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January 20 2010

"Stimulus Too Small"

I agree with Brad DeLong:

Stimulus Too Small, by Brad DeLong, WSJ: Fourteen months ago, just after Barack Hussein Obama's election, most of us would have bet that the U.S. unemployment rate today would be something like 7.5%, that it would be heading down, and that the economy would be growing at about 4% per year. ... Well, we have been unlucky. Unemployment is ... not 7.5% but 10%. More important, perhaps, is that the expectation is for 3% real GDP growth in 2010.
That leaves us with two major questions: First, why has the outcome thus far been so much worse than what pretty much everyone expected in the late fall of 2008? And second, why is the forecast ... for growth so much slower than our previous experience with recovery from a deep recession in 1983-84?
I attribute the differences to four factors:
First, the financial collapse of late 2008 did much more damage than we realized... The shock now looks to have been about twice as great as the consensus in the fall of 2008 thought. ...
And that leads us to Factor No. 2. The Obama administration envisioned a $1 trillion short-term deficit-spending..., had the administration known how big the problem would turn out to be, it would have sought a $2 trillion stimulus. And what did we get once Congress got through with it? A $600 billion stimulus—about one-third of what we needed.
Making matters worse: The stimulus was not terribly well targeted. In an attempt to attract Republican votes, roughly two-fifths of it was tax cuts. Such temporary cuts are ineffective... (It also failed to win any extra votes.) Roughly two-fifths ... was infrastructure and other ... direct federal spending. But it is hard to boost federal spending quickly without wasting money, and those projects that are shovel-ready are not terribly labor intensive.
Meanwhile, the most-effective stimulus would have been aid to the states... But senators don't want to hand out money to governors; the governors then tend to run against the senators and take their jobs away.
This problem with both the quantity and quality of the stimulus is tied up with the third factor: that the Obama administration declared victory on fiscal policy with the American Recovery and Reinvestment Act ... and then went home.
There was no intensive lobbying for a bigger program,... no attempts to expand the stimulus programs... The background chatter is that trying for more deficit spending would have been fruitless, given the broken Senate...That background chatter is probably right. But ... there is still the Federal Reserve. And that's where the fourth factor comes in.
It is true that as far as normal monetary policy is concerned, the Federal Reserve was tapped out... But there is more in the way of extraordinary monetary policy that could have been attempted in 2009—including inflation-targeting announcements, the taking of additional risky assets out of the pool to be held by the private sector, larger operations on the long end of the yield curve.
And I must confess that what the Federal Reserve thought and did in 2009 remains largely a mystery to me.

January 14 2010

The Financial Crisis Responsibility Fee

Calculated Risk summarizes today's proposal from the Obama administration for a "Financial Crisis Responsibility Fee" to recover the cost of the bailout of the financial system:

Proposed "Financial Crisis Responsibility Fee," by Calculated Risk: From Treasury:

Fact Sheet: Financial Crisis Responsibility Fee: Today, the President announced his intention to propose a Financial Crisis Responsibility Fee that would require the largest and most highly levered Wall Street firms to pay back taxpayers for the extraordinary assistance provided so that the TARP program does not add to the deficit. The fee the President is proposing would:
  • Require the Financial Sector to Pay Back For the Extraordinary Benefits Received: ...
  • Responsibility Fee Would Remain in Place for 10 Years or Longer if Necessary to Fully Pay Back TARP:
  • Raise Up to $117 Billion to Repay Projected Cost of TARP:
  • President Obama is Fulfilling His Commitment to Provide a Plan for Taxpayer Repayment Three Years Earlier Than Required: ...
  • Apply to the Largest and Most Highly Levered Firms: The fee the President is proposing would be levied on the debts of financial firms with more than $50 billion in consolidated assets ... Over sixty percent of revenues will most likely be paid by the 10 largest financial institutions.
There is much more detail at the link. The proposed fee would be 15 bps of covered liabilities per year.
Free Exchange gives the motivation for the tax over and abovethe desire to recoup the money spent bailing the banks out:
The administration is clear in its desire that this function as an incentive for banks to get smaller and less leveraged:
The fee the President is proposing would be levied on the debts of financial firms with more than $50 billion in consolidated assets, providing a deterrent against excessive leverage for the largest financial firms. By levying a fee on the liabilities of the largest firms – excluding FDIC-assessed deposits and insurance policy reserves, as appropriate – the Financial Crisis Responsibility Fee will place its heaviest burden on the largest firms that have taken on the most debt. Over sixty percent of revenues will most likely be paid by the 10 largest financial institutions.
What's mystifying, then, is that the fee will only apply until TARP has been repaid.

But how much impact will the tax actually have, i.e. is it substantial enough to serve as a deterrent? Will the levy be large enough to change the behavior of investment banks? FT Alphaville does some calculations:

A quick, very rough back-of-the-envelope calculation, has Goldman Sachs, for instance, paying a very conservative (i.e. assuming all of its deposits are FDIC insured, which is unlikely) 2008 figure of:
($884.55bn – $62.64bn – $27.64bn) * 0.0015 = $1.19bn.
Or, less than a tenth of the $10.93bn the bank spent on compensation and benefits that year.

Kevin Drum summarizes:

Ouch! That's hitting 'em where they hurt.

And if the Lucas critique type effects are stronger than anticipated (i.e. firms taking actions to avoid the tax), the tax burden will be even smaller.

What else might have been done? Progressive Fix has a list:

In the discussion of taxing banks and bankers, a couple of possibilities have been floated, some of which can reap short-term political points, others of which have the potential to promote progressive policies:
Bonus tax – One of the easiest – and politically most satisfying – would be a tax on excess bonuses. The British exercised this option on London bankers this past year. Bonuses in the City above a certain amount were taxed at a 50 percent rate. Banks responded by threatening to move offshore and – when that threat rang hollow – doubled the bonus pool they paid out to bankers. The end result was that the bankers whose decisions led in part to the crisis were financially unharmed, the British government raised a relative pittance in taxes, shareholders in City banks took a hit (as the bonus pools were increased at their expense), and the underlying fault lines in the British banking system remain unaddressed.
Transaction tax – The worst of the options would be a tax on transactions. As discussed before, this would merely pour sand in our financial system, breaking it and slowing economic recovery.
Excess profits tax – A more appealing option would be a tax on excess profits. A defining aspect of the financial bubble of the last decade was the fact that financial profits were 40 percent of overall corporate profits – more than double the slice financials made up of profits in the 1980s. A tax on these excess profits would rein that in. But while this could be useful, as Simon Johnson points out, it would be fairly easy to game, and end up being ineffective.
Tax on assets – A tax on bank assets above a certain amount addresses not just political sentiment that banks have made it through the crisis unscathed, but also the fact that banks are too big to fail. Encouraging banks to “right-size” themselves would make our economy safer from the systemic risk imposed by banks like Citigroup or Bank of America – which are debilitated but whose failure would be economically catastrophic.
Excess leverage tax – Taxing the leverage that financial institutions use to increase returns would allow us to avoid situations like that faced a year and a half ago when Lehman Brothers – leveraged over 30:1 – collapsed over the course of a weekend. It would make banks “safer” but would leave them still too big. In the event a bank were to fail, it would still be a systemic threat to our economy. This would be a more targeted version than an assets tax, but it would be harder to implement — definitions of leverage differ – and if not properly defined would leave hedge funds, insurance companies and other “non-bank financial institutions” untouched, leading to a crisis like that perpetuated by Long-Term Capital Management in 1998 or AIG last fall.

I'm not sure I agree with the conclusions on the transactions tax, particularly when applied to actions such as those described by Robert Solow:

Take an extreme example. I have read that a firm such as Goldman Sachs has made very large profits from having devised ways to spot and carry out favorable transactions minutes or even seconds before the next most clever competitor can make a move. Deep pockets in a large market can make a lot of money out of tiny advantages. (Of course, if you have any such advantage the temptation is irresistible to borrow a lot of money to enlarge your bets and your profits. Leverage is good for you, until it isn’t. It is not so good for the system.) A lot of high-class intellectual effort naturally goes into trying to invent ways to find those tiny advantages a few seconds before anyone else.
Now ask yourself: can it make any serious difference to the real economy whether one of those profitable anomalies is discovered now or a half-minute from now? It can be enormously profitable to the financial services industry, but that may represent just a transfer of wealth from one person or group to another. It remains hard to believe that it all adds anything much to the efficiency with which the real economy generates and improves our standard of living.

But that aside, I would have preferred to recoup the bailout money and increase the safety of the system at the same time through a tax on assets (to get at the too big to fail problem) and a tax on leverage (to reduce the damage the big banks can cause if they do fail).

[More on the proposal: NY Times, Washington Post, Wall Street Journal, Bloomberg, Financial Times, Steve Benen, Ezra Klein, , Mathew Yglesias, Felix Salmon, Jon Chait, Dean Baker.]

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January 10 2010

"A Job-Rich US Recovery is Still Plausible"

An argument that we don't need a "a major new stimulus program" devoted to job creation:

A job-rich US recovery is still plausible, by Robert Barbera and Charles Weise, Commentary, Financial Times: Only one short year ago, the world was staring depression in the face. Now the economy is recovering, but many commentators are warning of a “jobless recovery” of the kind that followed the last two recessions, in 1990-91 and 2001. ...
We believe that these meager expectations will turn out to be wrong, in large part because they mischaracterize how employment has swooned over the past two years. ... Our more optimistic outlook is based on a ... theory of why payrolls were cut so aggressively. Because of the turmoil in financial markets in autumn 2008, companies faced a severe cash crunch. As a result, they attempted to hoard cash in any way they could: they slashed order books, ran down inventories at an unprecedented pace and cut short-term borrowing. And they slashed payrolls. The drastic reduction in inventories and payrolls was not, in other words, a result of restructuring: it was symptomatic of panic, the same panic that caused the massive sell-off in equities, corporate bonds and mortgage-backed securities. ...
Nearly all projections for the US economy envision a sharp reversal for inventories in the coming quarters. We argue that the recovery in jobs should mirror the restocking of inventories because the collapse in employment and inventories during the recession had the same source in panic-driven cash hoarding. ...
The same logic can be applied to productivity. Using consensus expectations for current-quarter real GDP we estimate that the last three quarters of 2009 registered an average rate of advance in labor productivity of almost 7 per cent. We estimate that productivity is now above its normal level, so reversion to the mean over the next year implies a productivity growth rate substantially below trend.
The following scenario then appears quite plausible. Real GDP grows at a rate of 3.8 per cent in 2010, with productivity growth of 0.7 per cent and a modest increase in average weekly hours. In such a world, employment growth would average 2.2 per cent. This translates to an average of about 240,000 jobs per month.
This scenario, while wildly optimistic compared with current consensus forecasts, amounts to a weak recovery by historical standards. In the first full year of recovery after the 1981-82 recession, GDP growth was more than 7 per cent. Following the recession of 1974-75, growth was 6 per cent. It is not hard to imagine growth over the next year well in excess of our 3.8 per cent forecast, with jobs growth in the 300,000 per month range. We are not endorsing that as our forecast but we believe it is as likely as the jobless recovery predictions that define the conventional wisdom.
Barack Obama therefore needs to be patient. A modest fiscal stimulus focused on aid to the states would be a helpful insurance policy against a further weakening in the economy. But the trends are in the administration’s favour, and a major new stimulus program should be resisted. ...

They're not even willing to "endorse" their own forecast? They do implicitly define a forecast since they say the optimistic and pessimistic outcomes are equally likely. So why does a 50-50 chance that there will, in fact, be a intolerably slow recovery in the job market mean we should stand by and do nothing while we hope the coin comes up heads rather than tails? The average of the two forecasts - the most likely outcome by their reckoning - is not very rosy for labor and calls for something to be done.

There are lags between policy changes and changes in employment, and that means it's much easier to back off of action initiated now if things turn out to be better than expected than it is to do something later if the optimistic scenario fails to materialize. That is, the risks of failing to do anything and then realizing the pessimistic high unemployment outcome are much larger than doing something now and then having things turn out better than expected. Even on their own terms, I don't think their conclusion that we shouldn't devote any resources to job creation (other than protecting jobs through "modest" help for state and local governments) follows.

In any case, Dean Baker countered the part of the argument related to productivity before it was even made. Here's his response to similar claims about robust job growth:

Silliness on Productivity, by Dean Baker: In discussing the December jobs report the Post repeated some of the silliness about productivity that is currently circulating among people who imagine themselves to be knowledgeable about the economy. It told readers that:
Employers slashed positions more dramatically in the past two years, squeezing more productivity out of remaining workers. That has led many analysts to expect a substantial increase in the number of jobs in the early months of 2010, as companies must hire again just to keep up with demand for their products.
Actually, productivity growth averaged 2.6 percent annually over the last two years. This is somewhat more rapid than the growth rate over the prior two years but it is below the 2.9 percent average annual growth rate in the decade from 1995 to 2005. In other words, there is nothing extraordinary about the recent rates of productivity growth so there is no special reason for believing that a burst of hiring is imminent.

In case you somehow missed it, I'd be happy to be wrong, but I am not anticipating a sudden burst of job growth anytime soon, and this worry is not new by any means.

January 04 2010

Paul Krugman: That 1937 Feeling

There's a pretty good chance that the next few economic reports will make it appear that the economy is improving, but those reports may not be as positive as they seem on the surface. Will policymakers "misinterpret the news and repeat the mistakes of 1937?":

That 1937 Feeling, by Paul Krugman, Commentary, NY Times: Here’s what’s coming in economic news: The next employment report could show the economy adding jobs for the first time in two years. The next G.D.P. report is likely to show solid growth in late 2009. There will be lots of bullish commentary — and the calls we’re already hearing for an end to stimulus, for reversing the steps the government and the Federal Reserve took to prop up the economy, will grow even louder.
But if those calls are heeded, we’ll be repeating the great mistake of 1937, when the Fed and the Roosevelt administration decided that the Great Depression was over, that it was time for the economy to throw away its crutches. Spending was cut back, monetary policy was tightened — and the economy promptly plunged back into the depths. ...
As you read the economic news, it will be important to remember, first of all, that blips — occasional good numbers, signifying nothing — are common even when the economy is ... in a prolonged slump. ...
Such blips are often ... statistical illusions. But ... they’re usually caused by an “inventory bounce.” When the economy slumps, companies typically find themselves with ... excess inventories, [and] they slash production; once the excess has been disposed of, they raise production again, which shows up as a burst of growth in G.D.P. Unfortunately, growth caused by an inventory bounce is a one-shot affair unless underlying sources of demand, such as consumer spending and long-term investment, pick up.
Which brings us to the still grim fundamentals of the economic situation. During the good years of the last decade,... growth was driven by a housing boom and a consumer spending surge. Neither is coming back. ...
What’s left? A boom in business investment would be really helpful... But it’s hard to see where such a boom would come from: industry is awash in excess capacity, and commercial rents are plunging in the face of a huge oversupply of office space.
Can exports come to the rescue? For a while, a falling U.S. trade deficit helped cushion the economic slump. But the deficit is widening again, in part because China and other surplus countries are refusing to let their currencies adjust.
So the odds are that any good economic news ... will be a blip, not an indication that we’re on our way to sustained recovery. But will policy makers misinterpret the news and repeat the mistakes of 1937? Actually, they already are.
The Obama fiscal stimulus plan is expected to have its peak effect ... around the middle of this year, then start fading out. That’s far too early: why withdraw support in the face of continuing mass unemployment? Congress should have enacted a second round of stimulus months ago... But nothing was done — and the illusory good numbers we’re about to see will probably head off any further possibility of action.
Meanwhile, all the talk at the Fed is about the need for an “exit strategy” from its efforts to support the economy. One of those efforts, purchases of long-term U.S. government debt, has already come to an end. It’s widely expected that another, purchases of mortgage-backed securities, will end in a few months. This amounts to a monetary tightening, even if the Fed doesn’t raise interest rates directly — and there’s a lot of pressure on Mr. Bernanke to do that too.
Will the Fed realize, before it’s too late, that the job of fighting the slump isn’t finished? Will Congress do the same? If they don’t, 2010 will be a year that began in false economic hope and ended in grief.

December 30 2009

Will Economists Ever Learn?

Will the crisis teach economists not to be overconfident about their abilities?

My answer is here.

Christina Romer on Job Creation

It's looking as though the recovery of labor markets will follow the pattern of the last two recessions and lag significantly behind the recovery of output. Additional fiscal policy measures could be used to help employment markets recover faster, so this statement from Christina Romer about the administration's plans to create jobs is good to see. But how much of a priority will job creation be for the administration given that it has other things it would like to accomplish? The amount of political capital that the administration is willing to use to push an expanded version of this legislation forward will say a lot about its true commitment to job creation:

Making job creation a priority, by Christina Romer, Commentary, President Obama has laid out a series of steps that should be at the heart of our continuing efforts to accelerate job growth, rebuild our economy for the long term, and bring American families relief during these difficult times. ...
Our nation faces double-digit unemployment. Far too many Americans still are struggling to make ends meet. But to understand where we need to go, it's important to look back at where we started. On the first days after the president was elected, our economy was rolling toward the edge of a cliff with ever-increasing momentum.President Obama instructed his economic team to take swift action to stem the tide of crisis. And we did..., we took unprecedented - and often unpopular - action to stave off a total economic collapse.
We worked with Congress to pass the American Recovery and Reinvestment Act, which has already provided tax relief to millions of small businesses and families, saved more than a million jobs and begun to lay the foundation for lasting recovery. ... Today, our economy is growing for the first time in more than a year. Last month, employment was nearly stable and the unemployment rate dropped slightly.
But we understand that talking about what we've accomplished may mean little to someone who is still out of a job. That's why President Obama outlined plans earlier this month to accelerate private-sector job creation in three key areas.
First, because small businesses are the No. 1 driver of job growth in America, the president's plan encourages investment by ... proposing a one-year elimination of the tax on capital gains from new investments in small businesses.
We're also calling for the extension of Recovery Act provisions to give small businesses tax incentives to invest in new equipment and other types of capital goods. We will work with Congress to create a tax cut for small businesses that hire new workers. And we will eliminate fees and increase loan guarantees for small businesses that borrow through the Small Business Administration.
Second, because smart, targeted investments in energy efficiency can help create jobs, we will create new incentives for consumers who invest in energy-efficient retrofits to their homes. And we will expand Recovery Act programs to leverage private investment in energy efficiency and create clean-energy manufacturing jobs.
Finally, the president is calling for investments in a wide range of infrastructure, designed to get out the door as quickly as possible while continuing a sustained effort at creating jobs and improving America's long-run productivity. The infrastructure projects include highway, transit, rail aviation and water projects. ...
These are important steps, but there is still so much work that remains. President Obama ... will not rest until every American who wants a job has one.

State and local governments also need more help, and this could do a lot to save existing jobs, so I'd like to see that on the list as well.

December 24 2009

Unemployment and Excess Capacity


The excess capacity series is defined as 100 - capacity utilization rate.
The unemployment series is the civilian unemployment rate.

The excess capacity series (red line) peaked in June of this year, and has been moving downward ever since. If the pattern in the two most recent recessions holds, those in 1990-91 and 2001, the peak in the unemployment rate will come between 16 and 19 months after the peak in excess capacity, i.e. around a year from today (though prior to 1990 the peaks were coincident).

The most recent data on the unemployment rate showed a downward tick from 10.2 percent to 10.0 percent, so perhaps unemployment has already peaked and the lag will be shorter this time. But perhaps not. As an inspection of the unemployment series in the graph shows, the unemployment rate bounces around even when it is trending upward or downward. So it's hard to tell from one month's data whether the downward tick in the unemployment rate is temporary and unemployment still has a ways to go before peaking (as in the last two recessions), or a sign that a turning point has been reached and things are getting better (which would represent a reversion to the more coincident movement in the two series observed before 1990).

Note, however, that in the 2001 recession, unemployment fell briefly just after excess capacity peaked, but then resumed its upward movement for several more months before reaching a turning point 19 months after the turning point in excess capacity. Thus, while the recent downward tick in the unemployment rate is good news, certainly better than an uptick, we should be prepared for the possibility that the pattern in the last recession might repeat itself and unemployment will head back upward for several more months before it reaches its peak. I hope that doesn't happen, the sooner unemployment returns to normal the better, but we need to be better prepared than we are for the very real possibility that unemployment will continue to trend upward. I'd like to see more done on both the monetary and fiscal policy fronts as a preemptive measure, we can always ease off if things turn our better than expected, but at the very least we need to resist calls from the deficit and inflation hawks to begin pulling back and continue the programs that are already in place.

[Question: What happened from mid 1997 through the beginning of 1999 that caused the two series to move in opposite directions and separate?]

December 22 2009

Conducting Monetary Policy when Interest Rates Are Near Zero: Will it Work?

I have been more skeptical than most about the ability of quantitative easing to stimulate output and employment, so I thought I'd counter that with this explanation of how QE works, what might go wrong, and some of the evidence in its favor.

[My doubts come on two fronts. The first is the ability of QE to affect long-term real rates, and the evidence is somewhat favorable on this point, though not 100 percent compelling. It does seem that the Fed can lower long-term real rates, mortgage rates in particular, though why we want to stimulate investment in new housing in the aftermath of an housing bubble is a question we might want to ask.

My second objection is related to this - even if we do lower long-run real mortgage rates, will that stimulate new investment in housing given the inventory problem that already exists, and given the condition of the economy? I'm doubtful, and that doubt extends generally. The mechanism described below relies upon lower real interest rates stimulating new investment, but even if long-term rates fall across the board, will firms be inclined to go out and buy new factories and equipment when so much of what they have is sitting idle? 

Fiscal policy can put these resources to work directly, but monetary policy must induce firms to invest (or induce households to purchase housing and durables), and in a recession that may be hard to do. That's why I've emphasized fiscal policy, and that is what my objection is mostly about. The focus on the Fed has made it appear that monetary rather than fiscal policy is our best bet at this point. Monetary policy might be able to help for the reasons explained below, so I have no objection to trying, but fiscal policy needs to take the lead.

I should acknowledge that it may not be politically possible at this point to do more on the fiscal policy front, and the 3.5 percent growth rate for third quarter GDP that turned out to be a false signal didn't help at all (note, however, that the Fed is equally unlikely to respond to calls for it to do more). But there did seem to be momentum building toward providing more help through fiscal policy -- there was even a jobs summit -- however the talk about fiscal policy suddenly ended as people turned their guns on the Fed. While that may have been needed to get the Fed thinking harder about what more it can do, we should have also kept up the pressure on fiscal authorities. That fiscal authorities have been let off the hook is disappointing]:

Conducting Monetary Policy when Interest Rates Are Near Zero, by Charles T. Carlstrom and Andrea Pescatori, Economic Commentary, FRB Cleveland: This Economic Commentary explains the concerns that are associated with the combination of deflation, low economic activity, and zero nominal interest rates and describes how monetary policy might be conducted in such a situation. We argue that avoiding expectations of deflation is key and that the monetary authority needs to demonstrate an unequivocal commitment to preventing deflation. We also argue that price-level targeting might be a good device for communicating such a commitment.
While business cycles are inevitable, there is quite broad agreement among economists and policymakers that monetary policy can and should be used to damp fluctuations in economic activity. But some fluctuations can occur in an unusual economic environment in which the traditional tools of monetary policy become useless. When short-term interest rates are at or near zero, for example, monetary policy cannot be implemented in the usual way—by adjusting these short-term interest rates. If policymakers want to lower rates in such an environment, they must look for alternative ways of conducting policy. With the federal funds rate hovering just above zero since December 2008, the current U.S. economic situation is a case in point. To conduct monetary policy under these conditions, the Federal Reserve has had to turn to a new strategy and new tools.
Some economists have pointed to another problem that an environment of near-zero interest rates could pose for monetary policy. They suggest that the inability to lower interest rates could allow a sudden and unexpected fall in the demand for goods and services to push the economy into a deflationary spiral, a situation in which falling prices and falling output feed upon each other. The fear is that a negative demand shock that pushes down prices (in short, a deflationary shock) could further decrease output, thereby accentuating the deflationary process. This additional deflation will then lead to further output decline. Paul Krugman, the economist and New York Times columnist, has dubbed this downward spiral a “black hole,” from where there is no return.1
This Economic Commentary explains the concerns that are associated with the combination of deflation, low economic activity, and zero nominal interest rates and describes some of the ways in which monetary policy might be conducted in this situation. We conclude by emphasizing that to be effective in an environment of zero short-term nominal interest rates, monetary policy needs to be unequivocally committed to avoiding expectations of deflation. We also argue that price-level targeting might be a good device for communicating such a commitment. While this policy prescription follows from the assumption that the zero interest rate bound is a consequence of a negative demand shock hitting the economy, it is worth stressing that falling prices can also be the consequence of a supply shock, namely particularly high productivity growth (not a bad thing!). This would clearly call for different policy actions than the ones described here.
Zero Interest Rates and the Black Hole
The special problem deflation might pose in times of near-zero nominal interest rates has to do with what could happen to real interest rates in such an environment and the effect that they could have on economic activity.
Consider, for example, a firm that decides to borrow money at a stated, or nominal, interest rate of 7 percent. If prices, including the firm’s product price, are expected to grow at 2 percent per year, then the real cost of borrowing for the firm (the real interest rate) is 5 percent per year. In principle, the real rate should be determined only by the saving and investment decisions of market participants, plus adjustments for risks, not monetary policy. In fact, a permanent change in expected inflation, say from 2 percent to 1 percent, will change only the nominal rate (in this case from 7 percent to 6 percent) and leave the real rate unchanged.
However, inflation expectations do not change instantaneously. Because they adjust over time, a policy move that decreases the nominal interest rate will also, in the short run, temporarily decrease the real rate. The decrease in the real rate will increase the willingness of banks to lend and firms to borrow. This extra lending will then temporarily stimulate output. In this scenario, a central bank could easily counteract a deflationary shock that reduces prices and expected inflation (which could potentially raise the real rate temporarily and depress the economy) by lowering the real rate, or equivalently, by lowering the nominal rate by an amount greater than the fall in prices.
But if a deflationary shock occurs when nominal rates are already at or close to zero, policymakers cannot counteract the shock by further lowering the nominal interest rate. Even if long-term inflation is well moored, the deflationary shock may still lower short-term inflation expectations and therefore increase the real interest rate. The increase in the real rate may further depress investment, consumption, and aggregate demand, causing prices to fall further. This second bout of deflation will increase the real rate again and exacerbate the decline in output and the original deflationary shock.
It is important to stress that the extreme version of this scenario—the black hole Krugman refers to—is unlikely to occur, partly because firms anticipating a drop in demand will eventually cut production enough to stop excess supply. Nevertheless, our inability to offset a deflationary shock could conceivably prolong a period of deflation and falling output.
Will Quantitative Easing Work?
Many argue that reserve targeting (or quantitative easing when it is done in a zero-interest-rate environment), can still stimulate the economy when short-term interest rates are zero. But if quantitative easing is implemented through the purchase of short-term securities, this policy is almost certainly doomed to failure. Since banks’ cash reserves and short-term securities are perfect substitutes when nominal interest rates are at zero, banks have no incentive to lend the money out.
They are likely to simply substitute the cash they receive from the central bank for the securities they were holding in reserves. Therefore, the supply of money in circulation (that is, one common and useful definition of it, M1, which is currency held by the public plus demand and other checkable deposits) is not affected. To affect M1, banks need to lend the cash out to the private sector, which in turn will redeposit part of this cash into checking accounts, thereby increasing money in circulation. Because open market operations will not increase the money supply when short-term interest rates are zero, they can’t be used to increase either real economic activity or prices.
But this reasoning applies to the purchase of short-term government securities. In March 2009, the Federal Reserve embarked on a program of quantitative easing by purchasing longer-term securities to stimulate the economy. Unlike short-term securities, these still had a positive rate of interest. The longer-term securities included agency mortgage-backed securities, agency debt, and longer-term government securities.
The idea behind buying longer-term government securities is that doing so will drive up their demand and therefore the price of these securities. This will decrease their yield and therefore lower long-term interest rates. Lower long-term interest rates will end up stimulating investment and the economy. The assumption underlying this approach is that banks will not simply sit on the cash they receive from the Fed in exchange for the long-term securities, and the supply of money in circulation will actually rise in consequence. That is, banks cannot view long-term and short-term government securities as perfect substitutes. Otherwise, they will not attempt to buy other long-term securities or loan out this extra cash.
While evidence suggests that longer-term interest rates fell with the announcement that the Fed would purchase long-term securities, the challenge for this policy is to have a large and lasting impact. That impact rests on a couple of assumptions, one of which is that the markets for short- and long-term bonds are segmented from each other; that is, short-term and long-term securities are not good substitutes for one another. With segmented markets, the supply and demand schedules for loanable funds in each market are separate.
But even if markets are segmented, over time, traders will be “tempted out of their preferred market segment” by the lure of higher expected returns. By decreasing long-term rates, the risk-adjusted return for short-term treasuries increases. Long-term interest rates will start to increase as investors substitute away from long-term securities to short-term securities, or equivalently, zero-interest-earning excess reserves. The extra money pumped into the system by long-term security purchases may quickly wind up back in banks’ reserve accounts.
Another way to think about this is that eventually long-term interest rates are eventually determined by market fundamentals, namely long-term inflation expectations in conjunction with expected long-term economic growth. Long-run growth is driven by nonmonetary factors.
Even while purchases of long-term treasuries may be affecting long-term interest rates, it is not easy to assess the size of the purchase that is required to affect yields in the desired manner or the timing of those effects.
In terms of sheer numbers, quantitative easing was dominated by purchases of mortgage backed securities (MBS) and not long-term government securities after interest rates effectively hit zero. The idea behind purchasing MBS is that the real impact of the operation will be much larger. This is because MBS are nowhere near as closely substitutable with short-term securities as government-issued long-term securities are, which implies that the market segmentation between short-term government securities and private MBS will persist for a much longer period of time. The evidence does suggest that these purchases have been successful in lowering mortgage rates.
Communication as a Policy Tool
As we have seen, when short-term rates are zero, monetary policymakers must look beyond standard tools to influence inflation and output. But they have another tool not yet mentioned. The FOMC can communicate, usually through speeches and its policy statements, information that is meant to influence expectations about future changes in the federal funds rate. Expectations of future monetary policy can increase future money growth and hence expected inflation. Increased inflationary expectations will lower real interest rates. This is one way of understanding the FOMC’s current language that there are likely to be “exceptionally low levels of the federal funds rate for an extended period.”
We have discussed the importance of expected inflation in counteracting a deflationary spiral. If interest rates are at zero, increases in expected inflation will decrease today’s real interest rate, stimulating both the real economy and prices. Using communication to boost future inflation expectations in this environment requires policymakers to promise that they will “err” on the side of keeping interest rates low even after the economy starts to recover. In essence, this future inflation will stimulate the economy today and actually increase money today.
Perhaps the best way for the central bank to communicate that it plans to deliver on its promise to “err” on the side of future inflation whenever deflationary shocks hit is to develop a simple rule that the public can easily monitor to see whether the central bank is fulfilling its promise. One simple rule is a price-level target. With a price-level target, the central bank commits to sticking to a given path for the level of prices over some horizon. If prices start rising faster than a prespecified rate, policymakers must lower inflation in the future to get the price level back to the target. Similarly, if there is a deflationary shock, the central bank must inflate in the future because it has to bring the price level back up (see figure 1).

Figure 1. Inflation and Price-Level Responses to Different Targeting Regimes

Instead of a price-level target, many central banks around the world have adopted inflation targeting, where inflation over a period of around two years is on average kept constant. A credible inflation target will anchor inflation expectations over the specified horizon, which, by definition, is enough to avoid expected deflations and increases in the real rate.
However, there is an important difference between an inflation target and a price-level target. An inflation target “lets bygones be bygones,” while a price-level target corrects for past misses. If prices fall on a year-over-year basis, a price-level target requires the central bank to reinflate prices until they are back to the target. An inflation target requires only that the rate of inflation be returned to its target rate from the present onward.
A price-level target is essentially a promise that a deflationary shock today will increase inflation in the future and thus expected inflation today. This promise of future inflation will lower real interest rates even when short-term nominal rates are zero. Long-term inflation is still pinned down as it is with an inflation target. One of the rare positive elements of the recent period of turmoil has been the stability of any measure of inflation expectations (survey or market-based), especially at medium and long horizons. It is an open question whether a central bank targeting the price level would have the same credibility, so that long-term inflation expectations remained well-anchored.
One drawback of a price-level target is that it necessitates stimulating the economy whenever prices fall—no matter what the cause. For example, an expansion driven by a positive supply shock would naturally put downward pressure on prices and upward pressure on the real rate, but few economists believe that monetary policy accommodation is helpful in such a situation. An inflation target can potentially be changed, to respond to unusual economic conditions,but a price-level target has the advantage of responding according to a very simple and easy-to-understand rule.
Avoiding the Zero Lower Bound
Going forward, it is important to try and minimize the chances that short-term interest rates will hit zero in the future. One way of doing this is for the Fed to increase its implicit long-term inflation target. Instead of the 1.5 percent–2 percent range for long-term inflation that most market participants currently expect the Fed to pursue, John Williams of the San Francisco Fed argues that the Fed’s long-term inflation target may have to be increased to the 2 percent–4 percent range. This will increase the long-term federal funds rate, thereby giving the Fed extra “ammunition” before the zero lower bound sets in.
But instead of a higher long-term inflation target, a price-level target is another way to mitigate the chances that a zero lower interest rate bound will be hit in the future. (Recall that a price-level target still implies a given long-term inflation rate.) If the economy is hit by a major deflationary shock when nominal rates are close to zero, a price-level target has a clear advantage over an inflation target. If monetary policy aims at stabilizing prices, policymakers must create future short- to medium-term inflation to correct for past misses. The future inflation promised by a price-level target will increase expected inflation over the short- to medium-term and therefore increase nominal rates, helping to insure that the zero lower bound for interest rates is never reached.
Undeniably, the zero bound produces problems for monetary policy, but these problems are not insurmountable. Communicating future monetary policy is the best way for monetary policymakers to increase inflation expectations when short-term interest rates are constrained by a zero lower bound. Furthermore, a price-level target is something that can potentially be used to enhance this communication. An appropriate price-level target can also reduce the likelihood of ever hitting the zero bound to begin with.
1. Although we focus on deflation, we recognize that some people are concerned about inflation risk in the economy as well. Our focus on deflation is not intended to express a view on the likelihood of one outcome as being greater than another.
Recommended Readings
“Japanese Monetary Policy: A Case of Self-Induced Paralysis?” by Ben Bernanke. 2000. In Japan’s Financial Crisis and its Parallels to U.S. Experience, Institute for International Economics, special report no. 13, edited by R. Mikitani and A. Posen.
“It’s Baaack! Japan’s Slump and the Return of the Liquidity Trap,” by Paul Krugman. 1998. Brookings Papers on Economic Activity, vol. 2, edited by W. Brainard and G. Perry.
“Crisis in Prices,” by Paul Krugman, 2002. New York Times.
“Heeding Daedalus: Optimal Inflation and the Zero Lower Bound,” by John C. Williams. 2009. Forthcoming in Brookings Papers on Economic Activity.
“The Zero Bound on Interest Rates and Optimal Monetary Policy,” by Gauti Eggertsson and Michael Woodford. 2003. Brookings Papers on Economic Activity, vol. 1, edited by W. Brain.

December 18 2009

The Fed Can Help, But Fiscal Policy Is The Key To Job Creation

At CBS MoneyWatch, why I haven't joined the loud calls for the Fed to engage in quantitative easing as a means of creating jobs:

The Fed Can Help, But Fiscal Policy Is The Key To Job Creation, by Mark Thoma: There are many people currently criticizing the Fed for worrying too much about inflation and not enough about employment. They want the Fed to use quantitative easing - the purchase of financial assets when interest rates are already at zero - as a means of stimulating the economy and creating jobs. I think it's a mistake ...[...continue reading...]...

December 10 2009

Krugman versus Bartlett on Job Creation

[The discussion begins at the 2:30 mark on the video. Source and transcript.]

The main issues they debate are whether another stimulus package is needed at this point, and if so, whether money allocated to the TARP program should be redirected to job creation.

December 09 2009

The Administration’s Job Creation Proposal is Inadequate

At CBS MoneyWatch, a brief summary and evaluation of the president's job creation proposal:

The Administration’s Job Creation Proposal is Inadequate, by Mark Thoma: The president unveiled his job creation strategy yesterday, and it contains three main elements, tax incentives that encourage small businesses to hire more workers, more spending on infrastructure and other large projects, and rebates for consumers who invest in energy saving improvements for their homes (the so-called "cash for caulkers" program).

How will this program be financed? According to Robert Reich, the plan is to use $70 billion of the recent unexpected $200 billion in savings on the TARP program arising from new estimates of the program's cost.

This proposal is not very specific, and if it makes it through the legislative process it will likely change quite a bit. But as it stands there are three problems with it. First, it does not create jobs directly, all job creation occurs indirectly through incentives such as reduced capital gains taxes for small businesses, other measures that make investment cheaper, rebates for home weatherization, etc. The program relies upon people acting upon these incentives, which they may or may not do, and even if the incentives are acted upon job creation is likely to be slow due to its indirect nature. Second, the amount, $70 billion, is too small to make much of a difference given the size of the unemployment problem. Third, it's disappointing that one of the best job creation/preservation measures the administration could have proposed, more help for state and local governments battered by budget problems arising from the recession is not part of the proposal. [Summary of various types of job creation strategies]

We need more direct and more immediate job creation than this proposal puts forth, and we need a much larger job stimulus package to make a noticeable dent in the problem. The argument for the package as announced is that this is the most that the administration can possibly get, anything larger or involving direct hiring won't be politically feasible due to worries over the deficit and worries that direct hiring amounts to wasteful "make-work" (a view I disagree with).

Thus, given the meager size of the proposal and the manner in which it is structured, it seems that this is intended more for its political effects than for its economic effects. The attempt is to tell workers, small businesses, and others that the administration cares about them, it "feels their pain" to borrow a phrase from a previous administration.

But I think this strategy is a mistake both economically and politically. Economically, it leaves people unemployed who could be working and paying taxes, an unacceptable outcome given the struggles unemployed households face. Politically, if the administration and congress are going to do another stimulus package, it needs to be large enough to make a difference.

In the end -- which for a politician means the next election -- people won't care that Obama threw a speech and a few billion dollars their way, that he understood the difficulties they face. People want action, some demonstration that the administration understands the problem and has done what is needed to fix it, and measures intended purely for their political effect won't get us there. Perhaps the plan is to blame Republicans for preventing more aggressive programs if jobs are still a problem as the election approaches, but I don't think that will work, particularly since Democrats do not appear to be willing to fight tooth and nail for a larger package. If jobs are not forthcoming, it's the Democrats not the Republicans who will face the wrath of voters. [Permalink]

December 06 2009

Will Deficits Bankrupt Our Grandchildren?

Robert Frank says complaints that running deficits to offset downturns will bankrupt our grandchildren are "absurd":

How to Run Up a Deficit, Without Fear, by Robert H. Frank, Commentary, NY Times: Few subjects rival the federal budget deficit in its power to provoke muddled thinking.
It’s a pity, because there are really only three basic truths that policy makers need to know about deficits: First, it’s actually good to run them during deep economic downturns. Second, whether deficits are bad in the long run depends on how borrowed money is spent. And third, eliminating deficits entirely would not require any painful sacrifices. ...
The first proposition comes from ... Keynes, who argued that when total spending falls well below the level required for full employment, the economy won’t recover quickly on its own. Consumers won’t lead the way... And most businesses won’t invest... Only government ... has both the motive and opportunity to increase spending significantly during deep downturns.
Of course, if the government borrows to do so, the debt must eventually be repaid (or the interest on it must be paid forever). That fact has provoked strident protests about government “bankrupting our grandchildren.”
It’s an absurd complaint. Failure to stimulate the economy would mean a longer downturn. That ... would mean ... reduced tax receipts, increased unemployment insurance payouts, and depressed private investment. The net result? Higher total public borrowing and a permanent decline in productivity...
Once the economy is back on its feet, deficit logic changes. At full employment, extra borrowing often compromises future prosperity, just as critics say. ...
But the reverse would be true if government borrowing were used for productive investments. After decades of neglect of the nation’s infrastructure, attractive public investment opportunities abound. ... When government undertakes such investments, our grandchildren become richer, not poorer. ...
To eliminate deficits, we need additional revenue. The encouraging news is that we could raise more than enough to balance government budgets by ... tax[ing] activities that cause harm to others. Called Pigovian taxes ... such levies create a burden that is more than offset by the reductions they cause in costly side effects of everyday activities. ...

When producers emit sulfur dioxide into the atmosphere,... the resulting acid rain harms others. As the ... Clean Air Act demonstrated, the most efficient ... remedy was to tax sulfur dioxide emissions. ... Similarly, when motorists enter congested roadways, they impose additional delays on others. Here, too, taxation is the best remedy...

When the transactions of financial speculators fuel asset bubbles, they increase the risk of financial meltdowns. A small tax on those transactions would reduce this risk. ... Carbon dioxide emissions contribute to global warming. Here as well, taxation offers the most efficient and least intrusive remedy.
Anti-tax zealots denounce all taxation as ... depriving citizens of their right to spend their hard-earned incomes as they see fit. Yet nowhere does the Constitution ... does it grant us the right to harm others with impunity. No one is permitted to steal our cars or vandalize our homes. Why should opponents of taxation be allowed to harm us in less direct ways?
Taxes on harmful activities would be justified quite apart from any need to balance government budgets. But such taxes would also generate ample revenue for the public services we demand, quieting the ill-considered commentary about deficits. ...

[See also: "Bogus Arguments about the Burden of the Debt"]

December 02 2009

"The Wrong Jobs Summit"

Brad DeLong says the wrong people are meeting at the jobs forum:

The wrong jobs summit, by Brad DeLong, Commentary, The Week: The White House is hosting a jobs summit this week. I, however, cannot but think that ... it will be the wrong people talking about the wrong things.

Let me back up. Ever since the 1930s, economists trying to analyze the determinants of spending have focused on two of the economy’s markets: the market for liquidity and the market for savings. ...
For the government to boost jobs, it must to do something to change the balance of supply and demand in either the market for liquidity or the market for savings. In general, the ... Federal Reserve ... acts to tweak supply and demand in the market for liquidity. The president and Congress act to tweak supply and demand in the market for savings. ...

Right now, if you ask the decisive members of congress—by which I mean the Blue Dog Democrats in the House, or the most conservative Democrats and most liberal Republicans in the Senate —why the president and the Congress are not doing more to reduce unemployment and boost spending and income, the answer you’ll get is ... well, you probably wouldn't get an intelligible answer.

But if you did get an explanation for the lack of congressional action it would go something like this: Attempts to ... boost spending would (a) increase the national debt burden on future taxpayers and (b) lead to a large decline in bond prices and a boost in interest rates. Why? Because businesses would try to increase their liquidity to support higher spending, driving up interest rates, which, in turn, would cause businesses to cut back on investment, thus neutralizing most or all of the stimulative policies.

Similarly, if you were to ask the Federal Reserve why it isn’t doing more to reduce unemployment and boost spending and income, the answer you would get is this: Spending is in no way constrained by a shortage of liquidity..., indeed we have “flooded the zone” with liquidity. As a result, the Fed is disinclined to pursue additional tweaks ... in ... liquidity because it fears such efforts would fuel destructive inflation in the future without boosting employment and spending in the present.

Both of these arguments are comprehensible... But they cannot both be true at the same time. Either the economy is so awash in liquidity that the Federal Reserve cannot do much to boost spending—in which case additional spending by the government won’t generate any substantial rise in interest rates. Or additional government spending will crowd out investment...—in which case the economy is not awash in liquidity, and quantitative easing by the Federal Reserve could do a lot right now to boost spending and employment.

It appears that what we have here is a failure to communicate. ...

Thus we need a jobs summit right now. We need the White House's National Economic Council and key congressional “centrists” on one side and the Federal Reserve Open Market Committee on the other to meet. Those two groups seem to have very inconsistent views of the economic situation. ... Something has to give. If they could reach agreement on whose view ... is likely correct, then a rescue plan—entailing either more government spending or greater liquidity—would become obvious.

Until that “jobs summit” is convened, others are moot.

December 01 2009

November 27 2009

DeLong: Time to Give Thanks for the Bailouts

Brad DeLong says those who argue that fiscal stimulus policies can't work and are too costly "rely on arguments that are incoherent at best, and usually simply wrong, if not mendacious":

Why Are Good Policies Bad Politics?, by J. Bradford DeLong, Commentary, Project Syndicate: From the day after the collapse of Lehman Brothers last year, the policies followed by the United States Treasury, the US Federal Reserve, and the administrations of Presidents George W. Bush and Barack Obama have been sound and helpful. The alternative – standing back and letting the markets handle things – would have brought ... higher unemployment than now exists. Credit easing and support of the banking system helped significantly...
The fact that investment bankers did not go bankrupt last December and are profiting immensely this year is a side issue. Every extra percentage point of unemployment lasting for two years costs $400 billion. A recession twice as deep as the one we have had would have cost the US roughly $2 trillion – and cost the world as a whole four times as much. In comparison, the bonuses at Goldman Sachs are a rounding error. ...
The Obama administration’s fiscal stimulus has also significantly helped the economy. Though the jury is still out on the effect of the tax cuts in the stimulus, aid to states has been a job-saving success, and the flow of government spending on a whole variety of relatively useful projects is set to boost production and employment in the same way that consumer spending boosts production and employment.
And the cost of carrying the extra debt incurred is extraordinarily low: $12 billion a year of extra taxes ... at current interest rates. For that price, American taxpayers will get an extra $1 trillion of goods and services, and employment will be higher by about ten million job-years.
The valid complaints about fiscal policy ... are not that it has run up the national debt..., but rather that ... we ought to have done more. Yet these policies are political losers now: nobody is proposing more stimulus. This is strange... Good policies that are boosting production and employment without causing inflation ought to be politically popular, right?
With respect to Obama’s stimulus package, it seems to me that there has been extraordinary intellectual and political dishonesty on the American right, which the press refuses to see. For two and a half centuries, economists have believed that the flow of spending in an economy goes up whenever groups of people decide to spend more... – and government decisions to spend more are as good as anybody else’s. ...
Obama’s Republican opponents, who claim that fiscal stimulus cannot work, rely on arguments that are incoherent at best, and usually simply wrong, if not mendacious. Remember that back in 1993, when the Clinton administration’s analyses led it to seek to spend less and reduce the deficit, the Republicans said that that would destroy the economy, too. Such claims were as wrong then as they are now. But how many media reports make even a cursory effort to evaluate them?
A stronger argument, though not by much, is that the fiscal stimulus is boosting employment and production, but at too great a long-run cost because it has produced too large a boost in America's national debt. If interest rates on US Treasury securities were high and rising rapidly as the debt grew, I would agree... But interest rates on US Treasury securities are very low...
Those who claim that America has a debt problem, and that a debt problem cannot be cured with more debt, ignore (sometimes deliberately) that private debt and US Treasury debt have been very different animals – moving in different directions and behaving in different ways – since the start of the financial crisis. /blockquote>

What the market is saying is not that the economy has too much debt, but that it has too much private debt, which is why prices of corporate bonds are low and firms find financing expensive. The market is also saying – clearly and repeatedly – that the economy has too little public US government debt, which is why everyone wants to hold it.

Just one comment: Brad's right.

November 23 2009

Paul Krugman: The Phantom Menace

Why is the administration so fearful of doing more to help employment recover?:

The Phantom Menace, by Paul Krugman, Commentary, NY Times: A funny thing happened on the way to a new New Deal. ... Consider the contrast between what Mr. Obama’s advisers were saying on the eve of his inauguration, and what he himself is saying now.
In December 2008 Lawrence Summers ... called for decisive action. “Many experts,” he warned, “believe that unemployment could reach 10 percent by the end of next year.” In the face of that prospect, he continued, “doing too little poses a greater threat than doing too much.”
Ten months later unemployment reached 10.2 percent, suggesting that despite his warning the administration hadn’t done enough to create jobs. You might have expected, then, a determination to do more.
But in a recent interview..., the president sounded diffident and nervous about his economic policy. He spoke vaguely about possible tax incentives for job creation. But “it is important though to recognize,” he went on, “that if we keep on adding to the debt, even in the midst of this recovery, that at some point, people could lose confidence in the U.S. economy in a way that could actually lead to a double-dip recession.”
What? Huh?
Most economists I talk to believe that the big risk to recovery comes from the inadequacy of government efforts: the stimulus was too small, and it will fade out next year, while high unemployment is undermining both consumer and business confidence.
Now, it’s politically difficult for the Obama administration to enact a full-scale second stimulus. Still, he should be trying to push through as much aid to the economy as possible. ...
Instead, however, Mr. Obama is lending his voice to those who say that we can’t create more jobs. And a report on suggests that deficit reduction, not job creation, will be the centerpiece of his first State of the Union address. What happened?
It took me a while to puzzle this out. But the concerns Mr. Obama expressed become comprehensible if you suppose that he’s getting his views, directly or indirectly, from Wall Street.
Ever since the Great Recession began ... some (not all) major Wall Street firms have warned that efforts to fight the slump will produce even worse economic evils. In particular, they say, never mind the current ability of the U.S. government to borrow long term at remarkably low interest rates — any day now, budget deficits will lead to a collapse in investor confidence, and rates will soar.
And it’s this latter claim that Mr. Obama echoed in that ... interview. Is he right to be worried? ... A ... model ... is Japan in the 1990s, which ran persistent large budget deficits, but also had a persistently depressed economy — and saw long-term interest rates fall almost steadily. ...
And shouldn’t we consider the source? As far as I can tell, the analysts now warning about soaring interest rates tend to be the same people who insisted, months after the Great Recession began, that the biggest threat facing the economy was inflation. ...
Still, let’s grant that there is some risk that doing more about double-digit unemployment would undermine confidence in the bond markets. This risk must be set against the certainty of mass suffering if we don’t do more — and the possibility, as I said, of a collapse of confidence among ordinary workers and businesses.
And Mr. Summers was right the first time: in the face of the greatest economic catastrophe since the Great Depression, it’s much riskier to do too little than it is to do too much. It’s sad, and unfortunate, that the administration appears to have lost sight of that truth.

November 18 2009

Obama's Wrong-Headed Thinking on the Deficit

Edward Harrison catches this quote from Obama:

The president is in Beijing as part of his tour through several Asian countries to address economic challenges. He spoke candidly about the precarious balancing act his administration is trying to perform. He wants to spend money to kick-start the economy, but at the same time is in danger of creating too much red ink.
Obama warned the United States' climbing national debt could drag the country into a "double-dip recession," though he said he's still considering additional tax incentives for businesses to reverse the rising unemployment rate.
"There may be some tax provisions that can encourage businesses to hire sooner rather than sitting on the sidelines. So we're taking a look at those," Obama told Fox News' Major Garrett.
"I think it is important, though, to recognize if we keep on adding to the debt, even in the midst of this recovery, that at some point, people could lose confidence in the U.S. economy in a way that could actually lead to a double-dip recession."

I hope his economic advisers set him straight, though I suppose there's a chance that this nonsense is coming from them. We needed a larger stimulus package to begin with, and the economy could still use more help, labor markets in particular.

Let's hope that this doesn't turn into a call to actually start balancing the budget before the economy has fully recovered as that would increase the chances of the double dip recession that he is so worried about (something we should have learned from the 1937-38 experience where an attempt to balance the budget prematurely plunged the economy back into recession).

These comments also make it sound like any jobs program, if we get one at all, will be limited to (right-wing approved) tax cuts which is, in my opinion, inferior to direct job creation strategies. Tax cuts can be part of the mix, but by themselves are unlikely to do enough to solve the employment problem.

November 15 2009

"Unlike the New Deal, Obama’s Plan does not put People on the Public Payroll"

I missed this when it first ran in the Washington Post:

Unlike the New Deal, Obama’s plan does not put people on the public payroll, by Alec MacGillis, For The Washington Post, The Register Guard: To hear President Obama tell it, he’s been busy creating jobs since taking office. The $787 billion stimulus package, he said last winter, would “save or create 3.5 million jobs.” The White House is touting reports from recipients of stimulus funds asserting that they have created or saved 640,000 jobs so far.
Yet the national unemployment rate has now hit 10.2 percent... Obama declared recently that more action is needed: “I can promise you that I won’t let up until the Americans who want to find work can find work.”
It was a strong vow, but it raises a question: Why has a White House that talks so much about boosting employment steered clear of the most direct strategy that could keep Americans on the job?
Since taking office, the Obama administration has studiously avoided paying people to go to work, which could be accomplished by subsidizing workers’ private-sector employment or by creating new government-paid jobs. ...
Instead Obama’s team has taken a more indirect approach, a prudence that critics on the left say is misplaced. ... Engaging in more forthright job creation could invite some political pitfalls (such as those constant accusations of socialism), but is double-digit unemployment any less a political risk?
The administration is “scared of (any plans) seeming like old-fashioned make-work, but that’s what it is: You’re giving (people) jobs because they have nothing left to do,” said Dean Baker... “Giving people a shot at a job has to be worth a little bad publicity … but as in a lot of areas, they proved more cautious.”
White House officials ... say they opted against direct jobs programs not for political reasons but because they thought such efforts would not produce long-term value.
“I think we got the Recovery Act right,” Larry Summers, the president’s chief economic adviser, said in an interview. “The primary objective of our policy is having more work done, more product produced and more people earning more income. It may be desirable to have a given amount of work shared among more people. But that’s not as desirable as expanding the total amount of work.”
Two-thirds of the stimulus went toward tax cuts, fiscal aid to states, and expanded unemployment benefits and food stamps. These efforts helped cushion the recession’s blow, saved public jobs and, by injecting demand into the economy, bolstered employment indirectly.
The remaining third of the stimulus, however, was expected to be the real jobs generator: $250 billion for infrastructure — roads, transit, water treatment — and for investments in energy efficiency, broadband access and other areas. But it is becoming clear that much of that spending is not producing many new jobs. ...
Administration officials argue that these investments, if done right, will lay the groundwork for growth for years to come. And they say that given the depth of the recession, it’s hardly a bad thing for the stimulus to deliver some punch a year or two from now. ... Summers said. “We designed the Recovery Act to ramp up over time, through 2010, and to make sure that the investments we made were important for the country’s future.”
In addition, public-works programs take longer to get started than people realize, officials say. ... None of this persuades the critics... [who] ... argue that there is plenty of direct job creation that could be done, short of heavy infrastructure, that could have lasting value. The liberal Economic Policy Institute has drafted a plan that, along with a new business tax credit for hiring that the White House is already considering, includes a pure public jobs proposal: giving money to states and cities to hire people to paint schools, board up vacant homes, staff child-care centers and reopen library branches. Workers would be paid the market wage. It would cost $35 billion for a year, not much more than the combined price tag for the homebuyers’ tax credit and the $250 checks that Obama has proposed sending to Social Security recipients. ...
Conservative economists stand steadfast against any movement toward direct job creation. ... Jobs programs “sound so good in theory, but it just doesn’t work that way,” said Larry Lindsey, director of the National Economic Council under President George W. Bush. It would be better to stick with safety-net benefits for those most in need and to enact new tax cuts, such as a suspension of the payroll tax to encourage hiring. ...

One confusion here is the strict demarcation between "growth policy" and "stabilization policy." Growth policy is an attempt to make the economy grow faster, and stabilization policy attempts to keep the economy as close as possible to that trend, i.e. to avoid business cycles.

When Republicans had the political microphone, they emphasized growth policy (because it allowed them to argue for what they really wanted, lower taxes, growth policy was simply the vehicle that allowed them to get there), and this was supported by academic work from people such as Robert Lucas who claimed that, from a welfare perspective, stabilization was of second order concern, growth policy was where policymakers should focus their effort if they wanted to enhance welfare. Summers' remarks reflect this type of thinking.

But, as Stephen G Cecchetti, Piti Disyatat and Marion Kohler note, stabilization policy can also have first-order effects:

The primary objective of macroeconomic policy is to maximize welfare – measured typically as income per capita. In working to meet this goal, the first question is whether policymakers should be concerned with stabilizing the economy around its long-run growth path. Stabilization is secondary if it has little or no effect on the level of real growth; while fluctuations have distributional consequences, they are of little direct concern...
The current consensus – as embodied in a variety of New Keynesian models – is that volatility can lower the long-run level of growth; so, smoothing fluctuations has first-order effects on welfare. While this conclusion is not without dissenters – see, for example, Lucas and Sargent (1979) and Lucas (2003) – it is accepted among policymakers, as is clear from the explicit or implicit role that output smoothing plays in the objectives of many central banks.

Even so, as Summers makes clear, the administration shunned "make-work" type stabilization policy in favor of policies devoted to building (or rebuilding) infrastructure because they could defend these policies against political attacks by pointing to their growth enhancing capabilities (same for tax cuts, even though everyone knew they were intended mostly for stabilization). So called make-work programs were denounced as wasteful by the opponents of stabilization policy, in part because they completely ignore the potential multiplier effects of such spending, but also because they ignore the value to communities that comes from the types of "make work" activities such as, say, those listed above in the discussion of a proposal from the EPI, and because they forget that stabilization can affect long-run growth in modern models.

Letting people struggle when they could be helped is not an acceptable policy, but it seems to be the one we've adopted. Putting unemployed people to work doing things of value for their communities is not wasteful, and given the very poor state of the labor market, we need to do something, and we need to do it now.

Update: See Alan Blinder's comments.

November 12 2009

"Obama has Lost his Way on Jobs"

Jeff Sachs:

Obama has lost his way on jobs, by Jeffrey Sachs, Commentary, Financial Times: ...The Obama administration’s stimulus policies are not well-targeted. The Republican alternatives are even worse. Both sides are missing the key fact: the US economy needs structural change that requires a new set of economic tools.
Consumer and investment demands are too low for full employment. ... Following a Keynesian approach, the Obama administration has focused on restoring consumer spending. ... During the previous bubble, the US consumer was encouraged to over-borrow. Recreating a new bubble is like offering just one more drink, on the government’s account, to overcome a mass hangover. ...
The Republican alternative is equally fatuous. For every problem there is a single Republican answer: tax cuts. Simple arithmetic reveals the stunning shortsightedness of this proposition. ...
There are three parts of a long-term solution. The first is to promote greater exports, partly through dollar depreciation and partly through expanded government support for export financing, for example extended to credit-constrained low-income countries that want to purchase US-produced technology. ...

A second component is a massive expansion of education spending and job training. The unemployment rate ... is 15.5 per cent among those without a high-school diploma. The US woefully under-invests in education outlays for the poor, who drop out of school and then cannot find gainful employment. ...

The third component is to spur an investment boom in areas of high social return... The conversion to a low-carbon economy would create jobs in the short run, a more productive economy in the medium run, and US technological leadership in the longer run.
The same is true with the overhaul of America’s ageing infrastructure at a time when cutting-edge technologies can dramatically improve the efficiency of resource use ... and the sustainability of our ecosystems.
During the Obama campaign we were told about a green recovery... We were told about ... complex multi-state projects that would employ huge numbers of workers while building a cutting-edge economy.
Little bits of these efforts are strewn through the stimulus legislation... But the administration has not done the hard work to bring these complex initiatives to reality. Intercity rail does not just appear by itself. Direct-voltage transmission lines require a new federal and regional power grid strategy. Nuclear power requires presidential leadership to get moving again. Carbon-capture and storage requires a partnership of science and industry, backed in early stages by public technology funds.
The president has lost the economic initiative, weighed down by a tedious fight between two outmoded ideologies: Keynesianism and supply-side tax cuts, as well as by the president’s excessive deference to Congress. ...

Move now, Mr President, or we will spend our time digging out of the next consumer bust and buying our technology from China.

November 06 2009

Paul Krugman: Obama Faces His Anzio

The failure to give the economy the fiscal stimulus it needs may be costly Democrats:

Obama Faces His Anzio, by Paul Krugman, Commentary, NY Times: Remember those Republican boasts that they would turn health care into President Obama’s Waterloo? Well, exit polls suggest that to the extent that health care was an issue in Tuesday’s elections, it worked in Democrats’ favor. But while health care won’t be Mr. Obama’s Waterloo, economic policy is starting to look like his Anzio.
True, the elections weren’t a referendum on Mr. Obama. Most voters focused on local issues... Yet there was a national element to the election. Voters ... are in a bad mood, largely because of the still-grim economic situation. And when voters are feeling bad, they turn on whomever currently holds office. ...
This bodes ill for the Democrats in the midterm elections next year ... because all indications are that ... unemployment will still be painfully high. And Republicans may well benefit, despite having become the party of no ideas.
Which brings me to the Anzio analogy.
The World War II battle of Anzio was a classic example of the perils of being too cautious. Allied forces landed far behind enemy lines, catching their opponents by surprise. Instead of following up on this advantage, however, the American commander hunkered down in his beachhead — and soon found himself penned in by German forces on the surrounding hills, suffering heavy casualties.
The parallel with current economic policy runs as follows: early this year, President Obama came into office with a strong mandate and proclaimed the need to take bold action on the economy. His actual actions, however, were cautious... They were enough to pull the economy back from the brink, but not enough to bring unemployment down.
Thus the stimulus bill fell far short of what many economists — including some in the administration itself — considered appropriate. ... Meanwhile, the administration balked at proposals to put large amounts of additional capital into banks, which would probably have required temporary nationalization of the weakest institutions. ...
Administration officials would presumably argue that they were constrained by political realities... But they never tested that assumption, and they also never gave any public indication that they were doing less than they wanted. The official line was that policy was just right, making it hard to explain now why more is needed.
And more is needed. Yes, the economy grew fairly fast in the third quarter — but not fast enough to make significant progress on jobs. And there’s little reason to expect things to look better going forward. The stimulus has already had its maximum effect on growth. ... Many economists predict that the economy’s growth, such as it is, will fade out over the course of next year.
The problem is that it’s not clear what Mr. Obama can do about this prospect. Conventional wisdom in Washington seems to have congealed around the view that budget deficits preclude any further fiscal stimulus — a view that’s all wrong on the economics, but that doesn’t seem to matter. Meanwhile, the Democratic base, so energized last year, has lost much of its passion, at least partly because the administration’s soft-touch approach to Wall Street has seemed to many like a betrayal of their ideals.
The president, then, having failed to exploit his early opportunities, is pinned down in his too-small beachhead.
If the Democrats lose badly in the midterms, the talking heads will say that Mr. Obama tried to do too much, this is a center-right nation, and so on. But the truth is that Mr. Obama put his agenda at risk by doing too little. The fateful decision, early this year, to go for economic half-measures may haunt Democrats for years to come.

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