Another by Uwe Reinhardt

What if universities were run like our health care system?

Why the French are to blame for the banking crisis

Uwe Reinhardt explains. I note with favor that Reinhardt offered a solution similar to what I was peddling last year: rather than bailing out the banks that got us into this mess, the government could take the same money and create new banks that would keep lending going. (I proposed using existing entities like the Federal Reserve, Small Business Administration, Department of Education, etc. to keep loans flowing in vital areas of the economy. I also proposed capitalizing healthy banks that had kept their noses clean during the boom. But it amounts to essentially the same idea.)

It's still a recovery

Recent data is all indicating that the economic recovery is back on track (if not the best of all possible tracks) after some tense moments over the summer. Initial jobless claims have started falling again, stocks are up, exports are up,... Earlier this month the Bureau of Labor Statistics reported that hours worked in the second quarter of 2010 rose at the highest rate since the first quarter of 2006. Since October 2009 aggregate hours worked in the private sector has increased 2.4 percent. This would translate into 2.5 million private sector jobs if the workweek stayed constant; the reason we have seen an increase of only 755,000 private sector jobs over that time is that much of the increase in hours showed up as an increase in hours worked per week. Average weekly hours fell from about 34.6 to 33.8 during the recession and have crawled back to 34.2. That is, we've erased about half of the fall in weekly hours. This suggests that meaningful job growth is not too far in the future.

The latest piece of good news is retail sales: up 0.4 percent overall in August, 0.6 percent excluding motor vehicles and parts.



Alan Krueger says there's hope for meaningful recovery in the months ahead. Most interestingly, he argues that the reason recoveries have been "jobless" in the last few decades is that companies use recessions to increase productivity by restructuring. That phase of this business cycle, he says, is over.

So I'm starting to get optimistic again.

Greg Mankiw makes a good point about the investment tax credit

An investment tax credit is probably less effective when interest rates are very low, as they are now, than in normal times. As Greg Mankiw explains:

However, the impact will be relatively modest. Notice that expensing merely accelerates deductions. Thus, the value to the firm depends on interest rates. With interest rates near zero, the impetus to investment is small. Put another way, this policy can be seen as giving firms a zero-interest loan if they invest in equipment. But with interest rates near zero anyway, the value of the loan is not that great.

Thomas Sargent on modern macroeconomics

Another entry in the debate begun by Paul Krugman as to whether the developments of the last 30 years - from the New Classical revolution to Real Business Cycles to New Keynesian macroeconomic theory - was all a waste of time. Here Mark Thoma presents an interview with Thomas Sargent, who defends "modern macro":

The criticism of real business cycle models and their close cousins, the so-called New Keynesian models, is misdirected and reflects a misunderstanding of the purpose for which those models were devised.⁶ These models were designed to describe aggregate economic fluctuations during normal times when markets can bring borrowers and lenders together in orderly ways, not during financial crises and market breakdowns.

But isn't that just Krugman's point? The profession has made tremendous progress on models of an economy where everything is going pretty well. But it is when markets break down and the world is hurtling toward depression that policymakers pick up the phone and ask macroeconomists what the hell is going on and how do we get out of this mess? And when they got that call in 2008, "modern" macroeconomists had no answer. The old fuddy-duddy Keynesians did.

The sentences following Keynes' most famous quote are relevant here: "Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is past the ocean is flat again."

(The preceding sentence: "In the long run, we are all dead.")

Some cool macroeconomics

Naryana Kocherlakota, President of the Federal Reserve Bank of Minneapolis, kicked up a dust storm when he suggested that by raising interest rates the Fed may be able to increase inflation and pull the economy out of a deflationary spiral (that is, if we are in fact in such a spiral).

Paul Krugman and Nick Rowe jumped all over this, arguing that Kocherlakota was making mistakes in logic that we would not tolerate if they were made by undergraduate economics students. Steve Williamson came to Kocherlakota's defense with the aid of a simple macro model. The debate thus far is between the neoclassical economists (Kocherlakota and Williamson) who appeal to high-tech new-fangled macro theory, and Keynesians (Krugman, Rowe (maybe?)) who argue that the neoclassicals have been so obsessed with the beauty of their models that they have forgotten some simple macroeconomic lessons that we used to teach undergraduates and graduate students back in the 1970s.

Now comes along George Evans, the high-techest of the high-techies when it comes to New Keynesian models with adaptive learning. Mark Thoma gets him on film walking through some state-of-the-art macro models in a remarkably lucid fashion to prove that Kocherlakota is absolutely, 100 percent wrong. High tech, low tech, it doesn't matter - you don't raise interest rates when your economy is in recession on the verge of deflation. Watch the movie!

David Leonhardt on tax cuts

David Leonhardt makes the point in yesterday's NY Times that I have been thinking about for awhile. If President Obama is smart (and I know he is) and if he hasn't given up on trying to save the economy from a double dip and save Congress from falling to the Republicans (of that I'm not so sure), here's what he does: propose legislation to extend the Bush tax cuts for all but the highest income earners; let the tax cuts for the top earners expire, but take the proceeds for the next two years and use them to fund a set of tax cuts that moderate Democrat, Republican and independent voters will understand and approve. These include a payroll tax holiday and investment tax credit. I'd toss in the support for community banks to finance loans to small businesses if we can all avoid calling it TARP for small banks. It's good for the economy, and it's good politics.

There's a lot of disagreement out there as to whether tax cuts of any kind, but especially tax cuts for the rich, have a stimulative effect on the economy. Leonhardt presents a very strong argument that tax cuts for the rich have very little effect: we've tried that twice in the past (1981 and 2001) and each time the tax cuts were followed by many months of continued declines in employment. Not an airtight case, but certainly if you do something twice and it doesn't work, you might want to think again about doing it a third time.

The Social Security "crisis"

The Center on Budget and Policy Priorities notes that the long-run deficit in Social Security is almost precisely equal to the cost of extending the Bush tax cuts for upper-income taxpayers.

Anyone who argues that Social Security is unsustainable in its current form should also be willing to say that we cannot afford to extend the Bush tax cuts.

President Obama, send Charles Evans some help now!

Brad DeLong links to FRB Chicago president Charles Evans calling for more aggressive monetary policy actions to reduce unemployment - including letting inflation rise above the Fed's 2 percent target in the near term. Apparently the FOMC is sharply divided between the "doves" like Charles Evans and the "hawks" like Naryana Kocherlakota who believe that a more expansionary monetary policy would let loose the dogs of inflation. There are two vacant seats on the Board of Governors. President Obama, fill them with economists who think like Charles Evans!

The tragic fate of a slow-footed, dim-witted macroeconomist with a heavy teaching load

The paper I planned on writing eventually, "Monetary Policy Rules, Fiscal Policy Drools," has already been written, by Eric Leeper, under the title "Monetary Science, Fiscal Alchemy". His paper is excellent but I like my title better.

Good reads

This paper by Christiano, Ilut, Motto and Rostagno from last year's Symposium (back when Fed economists seemed to care about whether they could do anything to help pull the world out of recession) is very interesting. Cliffs Notes version: Contrary to conventional wisdom, stock market booms are generally associated with low inflation. This is because anticipated increases in productivity which fuel stock market booms (think the internet bubble) also imply reduction in costs for producers, meaning lower future inflation. Forward-looking price-setters will put off price increases or cut prices today in anticipation of lower future prices. If the Federal Reserve conducts monetary policy using an inflation target (as is its current practice), it will lower interest rates when it sees inflation fall. This causes the economy to accelerate and exacerbates the stock market boom, destabilizing the economy. Instead the Fed should raise interest rates when expected productivity increases spark stock market booms. The optimal policy can be approximated by including a measure of credit in the Federal Reserve's monetary policy reaction function (that is, the Fed raises rates when unemployment falls, inflation rises, or total credit rises). Christiano et al. demonstrate this elegantly in a standard New Keynesian model.



Paul Krugman and others are skeptical that inflation could ever be a problem with the economy in as deep a recession as we currently are, and therefore are very critical of the Federal Reserve's reluctance to get more expansionary in light of recent increases in inflation. The Christiano et al. paper sheds a little light on this argument. Flip the paper's logic around. An anticipated decrease in productivity - could be due to anything, but let's say concerns about excessive government regulation, higher taxes, or deterioration of skills among the long-term unemployed - causes asset prices to fall. It also causes firms to anticipate higher inflation in the future. They therefore start increasing prices now, causing inflation to rise. Boom - standard economic theory (which one should acknowledge Krugman is not wild about) suggests you can have inflation even during a deep recession.



However, standard economic theory, articulated in Christiano et al., also says that the Fed should lower, not raise interest rates in response to this upward pressure on inflation. The Fed should be setting the market interest rate to track the natural rate, which falls when productivity falls. Krugman's wrong that there is no coherent argument that inflation can rise during a severe recession, but correct in his criticism of the Fed's monetary policy.

Bernanke and the Symposium

I didn't think that in his speech at the Jackson Hole Symposium Bernanke would drop any hints about more aggressive monetary policy actions to come, and in that sense he did not disappoint. I am nonetheless awestruck that with the unemployment rate stuck above 9 percent for two years now, GDP at a standstill, financial markets in panic, and evidence of renewed contraction in manufacturing and housing, the Federal Reserve seems content to sit on its hands. People, if you believe that further monetary policy action would be ineffective, tell us so and maybe also tell us what nonmonetary policies might be helpful. If you believe that a more expansionary monetary policy would help spur the economy, and nevertheless do not plan on undertaking such policy, then tell us what freakin' objective function your policy is designed to maximize. What does the weight on the inflation parameter have to be to justify doing nothing when the unemployment rate is 9 percent and inflation is 2.5 percent? Is that weight consistent with the preferences of the typical American?



The program for the Symposium is similarly disheartening. Papers on long-run growth in emerging markets, managing natural resources, and so on. Nothing on the sputtering economy. Didn't someone think to organize the conference around questions like "what's next for monetary policy" or "can we have growth and fiscal contraction at the same time" or "the dangers of excessive sovereign debt" or "can Europe survive"? I get the sense that they're all just too exhausted from their efforts at putting out the fires of the last four years and have decided to pretend that the flames that are consuming the world economy just don't exist.

A-List

Here are the economists and policymakers attending this year's Jackson Hole Economic Policy Symposium. Not enough bloggers - how are we ever going to get the inside skinny on what everyone's saying behind closed doors?



[Oops, that's last year's list. Still, it's interesting to see who central bankers are listening to.]

A fiscal stimulus allegory

A guy walks into the doctor's office with a splitting headache. The doctor prescribes him some painkillers, but wanting to save some money, the guy takes only half the dose. He goes back a week later and says "Doc, I've still got this splitting headache." The Doc says, well why don't you just take the full dose this time. "The painkillers didn't work last time around," the guy responds, "why don't you just hit me over the head with a hammer instead?"

What's the Fed thinking?

At the August 10 meeting the Fed was confronted with 9.5% unemployment, inflation below the 2% target, and a visibly slowing economy. The proposal on the table was to begin reinvesting proceeds from the Fed's portfolio of bonds. To recap, the Fed had purchased about $2 trillion of government bonds and mortgages in 2009-10 (creating that amount in bank reserves) in order to stimulate the economy. In March the Fed stopped new purchases, which meant that as bonds matured the Fed was turning money back to the Treasury, shrinking its holdings of bonds and reducing bank reserves. Reinvesting the proceeds instead would maintain the size of the Fed's balance sheet and therefore maintain the amount of monetary stimulus being provided.

This seems to me to be an easy call. Any tightening of monetary policy is inappropriate given the weakness in the economy, even if that tightening occurs in a passive way. But as this article by Jon Hilsenrath shows, at least seven of seventeen FOMC members were opposed to the proposal or expressed reservations. Kevin Warsh thought reinvesting the bond proceeds would send a signal to investors that the Fed was paving the way for more aggressive actions in the future, which he would not support. "Some officials" thought they needed more information about the economy before they could support such a move. Richard Fisher thought more bond purchases wouldn't do any good since banks were already flush with reserves. Charles Plosser argued that action wasn't necessary because growth projections for 2011 had not changed. And Narayana Kocherlakota argued that the economy was suffering from a problem of mismatch between available jobs and skills, which monetary policy could not resolve.

Paul Krugman rightly takes Kocherlakota to task for adhering to a primitive form of the "hangover theory" that says that recessions are needed to facilitate the movement of workers from one sector of the economy to the other. This is indeed a nonsensical argument - there's no reason workers can't be pulled into new sectors through higher wages and a booming economy instead of pushed by unemployment, and at any rate all sectors of the economy have seen declines in employment during this recession. But it seems to me that the most important cause of the Fed's reluctance to act is timidity, an excess of caution. For some reason 9.5% unemployment, declining inflation, and a falling GDP growth rate are not sufficient to imbue a significant faction within the Fed with any sort of urgency. That is very odd. The Fed should be doing everything in its power to stimulate the economy and should not stop stimulating until it sees strong growth and a declining unemployment rate.

Why people hate the Wall Street Journal

Because they consistently print opinion pieces that they must know are total nonsense. Jonathan Chait takes down today's piece by Stephen Moore. To add to what Chait says, first the truly crazy part of Moore's article:

The grand pursuit of economics is to overcome scarcity and increase the production of goods and services. Keynesians believe that the economic problem is abundance: too much production and goods on the shelf and too few consumers. Consumers lined up for blocks to buy things in empty stores in communist Russia, but that never sparked production.

Mr. Moore: the Soviet Union was a communist, centrally-planned, non-market economy! Keynesian theory is a theory of market economies such as ours. The Keynesian argument says that firms respond to incentives, so when they see customers lining up they increase production in order to get more profits. That obviously wasn't going to happen in the Soviet Union since the central planners didn't really give a rat's a** about customers standing in line. It is equally true that lines of shoppers in the Soviet Union did not cause prices to increase - does this disprove neoclassical economics?

Now the merely ignorant:

Or consider the biggest whopper: Mr. Obama's thoroughly discredited $830 billion stimulus bill. We were promised $1.50 or even up to $3 of economic benefit—the mythical "multiplier"—from every dollar the government spent. There was never any acknowledgment that for the government to spend a dollar, it has to take it from the private economy that is then supposed to create jobs. The multiplier theory only works if you believe there's a fairy passing out free dollars.

But ignorant in a big way. Moore is basically dusting off the British Treasury view of the 1930s and employing it as if Keynes had not decisively demolished it in the General Theory. Ok, here's the logic. Suppose I decide to spend $10,000 to have a new roof put on my house. That creates a job for the roofer, does it not? Why wouldn't it?

- Well, maybe the roofer was booked solid so that to do my roof he has to cancel a job for another customer. In that case there's no employment effect.

- Or perhaps to buy the roof I had to cancel my plans to buy a car. In that case the roofer's employment is offset by unemployment in the auto industry.

- Or (and this is a little convoluted) perhaps when I took money out of the bank to pay for the roof, that caused the bank to be somewhat short of cash to lend out, so it raised the interest rates on loans and my neighbor who wanted to borrow to buy a car decided it was too expensive; there again unemployment in the auto industry offsets the new job for the roofer.

In a recession, none of those caveats apply. The roofer is not booked solid - he's spending long hours at home waiting for the phone to ring, and my job crowds out his time spent watching Nascar rather than someone else's roof job. I didn't have plans to spend the money on a car; in a recession people hoard money rather than spend it, so the money comes from savings rather than from spending on other goods. The bank didn't have to raise the interest rate on loans because the Federal Reserve is keeping interest rates fixed at near zero; the bank can acquire reserves from the Fed in essentially unlimited quantities to make all the loans it wants to at that rate.

Or as Keynes put it, the resources for the purchase of the roof come from idle savings and idle labor. No fairy is required: with 20 million or so people unemployed or underemployed, there are plenty of free resources to be drawn upon to finance purchases of whatever the government wants to buy. So it should do so.

Class warfare

John Stewart says much smarter things about the budget battles than I ever could. Please Republicans, PLEASE make raising taxes on the 50 percent of Americans who don't earn enough to pay federal income taxes a centerpiece of your platform in 2012!

Pic of the day

I find this pretty remarkable, though it's somewhat unfair to assign credit or blame to a president for the macroeconomic performance that occurs on his watch. Still...



For the record, Obama is currently at -2.3%, but +1.0% in 2010. I know you would have guessed that G.W. Bush would have the worst record of private sector job creation, but would you have picked Carter for the best?

The seasonal job surge

Casey Mulligan has a provocative piece in the NY Times (here, here). He shows that teenage employment surges in the summer when school lets out as shown in the graph below. This isn't really an astounding finding, but it does seem to imply that a shock to labor supply (the school year ends, making kids available for employment) can affect employment even in the middle of a severe recession. This implies that if government efforts to stimulate demand come with impediments to labor supply they may end up being ineffective or counterproductive. Mulligan makes exactly this claim about ARRA, though what these restrictions are isn't exactly clear.

The argument is interesting, but there's an obvious demand-side explanation for the surge in teen employment during the summer. Summer brings demand for lifeguards, amusement park ride operators, lawn care workers, house painters and other types of jobs typically taken by teenagers. Mulligan's a smart guy, surely he could figure out how much of the surge is due to the opening up of this type of employment in the summer months and how much is due to the release of workers.

[Note: Ryan Avent makes the same argument as me here, with some data.]

GDP versus final sales

Bob Barbera tells me there is information in the data on "final sales to domestic purchasers." Final sales to domestic purchasers is GDP minus net exports and inventory investment. It measures demand for goods and services from US households, businesses and government, regardless of whether those goods and services are imported or domestically produced. GDP, by contrast, measures demand for US-produced goods and services, regardless of whether that demand is from foreigners or US residents. Here's a graph of quarterly growth rates of real GDP and final sales:

The GDP numbers show a weakening of growth, from 5% in 2009Q4 to 3.7% in 2010Q1 to 2.4% in 2010Q2 (the latter number likely to be revised further downward). But the final sales figures show the opposite: growth in demand accelerated from 0.2% in 2009Q4 to 1.3% in 2010Q1 to 4.1% in 2010Q2.

What does this mean? It means that the slowdown in GDP growth is due to a dramatic rise in imports - the BEA's report on 2010Q2 GDP says that import growth reduced GDP growth by 4 percent in the quarter. People - most importantly, businesses - are buying, but they're buying imported goods rather than domestically-produced goods. The result is little feedback to domestic employment. If I had to guess, I would guess that the problem is that weakness in the housing sector means lower than normal demand in sectors heavy on domestic production. Business investment in equipment and software has been leading growth the last few quarters, and much of this stuff is probably imported.