Economics One

State of the Union: From Ringside to the WSJ

2012-01-24T23:09:00.000-08:00

I was at the State of the Union tonight. You cannot help but love the pomp and circumstance of the event, even if you do not agree with everything the President says. In this case, his opening lines on what we can learn from America's “generation of heroes,” the next greatest generation, were particularly moving to hear in person as was the closing which returned to that theme with “Each time I look at that flag, I’m reminded that our destiny is stitched together like those fifty stars and those thirteen stripes."

But in between there was much to disagree with, especially from an economic policy perspective as I describe in tomorrow’s Wall Street Journal piece which I excerpted from First Principles. For one thing it is a stretch to say that “The state of our Union is getting stronger.” We are not really recovering from the recession, at least not compared to the period after previous big recessions such as the early 1980s as this graph makes clear.

The reason is pretty clear. In the Wall Street Journal piece I refer to and quote from a memo written by President Reagan’s economic adviser George Shultz and others after the 1980 election. It laid out the long run economic strategy they recommended and which Reagan followed. Contrast that with the memo Larry Summers sent to President-elect Obama after the 2008 election, which is making the internet rounds. It laid out the short-run Keynesian policy Summers recommended and which Obama has followed. The big policy differences largely explain the big economic performance differences.

First Principles on the Business News Networks

2012-01-21T21:34:00.000-08:00

Yesterday I spent the day visiting the TV studios of CNBC, Bloomberg Television, and the Fox Business Network to discuss my new book First Principles. Thanks to the news anchors the discussion—and debate—was interesting and lively.

I started early, co-hosting Squawk Box from 7 to 9 am with anchors Becky Quick, Joe Kernan, and Andrew Ross Sorkin on the set at CNBC studios in New Jersey. Here is a video from the opening where I briefly presented the theme of the book—that America has deviated from the principles of economic freedom—and responded to some good questions from Joe and Andrew (author of the best seller, Too Big To Fail). Later in the show Steve Liesman joined us on the set and we had a rousing debate segment about the Fed and why economists so often disagree while Joe Kernan raised doubts about the whole subject of economics (had to work hard to get a word in edgewise here). At the end of the show Andrew and I wrapped up with a brief discussion of the economic implications of the 2012 election and where the big economic differences are between Mitt Romney, Newt Gingrich, and Barack Obama

Then over to midtown Manhattan to Bloomberg News studios on Lexington Avenue for an hour’s visit on Surveillance Midday anchored by Tom Keene. Tom has great ways to bring economic ideas into the news of the day and make them entertaining, and he certainly did that with the ideas in First Principles. Here is a video of the opening and ending of that show. Allan Meltzer joined us halfway through the show via a remote video feed, and he added his strongly held views that monetary policy needed to be less discretionary and more rule-like, which I appreciated.

At the end of the day I went over to News Corporation Building on Sixth Avenue for an interview with Gerri Willis on her Fox Business News show The Willis Report . It was a fast-moving on-point interview (4½ minutes) in which she managed to bring out a host of issues ranging from Fed policy to crony capitalism.

Different Economics Texts for Different Economic Views

2012-01-18T14:13:00.000-08:00

Alan Blinder and I are frequently on different sides of economic debates, especially when it comes to the effects of monetary and fiscal policy and the impact of short-term discretionary actions. For example, we have both testified together in Congress about the recent stimulus packages. He says they worked. I say they didn’t.

We also both have introductory economics textbooks which we have just revised in different ways in light of the experience with the recent financial crisis, the great recession, the policy response, and the slow recovery. In fact we have the same publisher who recently asked us to explain the rationale for the revisions, and then made videos of the answers. Here is Alan’s video and here is my video. It is not surprising that our approaches to the revisions are somewhat different, but perhaps not as much different as one would expect given the big differences in our views.

American Economic Freedom: Moving in the Wrong Direction

2012-01-12T23:35:00.000-08:00

Economic freedom in the United States continues to decline according to the latest Index of Economic Freedom (compiled by the Heritage Foundation) as reported today by Ed Feulner in the Wall Street Journal.

This chart plots the Index from 2006 to 2012. There has been a decline every year since 2007 with a record decline from 2009 to 2010 and another large decline from 2011 to 2012. While nearly every component of the index has declined since 2007, two of the larger declines were due to an increase in government spending as a share of GDP (forcing that component down from 60.3 to 46.7) and a reduction on monetary freedom (bringing that component down from 83.8 to 77.2). The decline in monetary freedom was not due to all the discretionary interventions by the Fed (which the index does not measure), but rather to more government interventions in the price system. Here are the details.

This is not the only quantitative measure to show a decline in economic freedom for the United States. The Economic Freedom Index (compiled by the Fraser Institute) also shows a decline as Gene Epstein points out in this recent Barron’s column, though the data only currently go through 2009

No, Austan, Washington Is Spending Too Much

2012-01-07T22:25:00.000-08:00

In yesterday’s Wall Street Journal, Austan Goolsbee argues that Washington Isn't Spending Too Much. "It’s completely normal,” he says “that spending rises during big downturns….As the economy grows back to health, the government share of the economy will fall,” making it seem as if the Administration’s plan all along was to bring the federal spending share back to what it was before the recession started. It wasn’t.

Take a look at this chart. The top line shows the federal spending share with the budget plan submitted by the Administration last February when Austan Goosbee was Chairman of President’s Council of Economic Advisers. It makes no attempt to bring spending back to pre-recession levels as a share of the economy. While the Congress was able to make a dent in the Administration’s spending plan, we still have a long way to go to gradually get spending back to 2007 levels, which is the pro-growth thing to do, as I explain in First Principles, out later this month.

Argentina in December 2001 versus Europe in December 2011

2011-12-31T07:04:00.000-08:00

This month marks the ten-year anniversary of Argentina’s massive sovereign debt default, an event with many lessons for the European sovereign debt crisis of today, though analogies are far from perfect.

First, as has been discussed and debated on planet money and naked capitalism, the Argentine economy actually recovered quickly from the painful default and crisis of 2001 after it negotiated a substantial write-down of its sovereign debt.

Second, the experience of Argentine’s neighbor Uruguay shows that the economic pain of such crisis is less severe if a more orderly restructuring is employed from the start rather than a chaotic default. Such an orderly restructuring could have taken place in Greece two years ago as it did in Uruguay ten years ago as veteran debt expert Carlos Steneri and I discuss with Juan Forero in this NPR price "What Greece Can Learn from South America" which aired last week. (I worked closely with Steneri during the Uruguayan crisis when I was US Treasury Under Secretary).

Third, and most important, despite the immediate and sharp impact of the default in Argentina, there was very little international contagion at the time of the default. This outcome was contrary to many warnings at the time that such a default would have large contagion effects much as the Russian default three years earlier in 1998. The first chart shows the contagion following the Russian default in terms of emerging market bond spreads in Asia. The second chart shows, using the same measure, that there was virtually no contagion following the Argentine default.

In my view the reason for this remarkable difference is that the IMF and the international policy community was clear (at least following an increase in loans in August 2001) that the bailouts of Argentina would stop, making a debt restructuring inevitable or at least more predictable than the surprise withdrawal of support for Russia in 1998 which caused the contagion then. Contagion is not automatic if the policy is clear and predictable.

As the investigative reports in the Wall Street Journal this week make clear, this same type of fear of contagion (expressed, according the the WSJ story, very strongly by Jean-Claude Trichet during the past two years) is why a restructuring of Greek sovereign debt has been kicked down the road so many of times. Instead of reducing the role of bailouts as occurred for emerging markets around the time of Argentina, the role of bailouts in European policy has increased and this has made policy even less predictable. As the prospects of bailout increased, the political incentives to take action to reduce deficits and debt decreased as evidence in Italy over the past year and made the crisis much worse.

The Return of the Best Economics 1 Lecturer Ever -- Plus One

2011-12-20T23:56:00.000-08:00

This fall was a great quarter to teach the introductory course (Economics 1 at Stanford) with plenty of good examples from Occupy Wall Street, the crisis in Europe, the continuing debate in Washington over economic policy, and the rising federal debt. Unfortunately nothing much has changed about the debt as I tried to illustrated with the return of a guest lecturer.

In 2009 I invited this guest lecturer to my Economics 1 class to illustrate the burdens of the debt on future generations. Though only a few months old, the guest lecturer turned out to be the best ever (here is a  video excerpt). Students in that class still remember her message as she looked up at the exploding debt chart on the big screen, and said "fix it."

So this fall I invited her back to this year’s Economics 1 class , and her brother joined her, as seen in this second video excerpt (click on the closed caption option as the audio is weak).  Again she looked up at the chart on the big screen in the lecture hall , and again it was "scary." In fact, it was even worse! Unfortunately, no one has fixed it, either in 2009, 2010, or 2011. I said I'd like to keep bringing them back as guest lecturers until it is fixed.

(The chart in the first video was developed from Congressional Budget Office data from the long term projection made in 2009; the chart in the second video is from the CBO long-term projection made in 2011.)

Economic Freedom in the News

2011-12-19T23:59:00.000-08:00

People are writing about economic freedom a lot these days. George Will’s recent Washington Post column Testing the Waters of Economic Liberty focusses on a big deviation from economic freedom in the State of Washington with implications for America. Jeb Bush’s recent Wall Street Journal article Capitalism and the Right to Rise summarizes the great benefits of economic freedom to improve people's lives. My new book, First Principles, out in January, shows that America has deviated from the principles of economic freedom in recent years, and proposes ways to get back to them.

Of course the concept of economc freedom has been a pillar of basic economics courses for years. When I lecture about economic freedom to Stanford students I like to build on the Stanford motto which translates from the German words on the Stanford seal as “Let the Winds of Freedom Blow”

Krugman is Wrong

2011-12-07T22:04:00.000-08:00

Paul Krugman is wrong in his criticism of my brief summary of last week’s economic policy conference at Stanford’s Hoover Institution. Krugman was not at the conference, which lasted a full day and went well beyond previous research by the participants. In general people focused on policies to restore strong economic growth and reduce unemployment in the United States.

First, Krugman incorrectly claims that I mischaracterized the research of my Stanford colleague Nick Bloom and his coauthors Scott Baker and Steve Davis presented at the conference. Krugman says my conference summary suggested that “Bloom, Baker and Davis had showed that fear of Obama was holding the economy down.” No, my summary said or implied no such thing; there is no mention of Obama, Bush, or any politician in my summary. It simply says that these authors “presented their empirical measures of policy uncertainty and showed that they were negatively correlated with economic growth.” And that is what they did at the conference. Second, Krugman claims that my summary mischaracterized the presentation of my Stanford colleague Bob Hall, making it look like something it wasn't. My summary referred to Bob’s interesting presentation at the conference. As part of his presentation Bob said that now and going forward we should assume “no chance of conventional fiscal expansion; rather, possible cutbacks motivated by excessive federal debt.” That is why Bob focused his paper at the conference on monetary policy and the problem of the zero lower bound, and that was what all the discussion of his paper was about, rather than on his earlier work on the multiplier, which is now part of a huge literature recently nicely reviwed by Valerie Ramey.

I stand by my brief summary of the conference as a being accurate. Lee Ohanian and I, as co-organizers of the conference, hope that we can soon get a book published containing the full proceedings (written versions of the individual presentations and many comments by participants), as has been done with other recent Hoover economic policy conferences: The Road Ahead for the Fed and Ending Government Bailouts As We Know Them. We hope the results of each author will be read carefully by policy makers and other researchers.

Restoring Robust Growth in America

2011-12-05T23:38:00.000-08:00

Why has the recovery been so slow? What can we do about it? Alan Greenspan, George Shultz, Ed Prescott, Steve Davis, Nick Bloom, John Cochrane, Bob Hall, Lee Ohanian, John Cogan and I recently met at the Hoover Institution at Stanford to present papers and discuss the issue with other economists and policy makers including Myron Scholes, Michael Boskin, Ron McKinnon and many others. Here is the agenda.

We plan to publish a book on the conclusions, but here is a very brief summary of the presentations. George Shultz led off by arguing that diagnosing the problem and thus finding a solution was extraordinarily important now, not only for the future of the United States but also for its leadership around world. Tax reform, entitlement reform, monetary reform, and K-12 education reform were at the top of his pro-growth policy list. Alan Greenspan presented empirical evidence that policy uncertainty caused by government activism was a major problem holding back growth, and that the first priority should be to start reducing the deficit immediately; investment is being crowded out now. He also recommended starting financial reform all over again because of the near impossibility of implementing Dodd Frank. Nick Bloom, Steve Davis and Scott Baker then presented their empirical measures of policy uncertainty and showed that they were negatively correlated with economic growth.

Ed Prescott had the most dramatic policy proposal which he argued would cause a major boom and restore strong growth. He would simultaneously reform the tax code and entitlement programs by slashing marginal tax rates which would increase employment and productivity. John Cochrane focused on the bailout problems in the European and American financial sectors, arguing that they would continue to be a drag on growth until policy makers stopped kicking the can down the road.

Bob Hall argued that fiscal policy was not working, and focused on alleviating the zero lower bound constraint on monetary policy. One of his proposals was a gradual phase-in of a tax reform in the form of a consumption tax, which would make consumption today relatively cheap and thereby increase aggregate demand. I presented research with John Cogan on fiscal policy showing that it had not been successful in raising government purchases and was ineffective regardless of the size of the multiplier. Finally Lee Ohanian showed that unemployment remained high in part because of restrictions on foreclosure proceedings which increased search unemployment by allowing people to stay in their homes for longer periods of time.

In sum there was considerable agreement that (1) policy uncertainty was a major problem in the slow recovery, (2) short run stimulus packages were not the answer going forward, and (3) policy reforms that would normally be considered helpful in the long run would actually be very helpful right now in the short run.

Omitted Facts in a Speech on Omitted Variables

2011-11-21T22:59:00.000-08:00

Christina Romer gave a speech at Hamilton College earlier this month which criticizes my findings that recent temporary tax rebates had little or no effect on aggregate consumption. Romer claims that in analyzing this “relationship between two variables” I did not consider the impact of third variables “influencing both of them.”

Romer’s claim is wrong. In fact, in my paper which Romer cites (first presented on January 4, 2009 at the AEA meetings and published in the American Economic Review), I explicitly state that one must take account of other variables. Here is a quote from that paper: “policy evaluation requires going beyond graphs and testing for the impact of the rebates on aggregate consumption using more formal regression techniques….an advantage of using regressions is that one can include other factors that affect consumption.” In that investigation, which focused on the 2001 and 2008 rebates, I used monthly data and included in the regressions monthly data on oil prices, which rose dramatically in the first half of 2008 and which would be expected to reduce consumption around the time of the rebates. Indeed, oil prices had a highly significant coefficient in the regressions, and yet I found no significant effect of the rebates as shown in Table 2 of the paper. In another paper published in the Journal of Economic Literature, (discussed in the blogosphere here and here) I used quarterly data to investigate the 2001 and 2008 stimulus packages and also the 2009 stimulus. With quarterly data, I also included a household net worth variable from the Fed’s flow of funds accounts, along with the quarterly average of oil prices. The net worth variable had a significant effect, and yet I still found no statistically significant impact of the temporary payments as shown in Table 1 of the JEL paper.

In sum, my research does consider the impact of third variables, contrary to what Romer claimed. And the results I reported are robust to adding such variables, contrary to what Romer conjectured.

More on Nominal GDP Targeting

2011-11-18T23:18:00.000-08:00

Several people have asked me to comment on nominal GDP targeting, as recently proposed by Scott Sumner, Christina Romer and Paul Krugman. I did research on nominal GDP targeting many years ago and found that such targeting proposals had a number of problems, which I summarized in the paper “What Would Nominal GNP Targeting Do to the Business Cycle?” Carnegie-Rochester Series on Public Policy, 1985. Although much has changed in the past quarter century I find many of the same problems with the recent proposals.

One change is that, in comparison with earlier proposals, the recent proposals tend to focus more on the level of NGDP rather than its growth rate. This removes some of the instability of NGDP growth rate targeting caused by the fact that NGDP growth should be higher than its long run target during the catch up period following a recession. But it introduces another problem: if an inflation shock takes the price level and thus NGDP above the target NGDP path, then the Fed will have to take sharp tightening action which would cause real GDP to fall much more than with inflation targetting and most likely result in abandoning the NGDP target.

A more fundamental problem is that, as I said in 1985, “The actual instrument adjustments necessary to make a nominal GNP rule operational are not usually specified in the various proposals for nominal GNP targeting. This lack of specification makes the policies difficult to evaluate because the instrument adjustments affect the dynamics and thereby the influence of a nominal GNP rule on business-cycle fluctuations.” The same lack of specificity is found in recent proposals. It may be why those who propose the idea have been reluctant to show how it actually would work over a range of empirical models of the economy as I have been urging here. Christina Romer’s article, for instance, leaves the instrument decision completely unspecified, in a do-whatever-it-takes approach. More quantitative easing, promising low rates for longer periods, and depreciating the dollar are all on her list. NGDP targeting may seem like a policy rule, but it does not give much quantitative operational guidance about what the central bank should do with the instruments. It is highly discretionary. Like the wolf dressed up as a sheep, it is discretion in rules clothing.

For this reason, as Amity Shlaes argues in her recent Bloomberg piece, NGDP targeting is not the kind of policy that Milton Friedman would advocate. In Capitalism and Freedom, he argued that this type of targeting procedure is stated in terms of “objectives that the monetary authorities do not have the clear and direct power to achieve by their own actions.” That is why he preferred instrument rules like keeping constant the growth rate of the money supply. It is also why I have preferred instrument rules, either for the money supply, or for the short term interest rate.

Rules for the instruments are what monetary policy needs, not excuses for discretionary actions. I welcome more research looking for better instrument rules which are explicit and operational enough to be evaluated with empirical economic models. Even an historical comparison of different rules would be welcome, and Allan Meltzer's monumental History of the Federal Reserve would be a good foundation to build on. As he summarized in a speech this week, “Economists and central bankers have discussed monetary rules for decades. A common response of those who oppose a rule, or rule-like behavior, is that a central banker’s judgment is better than any rule. The evidence we have disposes of that claim. The longest period of low inflation and relatively stable growth that the Fed has achieved was the 1985-2003 period when it followed a Taylor rule. Discretionary judgments, on the other hand, brought the Great Depression, the Great Inflation, numerous inflations and recessions. The Fed contributed to the current crisis by keeping interest rates too low for too long.”

Price Explosion for Stanford Oregon Tickets

2011-11-11T08:25:00.000-08:00

We just finished Week 7, and Lecture 27, in Economics 1 with a midterm exam coming up next week. What a great time to be teaching and learning economics, with the questions about the bailouts and the top 1 percent coming out of OWS, debate over another stimulus package, the debt crisis in Europe, presidential candidates proposing major tax reform, and great sports examples, especially at Stanford with football nationally ranked at No 2 in the USA Today poll and No 3 in the AP top 25.

Of course that’s a learning experience not only for the fans and players in class who have to allocate scarce time to prepare for the Stanford-Oregon game tomorrow and the midterm next week, but also for anyone who wants to understand markets and the role of prices in allocating scarce resources, namely tickets to the crucial game tomorrow. The price of tickets to the game has exploded in the seven weeks since the term started. As the chart shows the price of an average ticket has gone from $124 when we started the course to $302 now, an increase of 142%. Some tickets are going for as a high at $650 today according to StubHub.

More On Economic Freedom and Monetary Policy

2011-11-01T23:48:00.000-07:00

My Wall Street Journal article today is quite critical of recent interventionist fiscal and monetary policies in the United States. In my view, they have not only been unhelpful to the American economy, they have also been unhelpful to the world economy. The monetary and fiscal policies I am criticizing go back to before the start of the Obama administration, as I showed in this article on fiscal policy recently published in the Journal of Economic Literature and in this piece on monetary policy published in November 2008 by the Bank of Canada. So I view this criticism as being non-partisan, as has been my historical review of the swings between rules and discretion.

In a long rebuttal to my criticism in today’s Wall Street Journal article, David Glasner argues that I mischaracterized America when I wrote that it was a leader in economic freedom following World War II, when it helped Japan and Europe recover and helped create the GATT and other international financial institutions. It is certainly true that American economic policy was not perfect with its regulations and high marginal tax rates, but comparatively speaking the American model was a far cry from what was being set up in the large areas of the world which were not free either economically or politically.

Another quite different part of his rebuttal is the argument that I had a different view of monetary policy as implemented in Japan in the early 2000s, when I was U.S. Under Secretary of Treasury for International Affairs, a period which I reviewed in my book Global Financial Warriors. I had similar views in the 1990s when I was a foreign honorary adviser to the Bank of Japan.

For several reasons, the economic policy situation in Japan in the 1990s and early 2000s, when I was in the Treasury, was quite different from the situation in United States today In the 1990s, but especially in the early 2000s, there was a deflation in Japan: the GDP deflator fell from 1999 to 2003. In the United States we have seen no such prolonged declines in the GDP deflator in recent years.

Second, the purpose of increasing the monetary base in Japan, as I argued in those days, was to get the growth rate of the money supply (such as M2+CD) back up. As I showed when I was an adviser to the BOJ, a decline in money growth was largely responsible for the deflation and for the poor economic performance in the 1990s. So the goal of the Japanese policy in the early 2000s, which I was approving of while I was at Treasury, was to get money growth back up. It was not to try to drive up temporarily the price of mortgage securities or stock prices, which is what is frequently used to justify the quantitative easing by the Fed today. Here are my specific views on Japan written while I was an adviser to the BOJ.

A third difference is related to the rules versus discretion debate. If a central bank follows a money growth rule of the type Milton Friedman argued for—and which is quite appropriate when the interest rate hit zero in Japan—then the central bank should increase the monetary base to prevent money growth from falling or to increase money growth if it has already fallen. In other words such an easing policy can be justified as being consistent with a policy rule, in this case a rule for the growth of the money supply. The rule calls for keeping money growth from declining. But the large-scale asset purchases by the Fed today are highly discretionary, largely unpredictable, short term interventions, which are not rule-like at all. It is the deviation from more predictable rule-like policy by the Fed (which began in 2003-2005 and continues today) that most concerns me.

The Texts They Are A-Changin'

2011-10-26T23:50:00.000-07:00

How should the introductory economics text change in response the financial crisis, the recession and the very slow recovery? The question will be discussed at a big economics teachers’ conference in New Orleans this week. I will be there to give a talk on the issue by describing the just released 7th edition of my text with Akila Weerapana of Wellesley. We incorporated many crisis issues in the 6th edition in 2009 (the first text to do so), and gained experience for the 7th which I will share with other teachers at the conference.

The answer to the question depends a lot on what you think caused the crisis. If you think that it shows our economic theory—especially our macroeconomic theory—was wrong, and thereby gave the wrong policy prescriptions, then you have to think about massive changes. If you think the crisis shows that our economics was basically correct and that policy deviated from the recommendation of the theory, then you want to revise the text differently, and show with example after example how this happened. It is a unique teaching moment.

While there is some truth in both of these views, my research has led me to conclude that the second is closer to the reality. Certainly room should be given for different views, but this second view must be represented. My principles text with Akila Weerapana reflects this.

Here are the slides for my talk

Congratulations and Thanks to Tom Sargent and Chris Sims

2011-10-10T20:20:00.000-07:00

The Nobel Prize committee made an excellent choice in awarding the 2011 economics prize to Tom Sargent and Chris Sims for their influential contributions to macroeconomics.

One of the first papers of Tom Sargent I read was his little “Note on the Accelerationist Controversy” published 40 years ago in 1971. It showed how commonly-used statistical tests rejecting the vertical long run Phillips curve were flawed because they did not take expectations into account properly. Then his 1975 Journal of Political Economy paper with Neil Wallace, which showed that monetary policy was ineffective in models with rational expectations and perfectly flexible prices, made it clear to me that we had to find a tractable way to put sticky prices into rational expectations models. Tom’s 1978 paper with Robert Lucas “After Keynesian Macroeconomics” pointed out many of the problems with Keynesian approach to economic policy. I recently found that our current policy experiences, 30+ years later, confirm that view. Tom’s emphasis on “cross equation restrictions” in rational expectations models set new standards for empirical estimation as he showed in his 1980 paper “Formulating and Estimating Dynamic Linear Rational Expectations Models” with Lars Hansen. Tom has also made his technical research accessible to economics students. His book Macroeconomic Theory published in 1979 is an early example, and last spring we used his more recent textbook with Lars Ljungqvist in the first year Ph.D. program at Stanford. His 1986 book Rational Expectations and Inflation made the technical subjects accessible at a non-technical level.

Chris Sims introduced the use of vector auto-regressions into macroeconomics in his1980 paper “Macroeconomics and Reality.” This work has had a deep and pervasive effect on macroeconomics which persists today. I first used his methodology in a paper published that same year (in the same journal and issue as the Hansen-Sargent paper mentioned above) to demonstrate that the stochastic dynamics of the business cycle in all the major industrial countries could be explained by a combination of a monetary reaction function and a particular form of staggered price setting, revealing a trade-off between output and price stability. Work I did in 1985 on nominal GDP targeting used estimated and theoretical impulse response functions as suggested by Sims. That research indicated that nominal GDP targeting had several flaws and pointed the way to a different kind of policy rule.

Both Chris Sims and Tom Sargent are of the school that you should evaluate policy proposals rigorously with estimated and theoretically well-founded models, rather than just speculate on how a policy would work or did work, and that is also an important model to follow.

Congratulations and thank you, Tom and Chris.

Higher Inflation Is Not the Answer

2011-10-07T11:14:00.000-07:00

Today's NPR Morning Edition presented two sides to the question "Does The Economy Need A Little Inflation?" By "a little" they mean 5 percent per year for a few years. The former IMF chief economist and Harvard professor Ken Rogoff argued in the affirmative and was featured in the radio segment, as he has been arguing this view along with his successor at the IMF, Olivier Blanchard, for a while now. I argued for the negative in the segment saying it would do more harm than good to the economy, a point Paul Volcker has been making forcefully. A recent column by George Will puts the issue in the broader context of U.S. economic policy and also comes out on the negative side.

The Dangers of Misrepresenting Past Economic Debates

2011-10-06T18:12:00.000-07:00

“What’s past is prologue,” says Future, the statue at the National Archives. But in macroeconomic policy—monetary and fiscal—the past is often misrepresented, and that unfortunately leads Future astray. A common misrepresention these days pertains to past views of economists about monetary and fiscal policy. Consider David Frum’s recent opinion piece for NPR’s Marketplace Radio claiming that “The Great Recession has changed the way many conservatives talk about economic policy.” I don’t see the kind of change Frum and others claim has taken place.

Frum says that in the past “Liberals favored active government measures: government spending to fight recessions, tax increases to curtail inflation. Conservatives by contrast preferred monetary instruments: raise interest rates to stop inflation, loosen money during recessions.” And because many conservatives are now against the monetary activism of the Fed, they have “changed their minds,” says Frum.

But nowhere in his piece does Frum refer to the major distinction between liberals and conservatives in economic policy: liberals prefer active interventionist policy and conservatives prefer predictable rule-like policy. At least since the macroeconomic debates began in Washington in the 1960s, this has been the major difference. Consider two of the most influential policy documents published in the 1960s: The 1962 Economic Report of the President, largely authored by James Tobin, who was recruited by Paul Samuelson to go to Washington, and Capitalism and Freedom authored by Milton Friedman and published that same year. The Report made the case for macroeconomic activism—both monetary and fiscal. Capitalism and Freedom made the case for rules and less discretion—both monetary and fiscal, and argued strongly for less interventionist policies. Earlier Friedrich Hayek was making the same conservative arguments against Keynesian activism when Keynes himself was on the other side.

And this is exactly what conservative are saying now. Stop all the interventions—the short-term discretionary fiscal stimulus packages and the massive quantitative easings and the operation twists of monetary policy. The unpredictability caused by these policies is causing uncertainty and holding the recovery back. Instead put in place more permanent reforms which will create economic recovery and return the economy to the kind of performance we saw in the 1980s and 1990s.

So conservatives have not changed their minds, at least not in the way Frum claims. He may believe, as he says in his piece, that “conservatives have little useful to say.” But when rules-based, less intervnetionist policies were followed we saw good economic preformance as in the 1980s and 1990s.

Good Economics Is Good Politics

2011-10-04T19:23:00.000-07:00

My oped today with John Cogan in the Wall Street Journal shows that temporary fiscal stimulus packages are not good politics. Historical evidence reveals that politicians who enact them tend not to get re-elected. Our previous Wall Street Journal articles here and here showed that these packages are not good economics either.

The lesson for students of economics is that, more often than not, good economics is good politics.

In Praise of an Extraordinary Teacher of Economics

2011-10-03T22:54:00.000-07:00

Those of us who teach economics stand on the shoulders of those who taught us economics.

I just heard the sad news that one of my truly extraordinary economics teachers, E. Philip Howrey, recently died in a biking accident. When I was an undergraduate, Phil taught me an approach to macroeconomics—very new at the time—which has served me well throughout my career, and for which I will forever be grateful. Several years ago Robert Leeson asked me “Who influenced you most when you were an undergraduate at Princeton? What sparked your interest in policy rules?” I talked mostly about Phil in my answer.

Looking back I would say that Phil Howrey had the most influence on me, at least in areas that turned out to be closely related to my career as an economist. Phil had a great deal of interest in time series analysis as it applied to macroeconomics. For example, he had written an important paper on the "Long Swing" hypothesis with Michio Hatanaka. Hatanaka had published a book in 1964 with Clive Granger on Spectral Analysis of Time Series. Granger visited Princeton at the invitation of Oscar Morgenstern who had an interest in applying frequency domain techniques to economic data. While I met Morgenstern then, I did not meet Granger until many years later.

I think my initial interest in policy rules goes back to a course I took from Howrey. Except for Economics 101, it was probably my first introduction to macroeconomics. But we didn't study ISLM or the other textbook models of the time; instead we studied dynamic models of the economy, with equations that included lags and shocks defining the stochastic processes. In retrospect it was quite unusual that I had the opportunity to learn about these methods as an undergraduate, but at the time I had no idea that it was unusual. The methods forced me to think of the economy as a moving dynamic structure. So the only way one could think about policy was with some kind of policy rule. You couldn't say let's shift the LM curve by increasing the money supply by one unit or do whatever people would be doing at the time. Instead you had to have some kind of policy rule. So to me it was natural. I couldn't think of how else you would do it in those models.

When it came time to choose a topic for a senior thesis, I approached Phil Howrey saying that I was interested in macroeconomic policy issues and wanted to work with the types of models we studied in his course. He suggested that I look into stabilization policy in a model that combined economic growth and the cycle, which we called "endogenous cyclical growth" at the time; he said that no one had done this before, and so it sounded like a great topic and that is what I did. In the preface to my senior thesis I thanked Phil "for suggesting the topic and indicating how I might proceed." In the end the thesis was about simulating different types of monetary policy rules.

Day 1 of Economics 1

2011-09-26T23:14:00.000-07:00

I find the first day of the school year to be exciting, especially when a lot of first-year students are in my classes as is the case with Economics 1, the introductory economics course I teach at Stanford and the course which this blog is named after. Many Day 1 questions are interesting and revealing of the times: Q: “Is this course Keynesian or Austrian?” A: “Adam Smithian.”

On Day 1, of course, we focus on the central idea that economics is about choices people make when faced with scarcity and the interaction between people when they make these choices. Accordingly, we modify slightly the Stanford motto, “The Winds of Freedom Blow” (Die Luft der Freiheit Weht) to get the Economics 1 motto: “The Winds of Economic Freedom Blow. Examples of opporunity costs this year were hi-tech leaders Mark Zukerberg, Steve Jobs and Larry Ellison, who considered the opportunity cost of college, dropped out, and did pretty well—or Eric Schmidt, John Chambers, and Art Levinson (Google, Cisco, Genentech) who also considered opportunity cost of college, stayed in, and also did pretty well.

This year we are trying out a new Economics 1 lecture hall, CEMEX Auditorium in Zambrano Hall, named after the Mexican-based global cement company and its CEO Lorenzo Zambrano, who also didn’t drop out of college and then did well enough to donate the money for the lecture hall.

Not More of the Same Model Simulations!

2011-09-25T11:52:00.000-07:00

Simulations of Mark Zandi’s economic model, which are reported in the press to show that a new temporary stimulus package will create 1.9 million jobs, are being touted as evidence that it will work. This is the same type of model simulation that predicted the very similar 2009 stimulus package would create millions of jobs, and the same type of simulation that claimed that that package worked. Andrew Ferguson reviews the predictions in a recent article in Commentary.

But simulations of such models do not provide such evidence, as I have explained on this blog before, for example here and here. They are wrong because they assume “multipliers” for temporary one-time payments or tax changes far in excess of the basic “permanent income” or “life cycle” models (which we teach in Economics 1). They are wrong because they assume that state and local government infrastructure and other purchases respond to federal stimulus grants in a mechanical way, unlike what we have seen practice, as I explained in this article with John Cogan. And they are wrong because they do not take account of the negative growth effects of expected future permanent increases in tax rates. I have debated Mark Zandi on these topics many times before, for example on the NewsHour and in congressional testimony.

However, the terribly weak economic recovery has forced an important change in the way that these predictions are put forward by modelers like Zandi. They have to admit that even their exaggerated estimated impacts of the temporary stimulus packages are, yes, temporary. Macroeconomic Advisers reports the same thing: “the GDP and employment effects are expected to be temporary” and more specifically that “these proposals will pull forward increases in GDP and employment, not permanently raise their level.”

In other words, even if, on balance, jobs are created by the package (which is doubtful), they will be destroyed as soon as the temporary package is over, according to Zandi. Thus even the promoters of such temporary packages agree that they will not jump-start the recovery, which is what is needed to really reduce unemployment.

Perhaps more than anything else, this is the reason why we need to do something besides “more of the same,” and instead follow the wisdom put forth in this speech (video, transcript) by George Shultz upon winning the first Economic Club of New York Award for Leadership Excellence this past week.

When So-Called Hawks Are Really Doves

2011-09-17T16:41:00.000-07:00

The Fed's dual mandate of “maximum employment” and “stable prices” is in the news again. At the recent presidential debate, the major Republican candidates made the case for repealing the dual mandate, while the President of the Federal Reserve Bank of Chicago, Charles Evans, made the case for doubling down on it.

It's an important issue to understand and discuss. In my Bloomberg News article yesterday, I argued that history indicates that removing the dual mandate will actually help lower unemployment by reducing discretionary interventions and encouraging more predictable rule-like policy.

In this regard the frequently used terms monetary "hawk" and "dove" are quite misleading. A hawk is usually defined as someone who would like the Fed to focus on long run price stability. But according to the evidence I discuss in my article, such a focus would better characterize a dove in that unemployment would be lower not higher.

Two Congressional Hearings on the Second Stimulus and Alternatives

2011-09-13T23:13:00.000-07:00

Congress was busy working on fiscal policy today. This morning, over on the House side, it held its first hearing on President Obama’s fiscal stimulus proposal. As one of the witnesses, I argued that the fiscal policy responses thus far to the unemployment problem have not been effective. Consisting mainly of short-term temporary and targeted interventions, the policy has not had a sustainable impact on economic growth and unemployment. Instead, the policy has increased the federal debt and raised uncertainty, which is an impediment to economic growth. Unfortunately, the proposals made by President Obama on September 8 consist largely of the same type of temporary and targeted interventions that have been tried for the past several years. Recent experience and past experiences show that this type of fiscal policy will not increase economic growth, certainly not on a sustained basis. It will not therefore bring the unemployment rate down to pre-recession levels which should now be the goal of policy.

Over on the Senate side this afternoon, there was a hearing on more comprehensive tax and budget reform. I testified there too, along with Alan Greenspan and Martin Feldstein. I briefly laid out a more permanent and predictable alternative to the President's temporary and targetted proposal—a budget strategy to raise economic growth with revenue-neutral tax reform. It builds on the Budget Control Act and brings spending to the level of 2007 as a share of GDP.

The Financial Front in the War on Terror

2011-09-09T06:48:00.000-07:00

Few Americans now remember that the United States launched its first post-9/11 attack on terrorists from a very unusual front—the financial front. As President George W. Bush put it, “the first shot in the war was when we started cutting off their money, because an al Qaeda organization can't function without money.” Here is my Bloomberg News piece about this financial aspect of the war on terror. The detailed story of the people and what they did is fascinating as I try to describe in more detail in my book Global Financial Warriors: The Untold Story of International Finance in the Post-9/11 World. I will be talking with Tom Keene and Michael McKee about it on Sunday at noon. They will be broadcasting on Bloomberg Radio live from the World Trade Center site.

I was head of Treasury’s international affairs division when the operation began. Under U.S. law, the president had the authority to call on U.S. financial institutions to freeze the accounts of terrorists. In the years before 9/11, however, that law was not used very aggressively. As described later in the 9/11 Commission’s Monograph on Terrorist Financing, “Terrorist financing was not a priority….the Treasury organization charged by law with searching out, designating, and freezing Bin Laden assets, lacked comprehensive access to actionable intelligence and was beset by indifference of higher-level Treasury policymakers.”

Our first action was to end the indifference and define the mission clearly: first to freeze terrorist assets and thereby thwart future attacks; second to trace their assets and thereby get information about terrorists.

We had to have international cooperation; without it, the terrorists and their financiers could escape a U.S. freeze by moving their money to banks abroad. No mechanism for cooperation existed, so we had to create one. We began with the G7 and then fanned out. As Treasury press spokesperson, Michele Davis, said at the time, “We’re talking to everyone under the sun.” A report sponsored by the Council on Foreign Relations in 2002 found that: “The general willingness of most foreign governments to cooperate with U.S.-led efforts to block the assets…has been welcome and unprecedented.”

A total of 172 countries issued freezing orders, 120 countries passed new laws and regulations, and 1,400 accounts of terrorists were frozen worldwide. The total value of frozen accounts was $137 million, much during the crucial months in the fall of 2001. Valuable information from tracking money helped prevent attacks, and to obtain more information about terrorists, we partnered with a global financial messaging service called SWIFT, the Society for Worldwide Interbank Financial Telecommunication. Using this information, intelligence experts mapped terrorist networks and filled in missing links.

Don't Stay the Course

2011-09-07T00:02:00.000-07:00

Here is my New York Times oped Not More of the Same on why it is urgent to change the course of economic policy.

My critique of Keynesian countercyclical policy, which is summarized in the NYT article, has been challenged by Fred Bergsten of the Peterson Institute who said at the Jackson hole meeting last week that the Reagan tax cut is an example of a countercyclical policy that successfully stimulated the economy, and therefore disproves my case. But as Larry Summers famously described it, Keynesian countercyclical policy is "temporary, targeted, and timely." The Reagan tax cut was certainly not temporary. And it wasn't targeted either; it was across the board. And it wasn't timely because it lasted well beyond the recession and the recovery. In fact, it is just the kind of "permanent, pervasive, and predictable" policy that we need now.

On the New Greatest Generation

2011-09-03T17:02:00.000-07:00

With the 10-year anniversary of 9/11 approaching people have been asking me to write about the impact of 9/11 on economic policy making in Washington, where I ran the international division of the U.S. Treasury at the time, and to reflect on how the world has changed since then. One request for 150 words came from the Stanford News Service. While there are many amazing economic stories to tell, I thought the first one should reflect on the new greaest generation which will help lead the way out of the difficult times we are still in.

Ten years after 9/11 we now have a "new greatest generation" of Americans on the scene and ready to lead. It includes, of course, all the post 9/11 Afghanistan and Iraq veterans to whom Time Magazine dedicates its cover this week. Fifty-one have enrolled at Stanford with more to come. As [Stanford President] John Hennessy and [Stanford Provost] John Etchemendy say, "We are honored and proud to have many excellent current students and alumni who have served in the military.

But I see a new greatest generation that also includes equally dedicated civil servants, like those at the US Treasury who froze terrorists' assets after 9/11 or funded new schools in Afghanistan; young entrepreneurs, who through ingenuity and hard work have been developing new products to improve peoples' lives; and the teachers, the doctors, the engineers who are just beginning their careers.

This is the best news and the most promising.

The Economic Past is Economic News

2011-08-24T23:17:00.000-07:00

You cannot really understand monetary economics or monetary policy without knowing economic history. No self-respecting monetary economist goes to work without knowing the ins and outs of historical periods like the Depression of the 1930s or great works on such periods, such as Milton Friedman and Anna Schwartz’s Monetary History of the United States, Allan Meltzer’s History of the Federal Reserve, or Amity Shlaes recent popular book The Forgotten Man: A New History of the Great Depression building on the research of Harold Cole and Lee Ohanian.

Among fields of economics, this is especially true of monetary economics, where the theories can get quite abstract and thus benefit greatly from historical groundings, though it applies to other field as well. That’s why I took economic history as one of my Ph.D. fields along ago, and why I’m happy that my department at Stanford has always emphasized economic history with historians like Ran Abramitsky, Paul David, Avner Grief, Nate Rosenberg and Gavin Wright, even as it has been de-emphasized in other departments.

That's why I'm also pleased that the new opinion page at Bloomberg News has decided to establish a blog called Echoes overseen by Amity Shlaes under the courageous assumption that “The past is news,” as Amity puts it. Echoes should remind traders that today’s profit opportunities can often be found in the economic echoes from the past, or at least remind policy makers that opportunities to improve policy can also be found there.

Here are a few pieces I wrote for Echoes since it was established in late May, mostly on policy lessons, including one from today, where I write that Fed officials should listen to a few of those echoes as they gather in Jackson Hole tomorrow:

As Fed Meets, Two Lessons from 30 Years at Jackson Hole, August 24

“Steady As You Go” Still Good Policy for Uncertain Times, August 11

Done Right, A Debt Agreement Could Still Yield Positives, July 31

A Two-Step Approach to Solving the Budget Impasse, July 13

On the 10th Anniversary of the Keynesian Revival, July 7

Paul Volcker's Most Important Lesson, June 22

Government Is More to Blame for Weak Recovery Than Fading Stimulus, June 9

History Lesson for Entitlement Reform, June 2

After Revolution, the Hard Part, May 26

Why the M2 Growth Spurt?

2011-08-21T12:39:00.000-07:00

Quantitative Easing (both I and II) has caused the monetary base—the sum of currency and bank reserves—to explode in the past three years, but has not resulted in similarly large increases in the growth of broader measures of the money supply such as M2. Instead banks have largely held the extra money that the Fed created in order to finance its purchases of longer term Treasuries and mortgage backed securities. You can see this in the following time-series chart. As the monetary base (right scale) increased sharply, the ratio of M2 to the monetary base—the M2 multiplier (left scale)—has moved in the opposite direction in complete lock-step fashion. Thus changes in the multiplier have offset increases in the monetary base.

But if you look closely at the lower right of the graph, you can see that this pattern may have shifted recently as the M2 multiplier increased. In fact, over the past couple of months, M2 growth has spurted, as you can see in the next chart showing monthly M2 averages through July.

It's important to find out why. Is quantitative easing finally leading to a rapid increase in the supply of the broader money aggregates? If so, the Fed will need to be concerned about the ultimate effect on inflation, and perhaps start reducing the size of its balance sheet (and thus the monetary base) sooner than it would otherwise. Or is the increase due to a sudden rise in the demand for M2, which, with the elevated level of the monetary base, would not require additional adjustments. It’s probably too early to tell for sure, but the Fed’s weekly Money Stock Measures, released each Thursday afternoon, will be important to monitor in the weeks ahead.

The next chart shows the weekly data on M2 through August 8, which were released last Thursday afternoon. Based on a scan through the release, it looks to me like demand deposits and savings deposits at banks are the two components of M2 that are most responsible for the recent increase in M2. I have plotted the sum of those two items below M2 in the chart to demonstrate this (note the dual scale with M2 on the right and the sum on the left). Other components of M2 such as currency, small denomination time deposits, and other checkable deposits have not increased in this way.

What’s the reason for the sharp increase in demand deposits and savings deposits at banks? Perhaps the collapse of interest rates on Treasuries and the risk that Treasury prices could fall from these high levels have made such deposits more attractive, recalling the phrase of Keynes that the bond bulls "join the bear brigade." The newly announced policy at Bank of New York Mellon that large depositors will have to pay to lodge their funds is consistent with this story. If so, we are seeing a shift in the demand for money. But stay tuned.

So Much For People To Learn About Medicare Reform

2011-08-19T18:15:00.000-07:00

There is so much more for people to learn about the various Medicare proposals out there. Many people I talked to were surprised to learn that both the Ryan and the Obama Medicare proposals reduce the growth of federal outlays on Medicare by very large amounts compared with current law, as Dan Kessler and I pointed out in our article in the Wall Street Journal this week. In commenting on our article Arik Roy emphasizes this little known fact (he had pointed it out earlier), suggesting that “an excellent reform plan for a GOP Presidential candidate to take up: the Ryan plan, tweaked to adhere exactly to the Medicare target growth rates advocated by the President…Such an approach would completely neutralize the charge that Republicans (or Democrats, for that matter) were unfairly cutting Medicare, and allow the candidates and the country to have a more substantive debate.”

Some commenters on our article were surprised to hear that President Obama even had a Medicare proposal, assuming that reform was part of Obamacare passed last year. But the Obama Medicare reform proposal was just put forth in an April 13, 2011 speech. Here is the fact sheet from that speech which calls for "setting a more ambitious target of holding Medicare cost growth per beneficiary to GDP per capita plus 0.5 percent beginning in 2018, through strengthening the Independent Payment Advisory Board (IPAB).”

Some commenters said that people could learn more about the proposals with a numerical side-by-side comparison of federal outlays under the two proposals going out into the future. Well I agree, and CBO has prepared such a comparison of current law versus the Ryan plan, but they said they could not estimate the impact of the April 13 proposal because the Administration did not provide enough information in the proposal. Here is a video of CBO Director, Doug Elmendorf, explaining that “We don’t estimate speeches. We need much more specificity than was provided in that speech for us to do our analysis.”

Some questioned our claim that physicians have begun requesting additional fees—‘concierge’ or ‘retainer’ payments—from Medicare beneficiaries to remain part of their practices, saying that they are illegal. But such fees are legal if the doctors accept Medicare and charge on top of this for services uncovered by Medicare, such as telephone or email consultations, though one can see fuzzy lines between this and billing extra for a covered service, which is illegal.

Some were surprised to hear that the Ryan reform proposal is much like the already existing Medicare Part D, which benefitted many at much less cost than experts predicted. This should help remove doubts—which obviously still exist in some quarters—that markets and competition can be a positive force to create better services for each dollar spent.

No Near-Consensus Among Economists for Another Stimulus Package

2011-08-15T21:54:00.000-07:00

Sunday’s Weekend Edition on NPR gave listeners a chance to hear different economic views on how to reduce the high unemployment rate. Joe Stiglitz represented the view that we need another deficit-financed stimulus package with more spending now and tax increases later. I represented the view that the 2009 deficit-financed stimulus didn’t work and that we need to address the problem of expanding debt and regulations, which are holding back investment and job creation, and that we should not increase taxes. In selecting excerpts from an earlier taping, I think the NPR editors gave a fair representation of the views that are out there.

In the meantime, an article in the New York Times over the weekend suggested that there was a new consensus for the view which Joe put forward. I see no such consensus. Some economists such as Joe, Paul Krugman, and Robert Reich have that view, but that is not new for them. And it is nothing new for Warren Buffett to argue for tax increases as he did in an New York Times op-ed today: When he was an adviser to Arnold Schwarzenegger in the 2003 California recall election, Buffett recommended tax increases, but Arnold told him to cool it or do 500 pushups for punishment. And there are plenty of economists who think that gradually reducing spending and not increasing taxes is better for job creation. In June, for example, 150 economists (including me) wrote that a debt deal “that is not accompanied by significant spending cuts and budget reforms would harm private-sector job growth”

When Economic Principles Were Ignored

2011-08-12T00:32:00.000-07:00

In televised speech on Sunday evening August 15, 1971, Richard Nixon shocked the world with these words: “I am today ordering a freeze on all wages and prices throughout the United States for a period of 90 days,” (see video) and “I have directed Secretary Connally to suspend temporarily the convertibility of the dollar into gold or other reserve assets…” (see video).

There are many lessons learned from this Nixon shock, as Amity Shlaes, Joe Thorndike and I wrote in pieces this week on Bloomberg Echoes here, here, and here, respectively. Perhaps the most important lesson, a warning actually, is how a presidential administration with economic principles emphasizing free markets and limited government intervention can end up implementing an economic policy of controlled markets and extensive government intervention, with terrible consequences. By reading contemporary reports, such as the Newsweek columns of Milton Friedman mentioned in my piece, you can see how politics drove the decision making and how administration economists either succumbed or were overruled. In marked contrast, a decade later another free-market, limited-government administration came into power in Washington and stuck to its principles—and the economic performance turned out to be far better.

For a useful quick summary of how these momentous decisions were made (with candid commentary by Milton Friedman and George Shultz), watch this short 5-minute video from Commanding Heights.

Regulatory Capture across the Hudson

2011-08-09T23:14:00.000-07:00

The book Reckless Endangerment by Gretchen Morgenson and Joshua Rosner is filled with examples of regulatory capture which the authors uncovered in their investigative reporting of the financial world. Here is my review in the Washington Post. Many of the examples are useful for teaching Economics 1—including what the authors see as a cozy connection between the New York Fed and the Wall Street firms it regulates.

Orley Ashenfelter, President of both the American Economic Association and American Association of Wine Economists, has done some of his own investigative reporting on the other side of the Hudson River. As he explains in a recent oped, the New Jersey liquor lobby has captured the State legislature, and has done so since the Great Depression.

I think these examples are better than the financial industry examples for teaching, at least at the principles level. Liquor stores are easier to visualize and explain than structured investment vehicles and the examples nicely illustrate the advantages of free markets, the dangers of government regulation, the role of special-interest lobbying, and how to reform the system, now that the wine growers in the state have started to rebel and change the law. Better than Jersey Shore as one of the commentators on the oped pointed out.

More on the S&P Downgrade

2011-08-07T17:49:00.000-07:00

Two years age in an article in the Financial Times I wrote that “Standard and Poor’s decision to downgrade… should be a wake-up call for the US Congress and administration.” At that time I was not, of course, referring to the decision of last Friday, but rather to S&P’s downgrade of “its outlook for British sovereign debt from ‘stable’ to ‘negative’.” In that May 26, 2009 FT article I listed several reasons why I was concerned that Washington might “sleep through that wake-up call,” and many of those played out, at least until the elections of last November which brought in many new members to Congress who woke up and came to Washington. As a result we have the Budget Control Act of 2011, which is a good first step in a longer term plan to reduce spending.

I have received several comments on my post yesterday on whether or not S&P’s initial assumptions about spending growth in its downgrade report represented a “difference of opinion” with other views or a “math error.” To my knowledge, the initial calculations which are in dispute have still not been made public, so perhaps we will never know for sure, but the main issue seems to be a “difference of opinion” about spending growth following the Budget Control Act (BCA). The argument that it was a “math error” is based on the idea that the BEA caps on discretionary spending are a fixed dollar amount and that S&P did not use those dollar amounts in their initial calculations.

I have been quite positive about the accomplishments of BCA, but its actual impact on spending may be less than the dollar amounts assumed by S&P in its final draft and closer to those apparently assumed in its first draft.

First, some of the deficit reduction could come in the form of tax increases (if the Joint Committee proposes some tax increases and they are approved) rather than spending reductions; in this case the change in tax revenues would have the same static dollar effect on the deficit, but then there are many potential offsetting effects, such as the current proposal to extend the payroll tax reduction or the slower economic growth if tax rates are raised.

Second, BCA excludes Iraq, Afghanistan, and related discretionary spending; I hope and expect these to come down compared to CBO baseline, but there are differences of opinion.

Third, BCA caps can be changed or altered in the future, perhaps when appropriators find it difficult politically to pass legislation to achieve the caps. Several people have emailed me about this problem in questioning my view that BCA is an accomplishment.

Fourth, and this relates specifically to the chart in my post of yesterday, BCA does not apply through the whole period of the long term budget outlook, which uses CBO’s alternative fiscal scenario.

To clarify these issues, the Treasury and S&P could put out the details of their dispute, including the before and after assumptions and calculations. On the other hand, I do think people should move on.

Treasury Versus S&P on the Downgrade: It’s Not a Math Error

2011-08-06T23:04:00.000-07:00

The White House and the Treasury are accusing Standard and Poor’s of making an elementary arithmetic mistake in the recent downgrade decision. Treasury’s John Bellows writes about what he calls a “$2 trillion mistake” saying that “After Treasury pointed out this error – a basic math error of significant consequence – S&P still chose to proceed with their flawed judgment by simply changing their principal rationale for their credit rating decision from an economic one to a political one.” White House adviser Gene Sperling adds that “The magnitude of their error combined with their willingness to simply change on the spot their lead rationale in their press release once the error was pointed out was breathtaking."

But if you examine the details of the S&P--Treasury--White House dispute, rather than a “math error” you will find what is better described as a “difference of opinion” about a forecast for future government spending. In other words, the issue is about the appropriate “baseline” for government spending in the absence of more actions. Since when did different views or assumptions about the future become a math error?

In their original draft report, S&P evidently assumed that discretionary government spending would grow by about 5 percent per year over the next 10 years if no further action were taken (beyond the Budget Control Act of 2011). In the final draft, at the urging of the Treasury, they assumed that discretionary spending would grow at about 2.5 percent per year if no further actions were taken. The first assumption leads to a higher level of debt than the second. Over 10 years the difference is about $2 trillion.

So this is a matter of different assumptions rather than a math mistake. In fact, the alternative assumption of faster spending growth is not so unreasonable, and whether or not S&P put it in their final report it is something they or anyone else should worry about. In fact this assumption is used by CBO in their “alternative fiscal scenario,” which I and others have used to project debt into the future as in the exploding debt chart below. CBO devoted part of its January 2011 Budget Outlook to considering such alternatives. See in particular Table 1-7 of that CBO report where they show that increasing discretionary appropriations at the rate of nominal GDP growth (assumed to be about 5%) increased the debt by $1.8 trillion, or about $2 trillion over ten years, compared with the 2.5% assumption.

There are of course reasons to dispute the downgrade decision of S&P, but a math error is not one of them. It would be more productive for government officials to move on and to use their time to find ways to reform taxes or entitlements, fix the exploding debt problem, and thereby prevent the likelihood of the outcome in this chart, which shows CBO forecasts (during the past three years) under their alternative fiscal scenario explained in more detail here.

Debating History and Policy with Reich and Krugman

2011-08-02T23:55:00.000-07:00

Tonight’s NewsHour debate between me and Robert Reich was about the role of Keynesian fiscal policy in the context of the today’s budget agreement. Reich was not supportive of the agreement because it precluded another stimulus package which, in his view, would create jobs. I was supportive because it was a start on budget consolidation path to restore sound fiscal policy which would reduce uncertainty over the exploding debt and thereby create investment and jobs. I think Jeffrey Brown gave us both a chance to make our case and provide historical evidence on what works and what doesn’t.

Such historical evidence will certainly play a role in the upcoming debates about the role of government in the economy. In this regard I see that Paul Krugman is on the attack again, this time about an article I wrote in the Wall Street Journal. Here is the paragraph from my article he criticizes following the pull out quote from Richard S. Grossman which he links to.

“With lessons learned from the century’s tougher decades, including the Great Depression of the ’30s and the Great Inflation of the ’70s, America entered a period of unprecedented economic stability and growth in the ’80s and ’90s. Not only was job growth amazingly strong—44 million jobs were created during those expansions—it was a more stable and sustained growth period than ever before in American history.”

So what’s the problem? No one can deny that the 1930s and the 1970s were tough decades for the economy. And job creation in the expansions of the 1980s and 1990s was amazing: There were two long expansions in the 1980s and 1990s: 1982-1990 and 1991-2001. In November 1982—the start of the1980s expansion—total non-farm payroll employment was 88,770 according to BLS historical statistics. In March 2001, the peak of the 1991-2001 expansion, it was 132,500. The difference in those 220 month was 43,730, about 44 million. There is no other 220 month period in the post war period where so many jobs were created. Note that this is not just the Reagan expansion; it includes all of the Clinton years.

And as the following graph illustrates the 1980s and 1990s were a period of “stable and sustained growth.” In fact because of the stable and sustained growth the period is called the Great Moderation which has been documented by many economists. Here is the Wikipedia entry which uses the same chart and contains many references. Unfortunately, the Great Moderation ended with the Great Recession and the non-existent recovery.

Paul Krugman also links to some total factor productivity plots to make his argument, but they are more supportive of my points. The charts show that productivity growth declined in the early 1970s (more evidence that the 1970s were one of the “tougher decades”). They also show that productivity growth picked up after the return to better macro and micro policies in the 1980s and 1990s. Of course, the pickup occurred with a lag most likely because of the slow diffusion of technology for the reasons emphasized by my colleague economic historian Paul David.

Why Much Was Accomplished in the Debt/Budget Negotiations

2011-08-01T20:16:00.000-07:00

Many are still debating how much was accomplished in the debt/budget agreement approved by the House today with the Senate to vote and the president to sign tomorrow. In my view, much was accomplished, and credit goes to all those who have been laying out the arguments and fighting hard for a return to sound fiscal policy as part of a pro-growth program to get the economy moving again.

You can see the impact of the agreement on spending with the following chart, which I have used before to show the recent federal spending binge and how to reduce it in a credible way.

It shows total federal government outlays—including both entitlements and discretionary spending—as a share of GDP for the past decade and the next decade under the various budget proposals. In previous posts and articles in the Wall Street Journal I have shown the top line, which is the original White House budget proposal submitted last February, and the bottom line, which is this year’s House Budget resolution due to Paul Ryan; this House proposal brings the budget into balance without any increase in taxes. The issue all year has been where between these two lines we would end up, and what would remain to be settled during the 2012 election.

The middle two lines show what has been accomplished this year. The line labeled “After BCA (Budget Control Act) Tranche 1” is the result of spending reductions agreed to in the Continuing Resolution of last spring and this past weekend’s agreement to cut and cap discretionary spending as part of the first $900 billion increase in the debt limit, along with adjustments in the CBO baseline. This all adds up to $1.4 trillion. The next line shows the additional spending cuts that will occur as a result of the second part of the debt limit increase, scheduled for the end of this year—another $1.5 trillion. (The “Tranche 2” line is drawn by distributing the $1.5 trillion amount to each year in the same pattern as outlay reductions in the “Tranche 1” line, though the actual pattern is yet to be determined.)

So it is clear that the budget has come a long way from the Administration’s first spending proposal—about half way to the House proposal—and it was accomplished without any tax increases. Some are disappointed that Washington did not do more, but there is no question that this represents a very big shift, even though the heavy lifting will go on with a good debate in the upcoming elections.

In addition to the hard work of those deeply concerned about the debt, the deficit, and the economy, an important idea or principle also deserves credit. This is the negotiating principle that “any debt limit increase has to be matched by spending reductions”—call it the Boehner principle. I wrote favorably about the principle in the Wall Street Journal in June and signed a letter with other economists supporting it when it was viewed as controversial, or even, as John Boehner said about himself today "when everyone thought I was crazy for saying it." But because of its simple reasonableness and good economic rationale, it helped carry the day and achieve an important agreement.

Charting the Disappointing Economic News

2011-07-29T08:57:00.000-07:00

The sad economic story in this morning’s GDP release can best be told with three simple charts.

First, economic growth in this recovery has been even slower than previously thought, and has averaged less than 1 percent so far this year. This is the main reason why unemployment has remained so high. And the recession was even deeper than previously estimated.

Second, inflation has been higher in the past two years than previously estimated. The broad GDP price index inflation rate has averaged 2.4 percent so far this year

Third, this recovery looks even worse in comparison with the sharp 1983-84 recovery from the deep 1981-82 recession. Real growth in the past eight quarters has averaged only 2.5 percent and has never exceeded 4 percent.

The Boehner and Reid Budget Plans Compared

2011-07-27T22:15:00.000-07:00

Today the CBO released its updated score of the Boehner budget proposal and the Reid budget proposal. So we can now do an apples-to-apples comparison of the year-by-year numbers in the two plans, and thereby get a better understanding of the differences between the two. A couple of charts will help.

The first chart shows the impact of the Boehner proposal on federal discretionary outlays. Compared to the March CBO baseline it reduces discretionary outlays by $756 billion over 10 years, which, with interest saving of $156 billion and other smaller changes, reduces the deficit by $917 billion. That is of course a lot less than the $6 trillion in the House budget resolution, but it is a good step in the right direction. The proposal correspondingly increases the debt limit on a nearly dollar-for-dollar basis by $900 billion, which should take us into early 2012. Since this increase will not last through the upcoming presidential election, the proposal also enacts a process to increase the debt limit by another $1.6 trillion with matching spending cuts, which would then last through the end of 2012.

As the chart shows the Boehner plan gets started reducing discretionary outlays in 2012 (by $25 billion) and again in 2013 and then remains well below the baseline. The chart also raises doubts about claims like the New York Times editorial page made yesterday saying that the Boehner plan “would eviscerate discretionary programs.” That is not what the CBO numbers show. If you look at the graph you can see that with the Boehner plan discretionary spending remains far above the levels of only 5 years ago: In 2012 the level of outlays is 27% above 2007, just before the financial crisis—another indication that there is more work to do following this step.

The second chart shows the Reid proposal, which also places caps on discretionary spending. Two lines are needed to explain how the Reid proposal works. The upper Reid line shows the caps on spending excluding Iraq and Afghanistan; this line is nearly the same as the Boehner line in the first graph; it saves $751 billion over 10 years.

The lower Reid line shows that by also capping outlays for Iraq and Afghanistan, well below current CBO baseline for those operations, the Reid plan can be scored as cutting more from outlays than the Boehner plan. However, the CBO baseline for Iraq and Afghanistan simply extrapolates existing budget authority for these operations; it is by no means a forecast of future spending; rather it is an overestimate given current stated policy of the Administration and others regarding Iraq and Afghanistan. But by capping spending below this overestimate of spending and then counting the difference as budget saving, the Reid plan overstates budget saving. It is in this sense that critics say that the Reid proposal is based on gimmicks. And the amount is large; by capping spending in this way the Reid plan brings deficit reduction up to $2.2 trillion over 10 years, thereby justifying a larger increase in the debt limit which goes past the 2012 election.

If the Reid proposal removed this second type of cap it would be very close to the Boehner proposal. And this suggests--assuming that the House votes to pass the Boehner plan tomorrow--that the Senate could vote to approve the Boehner plan or something close to it, perhaps with some compromise about how to treat Iraq and Afghanistan spending projections going forward.

Like the Boehner proposal, the Reid proposal avoids a tax increase. Following the ‘Boehner principle,” the Reid proposal ties the debt limit increase to reductions in spending growth in roughly dollar for dollar fashion; it is not a “clean” debt limit increase. And the Reid plan caps discretionary spending excluding Iraq and Afghanistan at the same level as the Boehner plan. In all these ways the Senate has moved dramatically toward the House in the last few weeks, and dramatically away from the White House, which this year has called for tax increases, a “clean” debt limit hike untied to spending, and no cuts to spending relative to baseline.

What Does Anti-Keynesian Mean?

2011-07-19T21:47:00.000-07:00

In the latest edition of his excellent series of podcast interviews, Russ Roberts asked me toward the end what I thought about being characterized as anti-Keynesian as I was in this Economist post The rise of the anti-Keynesians. In a follow-up to the Economist article, David Altig, with basic agreement from Paul Krugman, argued that it was a misnomer because I developed and used macro models (now commonly called New Keynesian) with price and wage rigidities in which the government purchases multiplier is positive (though usually less than one), or because the Taylor rule includes real variables in addition to the inflation rate. In my view, rigidities exist in the real world and to describe accurately how the world works you need to incorporate such rigidities in your models, which of course Keynes emphasized. But you also need to include forward-looking expectations, incentives, and growth effects—which Keynes usually ignored.

In my view the essence of the Keynesian approach to macro policy is the use by government officials of discretionary countercyclical actions and interventions to prevent or mitigate recessions or to speed up recoveries. Since I have long been critical of the use of discretionary policy in this way, I think the Economist is correct so say that I am anti-Keynesian in this sense of the word. Indeed, the models that I have built support the use of policy rules, such as the Taylor rule for monetary policy or the automatic stabilizers for fiscal policy, which are the polar opposite of Keynesian discretion. As a practical prescription for improving the economy, the empirical evidence is clear in my view that discretionary Keynesian policy does not work and the experience of the past three years confirms this view.

Milton Friedman wrote a wonderful review essay on Keynes’ influence on economics and politics which touches on these issues and is still well worth reading. Friedman distinguished between Keynes’ political bequest—the advocacy of discretionary actions taken by powerful government officials—and his economic bequest—the emphasis on aggregate demand as a source of business cycle fluctuations. In the last section of the essay Friedman argues—quoting extensively from Keynes’ famous letter to Hayek on the Road to Serfdom—that the political bequest was very harmful while the economic bequest has many important insights. For simlar reasons using rational expectations models with rigidities or advocating policy rules which react to real economic variables is not inconsistent with an anti-Keynesian or rules-based approach to policy in practice.

A Way Out Of the Budget Impasse

2011-07-13T09:13:00.000-07:00

In a column posted today on Bloomberg Views I suggested a way to resolve the budget impasse. It starts with the fact that about $6 trillion in deficit reduction is needed over 10 years to get to balanced budget.The proposal is that the President and the Congress agree now to $2.5 trillion spending growth reductions and increase the debt limit by the same amount. The question about how to close the remaining $3.5 trillion gap--tax increases or more spending reductions--is then left to debate next year as part of the 2012 election.

This chart--which I have used before--shows the feasibility of the idea. In a speech on April 13 President Obama already suggested about $2 trillion in spending growth reductions. So we are almost there.

A Tale of Two Labor Markets: Today and '83-'84

2011-07-08T13:35:00.000-07:00

Today’s jobs report provides yet more evidence that this is a recovery in name only. The 9.2 percent unemployment rate is certainly a serious problem, but you can understand the problem a little better by looking at the percentage of working-age Americans who are actually working. This percentage declined again to 58.2 percent in June, and is well below what it was when the recovery officially began.

The chart below shows the change--during the 24 months of this so-called recovery--in the percentage of people working and compares it with the recovery after the most recent deep recession of 1981-82. You can see the general recent decline. In contrast the percentage of people working rose sharply in 1983-84. So this time there really has been no recovery in the labor market.
The chart also tells you what might have been. For example, if the employment to population ratio had increased (rather than decreased) in the past 24 months by as much as it did in the 24 months following the 1981-82 recession, then 8.9 million more Americans would have jobs than actually have jobs.

Yesterday the House Budget Committee released a report on the jobs problem and, while mentioning several explanations, argued it is due to an economic policy problem, including the increase in the debt and deficit caused in part by the stimulus packages and spending boom of the past few years. My Bloomberg News column of yesterday shows that the Keynesian revival, which has its ten-year anniversary this month, hasn’t helped.

Time To Renew the Principles of 1776

2011-07-04T23:13:00.000-07:00

What’s the best way forward for American economic policy? On Independence Day it’s natural to look to the country’s founding principles—political freedom and economic freedom—for an answer. 1776 was not only the year when Thomas Jefferson wrote the Declaration of Independence, it was the year when Adam Smith wrote the Wealth of Nations. We can learn what to do by studying the alternating periods in American history when careful attention was paid to these principles and when they were recklessly neglected.

From the perspective of today’s dismal economic performance—high unemployment and a nearly non-existent recovery from a devastating recession—the final two decades of the 20th century are particularly relevant for they stand out as unusually good economic times. With lessons learned from the 20th century’s tougher decades, including the Great Depression of the ‘30s and the Great Inflation of the ‘70s, America entered a period of unprecedented economic stability and growth in the ‘80s and ‘90s. Not only were 47 million jobs created, economic growth was more stable than ever before in American history.

Economic policy in the ‘80s and ‘90s was less interventionist in comparison with earlier 20th century decades. Attention was paid to the principles of economic and political freedom: limited government, incentives, private markets, and a predictable rule of law. Monetary policy focused on price stability. Tax reform reduced marginal tax rates. Regulatory reform encouraged competition and innovation. Welfare reform devolved decisions to the states. With strong economic growth and control of government spending the budget moved into balance. As the 21st century began many hoped that applying these same principles to education and health care would create greater opportunities and better lives for all Americans.

But economic policy went in a different direction. Some public officials found the limited government approach to be a disadvantage; they wanted to do more—whether to tame further the business cycle or increase homeownership. Others took the good economic performance for granted, forgetting that good economic policies made that performance possible. Still others forgot the earlier lessons that interventionist policies frequently made things worse. Complacent about the success in the ‘80s and ‘90s, they let down their guard against political pressures that thwart good policy and lead to reckless ones.

So policy moved in a more interventionist direction. The result was not the intended improvement, but rather an epidemic of unintended consequences--a financial crisis, a great recession, and the high unemployment and wasted resources we see now. The change in direction did not occur overnight. We saw increased federal intervention in the housing market in the late 1990s. We saw a countercyclical fiscal policy in the form of rebate checks in 2001, and then a failure to control of government spending growth from entitlements to defense. We saw monetary policy moving in a more activist direction in 2003-2005, and interventionism reached a new peak with the bailouts before and after the panic in 2008. In the past three years Washington doubled down on the interventionist approach, and deficits and debt have exploded. With high unemployment and fears of a secular American decline, there is now an urgent need to get back to the principles of political and economic freedom put forth in the Declaration of Independence and in the Weath of Nations. The good news is that it’s not too late.

No, A Bigger Stimulus Would Not Have Worked Either

2011-07-03T22:39:00.000-07:00

Paul Krugman writes (citing Noah Smith) that he agrees with the empirical findings in my critique of the revival of Keynesian activism in the 2000s (the stimulus packages of 2001, 2008 and 2009). In particular, he writes that “it’s far from clear that the ARRA actually led to much of a rise in government spending, while the tax cuts that made up much of the stimulus were probably largely saved.”

But he then goes on to say that the stimulus was too small. That’s not what I found in my paper. As I stated in the paper, my “results do not lend support to” the view “that the stimulus was too small.” Rather the paper showed that “a larger stimulus package—with the proportions going to state and local grants, federal purchases, and transfers to individual the same as in ARRA—would show little change in government purchases or consumption.”

Now, I know that Krugman is trying to distinguish between good and bad Keynesian stimulus packages, and that he would like a stimulus package with higher proportions going to federal, state, and local government purchases than the 2009 stimulus, or, for that matter, the 2008 stimulus or the 2001 stimulus. But experiences from the 1970s raise serious doubts about the political and operational feasibility of such discretionary fiscal policy. So do recent experiences in many other countries, as shown by Hyun Seung Oh and Ricardo Reis.

In a simple Keynesian model, all the government has to do to combat a recession is quickly increase government purchases, but the difficulty with doing so in practice is one of the classic arguments against discretionary fiscal policy. Of course, it is not the only argument. Small or unreliable multipliers, the legacy of increased debt, the unpredictability and temporariness of such policies are some of the other arguments. Using dynamic models with expectations and incentives, I have found very small multipliers (around .5)

For these reasons I argued in the November 2008 article which Krugman cites that a better fiscal policy would be to rely on the automatic stabilizers and enact more permanent reductions in tax rates (or at least pledge not to increase tax rates in a recession).

As early as the summer of 2009 it was clear that ARRA was not working as intended, as John Cogan, Volker Wieland and I reported. Research since then has uncovered the reasons why. One reason is that very large stimulus grants to the states did not go to infrastructure spending as intended, and that’s what Ned Gramlich found out about Keynesian stimulus packages thirty years ago.

How to Resolve the Stimulus Debate: Use Data Not the Same Models Over Again

2011-06-30T21:35:00.000-07:00

Predictions made in early 2009 about whether the stimulus package would work varied widely because the models used to make the predictions varied widely. Models used by Christy Romer and Jared Bernstein predicted large effects of the 2009 stimulus (ARRA), while models used by John Cogan, Tobias Cwik, Volker Wieland and me predicted small effects.

Now that ARRA is winding down people are asking which prediction was right. Did ARRA stimulate the economy significantly or not? To answer this question the same models are again being used, but now to evaluate the policy. CBO, for example, takes this approach in their congressionally mandated impact studies of ARRA.

But you learn virtually nothing about whether a stimulus package worked using this approach because the models simply repeat the same prediction story over again.

Unfortunately, the complexity of models with a hundred or more equations makes it difficult to see this point, so I created an illustration with stylized one-equation models which people seem to like. A little algebra is needed.

Consider two models relating the size of the stimulus package (symbolized by S) to GDP (symbolized by Y). Model A is Y= αS + Z and Model B is Y = Z, where Z is an unobservable shock and α is a coefficient which we set to 1.5.

Suppose that a stimulus is enacted with S = 2, but Y falls to -1. Then the shock implied by Model A is Z = - 4 while the shock implied by model B is Z= -1.

Now consider policy evaluation of the stimulus based on a counterfactual where there is no stimulus so S=0.

Economists using Model A would say:
Just as we predicted, the stimulus package worked. Without it, Y would have fallen to -4 rather than -1. The decline in output would have been 4 times as deep, a Great Depression 2.0.

Economists using Model B would simply say:
Just as we predicted the stimulus package didn’t work.

The best way to way to deal with this problem is to look empirically at the direct effect of the stimulus using actual data, but without imposing a specific model structure like Model A or Model B. In a paper forthcoming in the Journal of Economic Literature I use this direct approach and find that the ARRA did not stimulate the economy.

Unchanged Debt Explosion

2011-06-24T11:56:00.000-07:00

CBO’s Long-Term Budget Outlook released this week is essentially the same as last year’s: without a change in policy the debt will explode to over 900 percent of GDP. One difference is that CBO decided not to print out the debt ratio in their spread sheet “Data Underlying Scenarios and Figures” as in the past two year once the ratio went beyond 200 percent. So in the following graph I computed the ratio from the revenues and spending projections. This means that the backdrop used two years ago by the "best Economics 1 lecturer ever" still applies, though the quest lecturer is now 2 years old and we still haven’t fixed the problem.

This is why it is so important to adopt reforms like the ones proposed this week by Congressman Kevin Brady, which would hold down federal spending as a share of GDP and stop the debt explosion. By using potential GDP rather than actual GDP his proposal would eliminate the pro-cyclical spending implied by many other spending cap proposals (which use actual GDP) where federal spending would rise rapidly during booms and fall rapidly during recessions.

Today I touched on the importance of getting spending ratios down and returning to sound fiscal (and monetary) policy in this “Big Interview' with Kelly Evans at the Wall Street Journal

The Two Year Anniversary of the Non-Recovery

2011-06-21T20:21:00.000-07:00

This month marks the two-year anniversary of the end of recession and start of recovery. But it’s a recovery in name only, so weak as to be nonexistent. And it has been weak from the start. Real GDP growth has averaged only 2.8 percent per year compared with 7 percent after last deep recession in 1981-82, as shown in the following chart. And the unemployment rate is still over 9 percent.
Today the Joint Economic Committee of the Congress held a hearing on whether a credible plan to reduce government spending growth would bolster or hinder the recovery. I argued that a credible budget strategy would strengthen the recovery, by removing the threats of another fiscal crisis, higher taxes, higher inflation and higher interest rates—all caused by the huge deficits and growing debt and all impediments to private investment and job creation (written testimony here and opening remarks at C-Span 6:23 minutes here). To balance the budget without increasing taxes the plan would have to reduce spending growth by $6 trillion over ten years.

Fortunately, there are some signs of progress: The election last November sent a message to Washington to reduce the deficit and the debt; the 2011 budget deal reduced 2010-2011 growth in discretionary budget authority from +$39B to -$39B; President Obama withdrew his first budget proposal for 2012 and is agreeing to less spending; and the idea of tying the debt limit hike to reductions in spending growth is holding, despite protests from the Treasury Secretary and the Fed Chairman.

One way to implement a credible budget strategy in our current divided government would be to agree now to reduce spending by $2.5 trillion over ten years (including material changes in 2012) as part of the $2.5 trillion debt limit hike, and then debate how to deal with the remaining $3.5 trillion gap in the presidential election. One side would say to close the gap by raising taxes. The other side would say to close the gap by reducing spending. While the outcome would still be uncertain, there would be far less uncertainty about the budget than currently exists.

Why Avoiding Bailouts is Good Policy

2011-06-16T23:37:00.000-07:00

Asgeir Jonsson’s interesting and perceptive article in today’s Wall Street Journal provides a clear lesson for students and policymakers alike about the harm that comes from bailouts and the good that comes from avoiding them. If a government recognizes the reality of a solvency problem early, and deals with it, its citizens will end up much better off than if it wishfully thinks it’s a liquidity problem and takes bailouts. Iceland recognized its problem early and took action, while Ireland thought wishfully and took bailouts, and that’s made all the difference.

It was a lesson learned by many emerging market countries about a decade ago, and it has made a big difference for them too. That's one reason why an emerging market leader would make a good IMF leader today. More on that later.

Why Not Go For 5% Growth?

2011-06-11T13:34:00.000-07:00

Some skeptics have complained about the 5% national economic growth target put forth by former Minnesota Governor Tim Pawlenty in his speech this week about his economic plan. They say it can’t be done. But I think the goal makes a great deal of sense. It would focus policymakers like a laser beam on the great benefits that come from higher growth and on the pro-growth policies needed to achieve it. As with any goal, if you take it seriously, you’ll choose policies that work toward that goal and reject those that don’t.

As stated in the speech, “5% growth is not some pie-in-the-sky number.” One way to see why is by dissecting the number into its two parts using basic economics. As we teach in Economics 1, economic growth equals employment growth plus productivity growth. Productivity is the amount of goods and services that workers produce on average in a given period of time. Thus, higher economic growth can come from higher employment growth or from higher productivity growth. Now consider some examples of average growth rates over the next ten years.

First, look at employment growth. Given the dismal jobs situation, that’s the highest priority. Currently the percentage of the working-age population (age 16 and over) that is actually working is very low at 58.4 percent. In the year 2000 it reached 64.7 percent, so that is at least a feasible number. Raising the employment-to-population ratio to 64.7 means an employment increase of 10.8 percent (64.7-58.4/58.4 = .108) or about 1 percent per year over 10 years, even without any growth of the population. Adding in about 1 percent for population growth (from Census projections), gives employment growth of 2 percent per year.

Now consider productivity growth. Since the productivity resurgence began around 1996, productivity growth in the United States has averaged 2.7 percent according to the Bureau of Labor Statistics. So numbers in that range are not pie in the sky. As Harvard economist Dale Jorgenson and his colleagues have shown, the IT revolution is part of the explanation for the productivity growth, and, if not stifled, is likely to continue, as is pretty clear to me as I sit a few hundred yards from Facebook and other high-tech firms.

Now if we add the 2.7 percent productivity growth to the 2 percent employment growth, we get 4.7 percent economic growth, which is within reaching distance of—or simply rounds up to—the 5 percent target set by Governor Pawlenty. Thus, five percent growth is a good goal to aspire to, whereas 3 or 4 percent would be too little and 6 or 7 percent too much. Of course, one can fine-tune these calculations--for example, by estimating changes in hours per worker or the difference between nonfarm business (which BLS productivity numbers refer to) and total GDP--or raise questions about demographic effects on the employment-to-population ratio. And one could use different examples, perhaps lower employment growth and higher productivity growth, but the basic point about the goal would be the same.

You can see how the types of pro-growth policies in the Pawlenty plan would work toward the goal by reducing spending growth enough to balance the budget without tax increases and thereby remove threats of a debt crisis; by lowering marginal tax rates to spur hiring and job growth; by scaling back unnecessary new regulations which impede private investment and higher productivity, and by restoring sound monetary policy to remove uncertainty about inflation or another financial crisis.

Comparing 2011 with 1937

2011-06-09T15:15:00.000-07:00

In today’s article in Bloomberg View I explore reasons for the current weak recovery, and in particular whether there is an analogy with what happened in the recession of 1937-38 which interrupted the recovery from the Great Depression. Several charts elaborate on numbers provided there which argue against such an analogy.

The first one relates to fiscal policy. It shows the ups and downs of real GDP growth in the 1930s and the contributions to that growth coming directly from government purchases and other components of GDP. (The data come from this interactive table at the Bureau of Economic Analysis ). Clearly the change in government purchases contributed little to the downturn in 1937 and 1938. Even with generous multiplier effects on consumption, the changes in government purchases are too small to make much difference. Given that any decline in government purchases now due to the end of the 2009 stimulus is even smaller than the declines in 1937, the fading out of the stimulus is unlikely to have much to do with the current slowdown.

The other two charts relate to monetary policy. One shows the large decline in the monetary base (currency plus reserves) from May 1936 to May 1937 and the other shows the large increase in the monetary base from May 2010 to May 2011. While the decline in the monetary base is likely to have been a reason for the slowdown in the 1930s, there is no such decline now to explain the current slowdown. The recent ups and downs in the monetary base are due to the quantitative easings and at some point the monetary base will have to decline again. The challenge for the Fed will be to carry out this exit strategy in a clear and transparent manner in order to minimize disruption and uncertainty.

Lessons From the Financial Crisis For Teaching Economics

2011-06-06T02:31:00.000-07:00

Last week at Stanford the American Economic Association hosted its first conference ever on teaching economics. It was a great success and a second conference will be held in Boston next year, sponsored by the Journal of Economic Education (JEE).

I was asked to speak at the conference about the impact of the financial crisis on teaching economics. Here are the slides from the talk, which will eventually be published in the JEE. I emphasized that one’s view of how economics teaching should change depends greatly on one’s view of the crisis. For example, Alan Blinder and I have different views of the crisis and the policy response, so naturally we have different views about how the crisis should affect teaching.

In my view the problem was that economic policy deviated from basic economic principles which had worked well. The result was a great recession, a financial panic, and now a very weak, nearly nonexistent, recovery. The deviations included a monetary policy which set interest rates too low for too long and a regulatory policy which failed to enforce existing rules. The deviations from sound principles continued when government responded with an ad hoc bailout process and temporary fiscal stimulus programs. The good news for the economy is that economic growth and stability can be restored by adopting policies consistent with basic economic principles.

The good news for teaching is that the crisis has left us with many examples where teachers can illustrate basic economic principles including that incentives matter, the permanent income hypothesis, regulatory capture, and the money multiplier. Moreover, the heated disagreement among economists about the crisis presents another opportunity to make the subject more interesting to students.

Economic and Political Leadership on the Budget

2011-06-02T21:09:00.000-07:00

The Wall Street Journal’s headline for my article today In Praise of Debt Limit ‘Chicken’ nicely conveys the idea that linking a hike in the debt to a cut in spending—which pundits call a game of chicken—is not a game at all. It’s good economic policy. Economists in Washington should show some leadership and try to implement that policy.

But political leadership is needed too, and from the White House not just from the House of Representatives. Here President Obama could take a page from historian David Kennedy’s Freedom From Fear (page 138 to be exact) which describes how none other than FDR, in March 1933, showed political leadership and trimmed the largest entitlement of the day. As I explain in this short piece from today’s Bloomberg View's Echoes, the entitlement in question amounted to 25 percent of the budget, a much larger percentage than Social Security today.

Taylor Rule Recommends Raising Rates

2011-05-31T17:03:00.000-07:00

Over at Market Beat: WSJ.com's inside look at the markets, Mark Gongloff reports that Standard Chartered’s David Semmens says that “Based on a strict Taylor-rule calculation, the first effective fed-funds rate increase shouldn’t come until the first quarter of 2013.”

And over at Business Insider, Art Cashin of UBS reports that Jim Brown of Premium Investor says that “the Taylor rule says the Fed funds rate should be -1.65%” suggesting the need for a QE 2.5.

But no calculations are provided in either report.

Over here at Economics One, I can report that the Taylor Rule says that the fed funds rate should now be 1 percent, and I can provide the calculations. Available data (through the 1st quarter) show that the inflation rate is about 1.6 percent (GDP deflator smoothed over four quarters) and the GDP gap is about 4.8 percent (average of San Francisco Fed survey). This implies an interest rate of 1.5 X1.6 + .5X(-4.8) + 1 = 2.4 - 2.4 +1 = 1.0 percent. I am not sure why other reports differ, but at least the coefficients and numbers are here to see and check. Perhaps they are using different coefficients, but David Papell writing at Econbrowser earlier this month showed why the coefficients reported here work well.

So I think the economy would be better off if the Fed started moving to a higher funds rate now rather than later, and I certainly see no rationale for another round of quantitative easing. Unfortunately, it looks like the Fed will continue with its zero interest rate for a while longer, and traders will continue to debate whether or not there will be a QE3 adding volatility to the market.

Splitting Difference Would Reduce Federal Spending By $4 Trillion

2011-05-31T11:08:00.000-07:00

When the Senate voted down the House Budget Resolution (the Ryan budget) by a vote of 40-57, it also voted down an Obama Administration budget (submitted in February) by a vote of 0-97. But the Obama Administration had already discarded that budget when President Obama outlined in general terms a new budget in his speech on April 13. The chart below shows the discarded budget and an estimate of the current budget based on the speech. (The chart is adapted from my April 22 Wall Street Journal oped)

The White House responded to last week’s votes by saying that “both sides will need to give some ground in order to reach a bipartisan agreement on meaningful deficit reduction.” That is, of course, true. But what should be the starting point for the negotiations? What would splitting the difference mean?

Currently there are two budgets on the table—the House budget proposal and the Administration’s April 13 outline of a proposal. The Administration’s outline proposal would reduce spending by $2 trillion over ten years, while the House would reduce spending by $6 trillion. Hence the bipartisan agreement should be to reduce spending by between $2 trillion and $6 trillion over ten years. Simply splitting the difference would be $4 trillion.

Speaking and Remembering on Memorial Day

2011-05-30T16:40:00.000-07:00

This year I was honored to speak at Stanford’s Memorial Day military appreciation barbecue. There are now 51 enrolled Stanford students who are veterans. I was once a Stanford student veteran. In 1969 I temporarily left Stanford’s Ph.D. program in economics for a tour in the Navy. That year the Stanford Faculty Senate voted to remove ROTC from campus, and this year, I was pleased to remind everyone at the barbecue, the Faculty Senate reversed that decision.

But I mainly spoke about a Stanford student, Ryan McGlothlin, who did not return to complete his Ph.D. and whose memory inspires us on Memorial Day. In 2004 Ryan left the Stanford Ph.D. program in chemistry to join the Marines. In November 2005 he was killed in Iraq. He is now honored in Stanford’s Memorial Auditorium, built 74 years ago to honor alumni who lost their lives in World War I and later expanded for World War II, Korea, Viet Nam, and now Iraq and Afghanistan.

Ryan was serving in Anbar province, close to the Syrian border, where Al-Qaida terrorists were streaming through. He was a rifle platoon commander, part of Operation Steel Curtain, with the mission to clear terrorists out of the town of Ubaydi and to protect the Iraqi people. Ryan was posthumously honored with a Silver Star for his heroic acts, and I can do no better than read from the award citation. “Second Lieutenant McGlothlin's platoon was engaged by 21 enemy personnel. The enemy delivered frontal and flanking automatic fire from four well-fortified, mutually supporting positions.… With complete disregard for his own safety, Second Lieutenant McGlothlin maneuvered through the insurgents' strongpoint and immediately engaged the insurgents to secure and recover his embattled Marines…. While his last Marine was being evacuated from the building, Second Lieutenant McGlothlin shielded the recovery effort from grenade blasts and commenced a fierce exchange of small arms fire with the enemy until he was mortally wounded…. By his bold leadership, selfless act of bravery, and complete dedication to duty, Second Lieutenant McGlothlin reflected great credit upon himself and upheld the highest traditions of the Marine Corps and the United States Naval Service.”

Regulatory Capture and Reckless Endangerment

2011-05-30T14:34:00.000-07:00

My review of the book Reckless Endangerment by Gretchen Morgenson and Joshua Rosner (published in yesterday’s Washington Post) gives examples of the many ways in which cozy relations between government and industry lead to reckless policies. Students of economics will recognize the problem as regulatory capture, which George Stigler introduced to economics many years ago.

How can we prevent regulatory capture and thereby avoid the harmful policy it causes? Studying economics is not enough, at least according to Reckless Endangerment: Amazingly, twenty-five economists appear in the book (if you count those with a PhD): Dean Baker, Ben Bernanke, Gerald Corrigan, William Dudley, Roger Ferguson, Phil Gramm, Alan Greenspan, Glenn Hubbard, Lawrence Lindsey, Rick Mishkin, Alicia Munnell, June O’Neill, Peter Orszag, Jonathan McCarthy, Robert Parry, Wayne Passmore, Richard Peach, Marvin Phaup, Robert Reischauer, John Snow, Gary Stern, Joseph Stiglitz, Larry Summers, Lawrence White, and Walker Todd. Yet only a handful of these are characterized as standing up to regulatory capture. I mentioned June O’Neill, John Snow, and Marvin Phaup in my review, and there are a few others, but many are criticized for not standing up. This isn’t proof, of course, and I am sure that many of those criticized did a good job.

Still, regulatory capture exists, and dealing with it is difficult. Lobbying per se can’t be avoided in a democracy, and industry should be able explain its case to the government. Some have suggested incentives for government officials so they can withstand pressures. Others have suggested more independence, or closing the revolving doors. Perhaps the best thing is to keep the regulatory rules simple and transparent so that it is clear if industry is getting favors. Reducing government subsidies to private firms will help. So will avoiding over-regulation.

In this regard, I am reminded of these lines from the latest Keynes-Hayek rap video:
Keynes: “Even you must admit that the lesson we’ve learned is that more oversight’s needed or else we’ll get burned”
Hayek: “Oversight? The government ‘s long been in bed with those Wall Street execs and the firms that they’ve led.”

Reckless Endangerment should make liberals and conservatives alike see the wisdom in Hayek’s reply to Keynes.

Opportunity Cost and the 20 Under 20 Prize

2011-05-28T15:55:00.000-07:00

On PBS NewsHour yesterday Peter Thiel argued that the opportunity cost of college may be surprisingly high for many students, and indeed, as widely reported this past week, he raised the opportunity cost for some impressive 20 Under 20 prize-winning entrepreneurs. Economist Richard Vedder was on Peter's side of the argument, and not so surprisingly Wesleyan University President Michael Roth was not.

But the opportunity cost argument is worth taking seriously, and the entrepreneurship example is certainly a good one for the introductory economics course. Ever since Tiger Woods took my Stanford Economics 1 course in 1996, I’ve started my text book and first lecture with the story about how he dropped out of Stanford and joined the pro tour after learning about opportunity cost from me. But in the 7th Edition (out this fall) we are using examples closer to Peter Thiel's (who also was a Stanford student).

This photo is a great visual aid for discussing opportunity cost. It shows Barack Obama along with entrepreneurs and chief executives of top technology firms: Apple, Cisco, Facebook, Genentech, Google, Netflix, Oracle, Twitter, and Yahoo. They’re meeting over dinner to talk about the economy.

Everyone at the table has amazing stories about making choices. Mark Zuckerberg, sitting to President Obama’s right, faced a big choice when he was in college in 2004: whether to finish his degree or to drop out and devote all his time to transform a novel idea into a start-up firm. Doing both college and the start-up was not an option because time is scarce, only 24 hours in a day, not enough time to do both activities and sleep a bit. So he had to make a choice. In choosing one activity, he would have to incur the cost of giving up the other activity. Dropping out would mean passing up a college degree which would help him get a good job. Staying in college would mean he could not start up a new firm. Zuckerberg chose to drop out, and it looks like he made the right choice.

Steve Jobs, sitting to the left of the president in the photo, also dropped out of college, but it was because he felt the cost of tuition was too high compared to what he was getting out of the formal courses. Better, he thought, to let his parents keep the money. A couple of years later Jobs founded Apple computer, but he credits its success to the freedom he gained to explore new activities without the structure of a college degree. Larry Ellison of Oracle, sitting right across from the president, also chose not to complete a college degree.

But it is very important to point out that not every executive in the photo chose to drop out of college. Carol Bartz, at the far end of the table, graduated with a degree in computer science, earning tuition money as cocktail waitress. Years later, it seems clear that she made the right choice for her: the college degree prepared her to run tech firms like Yahoo. Dick Costolo of Twitter also finished college. Others not only chose to finish college, they chose to go on for more advanced degrees. Reed Hastings of Netflix chose to get a masters in business. President Obama chose to go law school. Eric Schmidt of Google and Art Levinson of Genentech chose to get a Ph.D.

So behind the people in the photo are many different stories of scarcity, choice, and opportunity cost. Of course, neither the people in this photo nor the 20 Under 20 prize-winners are a representative sample. Gary Becker provides data that may be more relevant to most students.

To the G8: Don’t Let Aid Perpetuate Barriers to Growth in Tunisia and Egypt

2011-05-26T21:29:00.000-07:00

In this Bloomberg Echoes post, I argue that the United States should do whatever it can to promote economic freedom in the post-Jasmine Revolution Middle East and North Africa, and strongly support economic leaders who are committed to creating a private market economy. This is the lesson learned from the transitions from government control to market economies two decades ago in Eastern Europe, especially Poland and the Czech Republic. The U.S. government strongly supported those economic reforms—the removal of price controls, of barriers to new businesses, and of subsidies of old state enterprises, along with a restoration of the rule of law and property rights. And the United States also supported the reformers, including Leszek Balcerowicz in Poland, who carried out the reforms against much oppostion.

In this regard it is alarming to hear that the G8 support package for Tunisia and Egypt--being developed at the meeting in Deauville France today and tomorrow--may do just the opposite: encourage more government subsidies and controls. Indeed, a recommend list of actions in a recent letter to the G8 from top economists—mostly from France but including Joe Stiglitz and Nouriel Roubini from the United States—starts with the case for government subsidies. But as argued persuasively by Ned Phelps yesterday in an article in Le Monde (in English here), Tunisia needs an immediate and dramatic reduction in the barriers to entrepreneurship and job creation. It needs to open the economy, domestically and internationally, and the G8 can help in both as it implements a support package.

Are there new leaders in the Middle East and North Africa (MENA) who will support such economic changes? Of course there are. For example, it is very encouraging that the new Tunisian central bank Governor Mustapha Nabli, who obtained his Ph.D. in economics from UCLA in 1974, is a reformer. His recently published book Breaking the Barriers to Higher Economic Growth in MENA argues that “at its core, [economic growth] requires the region's public sector-dominated economies to move to private sector-driven economies, from closed economies to more open economies, and from oil-dominated and volatile economies to more stable and diversified economies.” His case is based on hard facts including a careful empirical comparison of Eastern European transitions with MENA, and an analysis of reform in practice, which strongly suggest a serious, relatively fast-paced reform worthy of strong support from the United States and the whole G8.

Causation From Base Money To The Multiplier: The QE2 Evidence

2011-05-22T20:24:00.000-07:00

During the panic in the fall of 2008 some interpreted the explosion of the Fed's balance sheet and the monetary base (MB)—currency plus reserves of banks at the Fed—as an appropriate monetary policy response to a shift in the demand for the monetary base. That monetary policy should try to accomodate such shifts in demand is a classic monetary principle.

Evidence offered in support of that interpretation was the sharp drop in the money multiplier (m)—the ratio of money (M) to the monetary base (m = M/MB). The claim was that the Fed offset the decline in the multiplier (m) by increasing MB, thus leaving the money supply (M = m times MB) comparatively unaffected by the drop in m. Indeed there is a striking negative correlation between the multiplier and the monetary base during the late 2008 and 2009 period, as shown in this graph.

However, I argued in a Business Economics article at the time that this striking correlation had another interpretation. It was due to a reverse causation: the increase in the monetary base caused the multiplier to decline as banks simply absorbed the inflow of reserves. The cause of the increase in the monetary base was the need for the Fed to finance its loans to bailout financial institutions, provide swaps to foreign central banks, and eventually make purchases of mortgage backed securities in its quantitative easing program—a strategy I called mondustrial policy in part to drive home this reverse causation.

But the very severity of the panic in 2008 makes it difficult to convince people that there was not a panic-driven increase in the demand for the monetary base at that time, and I frequently hear economists and economic students sticking to the original interpretation. In this respect QE2 provides more convincing evidence for the second interpretation. The months since the start of QE2 are not even close to the panic observed in the fall of 2008. So it is much more difficult to argue that the Fed was responding to a panic-driven or otherwise autonomous increase in the demand for the monetary base. Much more likely is that—as in the fall of 2008—banks simply absorbed the increased supply of the monetary base which the Fed used to finance QE2. In fact, if you look at the chart (which goes through April 2011), you can see the same inverse relationship between the money multiplier and the monetary base during QE2 as during 2008--2009

Regarding mondustrial policy, several new articles written this Spring expore its implications from an Hayekian perspective, raising concerns similar to the ones I mentioned when I coined the term, but with more emphasis on accountability, rules, and discretion.

Linking the Debt Limit Hike To Spending Cuts Is Good Economics

2011-05-18T11:55:00.000-07:00

For months now top economic officials in Washington have been arguing that the Congress should vote to increase the debt limit without any reductions in the growth of spending—in other words a “clean debt limit hike.” Just last Thursday Ben Bernanke compared linking the debt limit and spending reductions to playing a game of chicken with U.S. credit worthiness, adding “I think using the debt limit as a bargaining chip is quite risky.” CEA Chairman Austan Goolsbee and Treasury Secretary Timothy Geithner have been saying much the same thing.

But these arguments do not take account of important economic advantages of linking the debt limit to spending reductions. Such a link is good economics in theory and in practice. It is essential to a credible return to sound fiscal policy and an end to the ongoing debt explosion.

Here’s why. In the current political and economic environment—where more people than ever in the United States and around the world are aware of, and paying attention to, the country’s debt problem—the decision about the debt limit will be precedent-setting. They also know that government spending has increased rapidly in recent years, rising from 18.2 percent of GDP in 2000 to over 24 percent now. If Washington does not change the budget game now, people will sensibly reason, it will never change the game. If politicians just increase the debt limit now when spending has been growing so rapidly compared to revenues without correcting that rapid growth of spending, then they will be expected to do so in the future. In contrast if they tie any increase in the debt limit to a halt in the explosion of spending, then people will be more likely to expect them to control spending in the future. Linking the debt limit vote with spending establishes a precedent and valuable credibility.

Another way to think about this approach is to contrast it with the debt failsafe mechanism that President Obama has proposed. Under the debt failsafe plan, if spending grows too rapidly in the future (after 2015) relative to forecast, and the debt thereby rises more than budgeted for, then there would be an automatic reduction in spending. In other words, debt increases and spending reductions are linked in future. But if there is no link in the present, as in a case of a clean debt limit increase, how can one expect one to be followed in the future? How can today’s politicians expect future politicians to adhere to such a policy if they can’t do so today? This is a common problem in economics, called the time inconsistency problem, covered from principles courses to Ph.D. courses.

The principle of linking the debt increase and spending reductions—put forth in a recent speech to the New York Economics Club by Speaker John Boehner—is therefore an important goal which is worth trying to achieve. True, it may run some risks as the deadline is approached, but those risks are far smaller than the risks caused by the debt explosion which is likely if the Boehner link is severed.

More on Seniors, Guns And Money

2011-05-14T07:57:00.000-07:00

Paul Krugman returned to the debate with me about federal spending in his New York Times column yesterday. He says that federal spending cannot be brought back from its current high levels to the 19 to 20 percent range as a share of GDP, which we saw as recently as 2007. His argument consists of two points.

He declares that military spending as a share of GDP cannot go down. Why? Because, he says, “Republicans, needless to say, oppose.” But as I wrote when he first made this point, defense spending as a share of GDP can come down. And it could come down by an especially large amount as the size of GDP increases with higher economic growth. Krugman is taking defense off the table, not me, and not Republicans who are part of the budget debate in Washington. And he does not mention economic growth.

Krugman also points out that the number of retirees is projected to grow at a more rapid rate than the number of workers paying taxes. This point should not come as a surprise to anyone. But the implication is not that we should tax working people more. Rather the implication is that we should insist that programs like Medicare be reformed to improve their efficiency and deliver improved outcomes for future retirees for each tax dollar spent.

There is a good reform plan on the table which does just this. It would bring federal spending as a share of GDP to the 19-20 percent range and it would improve health care for Medicare recipients; it is none other than the House Budget Resolution of 2012; yes, the Ryan plan. Like the Obama Administration’s proposal, it aims to bring down the growth rate of future Medicare spending from the unsustainable levels under current law. Indeed, depending on economic projections, the Obama Administration’s new plan (presented by President Obama on April 13) proposes to bring the growth rate of future Medicare spending per beneficiary to about the same rate as the House budget plan, which has Medicare payments increasing faster than the CPI as people age.

But by reforming Medicare and thereby avoiding the destructive price controls needed to limit spending in the Administration’s proposal without reform, the House plan would make Medicare recipients relatively better off. The Ryan and Obama plans both propose to reign in the explosive future growth of Medicare spending. The difference is that the Ryan plan does so in a way that is much more beneficial for seniors.

The One Hundred Trillion Dollar Note and Other Visual Aids

2011-05-10T23:47:00.000-07:00

Patrick McGroarty and Farai Mutsaka have a great article in the Wall Street Journal about this famous one hundred trillion dollar note from Zimbabwe,including the fact that I carry one around in my wallet everywhere I go. Whenever someone says inflation is not caused by central banks printing too much money, I pull out this note and tell the story of Zimabwe’s hyperinflation. Although Paul Ryan and I collaborated on an oped on monetary policy recently, we did not coordinate on this use of the famous note.

If you are interested in relating this story to the Fed, I recommend adding a couple of other pictures including this photo of a QEIII license plate in Washington DC and the photo of $5 a gallon gasoline. I think these may have helped Fed rethink the idea of going beyond QEII.

Bringing Gadhafi’s Money to Rebels Recalls Bringing Saddam’s Money to Iraqis

2011-05-08T11:30:00.000-07:00

The plan to use Moammar Gadhafi’s frozen assets to fund the Libyan rebels faces legal obstacles according to this weekend’s Wall Street Journal story "Obstacles Loom on Path To Funding Libyans." This reminds me of the plan to use Saddam Hussein’s frozen assets to fund payments to the Iraqi people in 2003. The plan was developed before the military invasion and was part of an overall plan for financial stability. I was Under Secretary of Treasury with responsibility for the plan. Legal obstacles arose then too, and we had to develop legal procedures to deal with them.

Treasury lawyers determined early on that the President of the United States could legally issue an executive order calling on U.S. banks to vest Hussein’s frozen funds with the Treasury, which would then transfer them to the Iraqis. But an obstacle was the risk of law suits from Saddam’s victims, who could make claims on the funds, prevent their transfer, and thus threaten the financial stability plan. To deal with this risk, we recommended that the executive order contain an exception for such victims—but only if they had already made claims—and that the order state that using the frozen funds for the Iraqi people was in the interest of the United States.

So when the military operation began, President Bush issued Executive Order 13290, “Confiscating and Vesting Certain Iraqi Property,” saying that “All blocked funds held in the United States in accounts in the name of the Government of Iraq, the Central Bank of Iraq, Rafidain Bank, Rasheed Bank, or the State Organization for Marketing Oil are hereby confiscated and vested in the Department of the Treasury, except for the following....” The exception was for funds already claimed in a legal suit. The executive order also stated that “I [George W. Bush, the President of the United States of America] intend that such vested property should be used to assist the Iraqi people and to assist in the reconstruction of Iraq, and determine that such use would be in the interest of and for the benefit of the United States.”

Once the order was issued we opened an account at the New York Fed where Bank of America, JP Morgan Chase, and other banks transferred about $2 billion of Saddam’s previously frozen funds. The Treasury then withdrew the funds as needed. Cash was removed from the Fed’s warehouse in New Jersey, placed on armored trucks, shipped to Andrews Air Force Base, loaded on planes, flown to Iraq, and paid to Iraqis. I recall how Treasury staff went down to Andrews to inspect the first cash transfers. When they returned to report that the cash was airborne, they radiated well-deserved pride at their accomplishment. The picture shows David Nummy (blue shirt) of Treasury dispersing the cash (in the black box) to the Iraqis in Baghdad.

There are differences today—Saddam Hussein’s funds were frozen years before during the first Gulf war, but the legal procedures remain relevant. To overcome such obstacles, President Obama would have to say something like “I determine that using the funds to assist the Libyan rebels is in the interest of the United States.”

New Study Questions Justification For Quantitative Easing

2011-05-07T12:39:00.000-07:00

Proponents of Quantitative Easing frequently cite—inappropriately in my view—the Taylor Rule as support, saying that the rule calls for a federal funds rate as low as minus 6 percent, well below the zero bound. But in various pieces over the past year, such as Taylor Rule Does Not Say Minus 6 Percent, I have argued the contrary. If you simply plug in current inflation and output (gap) you will find that the interest rate is above zero with the policy rule coefficients I originally derived. But QE II proponents change the coefficients. Frequently they use a higher coefficient on output (around 1.0) rather than the lower coefficient (0.5) which I originally recommended. The higher coefficient on output gives a much lower interest rate now and is thus used by proponents of quantitative easing.

A new paper by Alex Nikolsko-Rzhevskyy and David Papell provides important evidence relevant to this debate. They show that, if history is any guide, the higher coefficient would lead to inferior economic performance compared with the original coefficient I recommended.

First, they look at the 1970s when monetary policy was too easy: in much of this period the interest rate was too low creating high inflation and eventually high unemployment. They show that the higher coefficient on output would have perpetuated the bad policy while the lower coefficient would have prevented it.

Second, they look at years in the 1990s when monetary policy is widely viewed as good, helping to create a long expansion. Here they show that the higher coefficient would have prevented this good policy. Actual policy was more consistent with the lower coefficient which I had proposed.

In sum, they find no reason to use a higher coefficient, and that the lower coefficient works better. David Papell’s guest blog yesterday on Econbrowser nicely puts these new results into the context of today’s policy debate and provides more details. He emphasizes that his paper with Nikolsko-Rzhevskyy does not endeavor to estimate the impact of QEII, but rather shows that the typical policy rule rationale for this discretionary action is flawed. In my view it is an example of “discretion in policy rule’s clothing.”

How to Avoid the New Bailout Authority

2011-05-05T23:33:00.000-07:00

Title II of the Dodd-Frank bill, which creates a new orderly liquidation authority for financial institutions, has recently come under fierce attacks from a variety of perspectives. Paul Ryan writing in the Wall Street Journal on April 5 argues that we should get “rid of the permanent Wall Street bailout authority that Congress created last year.” Then, after reading an FDIC report on how Title II would have worked in the case of Lehman, Simon Johnson in effect agrees with Ryan arguing that any Treasury Secretary, at least one in the Paulson-Geithner mold, would go right around Title II and simply bail out the creditors of large financial firms as in 2008. Recently Stephen Lubben has piled on in The FDIC’s Lehman Fantasy and Michael Krimminger (FDIC General Council) finally replied.

Missing from the recent debate is the role of a possible amendment to the bankruptcy code to deal with large financial firms. An amendment could supplement—or even replace—the orderly liquidation authority of Dodd–Frank and deal with the problems raised by Paul Ryan and Simon Johnson. One such amendment has been proposed by a group of lawyers, economists and financial institution experts sponsored by Stanford University’s Hoover Institution. The amendment is called “Chapter 14,” because this is currently an unused chapter number in the U.S. Code on Bankruptcy. Last week we (I'm a member of the group) presented the idea to Michael Krimminger at the FDIC and to the legal staff at the Fed which is responsible for a mandated study of the bankruptcy code. The idea is explained here.

In brief, the problems with the new orderly liquidation authority, at least in the absence of a new bankruptcy process, is that it increases uncertainty, raises constitutional due process issues, increases the probability of bailouts, and creates moral hazard. Chapter 14 would give the government a viable alternative to Title II and thereby avoid these problems. We argue that government officials would likely find Chapter 14 more attractive than Title II, or a more direct bailout, and thereby choose this option. So with such an alternative, bailouts would be less likely. As George P. Shultz puts it, "Let's write Chapter 14 into the law so that we have a credible alternative to bailouts in practice." Compared with Title II, Chapter 14 would more predictable and rules-based and it would minimize spillovers to the economy. It would also permit people to continue to use the company’s financial services—just as people continue to fly when an airline company is in bankruptcy.

Chapter 14 would differ from current bankruptcy law in Chapter 7 and Chapter 11. It would create a group of “special masters” knowledgeable about financial markets and institutions; a common perception is that bankruptcy is too slow to deal with systemic risk situations in large complex institutions, but under the proposal there would be capacity to proceed immediately. In addition to the typical bankruptcy commencement by creditors, an involuntary proceeding could be initiated by a government regulatory agency, and the government could propose a reorganization plan—not simply a liquidation. An advantage of this approach is that debtors and creditors negotiate with clear rules and judicial review throughout the process. In contrast, the orderly liquidation authority is less transparent with more discretion by government officials and few opportunities for review.

A Morale Booster for the Financial Front Too

2011-05-03T06:43:00.000-07:00

Anyone who has served in the military during the nearly ten years since 9/11 must feel a sense of closure with Bin Laden’s death. As Lindsay Wise writes in the Houston Chronicle “Bin Laden's death is a dramatic morale booster for those who served in the war on terror, now aptly dubbed The Long War.” The demise of Bin Laden marks an important victory to which all who served contributed in one way or another. A Marine who signed up just after 9/11 said this to me just after President Obama’s announcement: “It feels kind of like I can come home again,” but then, after a pause, “I guess we have a few more things to do.” An email was circulating around Stanford yesterday saying: “Congratulations to all Stanford veterans who laid the groundwork for this momentous occasion. Thank you for your service and your sacrifice.”

I think thanks are also due to the people who served in the financial front of the war on terror during these ten years—many in the United States Treasury. President Bush announced the terrorist asset freezing operation in the Rose Garden on September 24, 2001. It was before military actions in Afghanistan. It was the first shot in the war on terror. The announcement sent an important message to the terrorists and to the people at Treasury who were just entering to the fight. He said,

“Today, we have launched a strike on the financial foundation of the global terror network. Make no mistake about it, I’ve asked our military to be ready for a reason. But the American people must understand this war on terrorism will be fought on a variety of fronts, in different ways. The front lines will look different from the wars of the past….It is a war that is going to take a while. It is a war that will have many fronts. It is a war that will require the United States to use our influence in a variety of areas in order to win it. And one area is financial.”

Soon thereafter the G7 finance ministers released a statement pledging to work together to “freeze the funds and financial assets not only of the terrorist Usama bin Laden and his associates, but terrorists all over the world” setting off what turned out to be the most impressive effort in international coordination in the finance area in history. Soon financial intelligence networks were set up to get information about the terrorists, and new financial tools began to be used as a weapon against proliferation. To solidify these efforts a new position of Under Secretary of the Treasury for Terrorism and Financial Intelligence was created in 2004, and Stuart Levey was appointed to the position by President Bush. Stuart was asked to continue by President Obama, and only recently stepped down. Senator Kaufman’s praise on the Senate floor for Stuart and others in the Treasury shows why thanks are in order.

YouTube Assignment for Macroeconomics Students

2011-04-28T14:34:00.000-07:00

As a respite from comparing the “Keynesian cross” versus the “dynamic stochastic general equilibrium” model, watch this “Keynes” versus “Hayek” video with lyrics written by John Papola and my colleague Russ Roberts. But my favorite lines are more micro than macro:
Keynes: “Even you must admit that the lesson we’ve learned is that more oversight’s needed or else we’ll get burned”
Hayek: “Oversight? The government ‘s long been in bed with those Wall Street execs and the firms that they’ve bled.”

Spending Rise Has Much To Do With Policy

2011-04-27T23:20:00.000-07:00

The running debate between Paul Krugman and me is bringing more facts to bear on important budget and policy issues. Since I wrote my reply yesterday to Krugman’s criticism of my Wall Street Journal article, he has responded three times, with Taylor Digs Deeper, 2021 and All That, and One More Point about 2021.

Krugman now admits that spending as a share of GDP would rise from 19.6 percent of GDP in 2007 to around 24 percent in 2021 under the budget proposed by the Administration on February 14, which is what I showed in my original graph.

And since spending averages around 24 percent of GDP in 2009-2011, this confirms my point that “Mr. Obama, in his budget submitted in February, proposed to make that spending binge permanent.” Krugman also reports some of the components of the rise in entitlement spending, showing that Social Security, Medicare, and Medicaid spending rise as a share of GDP under Obama’s proposal.

But Krugman now argues that “the great bulk of this projected rise has nothing whatsoever to do with Obama’s policies.” This is wrong on two accounts.

First, in proposing his February 14 budget, Obama chose policies that did not control the growth of spending by enough to prevent an increase in spending as a share of GDP, even though he could have chosen such policies. In fact, the policies he chose for his second budget on April 13 did impose such controls including “setting a more ambitious target of holding Medicare cost growth per beneficiary to GDP per capita plus 0.5 percent beginning in 2018” (White House Fact Sheet April 13). These recent spending controls were proposed after the House budget proposal was put forth, and they take spending in the direction proposed by the House. That Obama’s second budget has lower spending than the first demonstrates that the rate of spending increase has very much to do with Obama’s policies.

Second, the Obama budget does propose new spending programs, including the new health care law. And there is a step increase in entitlement spending as a share of GDP in 2009-2011 which goes beyond what would be expected from the recession, and spending remains at the higher level through 2021. If demographic changes were the only reason for the increase in spending as a share of GDP, then you would not see such a step increase.

In the latest post on this subject, Krugman expands his criticism to include Senators Corker and McCaskill. Here Krugman admits that the rate of increase in government spending is affected by Obama’s policies, but he now gives reasons “why federal spending shouldn’t stay at or near the share of GDP it was at in 2007” arguing that Obama should not choose such policies. I disagree. Even with current demographic projections it is possible to institute good reforms which keep Medicare and Medicaid from rising so rapidly as a share of GDP and also deliver better health care services. And of course it is possible also to reduce other types of spending as a share of GDP, including national defense.

Paul Krugman Versus Budget Facts

2011-04-26T10:25:00.000-07:00

Yesterday Paul Krugman, citing Brad DeLong's post earlier in the day, joined the commentary on my Wall Street Journal article of Friday which I further discussed in my blog of Sunday. Krugman takes issue with my statement that “Mr. Obama, in his budget submitted in February, proposed to make that spending binge permanent” and instead claims to see no “huge expansion of the federal government” once one takes account of the slowdown in nominal GDP growth due to the recession.

Krugman is wrong. The Administration's budget did propose spending levels which make the recently increased rate of government spending as a share of GDP permanent, regardless of the reason for the recent increase. If you want to see this in a way that takes account of changes in nominal GDP growth related to the recession, then you can compare actual spending before the effects of the recession began with proposed spending after the effects of the recession are over. For all of 2007, spending was 19.6 percent of GDP. For all of 2021—after the impacts of the recession and the final year of the budget window—the budget submitted in February proposed spending equal to 24.2 percent of GDP. These two budget facts are part of the data presented in my Wall Street Journal chart and are taken directly from CBO tables. The 4.6 percentage point increase represents $1 trillion more federal spending per year at 2021 levels of GDP.

Much of the increase comes in the form of mandatory spending. Using the CBO baseline of January 2011 (which is below the February budget), mandatory spending would increase from 10.4 percent of GDP in 2007 to 14.0 percent of GDP in 2021.

DeLong mainly quotes from another post which focuses on the increase in spending during the Bush Administration. But in the Wall Street Journal I said explicitly that spending increased from 18.2 percent of GDP in 2000 (at the end of the Clinton Administration) to 19.6 percent in 2007, and my chart shows that spending started increasing more rapidly in 2008. The increase in 2008 was in part due to the stimulus package passed in February of that year; I have been critical of that stimulus package as I have been of the discretionary fiscal actions taken in 2009. My critique of policies leading up to the financial crisis Getting Off Track: How Government Actions and Interventions Caused, Prolonged and Worsened the Financial Crisis was written before any policies were enacted by the Obama Administration.

Notches and Disincentives in the Health Care Law

2011-04-25T21:41:00.000-07:00

My colleague Dan Kessler writes in today’s Wall Street Journal that Obamacare creates large disincentives to work. I've found the following graph useful for showing students why. (The same type of graph is used in of my economics text Chapter 14, p 404.) The graph shows income from work and the corresponding health care subsidy for a family of 4 headed by a 55-year old. The subsidy is paid to households earning up to 400 percent of the poverty line. With a poverty line of about $23,300 for a family of 4 in 2014 (when the legislation goes into effect) families earning as much as $93,200 will get a subsidy.

Observe how the subsidy declines with income and then is slashed to zero when 400 percent of the poverty line is hit. You can even see the V-shaped “notch” in the graph, which has become the technical term used to describe such sudden drops in subsidies. Consider the Lee family, for example. They earn $80,000 and thus get a subsidy of $16,100, bringing their total income to $96,100. But suppose they decide to work more. If they increase their income from work by $14,000, bringing their work earnings to $94,000, then their health care subsidy drops to zero. So they get less income by working more, and that's a big disincentive.

On the Budget Debate People Are Saying “All We Want Are the Facts”

2011-04-24T22:36:00.000-07:00

This graph from my Friday Wall Street Journal article simply presented basic facts about the second Obama budget and compared it with the first Obama budget and with the House budget.

So why did it attract so much attention here and here and other places? I think it's a sign that people are tired of rhetoric and demagoguery. They want to understand each side’s factual position in the debate. "All we want are the facts, ma'am," as Joe Friday would say. My guess is that people would like it if President Obama or Members of Congress took one or two charts to the town hall meetings or to the Sunday morning talk shows. Sometimes you hear the excuse that charts are too technical, but that certainly doesn’t apply to the techies at the Facebook town hall last Wednesday.

Still some have asked good questions about how to interpret my chart. Some thought it is misleading to plot government spending as a percent of GDP. But that's not unique to my chart, and in fact it’s pretty conventional. CBO and OMB regularly report spending this way. For example this recent CBO report on the first 2012 Obama budget measures outlays as a share of GDP (See Table 1-2 on page 4). Regarding recent history Table E-2 of this CBO historical data set presents the history of outlays as a share of GDP both before and after the recession. The point of my article is that there was a spending binge and that the binge would continue with the Administration budgets, and I think the chart showed that accurately.

Here is what my chart looks like if you do not divide spending by GDP. It reminds us that the under the House budget spending continues to grow, but less rapidly than the two Obama budgets. You can still see the spending binge of the past few years but the upward trend makes it harder to visualize.

Another question is why I did not include zero percent of GDP in scale of the chart. I teach Economics 1 students at Stanford to look at the scale of axes carefully, but I do not think it is misleading to choose the scale I did. If you are interested in what is happening to the stock market in the past few months, you do not plot the S&P 500 with a chart that includes zero. If you did you would not see much of anything on a day to day basis. For the record here is a version of my budget chart which includes zero. The story is the same, but the ups and downs are scaled down and are harder to see.

Why a Lack of Transparency in the Administration’s Budget II is a Problem

2011-04-15T20:39:00.000-07:00

A transparent budget proposal—such as the Administration’s first 2012 Budget presented by President Obama on February 14 or the House Budget presented by Paul Ryan on April 6—contains year-by-year tables showing the proposed path for government outlays over time. These are needed to estimate the economic impact of a budget and assess its credibility.

But the second Administration budget for 2012 and beyond presented by President Obama this week contains no such information, either in the speech or in the fact sheet to go along with the speech. How can one determine the impact of a budget on the economy if one does not know the path of proposed spending? This lack of transparency is not simply an issue for policy wonks as William Galston of Brookings explains in his critique of the Administration’s Budget II. It raises questions about the credibility of the budget process.

To illustrate the issue in concrete terms I “reverse engineered” one possible year-by-year path for government spending over the next ten years that is consistent with the information in the speech and the fact sheets on the Administration’s Budget II. In particular the path reduces the deficit by $4 trillion over 12 years compared to Budget I and there are three dollars of spending cuts and interest savings for every one dollar of tax increases. In other words, under Budget II, spending would be down by $3 trillion relative to Budget I over 12 years. The resulting path is one of several possibilities because one cannot go uniquely from a multiyear total to year-by-year amounts. The path calculated here for Budget II may have more spending up front and less in the out years compared with actual Budget II, but we do not know for sure because the budget is incomplete as presented.

The path for government outlays as a share of GDP under Budget II is shown in this graph along with the Administration’s Budget I, the House Budget, and recent history. The graph focuses on the next 10 years because that is the frame of reference for Budget I, the House Budget, and the current budget process. It is important to note, however, that my calculations imply that $1 trillion of the $3 trillion outlay reductions in Budget II compared with Budget I occur in the two years after the 10 year window. So in reality the proposed reduction in spending growth is $2 trillion rather than $3 trillion.

There are several implications of these calculations. First, if you view Budget I as an opening to a negotiation and the House Budget as a counter offer, then Budget II has moved in the direction of the counteroffer. But it is a relatively small move compared to the outcome of the 2011 negotiations, where the Administration moved two-thirds ($39 billion of $61 billion) in the direction of the House proposal. But stay tuned.

Second, the new Budget still leaves a great deal of the recent spending binge in place, at 22.3 percent of GDP compared with 19.6 percent in 2007.

Third, if the Administration wants Budget II to be part of the negotiations, then OMB should either submit a revised budget to replace the one sent to Congress on February 14 or provide the needed transparency in some other way.

Stanford Economist Jon Levin wins Clark Medal

2011-04-15T11:31:00.000-07:00

The American Economic Association has just chosen my colleague Jon Levin to receive the John Bates Clark Medal awarded each year to the best economist under the age of forty. Congratulations Jon! And a good prediction by Justin Lahart of the Wall Street Journal who wrote this about Jon yesterday before the decision was made: “An expert in industrial organization — the study of how firms and markets interact with each other — Levin has done work on subprime lending (before “subprime” was a dirty word), health insurance and internet markets. He also has researched the economics of getting into a top-flight school. In a paper with Christopher Avery, he developed a model of how the early admissions process at selective colleges and universities, where schools are trying to find the applicants who are most enthusiastic about attending, and students are able to signal their enthusiasm by applying for early admission.”

Why the Budget Agreement is a Game Changer

2011-04-09T23:50:00.000-07:00

The budget agreement that emerged from last week’s negotiations literally changes the direction of federal spending. As the chart shows the Obama Administration’s proposed increase in discretionary spending for 2011 has been reversed in the course of the negotiations into an actual decrease in discretionary spending. A year ago the Administration’s budget called for an increase in discretionary spending of about $39 billion. Remarkably the agreement calls for a decrease of about the same amount. No one could have predicted such a turn around one year ago.

Of course this is the first step of a longer term budget strategy. The next step is the 2012 budget and associated reforms. But this first step helps establish the credibility needed for the budget strategy to increase economic growth and encourage private investment.

Note that the data in the chart refer to discretionary budget authority as estimated by the CBO, excluding emergency appropriations, about which there are different scoring conventions. The totals reflect the $78 billion number emphasized by the White House and the $39 billion number emphasized by the House of Representatives.

The Simple Budget Choice: Remove or Lock-In the Spending Binge

2011-04-07T22:51:00.000-07:00

Much has been written on how the House Budget Resolution for 2012 presented on Tuesday by Paul Ryan compares with the Administration’s Budget for 2012. From a macroeconomic perspective, perhaps the biggest difference is that the House Budget brings outlays as a share of GDP back close to 2007 levels as a share of GDP, thereby removing the large spending increase of the years 2008-2009-2010, while the Administration budget effectively locks in that increase. This is shown clearly in the following graph of outlays as a share of GDP under the two budgets.

Thus a simple way to look at the budget debate which the country faces in the months ahead (once the budget for 2011 is settled) is whether to remove or lock-in that binge.

The chart also shows that the removal of the binge under the House budget occurs at about the same pace as the increase, which is somewhat faster than the pace of removal in the example Gary Becker, George Shultz and I showed in our Wall Street Journal article of last Monday.

A Credible Strategy to Reduce Government Spending Growth and Increase Economic Growth

2011-04-03T16:30:00.000-07:00

In tomorrow’s Wall Street Journal, Gary Becker, George Shultz and I present the economic case for a credible strategy to reduce the growth of federal government spending, bring the deficit down, and increase economic growth. We emphasize the words credible and strategy.

The essential first step in the strategy is substantial progress in reducing discretionary spending in 2011. This will help establish credibility and show that government can actually take needed actions, not just promise to take them. Think game-changer.

The second part of the strategy is a transparent longer term plan to get total spending (including entitlements) as a share of GDP down gradually to a level consistent with tax revenues generated by the current tax system. Credibility will be enhanced by showing that the needed spending share is close to shares seen in not-so-distant American history and that it is achieved gradually.

It’s important for the government to explain to the American people why such a strategy will help increase economic growth and reduce unemployment. This task is made easier by the fact that it is consistent with basic economics in which expectations and incentives figure prominently.

The two parts of such a strategy may be emerging from Washington this week in (1) some form of HR1 for 2011 and (2) the 2012 Budget Resolution to be put forth on Tuesday. Stay tuned.

Another Round on Investment and Unemployment

2011-04-02T22:35:00.000-07:00

Paul Krugman responded to my reply (March 31) to his two critiques (afternoon and evening of March 30) of my post (January 14) on the negative correlation between investment and unemployment. He now says that Taylor “professes himself baffled.” Of course I didn’t profess any such thing. I simply showed that that Krugman was wrong.

My original post showed that there is a negative correlation between total fixed investment (the sum of residential and nonresidential investment) as a share of GDP and the rate of unemployment over the past two decades. In his March 30 afternoon critique Krugman said that “It’s mostly the housing bust!” and continued that “The rest”—the business fixed investment part—“is just politically motivated mythology.”

In my reply I pointed out that, no, it’s not mythology; there is a strong negative correlation between business fixed investment as a share of GDP and the unemployment rate over exactly the same period as in my original post. The investment-unemployment correlation is not mostly housing. Some of the high unemployment now is due to low residential investment as it has been in many past periods of high unemployment. As I said in my original January 14 post, you should look at residential investment plus nonresidential investment.

Krugman devotes considerable space in his latest criticism of my January 14 post to comparisons of business investment in the Bush Administration and the Obama Administration as if that was something I did in that post. But I didn’t make such a comparison in my Janaury 14 post. If one is interested, I have found in other empirical work that policies earlier in the 2000s, including the policy that kept interest rates too low for too long in 2003-2005 and the stimulus package of February 2008, were part of what went wrong prior.

Rebalancing Monetary Policy and the G20 Agenda

2011-04-01T23:19:00.000-07:00

Yesterday’s meeting of the G20 finance ministers in China broadened the ongoing “rebalancing current accounts” agenda to consider international monetary policy reform. But few central bank governors came so an important monetary policy issue could not be discussed: the international rebalancing of monetary policy.

The Central Bank Watch Table released today by the economic forecasters at JPMorgan Chase illustrates this imbalance. The table gives the policy interest rate at the major central banks around the world and a forecast of future rates based on a combination of formal economic analysis and listening to central bankers. The table is quite long so I show a small section here for the western hemisphere countries. The shaded part of the table is the quarterly forecast from June 2011 to June 2012.

If you click on the whole table you see an amazing thing: The United States is the only country in the world, aside from troubled Japan and dollar-pegged Hong Kong, whose central bank is listed as “On hold” which means not expected to increase the interest rate until June 2012 or later. So there's an imbalance.

Now, just as with current account imbalances, one can say that there are good monetary policy imbalances and bad monetary policy imbalances. In current circumstances the low interest rate in the United States makes it harder for other central banks to combat rising inflation without possibly creating damagingly large appreciations of their currencies. It is not simply a China issue. Many emerging market central bank's feel the pressure and are intervening or talking about intervening, or even imposing capital controls. What is right for the U.S. is under some dispute now, and the disagreement is showing up in remarks by Fed presidents this week. The Taylor Rule says the rate should already be higher.

The IMF is now busy putting together the indicators of current account imbalances for their Mutual Assistance Process (MAP) for consideration when G20 and other countries meet in Washington later this month. Since the central bank governors will be there this time, it would be a good idea to put this table of monetary policy imbalances on the agenda for discussion.

Investment and Unemployment over Longer Periods of Time

2011-03-31T18:14:00.000-07:00

Like Paul Krugman, Justin Wolfers also wrote yesterday about my blog post of January 14 on the correlation between investment and unemployment. Wolfers argues that the relationship did not exist in earlier years. He is wrong.

His argument is based on the observation that the scatter of points for the 1990-2010 period, shown in one of my graphs, shifts up and to the right—higher unemployment for a given level of investment—if you include the 1970s and 1980s. The scatter of points shift back down and to the left if you go back further. This shift up in unemployment in the 1970s and 1980s was due in part to the well-documented longer term increase in the natural rate of unemployment in the 1970s and 1980s, which many macroeconomists have researched and written about, but which Wolfers does not mention. When you recognize that such longer-term historical trends exist, you can see that there is a strong correlation between investment and unemployment that goes back before 1990.

The time-series plot below goes back to 1960. You can see frequent ups and downs in the investment ratio and most of these are related to the downs and ups in the unemployment rate. The exceptions are mainly due to the secular, longer-term rise and fall in the unemployment rate.

If you go beyond the chart and use some statistics, you can confirm these observations and be more pricise. For example, a simple regression of the change in the unemployment rate on the change in the investment ratio has a large and statistically significant coefficient of -.7 with a t-value of -10 over the 50 period.

As always in economics there are many factors at work, especially when you consider longer periods. But a longer history confirms the strong correlation I wrote about.

Investment and Unemployment: A Reply

2011-03-31T08:26:00.000-07:00

Paul Krugman wrote a post yesterday afternoon and another one last evening on a January 14 post of mine. In the Janaury post I pointed out the strong correlation between total fixed investment as a share of GDP and the unemployment rate during the past two decades; total fixed investment equals business fixed investment plus residential investment. In his afternoon post, he argued that it’s misleading to look at total fixed investment because most of the recent swing has been in residential investment. “It’s mostly the housing bust!” he argued, continuing that “The rest”—the business fixed investment part—“is just politically motivated mythology.”

But the correlation I pointed out is not just due to housing. There is a close relationship during the past two decades between business fixed investment and unemployment. In fact it’s closer than for residential investment and unemployment. Here are the time series charts for business fixed investment and residential investment. You can see the ups and downs in business fixed investment as a share of GDP and the corresponding downs and ups in the unemployment rate, which result in the negative correlation; there is one big swing in housing. If you want to compare correlation coefficients, for business fixed investment the correlation is -.84 and for housing it is -.68. These are facts, not mythology, or whatever other name you want to use.

Curiously, in his post of last evening, Krugman includes a scatter diagram between business fixed investment and unemployment, in which he admits to a strong correlation after all. He then brings attention to six points on the lower right of the diagram (he reverses the axes from the diagram I first used), identifies them with the Obama Administration, and notes that they are off an apparent pattern: unemployment is even higher than the high level that would be expected from the low level of business fixed investment. But housing is now omitted from the argument. Remember the “housing bust!” from the afternoon post? Clearly the housing bust has added to the unemployment rate. It is business fixed investment plus residential investment, as I originally argued.

A Good Exit Strategy Proposed by Philadelphia Fed President Plosser

2011-03-29T00:00:00.000-07:00

Last Friday in New York, Charles Plosser, President of the Philadelphia Fed, proposed an exit strategy for the Fed. It’s the first explicit exit strategy to be put forth by a member of the FOMC, so it deserves careful consideration and discussion.

Previous statements about exits by Fed officials simply listed the tools that could be used in an exit strategy, but did not actually put forth an exit strategy. In contrast, President Plosser describes a specific strategy.

Two things are very attractive about the strategy. First, it aims to return monetary policy to one in which the federal funds rate is determined by the supply and demand for reserves. This of course requires that the Fed bring down the enormous supply of reserve balances on its balance sheet to a level closer to a quantity demanded by banks at a positive interest rate. Reserves were $26 billion on September 10, 2008 when the funds rate was 2 percent just before the panic, which gives an order of magnitude of where reserves should go. Plosser assumes $50 billion, which seems reasonable to me. But reserve balances will be around $1,500 billion by the time QEII is over, so it’s a long way down.

The second attractive feature of the exit strategy is that the path of reduction in reserve balances is tied to future movements of the federal funds rate. It is thus much like an exit rule, or a contingency plan, which both preserves flexibility and creates predictability. The exit rule would reduce reserves by $125 billion for each 25 basis point increase in the funds rate plus another $50 billion at each FOMC meeting. After 10 meetings $1,450 billion would be removed (the contingency plan starts at the second meeting) bringing reserves to $50 billion.

This chart, drawn from data in his speech, shows how the strategy would work if the Fed increased the federal funds rate by 25 basis points for ten consecutive meetings. Of course an advantage of this strategy is that the pace of reserve drawdown is tied to the funds rate—if the funds rate rises more quickly reserves will come down more quickly.

The strategy is very close to one I recommended a year ago in testimony, "An Exit Rule for Monetary Policy," prepared for a Congressional hearing at the House Financial Services Committee. I suggested $100 billion per 25 basis points with no constant amount, but that was before QEII when reserve balances were much lower. I argued that such a strategy would reduce risks in the markets. With increased predictability about policy, banks could better manage their own balance sheets and the price discovery process would be much smoother as funds traders and other market participants could better anticipate what the Fed would do, a view which was supported by Peter Fisher (head of the New York Fed trading desk in the 1990s), who I consulted about the idea at the time.

Of course the New York Fed trading desk should have some discretion about how to execute the FOMC’s directive if such a strategy is adopted. I hope it is.

Misunderstanding Prescriptive Versus Descriptive Monetary Policy Rules

2011-03-27T09:44:00.000-07:00

Monetary policy rules can be used both for prescriptive and descriptive purposes, but it’s important to be clear about which purpose one has in mind. A policy rule estimated over a period which included the Great Inflation of the 1970s, for example, might be a good description of policy during that period, but it would be a terrible prescription for policy today. Similarly, a policy rule estimated over a period which included the 2003-2005 period, when rates are unusually low, would not be a good prescription, in my view, for policy today.

Misunderstandings about whether a particular rule is meant to be descriptive or prescriptive can thus lead to policy mistakes. Consider this passage from the March 18, 2011 issue of JP Morgan’s Global Data Watch (p 16): “The original Taylor rule was descriptive and meant to match how Fed policy was set in the 1987-1992 period. Subsequently, some researchers found that variants of Taylor rules were optimal in certain economic models, and so could also be prescriptive. However, those classes of models were usually quite restrictive, such as assuming policy was not at the zero bound, or that the central bank only tried to influence the short end of the curve. In fact, very few optimal policy models even incorporate multi-period interest rates."

But the Taylor rule was not meant to be descriptive as I made clear in my original paper. Rather it was very explicitly meant to be prescriptive. I derived it by experimenting with different types of rules in stochastic simulations of different monetary models, including my multi-country model at Stanford, and by studying the results of other people’s simulations. This pinned down the left-hand side variable and the right-hand side variables, and led to simple functional forms and coefficients.

The models used to derive this rule were not restrictive in the sense used in the quoted paragraph. My multi-country model has a term structure of interest rates, with long rates affecting aggregate demand. Exchange rates are part of the monetary transmission mechanism through their effect on exports and imports. The zero bound on the interest rate was taken into account in the stochastic simulations. Later, simpler, three-equation, textbook models were used by other researchers to show that the Taylor rule was optimal using formal dynamic optimization methods (reverse engineering). These simpler models helped students understand how policy rules work.

I referred to the 1987-92 period in my original paper, but the rule was not an estimated rule over that period or any other period. After deriving the rule I noted that it was close to actual policy during in 1987-92 and used that result to work through several case studies of how such a rule would have worked in practice. A pure estimation strategy would not have focused on that period, and even if it did, it would have included more variables on the right hand side (such as money growth or the exchange rate). An example of an estimated rule in existence then was that of Ray Fair of Yale.

When teaching Economics 1, I stress the difference between positive (descriptive) economics and normative (prescriptive) economics. This discussion of policy rules illustrates the importance of understanding the difference in practice. You can’t justify QE2 by saying that the interest rate is negative with the prescriptive policy rule I proposed, because the implied rate is not negative, it’s close to 1 percent.

Blogging Blocked in Beijing

2011-03-26T00:41:00.000-07:00

One of the things I like most about blogging is that I can post from anywhere in the world—Tokyo, Milan, Washington—not just from my home or office at Stanford.

Well not exactly. This past week I could not post from Beijing where I was visiting. I normally use Google’s Blogger platform to post blogs, but when I attempted to post from Beijing I could not get on Blogger. I soon found that I could not even get on my blog, nor on Greg Mankiw’s blog, nor any Blogspot blog. When I asked some students what the problem was, they told me that all Google platforms were blocked in China, and so were Facebook and Twitter platforms. As I later discovered in this Wall Street Journal article, the blockage is evidently part of an effort to prevent Internet traffic related to the so called “Jasmine Revolution.”

So I had to wait until I returned to Stanford to start blogging again, as I did yesterday. But it’s sad to know that students in China who might be interested can’t read, for example, about how the U.S. and the Chinese stimulus packages differed, or about many more important things.

Why the Stimulus Failed to Boost Infrastructure in the US: A Comparison With China

2011-03-25T07:14:00.000-07:00

The data are now clear. Despite its large size, the 2009 U.S. stimulus package failed to increase government infrastructure spending or other government purchases as its promoters had claimed it would. The large federal stimulus grants sent to state and local governments for infrastructure spending were mainly used to reduce borrowing and thus did not result in an increase in purchases. Here is a summary of my research with John Cogan. The explanation is that local governments in effect acted as many American households did: when they received the stimulus money, they saved it rather than purchased goods and services. This is what permanent income theory would predict. It is also what previous empirical studies of the 1970s stimulus packages found.

To better understand this explanation one can look at other countries, and in particular at China’s recent stimulus package. This week I went to China and explored the question.

Local governments in China apparently did increase infrastructure spending in 2009 following the stimulus package. Why didn’t these governments simply reduce borrowing as did U.S local governments? Professor Chong-en Bai of Tsinghua University gave me the best answer using simple economic reasoning: the local governments appeared to behave more like liquidity constrained households than permanent income households. In China, local governments do not have much access to capital markets. They get their funding mainly from the central government, including loans from the central bank, and of course only for projects that are approved by the central government. At any point in time local governments are submitting new infrastructure projects for approval; some are being rejected and some are being accepted. If the central government wants to increase infrastructure spending by the local governments all it has to do is lower the acceptance criterion, instruct the central bank to provide the funds, and the volume of projects increases. This is apparently how the stimulus worked in China.

Note that the mechanism is essentially built into the structure of the economy, with characteristics similar to an automatic stabilizer in which the criteria are raised and lowered administratively according to the state of the business cycle. Of course, if the criteria before the stimulus were appropriate, then the projects accepted during the stimulus were of more dubious quality.

This hypothesis has yet to be tested, however. The type of data published by the U.S. Bureau of Economic Analysis—which John Cogan and I used to study the stimulus in the United States—are not publicly available in China, so alternative empirical tests will have to be devised.

Straightjackets and “We Rule” Shirts

2011-03-18T23:29:00.000-07:00

David Wessel writes about the "straitjacket" of a one-size-fits-all monetary policy in his Wall Street Journal column this week. He shows why a single interest rate set by the European Central Bank is not necessarily appropriate for all the countries in the Euro zone: it can push some countries off the Taylor rule which can lead to financial excesses and other problems. In the period leading up to the financial crisis, the Euro interest rate was way too low for Ireland, Greece, and Spain. So it’s not surprising they ran into financial difficulties. Germany in contrast was right on the rule. The chart below (a favorite of mine produced in March 2008 by the OECD) illustrates the same point: the larger was the deviation from the Taylor rule, the larger was the housing boom. The chart also illustrates that the single rate would not have been such a problem if it were closer to the Taylor rule during that period: all the other countries were to the right of Germany.

Additional evidence that you win with rules and lose with discretion was provided this week in a video produced by Stanford economics graduate students for the annual skit party. Simply wearing “we rule” shirts transforms losers into winners in the annual little big game with Berkeley.

Evaluating TARP

2011-03-17T10:40:00.000-07:00

Today’s TARP hearing at Senate Banking follows a slew of recent reports. The Congressional Oversight Panel (COP) issued its final report yesterday. Economists Simon Johnson, Allan Meltzer, Joe Stiglitz, and Luigi Zingales submitted testimony to COP two weeks ago. The Special Inspector General for TARP (SIGTARP) issued a comprehensive review in January. Three members of COP published an oped in today’s Wall Street Journal.

A common theme is the high cost of the TARP. I‘m not talking about whether the government lost or made money, which is not a good measure of effectiveness, but rather the costs to the economy (stability, growth, employment, etc). Since November 2008 I have been writing about the costs of the chaotic rollout of the TARP which in my view worsened the crisis and exacerbated the panic. (Here is my written testimony for today’s hearing.) In his recent book former FDIC chairman Bill Isaac concluded that “any objective analysis would conclude that the TARP legislation did nothing to stabilize the financial system that could not have been done without it. Moreover, the negative aspects of the TARP legislation far outweighed any possible benefit.” In his recent testimony Joe Stiglitz said that “TARP has not only been a dismal failure…but the way the program was managed has, I believe, contributed to the economy’s problems.”

Of course others are more positive about the stabilizing effect of TARP. Timothy Massad, current acting assistant secretary of Treasury, argues that the TARP prevented a more severe panic, citing as empirical evidence a paper by Alan Blinder and Mark Zandi. However, Blinder and Zandi explain that they don’t do a separate evaluation of the TARP: “We make no attempt to decompose the financial-policy effects into portions attributable to TARP, to the Fed’s quantitative easing policies, etc,” they say, so this is not really empirical evidence. COP is also positive about the short run impact though less positive than the Treasury

Though some disagree about the net costs of TARP in the short run, few disagree that the longer-run costs are substantial. In January the SIGTARP listed these costs:
· “damage to Government credibility that has plagued the program,”
· “failure of programs designed to help Main Street rather than Wall Street,”
· “moral hazard and potentially disastrous consequences associated with the continued existence of financial institutions that are ‘too big to fail’”
The COP final report listed these costs:
· “continuing distortions in the market”
· “public anger toward policymakers,”
· “a lack of full transparency and accountability.”
At the COP hearing, Stiglitz, Meltzer, Johnson, and Zingales (who rarely all agree) were unanimous in their view that the TARP actions have created an incentive for financial institutions and their creditors to take high risks due to the expectation of being bailed out, favoring big players and leaving the economy vulnerable to financial crisis. They also agreed that the Dodd-Frank legislation did not solve “too big to fail.”

To these costs I would add that the TARP established an unfortunate precedent of heavy-handed government intervention in the operations of businesses. The government forced some financial institutions to take TARP funds, even those that said they did not want them, by threatening actions from regulators. The government used the TARP for purposes other than originally stated in Congressional hearings, including the bailing out of automobile companies.

TARP is not popular with most Americans. Economic evaluations now rolling in support their view, but rather than pointing fingers, it is time to absorb the lessons and take actions to remove the legacy costs and try to end government bailouts as we know them.

A Credible First Step Toward a New Budget Strategy?

2011-03-12T16:59:00.000-08:00

Last week the Senate voted down the House proposal (HR1) to slow the growth of spending in the current fiscal year 2011. Now alternative plans are being laid to slow the growth of spending in 2011 by roughly the same amount as HR1, possibly through a series of shorter continuing resolutions prorated at $2 billion per week. Simultaneously the House is developing a budget resolution for 2012 with the aim of reducing spending growth and the deficit in later years. Hence, the 2011 budget actions should be viewed as a first step of a longer term budget strategy. This first step is crucial. It establishes the credibility of the whole strategy.

Would a step any smaller than HR1 be credible? The following chart tries to present the basic facts in a simple way. It shows federal outlays from FY2000 to FY2011 as a share of GDP with and without HR1. The data are from CBO.

First note the remarkable explosion in government outlays in the past few years. In 2007 outlays were 19.6 percent of GDP. In 2011 outlays will be 24.7 percent of GDP.

Second, note the very modest effect HR1 would have on total outlays as a share of GDP in 2011: outlays would be 24.6 percent rather than 24.7 percent of GDP. (According to CBO, HR1 would reduce outlays by $19 billion or .12 percent of GDP in 2011).

So HR1 is a small first step, especially compared to the binge of the past two or three years. It is hard to see how a first step could be any smaller and still represent a credible start on a new strategy. Anything much less would not even be visible on the chart. For a budget strategy to be credible it has to start with real actions, not just promises of future actions. An actual step at least this large is essential for restoring credibility and increasing economic growth. Reasonable people can disagree about particular programs, but they should be able to agree that a step of this size is the bare minimum needed to get on with the important task of a budget strategy.

Costs of the New Government Activism

2011-03-05T18:07:00.000-08:00

In “Activism,” a paper soon to be published by International Finance and already posted at the Council on Foreign Relations, Alan Greenspan delves into the consequences of the recent surge of what he describes as “government activism, as represented by the 2009 US$814 billion programme of fiscal stimulus, housing and motor vehicle subsidies and innumerable regulatory interventions.” Of course, this recent period of extraordinary government interventions has been commented on before. Gillian Tett in a Financial Times article called it the Ad Hoc Age. I called it the Great Deviation because it represents a major deviation from less interventionist or rules-based policies in the 1980s and 1990s. Noting that the current surge is one turn in a longer term cycle, Amity Shlaes argues in a Bloomberg column that we should speed up the cycle and get back to less intervention sooner.

But Alan Greenspan goes further by concentrating on the task of explaining and empirically estimating the costs of this intervention on the economy. “Much intervention turns out to hobble markets rather than enhancing them,” he explains, adding that “unpredictable discretionary government intervention scrambles the prospective underlying supply–demand balance.” More specifically he argues that government-induced uncertainty causes businesses to increase their liquid investments (bank deposits, government bonds, etc.) at the expense of illiquid investments (business fixed investment in structures and equipment). To test the theory he looks at the ratio of business fixed investment to the flow of internal funds which non-financial corporate businesses have available each quarter. That ratio is at historically low levels now which he attributes in large part to the increased activism.

Crowding Out Investment

Of course it’s hard to find a good quantitative measure of activism. Greenspan focuses on the cyclically adjusted budget deficit as a ratio to GDP. Because this measure does not include the “innumerable regulatory interventions” nor the monetary policy interventions not discussed in the paper, it is a downward biased metric of the recent surge in interventions. Nevertheless, he finds a large and significant negative effect of this variable: a one percentage point increase in the deficit as a share of GDP, due say to Keynesian stimulus programs, reduces the ratio of business fixed investment to internal funds by 3.3 percent after controlling for capacity in the nonfinancial corporate sector. (If you look at the regressions in the paper you will find logarithmic transformations of these ratios but they are very close to linear over the relevant range). This crowding out is one reason why he argues that “The recent pervasive macro-stimulus programs exhibit the practical shortfalls of massive intervention.”

The rest of the decline in investment he attributes to other aspects of the activism, concluding that “a minimum of half the post-crisis shortfall in capital investment, and possibly as much as three quarters, can be explained by the shock of vastly greater government-created uncertainties embedded in the competitive, regulatory and financial environments”

Relevant to the Recent Debate over the House Budget Proposals

The study is also relevant to the discussion over whether the new proposals by the House of Representatives to reduce government spending will ‘crowd in” private investment and thereby stimulate employment. Greenspan’s regression results (eg. Exhibit #5 in the paper) imply that reducing the cyclically-adjusted deficit through reduced spending will crowd in private investment as firms allocate a larger fraction of their cash flow to new investment. The estimated effect on investment is virtually immediate occurring within one quarter. I found it interesting that the size of the investment effect (as a share of GDP) is very close to the model simulations reported by Cogan, Cwik, Taylor and Wieland (see Figure 3 of that paper) using a modern “new Keynesian model.” The positive impacts on investment will be even larger as they are viewed as part of a credible longer term plan to reduce the deficit.

Lessons Learned from Ben Bernanke's Policy Rule Discussion at the Senate

2011-03-01T22:37:00.000-08:00

At yesterday's hearing before the Senate Banking Committee, Fed Chairman Ben Bernanke talked about monetary policy rules in response to a series of questions by Senator Pat Toomey. First, the Chairman stated that the Taylor Rule calls for interest rates “way below zero” and that this justifies methods such as quantitative easing. This is puzzling because I have reported for months that the Taylor Rule (see 1993 paper) does not call for an interest rate below zero. Second, when Senator Toomey then asked if Taylor believed the Taylor Rule called for rates below zero, Chairman Bernanke didn’t answer directly, but instead claimed that in 1999 I preferred a different rule to the one I published in 1993; he then said that the 1999 rule gives a much different rate. Senator Toomey then pressed on and specifically said the Taylor Rule called for rates higher than we have now, at which point Chairman Bernanke changed tack and argued that there were other policy rules that call for below-zero interest rates. Here is the relevant part of the transcript.

MR. BERNANKE: ... The Taylor Rule suggests that we should be, in some sense, way below zero in our interest rate, and therefore we need some method other than just normal interest rate changes to --
SEN. TOOMEY: Do you know if Mr. Taylor believes that?
MR. BERNANKE: Well, there are different versions of the Taylor Rule, and there's no particular reason to pick the one that he picked in 1993. In fact, he preferred a different one in 1999 which, if you use that one, gives you a much different answer.
SEN. TOOMEY: My understanding is that his view of his own rule is that it would call for a higher Fed funds rate than what we have now.
MR. BERNANKE: There are, again, many ways of looking at that rule, and I think that ones that look at history, ones that are justified by modeling analysis, many of them suggest that we should be well below zero. And I just would disagree that that's the only way to look at it.
But anyway, so I think there are some -- there is some basis for doing that.

There are several issues raised by this back-and-forth exchange.

Most important, at least from my perspective, is that contrary to what was claimed in the hearing, I did not say that I preferred a different policy rule in 1999 rather than the rule I originally published in 1993. I am not sure where this idea of my preferring another rule came from; I went back and looked at the academic papers I published in 1999 (here is a list); the paper on this list that Chairman Bernanke may have been referring to is A Historical Analysis of Monetary Policy Rules where I looked at two different policy rules during different periods of U.S. history. However, as I said in that paper (page 325), one rule was the “policy rule I suggested” and the other one was what “others have suggested.” The “others” were people at the Federal Reserve so for completeness I included that rule in the historical comparison. I did not propose or prefer an alternative rule in that 1999 paper, and it is hard to see how one could interpret the paper that way. This is not just a matter of academic niceties and citations; it is important to correct the record because the “others have suggested” rule has a much larger coefficient on the GDP gap and is therefore more likely to generate negative interest rates and be used to rationalize discretionary actions such as quantitative easing.

Second, the exchange between Chairman Bernanke and Senator Toomey suggests that the Fed is unclear about what monetary policy strategy it is using for the interest rate. Is it the Taylor Rule, as in the first response? Is it the rule incorrectly attributed to me in 1999, as in the second response? Is it some estimated rule, as in the third response? Or is it something else? It would be useful to know what the strategy is. Greater transparency about the strategy would add greatly to predictability and would help markets understand whether quantitative easing will be extended or when the interest rate will break out of the 0-.25 percent range.

For example if the strategy was reasonably well described by the Taylor Rule the interest rate would equal about 1.5 times the inflation rate plus .5 times the GDP gap plus 1. The most recent quarterly data (through the 4th quarter of 2010, released by Bureau of Economic Analysis on February 25, 2011) show that the inflation rate is about 1.4 percent (change in GDP deflator over the last four quarters). According to the average of the most recent survey by the Federal Reserve Bank of San Francisco, (January 28, 2011, Williams-Weidner) the GDP gap is about 4.4 percent. This implies an interest rate of 1.5 X1.4 + .5X(-4.4) + 1 = 2.1 + -2.2 +1 = 0.9 percent, or about 1 percent, which suggests that the Fed should be raising the rate sometime soon, perhaps before the end of this year. But if it is one of the other rules mentioned by the Chairman we might have to wait longer.

Third, the exchange shows how it would be quite feasible and useful to restore some of the reporting and accountability requirements which were removed from the Federal Reserve Act in 2000. As I have proposed, with such requirements the Fed would establish and report to Congress its strategy or policy rule for monetary decision making. If it later deviated from that strategy it would have to provide an explanation to Congress in writing and at a public congressional hearing. With such a reporting requirement, the testimony at such a hearing would be like this exchange between Chairman Bernanke and Senator Toomey with the very important exception that the Congress and the American people would have some idea of what the Fed's basic strategy was.

Goldman Sachs Wrong About Impact of House Budget Proposal

2011-02-28T08:12:00.000-08:00

Some claim that House budget proposal H.R. 1 to reduce the growth of federal government spending will cause a slowdown in the economy and even increase unemployment. Consider, for example, a recent report by Alec Phillips of Goldman Sachs which claims that the House proposal would reduce economic growth in the second and third quarters of this year by 1.5 to 2 percent if enacted into law next month. Nothing could be more contrary to basic economics, experience and facts. Unfortunately, the report has been widely cited by those wanting to hold back on this first step to restore sound fiscal policy. And the Washington Post reports this morning that Mark Zandi of Moody’s is starting to make similar claims, which should be questioned for the same reasons.

There are several things wrong with the analysis used in Goldman Sachs report. First, it does not take account of the beneficial effects of starting now on a credible plan to reduce the deficit. Basic economic models in which incentives and expectations of future policy matter show that a credible plan to reduce gradually the deficit will increase economic growth and reduce unemployment by removing uncertainty and lowering the chances of large tax increases in the future. The high unemployment we are experiencing now is due to low private investment rather than low government spending. By reducing some uncertainty and the threats of exploding debt, the House spending proposal will encourage private investment.

The analysis in this Goldman-Sachs report is based on the same type of “large multiplier” theory that predicted that the stimulus package of 2009 would stimulate economic growth. Research by me and my colleague John Cogan finds that more up-to-date theories, which bring important incentive and expectations effects into account, show far smaller multipliers. In these models a reduction in the growth of spending will immediately crowd in private investment. Moreover, by following the stimulus money, we found that in actuality the stimulus package of 2009 had no material positive effect on economic growth or employment. The same economic theory which said the stimulus would increase economic growth in the past two years, says that reversing that spending will reduce growth now. It was wrong in the past and it is highly likely to be wrong again.

The report also confuses budget authority, which is what H.R. 1 is proposing, with budget outlays, which is what is actually spent. Changes in budget authority do not immediately translate into spending; rather such changes gradually impact spending over time. Last Friday the CBO released its analysis of H.R.1 and found that discretionary outlays for 2011 would be $1,356 billion, which is only $19 billion below the CBO baseline of $1,375 billion published on January 26 (Table 3-1). This is less than 1/3 of the $60 billion cut which the Goldman Sachs report assumes in evaluating H.R. 1. Thus the cut in budget authority does not reduce spending “abruptly,” as the report assumes. Rather it is a quite gradual effect. Even if one used the flawed Keynesian multipliers implied by the report, the impact would be less than one-third what the report claims.

In fact, under H.R. 1, total 2011 discretionary outlays would be above 2010 discretionary outlays, which totaled $1,349 billion. And, of course, discretionary outlays are only part of the budget. Total budget outlays will increase by 6.7 percent from 2010 to 2011 under H.R. 1. This is less than the 7.3 percent increase in government spending under the CBO baseline, but it strains credibility to say that the large increase in government spending which still takes place under H.R 1 is too draconian for the economy. Indeed, doing anything less than H.R. 1 should be viewed as a completely non-serious step toward dealing with the debt problem and restoring sound fiscal policy.

As I have written before, the old-style Keynesian approach used by Zandi has many of the same flaws that are found in the Goldman Sachs approach: excessively large multipliers, inaccurate predictions of the effect of the 2009 stimulus, failure to recognize that reducing uncertainty about the debt can have positive effects, especially if it is done in a credible way by reducing spending growth now, not postponing it to a date uncertain in the future. After stating that “too much cutting too soon would be counterproductive,” Zandi claims that this is what the "House Republicans want" and what their budget does. But it's simply not credible to say that a budget that has government spending increasing at 6.7 percent per year cuts spending too much too soon.

In sum, there is no convincing evidence that H.R. 1 will reduce economic growth or total employment. To the contrary, there is more reason to expect that it will increase economic growth and employment as the federal government begins to put its fiscal house in order and encourage job-producing private sector investment.

2011 is the New 2008 in Federal Budget Debate

2011-02-19T15:51:00.000-08:00

If history is any guide, we are about to hear scores of scare stories about the harm caused by the spending reductions in the 2011 budget resolution (H.R.1) passed by the House early this morning. Maybe you’ve already heard how the budget threatens the “daily operations of National Weather Service.” In assessing these claims, it is very important to recognize and to emphasize that in 2009-10 we had an unprecedented binge of federal spending. The simplest way to understand the proposed budget is that it largely (not completely) undoes this two-year binge and brings spending back to about what agencies had to spend in 2008. If the government budget was enough for federal agencies—such as the Weather Service—to operate in 2008, then how can one claim that they cannot operate with roughly the same budget now?

The two charts help illustrate this. They focus on the non-defense non-security discretionary part of the budget, which has been the focus of the 2011 budget debate so far. Of course the other parts of the budget must be addressed starting with the 2012 budget, but if we cannot have a fact-based principles-based discussion of the 2011 budget, it will be virtually impossible to resolve the longer term issues.

The first chart compares the 2011 House budget appropriations (passed the House this morning) with appropriated spending in the 2008 budget enacted in December 2007. Note how the proposed 2011 levels are close to but slightly higher than the enacted 2008 levels. In fact they are about 5 percent higher which is more than enough to keep up with inflation during this period. The chart also illustrates the recent spending binge with the 2011 levels proposed in the Administration’s fiscal year 2011 budget. Clearly the House budget proposal represents cuts from the binge but not relative to right before the binge. The second chart divides the appropriated spending into nine budget categories (other than defense, homeland security, and military construction). The chart shows how close the 2011 proposal is to 2008 for each category, with some higher and others lower. Of course there will be understandable disagreement between Republicans and Democrats about the composition of spending between and within these budget categories, and this will be a reasonable subject for debate with the Senate and the President. But I think these data show that a reasonable compromise would be to keep the overall totals as in the House proposal and thus take a first important step toward restoring fiscal sanity.

The Empty Chairs at the ARRA Hearing

2011-02-16T12:19:00.000-08:00

Two years ago this week the 2009 stimulus package was enacted into law, and, to examine its effects, the House Committee on Oversight—Subcommittee on Regulatory Affairs held a hearing chaired by Jim Jordan of Ohio and ranking Member Dennis Kucinich also of Ohio. The first panel of witnesses consisted of Russ Roberts, J.D. Foster and me. All three of us testified that the 2009 package did little if anything to stimulate the economy. (There was also a second panel which I unfortunately missed.)

My testimony focused on the eight quarters of data since the start of the stimulus which have now been made available by the Department of Commerce, updating a recent study by John Cogan and me. The most striking finding of that data is that only .04 percent of GDP in the large $862 billion package went to federal infrastructure spending, and the large amounts of funds sent to the states for infrastructure spending have not resulted in an increase in infrastructure spending. Raul Labrador of Idaho asked me if the stimulus package would have worked better if there had been more infrastructure spending, but the lesson is that it’s not really feasible to start large government infrastructure projects in a timely enough manner to affect the economy in a recession. There is no such thing as “shovel ready.” In my view we learned that from the 1970s stimulus packages, and indeed it is part of the reason that many of us teach in elementary economics that such discretionary stimulus packages are ineffective.

There were also two missing chairs on the witness panel, which reminded me of an op-ed I wrote for the Washington Post several years ago called “The Empty Chair at the Iraq Hearings.” The name plate on the desk in front of one of the missing chairs said “Dr. Christina Romer” and the other said “Dr. Jared Bernstein.” Of course, Christina Romer and Jared Bernstein were the authors of the influential economic white paper on the stimulus package back in January 2009. They were invited to testify and give their views as the authors of that paper, but they declined. So the Committee decided to set up empty chairs, making a point similar to my earlier op-ed though on a different topic. To be sure, a broader discussion would be welcome.

Is the House on Track to Reverse the Spending Binge?

2011-02-10T09:21:00.000-08:00

The goal of the new House leadership is to reverse the spending binge of the past three years. They have already laid out the first step: the House Appropriations Committee has agreed to spending levels for nondefense discretionary spending for fiscal year 2011. However, because the previous Congress did not pass a budget for 2011, the year will be nearly half over before the new budget is passed and this is causing confusion about what the agreed spending levels mean, as illustrated by today’s Wall Street Journal news story headlined: “Republicans Splintering on Size of Cuts.” It is also causing confusion for Economics 1 students and their teachers trying to apply the principles learned in their economics textbook to current events.

A graph might help to see what's going on. To keep it simple consider the Congressional Budget Office's data on nondefense domestic discretionary outlays in the past few fiscal years:

2007 $459 billion
2008 $485 billion
2009 $538 billion
2010 $614 billion

(You can find these numbers in the supplemental material “Historical Budget Data” Table E7, Economic and Budget Outlook: Fiscal Years 2011 to 2021, January 27.)

The Continuing Resolution (which passed last December 21) put spending for fiscal year 2011 through March 4 at approximately 2010 levels, or $614 billion. The period from the start of the fiscal year through March 4 represents approximately 5/12 of the year. The House leadership said it wants to bring spending to 2008 levels. If the 2011 budget set spending to 2008 levels for the part of the fiscal year following March 4, it would have an actual spending of
614 X (5/12) + 485 X (7/12) = 539,
which is very close to the $537 billion in budget authority which the House Appropriation Committee agreed to. So in this sense the House has taken spending down to 2008 levels for what is remaining of 2011, and thus it begins to fulfill the goal of reversing the spending binge, as illustrated in the graph below. The graph shows the size of the budget from 2006 to 2011 with the 2011 budget interpreted as a blend of two levels.

But a very important question going forward is what will be the base for discussing budget proposals in 2012. If one keeps to the logic of the House leadership, then the base to reduce from should be $485B, not $537B, as shown by the dashed line. To complete the reversal of the spending binge, 2012 spending would be brought down to 2007 levels of $459B, which would be a 5 percent reduction from the appropriate 2011 base.

Of course much still depends on whether the House Appropriations bill for FY 2011 passes the Senate and is signed by the President. And we will see on Monday if the President’s budget for FY2012 comes close the goal of reversing the binge.

The Monetary Reform Debate is Joined

2011-02-05T02:05:00.000-08:00

The Atlanta Fed, through its “macroblog,” has joined the discussion about reform of the Federal Reserve. It’s a good discussion to have. David Altig, Senior Vice President of the Federal Reserve Bank of Atlanta and main blogger, wrote the latest entry on my Wall Street Journal article of last week which offered proposals to return to sound fiscal and sound monetary policy. Macroblog has no quarrel with the proposals for sound fiscal policy but, as in past posts, disagrees with the analysis of monetary policy.

The latest macroblog entry starts by appealing to a paper from New Zealand which shows that an “estimated” Taylor rule indicates that interest rates were not too low for too long in 2003-05 as I have argued. But the “estimated” policy rule in that paper doesn’t looks anything like what I proposed and given that there are already scores of existing models I fail to see the advantages of another model from New Zealand. For example, at the Federal Reserve Bank of Kansas City, George Kahn shows that deviations from a policy rule were a major reason for the housing price boom and bust. A chart from his paper which I copy below shows clearly that policy without the Taylor Rule deviation (TRDEV1) would have avoided the boom and bust.

The Atlanta Fed’s macroblog post also argues that the Fed has already laid out an exit strategy for reducing its balance sheet, and it gives a link to minutes of the FOMC with a list of tools. However, as I explained in testimony to Congress last year, a list of tools is not a strategy. A strategy is a path or contingency plan for the balance sheet over time. I gave an example in the tesimony. If it is good to lay out a path to reduce the federal debt as a share of GDP, then why not lay out a contingency path to reduce the Fed’s balance sheet?

Regarding my proposals to restore the Fed’s reporting and accountability requirements removed in 2000, I think macroblog post’s reference to Ben Bernanke’s speech at the American Economic Association last January supports my point rather than refutes it. If there had been such reporting requirements in place in 2003-05, then the Fed would have been required to report the strategy at the time in Congress, not 7 years later at the AEA. Also if you look back at the FOMC transcripts at the time you will see that the Fed was intentionally holding rates extra low for an “extended period” and only increasing them at “measured pace,” which does not seem consistent with policy as usual. In my view if the Fed had laid out its strategy at the time, then there would have been a more informed public discussion.

Then there is the question of the Fed’s multiple mandate. The record shows that explicit mention of the term “maximum employment” entered the FOMC Statement for the first time only last fall, after more than thirty years of no such mention since the mandate was put into legislation way back in 1977. So the connection between the mandate and QE2 seems most evident based on the record. In my view, the rate of inflation and the level of GDP last year justified an interest rate near zero, but not QE2. The Atlanta Fed macroblog post argues that QE2 was effective. But any connection between QE2 and its purported effects is tenuous when long-term Treasury securities, which the Fed has been purchasing, have declined in price, gone in the wrong direction.

The recent post by David Altig ends by referring to the Financial Crisis Inquiry Commission, which seems to have chosen a “perfect storm” explanation of the crisis where everyone shares some blame. In that report, the Fed shares blame, but mainly because of a failure to enforce existing regulations. The debate over interest rates seems to have ended in a draw in the Commission with short reviews of arguments made by Ben Bernanke, Alan Greenspan, and me. The conclusion of the minority that U.S. monetary policy may have contributed to the credit bubble is about as far as one could expect from such a commission and should be enough incentive to look for policy reforms to improve monetary policy in the future.

Learning From Monetary Mistakes and Doritonomics

2011-02-02T23:41:00.000-08:00

Following the financial crisis, it is understandable that central bankers want better advice from economists and their economic theories, as Mojmir Hampl of the Czech central bank writes this week in the European Opinion section of the Wall Street Journal. But Princeton economist and recent president of the American Economic Association put it best when he said “economic theory came out of this better than policy practice did.”

The lesson for central bankers from the financial crisis is straightforward: do not deviate from policies like the ones that worked well during much of the 1980s and 1990s. It was such a deviation--in the form of low interest rates compared with what good existing policy practice suggested--that was behind the excessive risk taking and housing booms in many countries as OECD research has shown. The chart below was published by the OECD before the problems in Greece, Ireland and Spain became so evident. I used it in my book Getting Off Track published two years ago. It predicts amazingly well which countries would suffer most from the low interest rate policy. That's the message of several talks I am giving in Europe this week.

But the message is simpler and more entertaining in DORITONOMICS from the Crash the Super Bowl contest.

Clarifying the Debt Limit Issues

2011-02-01T13:22:00.000-08:00

Last Friday I spoke at a conference at the Reagan Presidential library where over 50 currently serving members of Congress--including many new members--met to discuss the future. One of the big issues was the debt limit, which has already been the subject of partisan discussion and is now viewed as a key mechanism for the overall effort to reduce spending. Here is the best summary of the issue , prepared by J.D. Foster of the Heritage Foundation. It is short and very clear. Well worth reading.

More on a Two-Track Plan to Restore Growth

2011-01-31T08:59:00.000-08:00

The Wall Street Journal’s choice of a headline for my op-ed last Friday “A Two-Track Plan to Restore Growth,” was a great way to pair the proposed fiscal reform with the proposed monetary reform. The Congress and the President would lay out the fiscal track to reduce the exploding debt and then nail down the track with the golden spike of entitlement reform. In parallel the Fed would lay out the monetary track to reduce its exploding balance sheet and then nail down the track with the golden spike of reporting and accountability reform. In each case reform is needed: for fiscal policy entitlement reform is needed to provide incentives to control spending growth and improve the quality of services; for monetary policy, reform is needed to provide incentives to follow more rules-based policies.

Hearings at the House Financial Services Committee last Wednesday covered many of these same issues in detail with new members of Congress asking good questions. Witnesses were Don Kohn (former vice chair of the Fed) and I who focused on monetary policy, as well as Bill Poole and Hal Scott who focused on fiscal policy and regulatory policy, respectively. There was also a good second panel with witnesses from the private business sector.

Somewhat surprisingly, Don Kohn agreed that reporting and accountability about monetary policy decisions could be improved, as I had argued in my testimony and in the op-ed, though he was not sure whether legislation was needed. In my view Congress should restore the Fed’s reporting requirements which it removed in the year 2000 in a little-known section of the American Homeownership and Economic Opportunity Act of 2000. Don emphasized that the congressional committees could ask better questions and thereby hold the Fed more accountable even without restoring the former type of requirement.

Two other related policy matters from last week:

Bob Heller (like Kohn and Poole, a former member of the FOMC) spoke out forcefully against recent Fed policies. According to Bloomberg News: “While most critics of the Federal Reserve are investors and market pundits, one noteworthy individual was a former member of the U.S. central bank. Robert Heller, Federal Reserve Governor from 1986-1989, described the Fed’s second round of quantitative easing, QE2, as ‘dangerous’ and ‘misguided’ in a Bloomberg interview.”

Ron Paul reintroduced a bill to repeal the law (31 USC 714(b)) which now prevents GAO from auditing certain monetary policy activities at the Fed. The Bill would delete the following language “Audits of the [Federal Reserve] Board and Federal Reserve banks may not include— (1) transactions for or with a foreign central bank, government of a foreign country, or nonprivate international financing organization; (2) deliberations, decisions, or actions on monetary policy matters, including discount window operations, reserves of member banks, securities credit, interest on deposits, and open market operations; (3) transactions made under the direction of the Federal Open Market Committee; or (4) a part of a discussion or communication among or between members of the Board and officers and employees of the Federal Reserve System related to clauses (1)–(3) of this subsection." Other legislation related to the Fed is likely on the way.

A Law Might Speed Up the Taylor Cycle

2011-01-19T12:55:00.000-08:00

The phrase in the headline above concludes Amity Shlaes's "amazingly thorough" article (quoting AEA President Orley Ashenfelter here) on the long cyclical swings between rules and discretion which I documented in a speech at the annual AEA-AFA luncheon in Denver on January 7. Given that the previous period of discretion (in the 1960s and 1970s) lasted nearly two decades, a continuation of the normal cycle means that it might take another dozen years to get back to more stable rules-based monetary and fiscal policies, which is the length of time Amity Shlaes suggests. She also suggests that a law could move the balance back toward rules much sooner. I think that’s why we are beginning to see renewed interest in legislation to modify the Federal Reserve’s mandate and add reporting requirements and accountability for its monetary strategy.

Higher Investment Best Way to Reduce Unemployment, Recent Experience Shows

2011-01-14T09:23:00.000-08:00

Some economists argue that the efforts now underway to reduce government spending as a share of GDP will have adverse effects on unemployment. This is not what the data show. Consider this chart which shows the pattern of government purchases as a share of GDP and the unemployment rate over the past two decades. (The data are quarterly seasonally adjusted from 1990Q1 to 2010Q3.) There is no indication that lower government purchases increase unemployment; in fact we see the opposite, and a time-series regression analysis to detect timing shows that the correlation is not due to any reverse causation from high unemployment to more government purchases.In sharp contrast, the data on spending shares show that the most effective way to reduce unemployment is to raise investment as a share of GDP. The second chart shows the relation between unemployment and fixed investment over the past two decades. Higher shares of investment are associated with lower unemployment. The time series in the third chart show the relationship from another perspective. Either way you look at it, the relationship between unemployment and the investment share is remarkably close. It holds for both non-residential and residential investment, and is a subject of my current research. Of the four shares of GDP (the other two of course being consumption and net exports), the investment share shows by far the largest negative association with unemployment.
Encouraging the creation and expansion of businesses should be the focus on government efforts to reduce unemployment. The recent compromise agreement to prevent the increase in tax rates on small businesses and the move to lighten up on the anti-business sentiment coming out of Washington are two steps in the right direction.

Historical Evidence on the Benefits of Rules-Based Economic Policies

2011-01-07T23:33:00.000-08:00

Each year since 1948 the American Economic Association and the American Finance Association hold a joint luncheon with an invited speaker. Over the years the luncheon has grown to a very large affair usually held in the big hotel ballrooms. This year’s luncheon was held today in Denver, and I was the speaker. Like the first two speakers—Winthrop Aldrich, president of Chase National Bank, and Paul Douglas, U.S. Senator from Illinois and known to economists from the Cobb-Douglas production function—I spoke about monetary and fiscal policy. I presented evidence of an amazing six decade long correlation between rules-based policies and good economic performance. The correlation—along with basic economic reasoning—is strong evidence that rules-based monetary and fiscal policies are enormously beneficial to the economy. The historical swings away from rules toward discretion have been damaging whether during the Great Inflation of the 1970s or the recent Great Recession. Here is a copy of the speech and here is the video of the speech with introduction by AEA President elect Orley Ashenfelter (AEA ID is needed for video).