Economics

I think Casey Mulligan nails it:

The [Chicago city] council has debated mandating hybrid purchases. But the rumor among taxi drivers is that in addition, or perhaps instead, the city or other government agency will eventually subsidize the purchase of a hybrid.

Drivers have decided that they should not purchase a Prius or other hybrid until the subsidy arrived. Buying one now would mean over-paying.

Regardless of whether it is realistic to expect Chicago to someday subsidize purchases of hybrid taxis, the fact is that some cab drivers are considering the possibility. If taxi drivers consider future subsidies in their industry, then so must bank executives.

Last fall the public learned that banks were not selling many of their legacy mortgages and mortgage-backed securities, despite the impression that ownership of the assets were hindering the banks’ lending. A variety of theories have been put forward to explain this failure, and to suggest what the government might do to fix it.

But the lack of trade in mortgage-backed securities may have something in common with the lack of trade in hybrid Chicago taxicabs. The secondary market for legacy mortgages may have stagnated largely because of the (ultimately correct) anticipation of a huge government subsidy.

To prevent future crashes. I think most of these are pretty good. Explanations for each principle in Taleb’s FT piece. 

1. What is fragile should break early while it is still small.

2. No socialisation of losses and privatisation of gains.

3. People who were driving a school bus blindfolded (and crashed it) should never be given a new bus.

4. Do not let someone making an “incentive” bonus manage a nuclear plant – or your financial risks.

5. Counter-balance complexity with simplicity.

6. Do not give children sticks of dynamite, even if they come with a warning . 

7. Only Ponzi schemes should depend on confidence. Governments should never need to “restore confidence”.

8. Do not give an addict more drugs if he has withdrawal pains.

9. Citizens should not depend on financial assets or fallible “expert” advice for their retirement.

10. Make an omelette with the broken eggs.

James K. Galbraith’s Washington Monthly piece “No Return to Normal” is a mix of the completely sensible (propping up bad banks is a recipe for further looting by insiders and more stupid risk-taking) and a totally crazy conviction that modern states are economically magical institutions. That is, it is a James K. Galbraith piece. Here is some crazy:

Apart from cash—protected by deposit insurance and now desperately being conserved—the American middle class finds today that its major source of wealth is the implicit value of Social Security and Medicare—illiquid and intangible but real and inalienable in a way that home and equity values are not. And so it will remain, as long as future benefits are not cut.

Yes, 401(k)s are down, and Galbraith’s thesis seems to be that they always will be unless… guess what? But, okay, suppose he’s right and there is no recovery if we fail to embrace James K. Galbraithianism. In what crazy world does the economy both (a) fail to recover and (b) the government make good on already completely infeasible entitlement commitments? And how bizarre is it to say in the space of two sentences that a source of wealth is “real and inalienable” just as long as benefits are not cut through the democratic process — which of course they can be and probably must be if Galbraith is right about the likelihood of a no-recovery future. If voters can lose some portion of future government transfers by voting for politicians who vote them away, then those transfers are obviously alienable. (The courts clearly say there is no legal right whatsoever to these transfers.) And alienable future transfers from the government that are conditional on political will and economic feasibility are about as “real” as my future lovechild with Gisele Bundchen. Does anyone have an interpretation of Galbraith’s passage that makes sense?

He later goes on to claim, amazingly, that increasing spending on Social Security is “an economic recovery ace in the hole.” So the best I can do is guess that Galbraith is incoherently shuffling back and forth from a scenario in which we don’t use his “ace in the hole” (investments and home values worthless forever!) and one in which we do (Social Security checks good as gold.) But that’s hardly fair, is it? 

A main theme of Galbraith’s article is that things are so bad that mainstream economics can be of no assistance, so you’ve got to go heterodox. But he says nothing to clarify why, if we must abandon the consensus views of professional economics, one should prefer Galbraithianism over other departures from othodoxy. He seems to infer his own views from the alleged failure of standard views. It is rather gentle to note that that doesn’t follow. For example:

In short, if we are in a true collapse of finance, our models will not serve. It is then appropriate to reach back, past the postwar years, to the experience of the Great Depression. And this can only be done by qualitative and historical analysis. Our modern numerical models just don’t capture the key feature of that crisis—which is, precisely, the collapse of the financial system.

I largely agree about the inapplicability of many models, but it’s not at all obvious that the experience of the Great Depression is more rather than less applicable than those models. The Depression was a long time ago. The economy was a lot different then. If one is going to do “qualitative and historical analysis” then it seems that recent collpases in the financial systems of other countries are rather more germane. Why not look at those instead of reaching back “past the postwar years”? Because there’s some ineffable but essential Americanness to the American economy? Galbraith actually seems to think so, which is why one must look away from the examples of Argentina and Indonesia! This seems arbitrary and I don’t get it. Of course, if we go back to the Great Depression, we just become mired in competing “qualitative and historical” analyses, which in reality tends to sound a lot like “Must destroy Amity Shlaes!!!” And that’s obviously a lot more intellectually rigorous and helpful than stupid mainstream economists with their stupid mainstream models.

Russ Roberts rightly says “no,” and also strikes the right note of professional modesty:

So it’s a time for humility rather than hubris in my profession. Obama’s economic team, for all its brain power and good intentions, is in uncharted territory. There’s no recipe or manual or roadmap for getting the economy back on track. No one is quite sure how to correct imbalances in financial markets and the housing market. And no one knows how to create confidence, the biggest element lacking in the current economic climate.

No man or woman runs the economy. No man or woman or team of people can possibly plan the evolution of the economy in the coming months. America will come out of the recession but the time and pace are unknown. Obama can help. But he can just as easily slow down any recovery. Some part of the current mess we’re in is the result of erratic government policy that has added to the uncertainty facing consumer, investors, and entrepreneurs.

I certainly don’t mind aggregate demand economics as long as folks realize the limits of the stuff. I take it that one of the main lessons of living macro is that a stable framework of well-wrought rules tends to do better in the long run than periodic attempts to trick folks with the government’s amazing money-printing and money rearranging powers. I think this sort of thing would get through to people better if it were possible to to communciate the economy’s strategic micro-foundations: an economy is a massive, immensely complex coordination game. Maybe we’d like to think that there are Big Chiefs with scalpels and tweezers for fingers, but the fact is Big Chiefs have hams for hands. If the economy is a glassed-in ant colony and a recession is a confusion of non-connecting tunnels then “corrective” government intervention is banging the glass with a fat fist, like Fonzie banging a Jukebox. Barack Obama may be one cool cat, but the government ain’t no Fonzie. Mostly you get disoriented ants.

I’m not sure how to link soley to John Cochrane’s contribution to the Delong v. Zingales Economist.com debate, so I’ll just reprint it here:

Nobody is Keynesian now, really. Keynes distrusted investment and did not think about growth. Now, we all understand that growth, fuelled by higher productivity, is the key to prosperity. Keynes and his followers famously did not understand inflation, leading to the stagflation of the 1970s. We now understand the links between money and inflation, and the natural rate of unemployment below which inflation will rise. A few months before his death in 1946 Keynes declared:¹ ”I find myself more and more relying for a solution of our problems on the invisible hand [of the market] which I tried to eject from economics twenty years ago.” His ejection attempt failed. We all now understand the inescapable need for markets and price signals, and the sclerosis induced by high marginal tax rates, especially on investment. Keynes recommended that Britain pay for the second world war with taxes. We now understand that it is best to finance wars by borrowing, so as to spread the disincentive effects of taxes more broadly over time.

Really, the only remaining Keynesian question is a resurrection of fiscal stimulus, the idea that governments should borrow trillions of dollars and spend them quickly to address our current economic problems. We professional economists  are certainly not all in favour. For example, several hundred economists quickly signed the CATO Institute’s letter²opposing fiscal stimulus. 

Why not? Most of all, modern economics gives very little reason to believe that fiscal stimulus will do much to raise output or lower unemployment. How can borrowing money from A and giving it to B do anything? Every dollar that B spends is a dollar that A does not spend.³ The basic Keynesian analysis of this question is simply wrong. Professional economists abandoned it 30 years ago when Bob Lucas, Tom Sargent and Ed Prescott pointed out its logical inconsistencies. It has not appeared in graduate programmes or professional journals since. Policy simulations from Keynesian models disappeared as well, and even authors who call themselves Keynesian authors do not believe explicit models enough to use them. New Keynesian economics produces an interesting analysis of monetary policy focused on interest rate rules, not a resurrection of fiscal stimulus. 

Our situation is remarkable. Imagine that an august group of Nobel-prize-winning scientists and government advisers on climate change were to say: “Yes, global warming has been all the rage for 30 years, but all these whippersnappers with their fancy computer models, satellite measurements and stacks of publications in unintelligible academic journals have lost touch with the real world. We still believe the world is headed for an ice age, just as we were taught as undergraduates back in the 1960s.” Who would seem out of touch in that debate? Yet this is exactly where we stand with fiscal stimulus. 

Robert Barro’s Ricardian equivalence theorem was one nail in the coffin. This theorem says that stimulus cannot work because people know their taxes must rise in the future. Now, one can argue with that result. Perhaps more people ignore the fact that taxes will go up than overestimate those tax increases. But once enlightened, we cannot ignore this central question. We cannot return to mechanically adding up today’s consumption, investment and export demands, and prescribe the government demand necessary to attain some desired level of output. Every economist now knows that to get stimulus to work, at a minimum, government must fool people into forgetting about future taxes, an issue Keynes and Keynesians never thought of. It also raises the fascinating question of why our Keynesian government is so loudly announcing large and distortionary tax increases if it wants stimulus to work.
 
There is little empirical evidence to suggest that stimulus will work either. Empirical work without a plausible mechanism is always suspect, and work here suffers desperately from the correlation problem. Quack medicine seems to work, because people take it when they are sick. We do know three things. First, countries that borrow a lot and spend a lot do not grow quickly. Second, we have had credit crunches periodically for centuries, and most have passed quickly without stimulus. Whether the long duration of the great depression was caused or helped by stimulus is still hotly debated. Third, many crises have been precipitated by too much government borrowing. 

Neither fiscal stimulus nor conventional monetary policy (exchanging government debt for more cash) diagnoses or addresses the central problem: frozen credit markets. Policy needs first of all to focus on the credit crunch. Rebuilding credit markets does not lend itself to quick fixes that sound sexy in a short op-ed or a speech, but that is the problem, so that is what we should focus on fixing. 

The government can also help by not causing more harm. The credit markets are partly paralysed by the fear of what great plan will come next. Why buy bank stock knowing that the next rescue plan will surely wipe you out, and all the legal rights that defend the value of your investment could easily be trampled on? And the government needs to keep its fiscal powder dry. When the crisis passes, our governments will have to try to soak up vast quantities of debt without causing inflation. The more debt there is, the harder that will be.

Of course we are not all Keynesians now. Economics is, or at least tries to be, a science, not a religion. Economic understanding does not lie in a return to eternal verities written down in long , convoluted old books, or in the wisdom of fondly remembered sages, whether Keynes, Friedman or even Smith himself. Economics is a live and active discipline, and it is no disrespect to Keynes to say that we have learned a lot in 70 years. Let us stop talking about labels and appealing to long dead authorities. Let us instead apply the best of modern economics to talk about what has a chance of working in the present situation and why. 

Here is some Keynesian wisdom I think we should accept. 

“The difficulty lies, not in the new ideas, but in escaping the old ones, which ramify, for those brought up as most of us have been, into every corner of our minds.”

“How can I accept the doctrine, which sets up as its bible, above and beyond criticism, an obsolete textbook which I know not only to be scientifically erroneous but without interest or application to the modern world?”

“Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.”

I think Cochrane is right about bizarre denialist flavor of the recent vogue for undead Keynesianism and — about  most other stuff, too. But I’d also like to see him acknowledge the limits of post-Lucas macro modeling as well. I think the lesson for the economics profession is now pretty clear. Macroeconomics that is useful for policymaking needs to (1) include a lot more political economy and (2) work from more empirically-grounded behavioral assumptions. That is to say, it would be nice to see more top-flight economists like Cochrane acknowledging that macro policy is politics and that people act like people. I suppose doing this would make the math seem impossible, but nobody ever said science was easy.

David Frum’s new column for The Week nicely lays out what the chair of the White House Council of Economic Advisors really thinks of the administration’s economic policy: 

Invited by a reporter Monday to criticize President Obama’s economic plans, the chair of the White House Council of Economic Advisers, Christina Romer, naturally brushed the question aside. “You want me to tell you what’s wrong with the fiscal stimulus package?” she said. “SO not going to do that!” 
 
Too late! As it happens, the lecture Romer had just finished delivering at the Brookings Institute on Monday afternoon was criticism enough. 
 
An expert on the Great Depression, Romer organized her lecture around six lessons distilled from the era. The administration she serves seems to be disregarding every one of them. 

Read the rest for the lessons.

Brad DeLong and Luigi Zingales debate it at Economist.com

DeLong’s opening statement too effectively arrays a huge amount of intellectual firepower against him. If he could persuasively cut this team of giants down to size, it would be a killer opening. But his response to the challenge he erects seems to amount to the contention that this squad of bona fide geniuses are really benighted halfwits guilty of an elementary error. That’s pretty hard to swallow. Meanwhile, Zingales handily hops over the bar he sets for himself. I liked Zingales’ analogy:

[E]ven the third interpretation of the house statement—that we should follow Keynesian prescriptions to combat the current economic crisis [the interpretation DeLong wants to defend]—is false. I am not disputing the idea that some government intervention can alleviate the current economic conditions, I am disputing that a Keynesian economic policy can do it. With a current-account deficit that in 2008 was $614 billion, a budget deficit that was $455 billion and military expenditures of $731 billion, it is hard to argue that the government is not stimulating demand sufficiently. The current crisis is not a demand crisis, it is a trust crisis. Bad corporate governance coupled with bad government policies has destroyed the financial sector, scaring investors and freezing lending. It is as if a nuclear bomb had destroyed all roads in America and we claimed that to alleviate the economic impact of such an event we should invest in banks. It is possible that eventually the effect will trickle down. But if the problem is the roads, you want to rebuild roads, not subsidise the financial sector. And if the problem is the financial sector, you want to fix this and not build roads.

So far, DeLong is getting crushed in the voting, though he’s working the audience hard in the reader comments. Is that allowed? 

Also, here is Brad debating Michele Boldrin. I haven’t listened yet.

Hilzoy, like Yglesias, was put off by this passage of mine:

Here’s one way to understand the “going Galt” dramatics. Obama is causing a lot of Rand fans to completely flip their lids in part because Obama and his devotees are Bizarro World Randian romantics in the grip of an adolescent faith in the generative powers of the state.

I agree. This isn’t fair. I don’t mean that all liberals or Obama supporters are statist romantics, just that lots of them are. Hilzoy in particular wonders where I get the idea that Obama might seem to think that the state has special great-leap-forward powers. I guess I’ve developed that impression from all the speeches Obama has given informing us of his intention to use the state to transform the entire economy into one based on completely different sources of energy. 

I have to get ready for a fake prom party, so I’ll just leave you with this bit from the non-State of the Union Address:

Thanks to our recovery plan, we will double this nation’s supply of renewable energy in the next three years. We’ve also made the largest investment in basic research funding in American history — an investment that will spur not only new discoveries in energy, but breakthroughs in medicine and science and technology. 

The largest investment in American history that will spur “new discoveries” and “breakthroughs”! 

Why didn’t we think of this before? I know, I know. We did. Bush promised us hydrogen powered cars by yesterday and something crazy about switchgrass, which just goes to show that an adolescent faith in the generative powers of the state is not uncommon among presidents.

Matthew Yglesias’ posts emphasizing the interconnectedness of the global economy and the need for coordination, like this one, are quite correct in pointing out that economies are not contained in little national boxes with policy levers nation-states can pull to goose aggregate demand, brake the rate of job loss, and so on at will. Indeed, having a sound sense of the extent of global economic interconectedness is tantamount to admitting rather hard limits on the ability of national monetary and fiscal interventions to fix things.

Suppose Matt is right when he says:

The economy is very global, and it’s extremely difficult to see it pulling short of a depression if the European Union and Japan are twiddling their thumbs. Beyond that, if there isn’t meaningful global coordination of stimulus efforts then protectionist pressures are going to become harder-and-harder to resist in China and the United States to prevent free riding. That, in turn, would buy some short-term assistance at the cost of really hobbling the prospects for recovery down the road. 

That is to say, given globalization, effective stimulus is a lot like effective carbon-reduction policy: it requires overcoming incredibly difficult international coordination problems. One might argue that the global policy coordination problem is easier to solve if the U.S. is willing to be the first mover. But then one should also admit that the domestic efficacy of American stimulus is conditional on things beyond the control of American policymakers and that the odds of success are rather lower than most progressives have so far been willing to admit.

If I were a Democratic strategist, I would, like Matt, be broadcasting the importance of global coordination in order to prepare Americans for the possibility that domestic stimulus proves ultimately impotent in the face of a broader global decline. Democrats will then be able to say “At least we tried and it would have been worse if we hadn’t” in reply to Republicans keen to capitalize on the failure. If I were a Republican strategist, I would be pointing out how convenient it is for Democrats to have failed to mention the importance of perhaps unattainable global coordination when pushing through their plan. As it happens, I’m neither, so maybe I’m just concern trolling.

In this macro-brutalizing post, William Buiter lays down many passages I agree with. I don’t believe it was offered in this spirit, but I think Buiter does a servicable job of explaining why my fave econ gurus — F.A. Hayek, James M. Buchanan, Douglass North, and Vernon Smith — will make you smarter than your local macro textbook. Buiter:

[M]ost of the New Classical and New Keynesian macroeconomics assumes away the problem of contract enforcement.  This problem is especially acute in trade over time or intertemporal trade, where the net value to each party to a contract of fulfilling the terms of the contract varies over time and can change sign.  In a world with selfish, rational, opportunistic agents, able and willing to lie and deceive, only a small set of voluntary transactions will ever be observed, relative to the universe of all potentially feasible transactions.

The first set of voluntary exchange-based transactions we are likely to see are self-enforcing contracts - those based on long-term relationships, repeated interactions and trust.  There are some of those, but not too many.  The second are those voluntarily-entered-into contracts that are not self-enforcing (say because interactions between the same sets of agents are infrequent and market participants have a degree of anonymity that prevents the use of reputation as a self-enforcement mechanism) but are instead enforced by some external agent or third party, often the state, sometimes the Mafia (sometimes it’s hard to tell who is who).  Third party enforcement of contracts is again often complex and costly, which is why it covers relatively few contracts.  It requires that the terms of the contract and the contingencies it contains be third-party observable and verifiable.  Again, only a limited set of exchanges can be supported this way.

The conclusion, boys and girls, should be that trade - voluntary exchange - is the exception rather than the rule and that markets are inherently and hopelessly incomplete.  Live with it and start from that fact.  The benchmark is no trade - pre-Friday Robinson Crusoe autarky.  For every good, service or financial instrument that plays a role in your ‘model of the world’, you should explain why a market for it exists - why it is traded at all. Perhaps we shall get somewhere this time.

[...]

The future surely belongs to behavioural approaches relying on empirical studies on how market participants learn, form views about the future and change these views in response to changes in their environment, peer group effects etc. 

Yeah! Do some real science, economists!

Let me point out that Buiter badly oversteps his line of reasoning when he says that voluntary exchange, as such, is the exception rather than the rule, because trade is in fact a ubiquitous feature of human society. The baseline is not “no trade” but the far from negligible level of exchange in hunter-gatherer societies. What Buiter might have said had he not himself wasted so much time with macroeconomics textbooks is this: There are transactions costs. These limit the trades it makes sense to make. But a vastly greater number of trades can be made (and vastly greater gains from exchange realized) when transactions costs — such as the costs of enforcing complex contracts — fall. The complex order of spatially and temporally extended impersonal exchange is the exception, not the rule. And that’s why almost all of humanity has been poor for almost forever.

But the main idea here is right, and it’s good to see a central banker grasp it: economics that leaves out transactions costs simply assumes what humanity has only rarely managed to approximate. Modern economies are weird, pulsing, unsteady achievements of ongoing cultural evolution. Economies certainly aren’t machines governed by physics-like regularities. Nor is “an economy” the creature of specious nationalist bookkeeping studied in textbooks. There are lots of things we need to grasp if we are to “get somewhere this time.”

Rob Horning understands me! Please read his post on the economics and politics of “animal spirits.”

There are perplexingly many glosses “on animal spirits.” One of them is “confidence,” which is what investors faced with uncertainty about the economic climate are now lacking. Another might be “ambition.” As Chris Dillow writes in his mini review of Shiller and Akerlof’s new book:

What’s more, given that the private benefits of innovation are low, and the probabilities of success in many arts and industry small, it might be only animal spirits that give us artists and entrepreneurs. As Richard Nisbett and Less Ross wrote years ago:

We probably would have few novelists, actors or scientists if all potential aspirants to these careers took action based on a normatively justifiable probability of success. We might also have few new products, new medical procedures, new political movements or new scientific theories. 

Perhaps, then, it’s not just that animal spirits are ubiquitous - but they are necessary too.

It’s worth pointing out that it is exactly this sense of animal spirits, animated by the spirit of ambition or “emulation,” which Robert Frank and Phillip Cook declare inefficient in The Winner-Take-All Society, and argue we should tax into submission. But as Gary Becker and Kevin Murphy point out in Social Economics, echoing Nisbett and Ross, the expected payoff to entrepreneurial risk is so low that in the absence of positional competition, we would get very little of it. Entrepreneurial risk-taking is the source of innovation, which is the source of increasing productivity and wealth. So a society lacking this kind of status-seeking animal spirit might not grow at all, unless it was capable of successfully importing and deploying the innovations of more ambitiously inventive societies.

This focus on positional competition recalls the psychological microfoundations of Adam Smith and David Hume’s theories of civilization and economic growth. Their theories of motivation seem to me to do much more to illuminate the recent financial collapse than does modern macroeconomics. The myopia of financial executives making huge bets on securities graded according to algorithms that could not begin to understand was certainly driven by positional competition. The key insight of eighteenth-century political economy is that institutional rules and social norms must align ambitious, emulative, and status-seeking animal spirits to the aims of innovation, refinement, and advancement of the public good. The soaring abstraction of techno-high-finance — which decoupled investment decisions from any human sense of real economic value — encouraged the sense that the great race for astronomical bonuses was consistent with the public interest. And the sums involved discouraged the players from double-checking. It does seems that a kind of carelessness became contagious, and I don’t think it’s wrong to see “greed” as a source of Wall Street’s rather astonishing indifference to verifying the real utility of the game it was playing, though “greed” is not a very helpful diagnosis in the end. Ours was a failure of “regulation” in the broadest sense: the joint failure of institutional rules and the cultural climate to regulate the expression of positional ambition. But the lesson is not to discourage it, but to redirect it; to make it again not only safe but serviceable.

The big question is whether a risk-seeking society — which must maintain a status-seeking, ambitious culture — is or is not fated to run some of its institutions into the ground from time to time and occasionally wreak havoc on the context of trust and stable expectations that makes ordinary economic activity possible.

For those of a scholarly bent, here’s a passage from Adam Potkay’s A Passion for Happiness: Samuel Johnson and David Hume (I’ve removed the scholarly citation apparatus) on the central role of “emulation”–which is what they called positional ambition — in eighteenth-century accounts of progress.  

“An honest emulation,” rooted in a “self-love” that inspires us to think highly of ourselves in comparison with others,” is the source of all achievements, all greateness: “the philosopher’s curiousity may be inflamed by a catalogue of the works of Boyle and Bacon, as Themistocles was kept awake by the tropies of Miltiades.” Again we should recall Pope: “Envy, to which th’ ignoble mind’s a slave, / Is emulation in the learned or brave.”

The necessity of “emulation” to a beneficient progress is a, perhaps the, great theme of the Enlightenment in Britain, shared alike by Hobbes, Mandeville, and Shaftesbury, Hume and Johnson. It pervades Johnson’s Idler essays still more than his Rambler. The “renaissance of letters” that, according to standard eighteenth-century wisdom, began in fourteenth-century Italy is itself a product of emulation: “[T]he European world was rouzed from its lethargy; those arts which had been long obscurely studied in the gloom of monasteries became the general favourties of mankind; every nation vied with its neighbour for the prize of learning; the epidemical emulation spread from south to north and curiosity and translation found their way to Britain. Emulation is responsible for “elegance” of building, clothing, food; “commerce has kindle an universal emulation of wealth.”

Johnson and Hume agree that the fire that animates both the fine and practical arts “is not kindled from heaven. It only runs along the earth; is caught from one breast to another; and burns brightest, where the materials are best prepared.” The theme of emulation is omnipresent throughout Hume’s Essays and History of England–its responsibility for the enlightenment of both ancient Greece and modern Europe; the birth and refinement of all arts and sciences, mechanical arts and manufactures.

Earlier today I was thinking about the same Lane Kenworthy post Matt Yglesias discusses here. The upshot is that if you want to reduce inequality through redistribution, tax progressivity barely helps. You need to take a huge chunk of GDP in taxes in order to finance progressive spending. The more general, sort of obvious point is that if you want to massively increase government spending, the government needs a lot more revenue. But you can take everything from the rich and you still won’t have enough. So you’ve got to massively increase taxation on the middle class. The best way to do this is through a consumption tax. But Obama keeps reinforcing, again and again, that middle-class tax rates won’t rise, as if this is itself a matter of justice. So where’s all the money going to come from to do all these amazing things? Eventually, it’s a huge increase in taxes for the middle class or nothing. This may not be a big political winner.

The progressivity of the American tax system puts big-spending progressives in a bind. They should want a consumption tax with a huge, wide base. The easiest way for government to devour ever-larger chunks of economic output is through the device of a slow series of very small rate increases on a broad base. The smaller the tax base, the more dramatically you have to hike rates in order to significantly increase revenue. But dramatically hiking rates tends to discourage political buy-in from those who must pay. Indeed, it tends to incite heated resistance. Obama did very well with the rich. But that may not last if he hits them as hard as it looks like he’s aiming to. At the very least, pushback from this very powerful bloc of voters will limit his success in raising rates at the top. Perhaps he’s cagily playing a baseline-setting game, and by announcing large increases, he’ll effectively reduce resistance to small ones, which will look good in comparison. But even the large ones leave him massively short. And government spending cannot be debt-financed forever. And he can only inflate so much of it away.

So Yglesias is right (though he doesn’t quite put it this way). Democratic strategists need to be looking at clever ways for the government to take a lot more money away from middle-class families without thereby making the GOP look golden again. Obama’s been behaving as though he’s much less fiscally constrained than he really is. But by catering to the idea that middle-class taxes shouldn’t ever go up, he’s making it even tougher on himself. Unless he’s in the middle of some kind of ten-steps-ahead rope-a-dope wherein reaffirming the middle class’ right to not pay taxes is a way of softening them up to accept huge tax increases, he may be making a mistake. 

Here’s what I initially said about Kenworthy’s post about revenues and inequality, when I was writing for Free Exchange.

Jeffrey Sachs’s new SciAm column titled “The Economic Need for Stable Policies, Not a Stimulus” forcefully reinforces the lesson I drew from my interviews with Prescott and Phelps. Sachs highlights:

The U.S. political-economic system gives evidence of a phenomenon known as “instrument instability.” Policy makers at the Federal Reserve and the White House are attempting to use highly imperfect monetary and fiscal policies to stabilize the national economy. The result, however, has been ever-more desperate swings in economic policies in the attempt to prevent recessions that cannot be fully eliminated. 

President Barack Obama’s economic team is now calling for an unprecedented stimulus of large budget deficits and zero interest rates to counteract the recession.  These policies may work in the short term but they threaten to produce still greater crises within a few years.  Our recovery will be faster if short-term policies are put within a medium-term framework in which the budget credibly comes back to balance and interest rates come back to moderate sustainable levels. 

Looking back to the late 1990s, there is little doubt that unduly large swings in macroeconomic policies have been a major contributor to our current crisis. …

[...]

We need to avoid reckless short-term swings in policy.  Massive deficits and zero interest rates might temporarily perk up spending but at the risk of a collapsing currency, loss of confidence in the government and growing anxieties about the government’s ability to pay its debts. That outcome could frustrate rather than speed the recovery of private consumption and investment.

[...]

Most important, we should stop panicking. One of the reasons we got into this mess was the Fed’s exaggerated fear in 2002 and 2003 that the U.S. was following Japan into a decade of stagnation caused by deflation (falling prices). To avoid a deflation the Fed created a bubble. Now the bubble has burst, and we’ve ended up with the deflation we feared!

By the way, here’s my earlier post on “Managing Expectations Better.”

Prescott told me that he considers economic theory that treats the economy like a machine attached to policy levers that can be pulled to achieve the intended outcomes to be pseudoscience. He actually compared stimulus-mongering Keynesians to chemists before Dalton. (I gathered that Dalton is Robert Lucas.) Commenter Odograph gave me a bit of grief for quoting Prescott saying “Stimulus is not part of the  language of economics,” when of course, as Mankiw’s poll shows, 90% of economists believe you can get a growth boost by fiscally goosing the economy when resources are underutilized. I don’t know whether Prescott agrees or not (maybe not if he really thinks you can’t surprise an economy twice). But Prescott’s general point is pretty much the same as Sachs’s here: discretionary macroeconomic policy is very likely to be self-defeating and we’d do better to concentrate on setting in place a sound structure of stable rules. When I asked what he would have advised, Prescott said he wished Obama had used his considerable political capital to form some kind of task force to very deliberatively restructure the tax system, the entitlement system, the financial system, etc., instead of pushing for a stimulus. But when the President instead uses his political capital telling people to panic, you just get more of the kind of mess Sachs describes. The government under both Bush and Obama has been giving us ridiculous fool-in-the-shower macro policy, and it really needs to stop.

[HT: Tyler]

Maybe it helps to look at some figures. Here’s the 2009 Heritage Index of Economic Freedom top 10:

Pay special attention to Denmark at 8th, which is closer to the U.S. at 6th than the U.S. is to Ireland at 4th. According to the OECD, Denmark’s government spending as a percentage of GDP is 50.8 pecent. In the U.S. it is 36.6 percent. Now, note that size of government is an input to the formula that determines the ranking. Denmark takes a HUGE HIT for that in the index. No country in the top ten has that low a score on any dimension. In fact, they take a big hit twice, because tax rates are in the formula as well. Drop the size of government from the index, but keep the tax rates (i.e. “fiscal freedom”) and Denmark would score higher than the U.S. in economic freedom. Of course, Denmark, like the U.S., gets high marks in other rankings focused on political and civil liberties, like Freedom House’s. Denmark may be culturally weird, but I think it counts as a possibility proof of very big but quite limited government. Like the Economic Freeedom rankings, you might think that such high tax rates and big government count heavily against them, but it remains that they do nearly as well or better than every other country in the world in every other aspect of economic freedom. Tax rates and government size are in fact dissociable from regulation, barriers to trade, and so forth.  

Now, I’m just trying to reinforce a conceptual distinction. I’m not for one second arguing that the U.S. should have a bigger government. I think we’d be much better off in the extremely lean neighborhood of Singapore (about 15% I think). But I also think that the size of government in the U.S. is less important than some other aspects of economic freedom, and less important than the composition of spending, some of which is both immoral and wealth destroying. 

Consider that Denmark’s size of government is similar to that of France, which scores 64th in Economic Freedom, between Uganda and Romania. The implication is that France could become immensely more economically free without doing much by way of cutting the size of its government. The way to do this would be to severely limit, as Denmark has done, the ways in which the government may intervene in the economy. Likewise, holding size of government constant, the U.S. could be doing much better, though I’m afraid we’re rapidly moving in the other direction. 

More fun facts! Hong Kong is part of communist China, and so is lacking much assurance of liberty. Singapore is more or less an authoritarian technocracy. We don’t hit a liberal state until number 3. Australia, at 34.9 percent of GDP, has a smaller government that the U.S., as does Ireland, at 34.2 percent, while New Zealand is a bit bigger at 39.9. Switzerland is also smaller (35.4%) but the rest of the list is bigger. Canada is in the neighborhood of New Zealand, Denmark is WILDLY larger than the rest of the list, and the U.K is very big at 44.6 percent. The only countries in the OECD with bigger governments than Denmark is are France (52.4%) Sweden (52.6%), and both do have fairly dismal economic freedom scores. However, Sweden seems to have the right idea, as it has refused to bail out SAAB.

I decided to ask!

I talked to Edward Prescott and Edmund Phelps the day Obama signed the stimulus into law and wrote about it in my latest column for The Week.

I’m persuaded that the general logic of Prescott and Kydland’s work on time inconsistency applies to the present situation (and I don’t think you need to accept the strict rational expectations framework to see how it applies), but I was especially taken by Phelps’ concerns about the potentially damaging effects of the stimulus on entrepreneurship and innovation. Please check it out.

Talking to these giants of macro has convinced me that we need to be talking about is how to get the institutions right and keep them stable. What the government is now doing amounts to a pretty radical restructuring of our scheme of economic institutions, but with shockingly little deliberation about or regard for the optimality or stability of the overall incentive structure. This mess was precipitated by what turned out to be a disastrously unstable alignment of incentives. That fact would seem to prescribe taking a lot of care in thinking through how various large interventions might ramify through the system before jumping in. But our government’s behavior increasingly looks a bit like a zealous small-town narcotics squad, excited by its slick new SWAT gear, that’s just kicked down the door to a meth house and has started shooting at anything that moves.

Here’s Ed Glaeser:

Yet there are many Americans who spent the last eight years living within their means, and have plenty of resources left. For those Americans, the ones with cash in their bank accounts, this is the time to spend.

Cracking open the Champagne does not exactly feel in tune with today’s spirit of national austerity, but recessions get worse when prosperous people do not spend. In fact, if you can afford it, then this is exactly the moment to redo your kitchen or buy a car. Not only will you be able to get a good deal, but your spending will help revive the economy. The economist John Maynard Keynes convincingly argued 70 years ago that thrift was no virtue during a recession.

Despite the strength of the economic logic urging spending during a downturn, powerful psychological forces push in the opposite direction. America is hurting; thousands are losing their jobs. In today’s political climate, public displays of prosperity are the kind of thing that gets you lambasted by a Senate subcommittee.

I made a similar argument on Marketplace just before Christmas. Here’s what I said:

Most of us won’t lose our jobs, won’t face a pay cut. Yet we tighten anyway. Dollar-stretching tips circulate even among the most comfortable. But if your paycheck’s intact and you’re still cutting back, you may be part of the problem.

When home values surge, we tend to feel richer and spend a bit more, even if we don’t plan to sell the house. Economists call this “the wealth effect,” and it’s got a recessionary flip side. So when our 401(k)s dive as the economy hits a rough patch, we feel a bit of a pinch and rein in consumption — even when our incomes and the long-term value of our investments hasn’t changed a bit. In short, we don’t always look to our personal financial fundamentals when choosing whether to splurge or scrimp.

But just as “irrational exuberance” can keep a speculative bubble afloat, equally irrational anxiety, and the ethos of austerity it produces, can trap us in the doldrums. So maybe you went a bit crazy during the boom, and now’s the time to return to financial sanity. Good! But if you were living comfortably and responsibly within your means last year, you probably don’t need to cut back now. 

You know what? This argument DRIVES PEOPLE CRAZY. Check out Glaeser’s comments, and mine, which tend to confirm that there is in fact a Keynes-ish sort of pack psychology about appropriate consumption behavior. It’s funny that people get upset by a recommendation to do things that are both individually prudent (it’s just good financial stewardship to buy things when prices are low) and that have larger than ususual positive spillover effects. I doubt people really think it’s better to leave yourself and everyone else worse off. My diagnosis is that most people either don’t get the idea of periodic downturns and recoveries and so tend to suspect  with each serious recession that this time everything may go to shit permanently (which is true, it might, but what are the odds?) and to infer that prudence demands hoarding. My biggest worry about things going to shit is that government profligacy may leave us with a worthless dollar. But then why not spend all your dollars now on durable stuff!  I recently put a lot of my savings into a diamond ring, which I’m now thinking turned out to be fairly savvy move in several different ways.

I just stumbled on this, and don’t think I’ve seen it anywhere else, so I offer for your consideration economics Nobel Laureate Robert Mundell on the stimulus in a January 9th Turkish TV interview :

Ipek Cem: There is talk of a stimulus package in the US. We also know that the average US citizen is highly leveraged as a consumer. And when we talk about stimulus we are also talking about consumer pending. How to make the two of them, you know work hand in hand?

Robert Mundell: Well there’s a lot of questions about “What a stimulus package really is?” And I don’t think the major has been taken called a stimulus package are going to be much of a stimulus. To a certain extent, monetary policy, an easy monetary policy, is stimulating for us. But that’s not the pack what we mean by a “stimulus package” because “Federal Reserve” can always do that. What they mean by that is government spending. But government spending doesn’t have that bigger effect. If you have a big increasing government spending, without monetary expansion, they have to finance that deficit by bringing bonds. So while the spending adds to demand, the selling of the bonds, takes away the demand. So if there’s a multiplier in one process, there is a negative multiplier with the other process. And the other fact is that the exchange rate is flexible. So if you sell more bonds with a stimulus pending interest rates rise a little bit. And the capital comes in, the current account deficit increases. The trade deficit increases. So a good part of that stimulus package goes to the rest of the world.

Ipek Cem: So what kind of policy measures would you be advocating at a time like this?

Robert Mundell: Well I think that the difficulty of all the banks, they need to recapitalize the bank, which everybody says it’s necessary. And is also true with corporation you need to recapitalize the corporations like “General Motors”, “Ford” and “Chrysler”. The glories, what used to be glories of American capitalism in the 20th century. American manufacturing. They need to be recapitalized, too. And instead of the government taking its stimulus package, the bailout package, recapitalizing, buying stocking these banks, it is much more important to look at what’s happenning right now, what the goverment is doing today to economy. What the government does to the corporation today is take thirty five percent of the profits of the corporation. And without putting anything in. So with the 35 percent of corporate tax, they take all that, draining the corporation from that, without putting anything in. And so what the best thing to do for stimulus is to reduce or eliminate the corporation tax. It is a double taxation anyway, because the capital pays the tax to the corporation and the profits are taxed at the corporate level after 35 % is taken out. And then there are also tax in the individual level. So eliminate it. By the way the revenue isn’t going to be very much because the corporate tax used to earn 5 % of GDP in revenue. It’s gone down about 1,5 % of GDP. So it doesn’t add too much. And in a recession period there won’t be any profits and tax, so the revenue will be very little. So you don’t loose too much, but you would, if you stimulate economy all the other taxes will increase. And the revenue then from the tax cuts of corporations will increase the tax of every other corporation. Just recently, Germany has cut it it corporation tax from 25 % to 15 %. That’s a very good move and that’s what the United States should do. I think, I was going to say from 35 % to 20 %, but it would be even better if they do it to 15 %.

Recap: Bond-financed spending doesn’t much help. Recapitalize banks and eliminate radically reduce the corporate income tax.

I like how Jonathan Chait wrote a whole book accusing right-wingers of braindead supply-sider free-lunchism and now induldges in left-winger braindead demand-side free-lunchism with all the zeal of bizarro Jack Kemp on meth. 

I mean, check it out!

The point of stimulus spending … is simply to spend money–on something useful if possible, wasteful if necessary. Keynes proposed burying money in mineshafts, so that workers would be hired to dig it out. (Imagine what the GOP could do with material like that.) World War II was an effective stimulus that, economically speaking, consisted of 100 percent waste. If war hadn’t broken out, we could have enjoyed the same economic benefit by building all those tanks and planes and dumping them into the ocean. 

Oh my. Since Chait’s a pure empiricist with no agenda but truth, I’m sure he’ll be receptive to the facts revealed in Robert Higgs’ Depression War and Cold War. Here’s Price Fishback’s summary.

[UPDATE: Also see Tyler Cowen.]

I found Brad Delong’s new The Week column really stimulating. The lesson seems to be that the specifically Friedmanite version of classical liberalism isn’t a coherent position. Friedman wanted relatively free markets in everything but money. When it came to money, he made a huge exception and wholly endorsed central planning of the money supply. The problem is, the sources of money are in fact too many and too decentralized for Fed Central planners to control supply. That is, the Fed doesn’t really have sufficiently monopolistic control over money creation. So Friedman’s big monetary policy exception to laissez faire is undone by the fact that rational monetary central planning isn’t really possible. That’s a neat argument, and I suspect it’s true.

Here’s Brad:

The power of Friedman’s theory was, in part, rhetorical. “Keep the money supply growing smoothly” sounds like it means to keep the presses in the Bureau of Engraving and Printing rolling at a constant pace, printing out a steady flow of pictures of George Washington. But that is not how “money supply” actually works. In economic reality, “money supply” means not just cash money but also credit entries the Federal Reserve has made in commercial banks’ accounts at the Fed; plus all the credit entries commercial banks have made in households’ and businesses’ checking accounts; plus savings account balances; plus (usually) money market mutual-fund balances; plus (sometimes) trade credit and the ceilings between credit card limits and consumers’ current balances. 

No central banker controls all these vast and varied sluices of the money supply – at least not in economic reality. When banks and businesses and households get scared and cautious and feel poor, they take steps to shrink the economic reality that is the “money supply.” Businesses extend less trade credit. Credit card companies cut off cards and reduce ceilings. Banks call in loans and then take no steps to replace the deposits extinguished by the loan pay-downs. Without a single bureaucrat making a single decision to slow down a single printing press, the money supply shrinks—disastrously in episodes like the Great Depression. Thus in emergencies, to say that all the central bank has to do is to keep the money supply growing smoothly is very like saying that all the captain of the Titanic has to do is to keep the deck of the ship level. 

[...]

Friedman thought (a) that the central bank could exercise enough influence over the money supply to effectively control it, and (b) that banks and other financial intermediaries would be regulated tightly enough that what is now happening would be impossible. But he never resolved the tension between his view that banks need controls and the Chicago view that business must be unfettered. 

There are a couple ways to go from here. One conclusion we might draw is that successful control over the money supply requires heavier regulation of the financial sector–to in effect centralize control over alternative sources of money supply. It’s not clear to me whether Brad is calling for that or not. He seems primarily to be pushing the idea that when Monetariasm has to give way to Keynesian fiscal demand priming when monetary responses to recession get tapped out. But I think one could just as easily infer from Brad’s argument that since ideal monetary central planning isn’t really possible, we ought to give up trying and fully legalize markets in privately-issued money.

From Ray Fair:

The stimulus has a big effect in 2010, but by 2012 the economy is roughly back to baseline (except for variables like the federal government debt). In the baseline case the federal debt rises from $5.78 trillion at the end of 2008 to $8.74 trillion at the end of 2012. In the stimulus case the debt at the end of 2012 is $9.34 trillion, about $600 billion more than in the baseline case. This does not take account of possible increases in the federal debt from the bailout activity.

So there is short run gain from the stimulus bill, mostly in 2010, but the potential long run costs do not seem trivial. If the stimulus bill is passed and the bailout continues, it may be that large tax increases will be needed starting in late 2011 or 2012.

I don’t have a lot of confidence in Fair-style macro models, but it’s also a lot better than just guessing. Suppose he’s right. Will Obama and Congressional Democrats be willing to impose a big tax increase before the 2012 elections?

[Via Mankiw]

Clive Crook’s exchanges with Krugman and Barro are a must-read. In response to Crook’s quite reasonable charge that Krugman and Barro have both made themselves and their profession look bad, the Princeton Punisher charmingly replies, in a post titled “What Happened to Clive Crook”:

Clive used to be a reasonable guy; in his mind he probably still is a reasonable guy. But he has misunderstood what it means to be reasonable. 

So there you have it. If Crook thinks Krugman has made himself look bad, that’s probably because he’s forgotten what it even means to be a reasonable person. Clive amply demonstrates his reasonableness through the restraint of his persuasive reply. 

But the really fascinating part of Crook’s post is the email exchange with Robert Barro. Unlike Krugman, Barro wants to talk about the relevant economics, not politics. And Barro indeed thinks a lot of important people are guilty of “voodoo macroeconomics.” Is he being a dick? I don’t think so. Barro, unlike Krugman, is one of the world’s best, most cited, and most influential macroeconomists. And he keeps referring to a project he’s working on that provides evidence that the multiplier for non-defense spending is zilch. I’m looking forward to the published study, and to the professional response. If he’s right, we’re pretty clearly about to make an immense mistake. Barro also clarifies a useful distinction worth spreading:

One thing I think you need to be clear on is the distinction between Ricardian equivalence and Keynesian multipliers.  The first bears, for example, on how a deficit-finance tax cut affects aggregate demand.  The Ricardian view is no effect, and the “standard” view is that the effect is positive but less than one.  The multiplier has to do with how a change in aggregate demand affects output.  It is possible to have a large multiplier even with Ricardian equivalence, and it is possible to have a small multiplier even without Ricardian equivalence. 

True.

Expectations matter. A lot. Stable institutions in a context of trust are necessary for liberal prosperity. In this sense, the work of government is to manage expectations–to maintain a stable strategic framework within which plans can be formed and cooperative action successfully coordinated over the long term. That is why, for instance, I think quickly restoring a legal and administrative framework for functioning financial markets ought to be among the government’s chief priorities.

Yet I’m extremely suspicious of what strike me as intellectually contentious, ad hoc interventions into the economy aimed at expectation management. Countercyclical economic mood-control initiatives seem to me inconsistent with the maintenance of a general framework of stable rules — that is, they don’t take the importance of expectations seriously enough — while also smacking of illiberal state propaganda. It’s hard to draw a principled distinction between framework and ad hoc rules, but I think it’s intuitive enough. Steady, predictable expansion of the money supply seems like the good kind of expectation management, while fool-in-the-shower money supply management seems like the bad kind. Likewise, automatic stabilizers, such as the predictable increases in welfare and unemployment transfers during recessions, strike me as greatly preferable to freestyle panic-mode stimulus legislation.

I understand that on some theories, a spell of poor economic performance cannot be expected to end without government assistance, and the failure to open the monetary spigot and induce spending through tax cuts and government spending is to invite disaster. OK. Suppose we’re all convinced by those theories. (I’m not, but suppose.) Wouldn’t we be naive to ignore the opportunistic nature of democratic politics and to therefore fail to grasp how Keynesian theory plus economic decline will tend to invite a pork bonanza rather than timely, targeted, and temporary stimulus policy? Doesn’t taking both politics and the seriousness of recessions seriously suggest rigging policy in advance to include more automatic stabilizers? Why not have it as standing policy to halve payroll taxes, or increase TANF payments a certain percentage, or what have you, whenever the NBER gets around to calling a recession? If you insist on infrastructure, why not plan out, far in advance, some well-considered but non-urgent infrastructure projects that can be switched on immediately upon the onset of a downturn?

Wouldn’t this be better expectation management? People about to hit recession would know in advance what’s going to happen, instead of being made to wait on the outcome of the unpredictable, volatile and often self-undermining political wrangling of opportunistic panic.

The objections I anticipate to auto-stimulus are (1) it can’t work without the element of surprise and (2) that each recession is an unrepeatable precious snowflake that requires special initiatives targeted to its unique circumstances. About (1), why think the political process will reliably deliver the right surprise? About (2) the TARP stuff does seem like that. But so far, I don’t see anything in Obama’s bill that seems unique to the times. It’s just a train wreck of haphazardly considered tax cuts and spending.

Paul Zrimsek in the comments below offers us this gem:  

Last but perhaps not least among causes of the consumer funk is the administration’s own determined pessimism. Mr. Bush has a bully pulpit, and he is using it to preach economic alarm. This adds powerfully to the chorus of doomsaying. And when it comes to short-term economics, believing can sometimes make it so.

–Paul Krugman, 2/21/01

Oh snap!

In response to my post below, friend and former colleague Ryan Avent writes:

This is just too cute. The paradox of countercyclical macroeconomic politics is only a paradox if you believe that the current recession is the result of equal parts Democratic fear-mongering and facts on the ground. But can any sane person actually believe this? Does anyone really think that Barack Obama’s acknowledgement of economic reality and the op-ed warnings of lefty economists are the things producing this downturn, or perpetuating it, or deepening it?

I don’t think Ryan understands the cute argument. The cause of the recession is irrelevant. I never even intimated that Democratic fear-mongering caused it. (I think normal periodic breakdown of efficient-ish economic coordination + American houselust + democracy + fancypants finance + executive myopia + regulatory failure caused it.) So does anyone think that pants-wetting op-eds by Presidents and Nobel Prize-winning economists can perpetuate or deepen a downturn? Yes! For example, people like the President or Nobel Prize-winning economist Paul Krugman who believe that countercyclical macroeconomic policy works largely by manipulating consumer and investor psychology. If you don’t think Obama and Krugman’s confidence-destroying disaster forecasts hurt, then you probably shouldn’t accept confidence-restoration theories of stimulus, either. Or maybe Ryan knows of some research that shows that badly-targeted tax cuts and infrastructure spending effectively boost confidence and buoy markets while doomsaying from the most powerful man on Earth means squat. That would be interesting to see.