncertainty that we can observe (Mehra and Prescott). Estimates of labor supply should be consistent aggregate employment movements over time as well as cross-section, panel, and lifecycle evidence (Rogerson). This kind of cross-validation (or invalidation!) is only possible with models that have clear underlying economics: micro-foundations, if you like.

This is bread-and-butter stuff in the hard sciences. You try to estimate a given parameter in as many ways as you can, consistent with the same theory. If you can reduce a 3 orders of magnitude discrepancy to 1 order of magnitude you are making progress. Real science is hard work and you take what you can get.

"Unusual state"? Is that what we call it when our favorite models don't deliver what we had hoped? I would call that our usual state.

Paul Krugman: Fighting Fiscal Phantoms

The deficit scolds have been wrong again and again:

Fighting Fiscal Phantoms, by Paul Krugman, Commentary, NY Times: These are difficult times for the deficit scolds who have dominated policy discussion for almost three years. One could almost feel sorry for them, if it weren’t for their role in diverting attention from the ongoing problem of inadequate recovery, and thereby helping to perpetuate catastrophically high unemployment.

What has changed? For one thing, the crisis they predicted keeps not happening. Far from fleeing U.S. debt, investors have continued to pile in, driving interest rates to historical lows. Beyond that, suddenly the clear and present danger to the American economy isn’t that we’ll fail to reduce the deficit enough; it is, instead, that we’ll reduce the deficit too much. ...

Given these realities, the deficit-scold movement has lost some of its clout. ... But the deficit scolds aren’t giving up. Now yet another organization, Fix the Debt, is campaigning for cuts to Social Security and Medicare, even while making lower tax rates a “core principle.” That last part makes no sense in terms of the group’s ostensible mission, but makes perfect sense if you look at the array of big corporations, from Goldman Sachs to the UnitedHealth Group, that are involved in the effort and would benefit from tax cuts. Hey, sacrifice is for the little people.

So should we take this latest push seriously? No... As far as I can tell, every example supposedly illustrating the dangers of debt involves either a country that, like Greece today, lacked its own currency, or a country that, like Asian economies in the 1990s, had large debts in foreign currencies. Countries with large debts in their own currency, like France after World War I, have sometimes experienced big loss-of-confidence drops in the value of their currency — but nothing like the debt-induced recession we’re being told to fear.

So let’s step back for a minute, and consider what’s going on here. For years, deficit scolds have held Washington in thrall with warnings of an imminent debt crisis, even though investors, who continue to buy U.S. bonds, clearly believe that such a crisis won’t happen; economic analysis says that such a crisis can’t happen; and the historical record shows no examples bearing any resemblance to our current situation in which such a crisis actually did happen.

If you ask me, it’s time for Washington to stop worrying about this phantom menace — and to stop listening to the people who have been peddling this scare story in an attempt to get their way.

Links for 11-26-2012

• Ignorance as an excuse - Antonio Fatas
• Disaster Economics - James Surowiecki
• America’s chance to enter the 21st century - Edward Luce
• Defining countercyclical fiscal policy: a proposal - mainly macro
• Review of Sandel's The Moral Limit of Markets - Deirdre McCloskey
• Review of Keynes Hayek, by Nicholas Wapshott - Noahpinion
• Hard to Believe There Are Still Economists Who Claim ... - Brad DeLong
• The Fox News and MSNBC of Lincoln's day - James Choi
• Republican Senators Negotiating with President Romney - EconoSpeak
• The housing cycle is the business cycle--again - Richard Green
• Is the Cochrane-Orcutt Estimator Unique? - Dave Giles
• The decade of Xi Jinping - Gavyn Davies
• Cuba: A Trip Back to 1959 - Jeff Frankel
• A Short History of Takers - Paul Krugman
• Should We Increase Dividend Taxation? 3 Views - owenzidar
• Pragmatist arguments for democracy - UnderstandingSociety
• Elasticity, slope, scale, and collusion - Nick Rowe
• What is Apple's objective function? - Richard Green
• Incredible Credibility - Paul Krugman

Banking Must not be Left in the Shadows

I agree with Gary Gorton:

Banking must not be left in the shadows, by Gary Gorton, Commentary, Financial Times: ... Addressing the details of the recent financial crisis leaves open the larger question of how it could have happened in the first place. ... One of the findings of the Financial Stability Board report is that the global shadow banking system grew to $62tn in 2007, just before the crisis. Yet we are only now measuring the shadow banking system. ...

Measurement is the root of science. Our measurement systems, national income accounting, regulatory filings and accounting systems are useful but limited. ... Now we need to build a national risk accounting system. The financial crisis occurred because the financial system has changed in very significant ways. The measurement system needs to change in equally significant ways. The efforts made to date focus mostly on “better data collection” or “better use of existing data” – phrases that, at best, suggest feeble efforts. A new measurement system is potentially forward-looking in detecting possible risks.

Another problem is conceptual. Why weren’t we looking for the possibility of bank runs before the crisis? The answer is that we did not believe a bank run could happen in a developed economy. ... Why did we think that? For no good reason. But, when an economic phenomenon occurs over and over again, it suggests something fundamental... Another law, we now know, is that privately created bank money is subject to runs in the absence of government regulation.

I'll just add the periodic reminder that we do not yet have the regulation in place that is needed to address the problem of bank runs of "privately created bank money." Gary Gorton is skeptical that we can ever solve this problem, that's one of the pointsof th ecolumn, but if that's the case then we should be doing all we can to ensure that the consequences of a shadow bank run are minimized, and there is much more we can do along these lines.

Can You Beat the Market?

This got more attention than I expected on Twitter, Facebook, etc., so thought I'd highlight it here:

Still think you can beat the market?, by Tim Harford: One of the most maligned ideas in economics is the efficient market hypothesis... The EMH has various forms, but in brief its message is very simple: an individual investor cannot reliably outperform financial markets. The reasoning is equally simple... Anything that could reasonably be anticipated already has been anticipated, and so markets instead respond only to genuinely unexpected news.

But the EMH has a problem: researchers keep discovering predictable patterns in the data... That is a minor embarrassment for the EMH; and it becomes a major one if the anomalies persist after they have been discovered. Yet this seems doubtful. ...

A new research paper by David McLean and Jeffrey Pontiff explicitly examines the idea that academic research into anomalies is a self-denying endeavor. They find some evidence of spurious patterns... But what is really striking is that after an anomaly has been published, it quickly shrinks – although it does not disappear.

The anomalies are most likely to persist when they apply to small, illiquid markets – as one might expect, because there it is harder to profit from the anomaly.

The efficient markets hypothesis is surely false. What is striking is that it is very close to being true. For the Warren Buffetts of the world, “almost true” is not true at all. For the rest of us, beating the market remains an elusive dream.