Velocity of money

The quantity theory of money and measuring money:  Econobrowser.

I wanted to follow up on Menzie's recent observations about what's been happening to the supply and demand for money.

These discussions are sometimes conducted in terms of the following equation:

MV = PY.
Here M is a measure of the money supply, V its velocity, and nominal GDP is written as the product of the overall price level (P) with real GDP (Y). We have direct measurements on nominal GDP. And once we agree on a definition of the money supply (no trivial matter), we have a number for M. But where do we come up with data on this concept of the velocity of money, V?
The answer is, we don't have independent measures of the velocity of money. So if people talk about velocity as something they could measure, they're just referring to the value of V that makes the above equation true. That is, we measure the velocity of money from

V = PY/M.
As alluded to above, different people come up with different answers for how we should measure the money supply. One measure is M1, whose key components include currency held by the public and checkable deposits. Another measure is the monetary base, which is currency held by both banks and the public plus deposits banks hold in their accounts with the Federal Reserve. So we could use M1 as the value for M in the above equation, and call the resulting value for V the "velocity of M1". Or we could put the monetary base in for M, and call the resulting V the "velocity of the monetary base". You get the idea-- use your favorite M to get your favorite V.
Arnold Kling, for example, proposed that we might use for M the quantity of marbles.
Which perhaps sounds a little silly. Even if there's no particular relation between the quantity of marbles and the stuff we care about (inflation and real GDP), you could still go ahead and use the equation above to define the velocity of marbles. But what you'd find is that when marbles go up, the marble velocity goes down, and it makes no difference for output or inflation.
OK, so let's look at the velocity of M1. It turns out to look a lot like you'd expect the velocity of marbles to behave-- when M1 goes up, the velocity of M1 goes down by an almost exactly offsetting amount. Here's an update of a graph that I presented a year ago:

Top panel: annual growth rate of M1, 1980:Q1 to 2010:Q3. Bottom panel: annual growth rate of the ratio of M1 to nominal GDP. Horizontal line in each figure is drawn at the historical average for that series.

So maybe we'd be better off using the monetary base as our value for "M"? I don't think so.

Top panel: level of monetary base, 1980:Q1 to 2010:Q3. Bottom panel: velocity of base.

Obviously the interest in an equation like MV = PY comes not from using it as a definition of V for some arbitrary choice of M. Instead there must be some kind of behavioral idea, such as that there is some desired value of M1, or monetary base, or marbles, that people want to hold. Suppose it was the case that to a first approximation, this desired quantity was essentially proportional to nominal GDP. If that were true, we would see the graphs of V above behaving roughly as constants instead of simply tracking the inverse of whatever happens to M.
Now, I think it is true that, in normal times, nominal GDP is one of the most important determinants of the demand for M1 or the monetary base. In the absence of other factors changing these demands, there certainly is a connection between money growth and inflation, and you do find a correlation if you look at much longer horizons than the quarterly changes plotted above.
But conditions at the moment are far from normal. In particular, something quite remarkable has happened to the demand for the monetary base. In the current environment, banks have shown themselves to be indifferent between holding reserves (a risk-free way to earn a modest interest rate from the Fed) and making other uses of overnight funds. For this reason, the demand for reserves, and with it the demand for the monetary base, has ballooned without any corresponding changes in output or inflation.
Some people felt I was making a sophistic distinction in emphasizing that the Fed is creating reserves as opposed to printing money ([1], [2]). But I maintain this is a critical distinction. The demand for reserves has increased by a trillion dollars since 2008. The demand for currency held by the public has not. The supply of reserves could therefore increase a trillion dollars without causing inflation. The quantity of currency held by the public could not.
Now, the time will come when banks do see something better to do with these reserves, at which point the Fed will need to take appropriate measures in response, namely a combination of raising the interest rate paid on reserves and selling off some of the assets the Fed has been accumulating. This is of course a key long-term story that we will all be following with interest.
But someone who insists that inflation (P) must go up just because the monetary base (M) has risen may have lost their marbles.

Source: FRED.

There Is No National Sock Shortage

Yglesias:

This USA Today story about kids asking santa for basic necessities is actually more tragic than most people recognize:

Santa Claus and his elves are seeing more heartbreaking letters this year as children cite their parents’ economic troubles in their wish lists. U.S. Postal Service workers who handle letters addressed to Santa at the North Pole say more letters ask for basics — coats, socks and shoes — rather than Barbie dolls, video games and computers.

Something important to note here is that this is not only sad, but fundamentally avoidable. The world is not suffering from a shortage of socks. If the government tried to give an iPad to everyone who writes in asking for one, we’d swiftly run out of iPads. The supply is constrained. But we have lots of socks. There’s nothing stopping the government from buying socks and giving them to everyone. What about the money? Doesn’t the money have to come from somewhere? Not really. As Ben Bernanke says “[t]he U.S. government has a technology, called a printing press (or today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at no cost.”
Now of course having the Post Office initiate a big sock-purchasing program would be pretty goofy. But the point is that we have in this country right now lots of factories running below capacity. Lots of workers doing no work. Lots of trucks not delivering anything. We’re not short on ability to produce more things, or on ability to transport, and distribute more things. We have citizens who would buy more things if they had more money. The real shortfall we’re facing, in other words, is a shortage of money. This is a good kind of problem to have, since it’s actually really easy to fix: Just print more. But it’s also an extremely frustrating problem to have, since it’s so easy to fix. The shortage of money isn’t the only problem America has. We also have, for example, a shortage of really excellent teachers and it’s hard to know what to do with that. But our money shortage is very solvable.

Yglesias » Monetary Policy and Asset Prices

Yglesias » Monetary Policy and Asset Prices:

I was arguing yesterday that 25 years worth of wage stagnation, occasional recessions, and no episodes of inflation together constitute a powerful prima facie argument that monetary policy has been systematically too tight. That doesn’t necessarily mean it’s been dramatically too tight or anything. Maybe it’s just that interest rates should have been 0.25 percentage points lower from 1985 onwards. That would still make a big difference over time.

Something some people said in response is that we may not have had CPI inflation, but loose money might drive asset price bubbles. People say this fairly frequently, but I don’t understand how it’s supposed to work. I’ve seen several efforts to debunk the loose money = bubbles hypothesis via empirical work (PDF, for example), but I also think it’s very problematic as a theory. After all, what does it mean to say there’s a “bubble” in the price of houses or the price of tech stocks? It means, I think, that current prices are based on overestimating the long-run demand for homes or for the goods sold by tech firms.

Clearly, things like that do happen from time to time. But how would higher interest rates avoid those occurrences? It’s easy to see how tighter money could lead to lower asset prices via slower growth and reduced demand and expectations of demand. But that doesn’t eliminate the “bubble,” the mismatch between anticipated demand and actual demand, instead it lowers the price of the asset by actually lowering demand.

Bubbles, it seems to me, have to do with the fact that (a) making correct estimates is hard, (b) frailties of human psychology, (c) certain “the market can stay rational longer than you can stay liquid” asymmetries, and (d) to an extent bad regulatory incentives. Making money tighter or looser should alter the average price of assets but there’s no reason to think it would change the basic social and psychological dynamics that sometimes lead to large-scale mis-pricing.

What Is Money? - NYTimes.com

What Is Money? - NYTimes.com:

...the evils of increasing the money supply.

You hear it all the time: the Fed is printing money! Danger, Will Robinson! In some comments on this blog I see assertions that the true measure of inflation isn’t prices, it’s what happens to the quantity of money.

Now, one thing you might immediately say is that for those who care about, know, actually buying things — you can’t eat money — it’s prices of goods that matter; and for the past three decades, as shown above, there has been remarkably little relationship between the standard monetary aggregates and the inflation rate.

But here’s an even more basic question: what is money, anyway? It’s not a new question, but I think it has become even more pressing in recent years.

Surely we don’t mean to identify money with pieces of green paper bearing portraits of dead presidents. Even Milton Friedman rejected that, more than half a century ago. For one thing, a lot of those pieces of green paper are pretty much inert — sitting outside the United States, in the hoards of drug dealers and such. For another, checking accounts are clearly a close substitute for cash in hand.

Friedman and Schwartz dealt with this by proposing broader aggregates –M1, which adds checking accounts, and M2, which adds a broader range of deposits. And circa 1960 you could argue that those aggregates were good enough.

But now we have a large shadow banking system, in which things like repo serve much the same function as deposits; M3 used to capture some of that, but the Fed discontinued it, in part I think because it wasn’t clear which repo belonged there, and data on repo not involving primary dealers is scattered. Whatever.

The truth is that these days — with credit cards, electronic money, repo, and more all serving the purpose of medium of exchange — it’s not clear that any single number deserves to be called “the” money supply. Intellectually, this isn’t a problem; nor is there necessarily a problem maintaining monetary policy even if there isn’t any single thing you’re willing to call money. Mike Woodford has been writing about this stuff for years.

But if you’re determined to view economic affairs through a sort of paleo-monetarist lens, focused on the evils of “printing money”, you’re going to have a hard time in the modern world, where the definition of money is increasingly vague.

The SPECTRE of Inequality - NYTimes.com

The SPECTRE of Inequality - NYTimes.com:
there’s a scene early in [the old Bond film Thunderball] when the minions of SPECTRE, the evil conspiracy, are shown reporting on their profits from dastardly activities. ...

Even the big one — demanding a ransom for two stolen nuclear warheads — is 100 million pounds, $280 million. Adjusted for inflation, that’s about $2 billion — or one-eighth of the Goldman Sachs bonus pool.

It’s just an indicator of how huge top incomes have become that what were once viewed as impressive numbers, the kind of thing only arch-villains might demand, now look trivial. Or maybe the other way to look at it is that we have a lot more arch-villains around than we used to.

PS: Prices haven risen roughly sevenfold since the movie was made. So $280 million is, as I said, around $2 billion in today’s dollars — still a trivial sum by modern Wall Street standards.

Moral Hazard and Modern Finance

The Inequality That Matters - Tyler Cowen - The American Interest Magazine:

some investors opt for a strategy of betting against big, unexpected moves in market prices. Most of the time investors will do well by this strategy, since big, unexpected moves are outliers by definition. Traders will earn above-average returns in good times. In bad times they won’t suffer fully when catastrophic returns come in, as sooner or later is bound to happen, because the downside of these bets is partly socialized onto the Treasury, the Federal Reserve and, of course, the taxpayers and the unemployed.

To understand how this strategy works, consider an example from sports betting. The NBA’s Washington Wizards are a perennially hapless team that rarely gets beyond the first round of the playoffs, if they make the playoffs at all. This year the odds of the Wizards winning the NBA title will likely clock in at longer than a hundred to one. I could, as a gambling strategy, bet against the Wizards and other low-quality teams each year. Most years I would earn a decent profit, and it would feel like I was earning money for virtually nothing. The Los Angeles Lakers or Boston Celtics or some other quality team would win the title again and I would collect some surplus from my bets. For many years I would earn excess returns relative to the market as a whole.

Yet such bets are not wise over the long run. Every now and then a surprise team does win the title and in those years I would lose a huge amount of money. Even the Washington Wizards (under their previous name, the Capital Bullets) won the title in 1977–78 despite compiling a so-so 44–38 record during the regular season, by marching through the playoffs in spectacular fashion. So if you bet against unlikely events, most of the time you will look smart and have the money to validate the appearance. Periodically, however, you will look very bad. Does that kind of pattern sound familiar? It happens in finance, too. Betting against a big decline in home prices is analogous to betting against the Wizards. Every now and then such a bet will blow up in your face, though in most years that trading activity will generate above-average profits and big bonuses for the traders and CEOs.

To this mix we can add the fact that many money managers are investing other people’s money. If you plan to stay with an investment bank for ten years or less, most of the people playing this investing strategy will make out very well most of the time. Everyone’s time horizon is a bit limited and you will bring in some nice years of extra returns and reap nice bonuses. And let’s say the whole thing does blow up in your face? What’s the worst that can happen? Your bosses fire you, but you will still have millions in the bank and that MBA from Harvard or Wharton. For the people actually investing the money, there’s barely any downside risk other than having to quit the party early. Furthermore, if everyone else made more or less the same mistake (very surprising major events, such as a busted housing market, affect virtually everybody), you’re hardly disgraced. You might even get rehired at another investment bank, or maybe a hedge fund, within months or even weeks.

Moreover, smart shareholders will acquiesce to or even encourage these gambles. They gain on the upside, while the downside, past the point of bankruptcy, is borne by the firm’s creditors. And will the bondholders object? Well, they might have a difficult time monitoring the internal trading operations of financial institutions. Of course, the firm’s trading book cannot be open to competitors, and that means it cannot be open to bondholders (or even most shareholders) either. So what, exactly, will they have in hand to object to?

Why bubbles are structurally likely

Grasping Reality with Both Hands: "Sixth, the market will go wrong whenever its prices function as forecasting mechanisms. A proper forecasting mechanism would weigh each individual's opinion by the precision of his or her knowledge. A market tends on the contrary to weigh each individual's opinion by his or her wealth. This means that whenever economic processes tend to revert to seem average level that the market is likely to get things wrong, for when prices rise above average those who are optimistic become richer and their opinions carry more weight and so prices tend to rise further above their likely long-run fundamental values. Bubbles and crashes, manias and panics, are thus built into the system.

You Can’t Overwork Yourself By Smoking Joints and Watching Too Many Episodes of Jersey Shore « Modeled Behavior

 Modeled Behavior:

I think people are confusing cyclical prosperity with personal luxury. ...

However, this is not how we measure the cyclical wealth of nations. We measure it by employment and production. We say the economy is “doing well” when a lot of people are going to work and making stuff.

For example, we say that Germany’s economy seems to be recovering. However, consumption in Germany is not rising. Consumption is flat. Working is rising. Employment is rising. That is what it means to be doing well. It means that more people are doing more work.

This is why it makes no sense to say that a recession is inevitable because we overconsumed. Because we bought too much it is now inevitable that we work less? Why does that make fundamental sense? Surely something is going wrong. Shouldn’t we be working more to pay for all the stuff we bought.

Some [economists] say that the “something” is structural readjustment. We have to move towards an investment based economy and there are frictions. However, that story also works in reverse. A country could be consuming too little and then has to suddenly switch away from an investment based economy and will face frictions. Recessions in that story are not a punishment for overconsumption, they are a result of suddenly realizing that you have to shift paths. There are still problems here but they are on a deeper level about more subtle things.

The overconsumption theory by contrast says that the recession is natural because we bought too much stuff during the 2000s. Too many houses. Too many big screens. That’s why you are not working now. ...It doesn’t even make basic logical sense. ...If we consumed too much then shouldn’t we need to work extra hard? Why is society working less? What about spending too much money implies that the natural reaction is that people should go home and sit on the couch?

...this [is the] key question [that any macroeconomic theory must answer, but the overconsumption theory does not]:
WHY ARE PEOPLE WORKING LESS?

 Paul Krugman called this the hangover theory of recessions.

The Washington Post Embarrases Itself Once Again - Grasping Reality with Both Hands

The Washington Post Embarrases Itself Once Again - Grasping Reality with Both Hands: "Calculated Risk watches the train wreck:

Calculated Risk: Monetary Policy Confusion: An editorial in the WaPo yesterday - and some recent emails I've received - indicate there is some confusion on the difference between monetary and fiscal policy. From the WaPo yesterday:

Kicking the Fed: [B]uying hundreds of billions of dollars worth of federal debt in a deliberate effort to lower long-term interest rates and boost employment looks to many economists, market participants and politicians like fiscal policy by another name.

Calculated Risk says:

Well, these "economists, market participants and politicians" are confused.

Me? I don't believe these economists, market participants, and politicians exist. Expansionary monetary policy is when the Federal Reserve buys government debt for cash. Expansionary fiscal policy is when the U.S. Treasury sells government bonds for cash and uses the cash to fund its operations. See the difference between "buy" and "sell"? Buying something is not "like" selling it: it is the opposite of selling it.

The Topic of Depression Economics in a Nutshell - Grasping Reality with Both Hands

The Topic of Depression Economics in a Nutshell - Grasping Reality with Both Hands:

...how you should think about the topic of “depression economics. ...Why should there be such crashes in the level of employment? How can it be that there is not enough spending, not enough demand in the system to put everyone who wants to work to work productively? Back in 1803 Jean-Baptiste Say observed that nobody makes except to use or to sell. and nobody sells except to buy. Thus, he argued there can be particular shortages of demand in some commodities balanced by excesses of demand for others. But “overall excess demand” is self-contradictory because everybody’s spending is someone else’s income and everyone’s income is then spent sooner or later on something. How is it that the economy can wedge itself into a position like it is in today? That is an important question.

Read more at medianism.org:

Ratings Agencies and Predatory Lending vs. Irresponsible Borrowing

PBS NewsHour | Nov. 18, 2010 | PBS:

PAUL SOLMAN: You frame this book as a look back at the whole financial crisis, so I thought I would frame this interview as a: Who is the biggest culprit?

JOE NOCERA: I certainly would put the rating agencies right at the top of my list of bad guys, or my list of devils.

A place like Moody's took a culture that had a reputation for some integrity, and completely corrupted it in a drive for market share and profits.

PAUL SOLMAN: So, biggest culprit, ratings agencies; you agree?

BETHANY MCLEAN: I do agree. If they hadn't taken subprime mortgages and rated enormous quantities of them AAA, meaning they gave those bonds the same credit rating as the U.S. government debt has, this -- this whole thing couldn't have happened, because debt that is rated AAA is precisely the debt that is snapped up by the largest quantity of buyers all around the world, buyers who are not capable of doing the detailed work to analyze these bonds by themselves....

BETHANY MCLEAN: ...But one of the really interesting things, if you go back to the 1990s to the birth of subprime lending, it was never about homeownership.

PAUL SOLMAN: What do you mean it wasn't about homeownership?

BETHANY MCLEAN: It was never about homeownership, because subprime lending grew out of cash-out refinancings, meaning the ability of somebody to go to a bank, refinance their mortgage, and take cash out of their house in order to live on that cash.

And that enabled consumer spending through the 1990s and through the early part of -- of this decade. Most of the business of the major subprime lenders, from Countrywide, to Ameriquest, to New Century, was cash-out refinancing. It wasn't the first-time purchase of homes by homebuyers. And this was celebrated by Republicans, as well as Democrats.

JOE NOCERA: Homeownership was a giant fig leaf, particularly for the rise of subprime.

I was stunned, in the reporting of this book, how much subprime was about predatory lending. And it was way more than I thought. And then, when you find that a company like New Century, which really, you know, 85 percent of its business is refinancing, 15 percent of its business is homeownership, that's astounding.

PAUL SOLMAN: What does predatory lending mean in this situation?

JOE NOCERA: Taking advantage of unsophisticated people to put them into loans that -- knowing, absolutely knowing, that they can never pay them back, often lying about what the interest rate hike is going to be, prodding them to lie themselves about their income, about their true financial condition.

BETHANY MCLEAN: I -- I started this book with a bias toward personal responsibility, and, if consumers got in over their head on their mortgage, that was their fault.

And one of the big discoveries to me in the course of reporting the book is the extent to which these loans were sold; they weren't bought. And one of the most telling moments were these internal documents from Washington Mutual, one of the big subprime lenders, around 2003 talking about how to get consumers who really wanted safe 30-year fixed-rate mortgages to take out these dangerous option ARMs instead.

PAUL SOLMAN: ARMs meaning adjustable rate.

BETHANY MCLEAN: Adjustable rate mortgages -- how to sell those to people, and how to confront a consumer who said, but it doesn't feel right to me.I want to pay back my mortgage every month. This is what my parents did.

How do you get these people to take out a risky mortgage instead? You told them that home prices could only go up. And the reason Washington Mutual wanted to sell these option ARMs, instead of the 30-year fixed rate mortgages, is that Washington Mutual could turn around and sell these to Wall Street for a lot more money than it could sell the old 30-year fixed-rate loans.

Yglesias » The Importance of Models

Yglesias » The Importance of Models:

Try to draw up a model—a simple one, but one where you do try to make sure that your numbers all add up—in which everyone has high savings rather than high debt. Households have high savings. Firms have high savings. The government has high savings. And the governments of your trading partners have high savings. But so do their citizens. And their firms, too. It’s the old wisdom of common sense! You’ll find that it doesn’t add up. Japanese people save by lending money to the Japanese government, which borrows. I borrow to buy a condo, and the money I’m borrowing is the money other people have saved in the bank. You put your money in the bank rather than leaving it under the mattress because the bank pays you interest. But they pay you interest because they can charge interest to other people—people who are in debt.

The old wisdom isn’t nutty or anything. Borrowing a ton of money so you can buy a fancy new car is probably a worse idea than buying a cheap used car and saving your money. But if you’re poor live in a city with bad mass transit and you borrow money to buy a cheap used car so you can make sure you’re on time for work every day, you’re making a prudent investment in your own future. Likewise, if you’ve got a successful store and you take out a loan to open a second location, you’re building the future of the American economy. Thriftiness is a good character trait because it tends to make people averse to accumulating debts for frivolous reasons. But if you try to build a systemic model, you’ll see that universal thrift doesn’t work at all.

Indeed, though thrifty people play an important role in making the economy function, they do so in part because their thrift creates resources that others can use to be venturesome and fuel innovation, entrepreneurship, and prosperity. Capitalist success stories are built on the ability and willingness of people to fail. For every hugely successful startup, you’ve got a dozen or more failures and behind those failures you’ve got bad loans. The willingness to issue those loans makes the world go ’round, and we need the savers because without them there’s no money to lend.

- Sent using Google Toolbar"

What Should Macroeconomics Do? - Grasping Reality with Both Hands

What Should Macroeconomics Do? - Grasping Reality with Both Hands:

What is wrong with American macroeconomics? In a nutshell, when 2007-9 came along every single macro textbook (including mine) and every single macro course (save possibly Perry Mehrling's) was of little or no use in helping people who had read or taken them to read publications like the FT as they chronicled the downturn or understand the policy debates hosted by the FT.

At the very minimum, a macro course should teach people enough about the macroeconomy that they can then read the reporting of the FT. And it should teach people enough about the theoretical approaches that underpin policy advocacy that they can then understand and evaluate the policies proposed in contributions to the FT.

What would such a macroeconomics course look like?

It would, I think, teach the five still-live theories of the causes of economic downturns that underpin people's analyses:

• The theory that high unemployment is produced by real wages stuck at too high a level for a full-employment economy to sustain. It must be suffered.

• The theory that high unemployment today is the unavoidable consequence of past overinvestment. It must be suffered.

• The monetarist theory that a downturn is the result of a shortage of liquid cash money which induces people desperate to build up their cash balances to try to switch their spending away from currently-produced goods and services. It is fixed by expanding the money supply or increasing velocity and so reducing money demand.

• The Keynesian--or is it Wicksellian?--or is it a Hicksian?--theory that a downturn is the result of a shortage of bonds, of vehicles that savings can use to transfer purchasing power into the future which induces people desperate to build up their assets to try to switch their spending away from currently-produced goods and services. It is fixed by expanding the supply of bonds or reducing savings.

• The Minskyite theory that a downturn is the result of an overspeculation-caused panic that generates a shortage of safe high-quality assets, of vehicles that people to park their wealth and be sure it will not melt away while their backs are turned, which induces people desperate to build up their safe asset holdings to try to switch their spending away from currently-produced goods and services. It is fixed by expanding the supply of safe assets or restoring confidence and so diminishing the demand for safety.

• 
  

Accounting Identities - NYTimes.com

Accounting Identities - NYTimes.com:

Peter Dorman has a good post on the meaning of deficit misses in Europe, This Is What Accounting Identities Look Like. It meshes with the way I’ve been trying to explain our mess lately; so let me go back to Sam and Janet — that is, to how to think about the role of debt in our problems.

The background to the world economic crisis is that we went through an extended period of rising debt. Now, one person’s liability is another person’s asset, so rising debt made the world as a whole neither richer nor poorer. It did, however, leave the borrowers increasingly leveraged. And then came the Minsky moment; suddenly, investors were no longer willing to roll over, let alone increase, the debts of highly leveraged players. So these players are being forced to pay down debt.

The process of paying down debt, however, must obey two rules:

1. Those who pay down debt must do so by spending less than their income.
2. For the world as a whole, spending equals income.

It follows that

3. Those who are not being forced to pay down debt must spend more than their income.

But here’s the problem: there’s no good mechanism in place to induce those who can spend more to do so. Low interest rates do encourage spending; but given the size of the debt shock, even zero rates are nowhere near low enough.

So since the world economy can’t raise the bridge, it is lowering the water: without sufficient spending from those who can, the only way to make the accounting identities hold is for incomes to decline — specifically, the incomes of those not constrained by debt must decline so as to create a sufficiently large gap between their (unchanged) spending and their incomes to offset the forced saving of debtors. Of course, the mechanism here is an overall global slump, so the debtors are squeezed as well, forced into even more painful cuts.

To avoid all this, we’d need policies to encourage more spending. Fiscal stimulus on the part of financially strong governments would do it; quantitative easing can help, but only to the extent that it encourages spending by the financially sound, and it’s a little unclear what the process there is supposed to be.

Oh, and widespread debt forgiveness (or inflating away some of the debt) would solve the problem.

But what we actually have is a climate in which it’s considered sensible to demand fiscal austerity from everyone; to reject unconventional monetary policy as unsound; and of course to denounce any help for debtors as morally reprehensible. So we’re in a world in which Very Serious People demand that debtors spend less than their income, but that nobody else spend more than their income.

And the slump goes on.

Why Quantitative Easing Needs to Involve Securities Other than Government Securities - Grasping Reality with Both Hands

Why Quantitative Easing Needs to Involve Securities Other than Government Securities - Grasping Reality with Both Hands:

The point--from one point of view, the neo-Wicksellian point of view--behind quantitative easing is to reduce the interest rate that matters for private business investment: the long-term, default-risky, systemic-risky, beta-risky, real interest rates at which private businesses finance their capital expenditures. You can reduce this flow-of-funds equilibrium interest rate and raise the level of economic activity in any neo-Wicksellian framework in two ways:

1. Reduce the 'safe' real interest rate on short-term, safe government bonds.
2. Reduce the various premia--duration, default, systemic risk, and beta risk--between the rates the Treasury pays to borrow in T-bills and the rates businesses pay to borrow.

Conventional open-market operations that lower the nominal interest rate on T-bills accomplish the first. Once the nominal interest rate on T-bills has been pushed to zero, quantitative easing policies that create expectations of higher future inflation continue to lower the real interest rate on T-bills and thus help the situation.

Suppose, however, that the nominal interest rate on T-bills is zero and that you cannot alter inflation expectations--cannot commit to keeping your quantitative easing permanent, cannot commit to an exchange rate path, whatever, you cannot do it and inflation expectations are immovable. Then what?

Then, as Paul Krugman says, quantitative easing is working be altering the spread between the short-term safe T-bill rate and the long-term, systemic-risky, beta-risky, default-risky rate. How does it do that? Lloyd Metzler and James Tobin would say that it does so by altering relative asset supplies--by taking duration risk, systemic risk, beta risk, and default premia off of private savers' books and placing them on the government's books (and thus on the taxpayers, who are a very different group of people than are private savers). To the extent that quantitative easing thus involves assets whose risk characteristics are very similar--federal funds and two-year T-notes, say--we would not expect even a lot of quantitative easing to have much of an effect on anything.

Thus a quantitative easing program that is going to have bite should involve Federal Reserve purchases of long-term risky private assets rather than merely long-term U.S. Treasuries. Hiring PIMCO as an agent to manage a long bond index portfolio naturally comes to mind--if one could avoid its front-running.

And, of course, the most effective quantitative easing program of all would involve the Federal Reserve issuing reserve deposits and using that purchasing power to buy the assets that are the furthest away in their risk characteristics from short-term government bonds: bridges, dams, the human capital of American citizens, police protection, research and development. The best quantitative easing program of all is a money-financed fiscal stimulus, as Jacob Viner said back in 1933

The Young, the Old, the Unemployed » New Deal 2.0

The Young, the Old, the Unemployed » New Deal 2.0:

College educated 20-24 year olds have the highest percentage increase in unemployment. This should go against a structural unemployment story, as college educated people have the ‘freshest’ skills and incredibly high mobility. It’s worth pointing them out in particular because if their careers hit a rough spot, hysteresis sets in and they’ll have serious wage losses years down the road (see this classic White House blog post on the subject by Peter Orszag). Their situation is also important because the crisis is often seen as a small deal for college educated workers.

The other thing that jumps out at me is that the unemployment rate for everyone 55-64 has more than doubled. One thing we aren’t talking about enough is that someone who is 60 and has been unemployed for a year isn’t going to find a decent job again. Other ways of looking at the labor search outcomes of 55-64 year olds are even more worrying.

Economics and Politics - Paul Krugman Blog - NYTimes.com

Economics and Politics - Paul Krugman Blog - NYTimes.com:

Mike Konczal has has another excellent post, this time on the whole question of why employment remains so low. As he points out,

Why is unemployment so bad in this recession? There are two theories at work. The first is a story of aggregate demand. The second theory is one of a mismatch in skills.

What he doesn’t say explicitly, although it’s clearly implied, is that these two theories have very different policy implications. If it’s aggregate demand, we should be doing everything we can to raise demand, including fiscal expansion and unconventional monetary policy. If it’s mishmash mismatch, we should do nothing, because any effort to create jobs leaves part of the work of depressions undone.
So how would you decide between these theories? The answer is to look at the evidence — specifically, to ask whether what we see bears the “signature” of one story or the other. The aggregate demand story suggests that we should see depressed employment in all industries, that we should see workers of every skill type facing a poor job market. The mismatch story says that we should see surpluses of labor in some places, but shortages in others.
And Mike shows that the data overwhelmingly fit the demand story, not the mismatch story; Every single major industry has seen a rise in involuntary part-time work; so has every major occupation. There’s no hint that any major kind of labor, in any sector, is in short supply.
Let me add another piece of evidence. We’ve been talking a lot lately about the NFIB data on small businesses, and how weak sales — not concern about taxes or regulation — has soared as the perceived biggest problem. But there’s something else these data show: concerns about quality of labor have plunged:

National Federation of Independent Businesses

This strongly suggests that it’s a weak labor market for everyone out there, and businesses have no trouble finding the workers they need; they just don’t know what to do with those workers, given weak demand.
The evidence, then, is overwhelmingly in favor of a demand story. But the mismatch people don’t want to hear that — and they have substantial influence. And so the slump goes on.

Yglesias: [Also] see the new paper from Arjun Jayadev and Mike Konczal showing that a big shortfall in demand (PDF) rather than a sudden uptick in skill mismatch is the main story of the recession. 

Fannie / Freddie Acquitted « Modeled Behavior

Read the whole thing:

Fannie / Freddie Acquitted « Modeled Behavior: "being creepy, a bad person, or even a usual suspect does not make one automatically guilty of any particular crime. In this case government subsidies in the housing market are a bad idea for a host of reasons and have been for years. I will testify to this with vigor and passion.

However, that does not mean that Fannie or Freddie caused the housing bubble. Indeed, by my count they were among the biggest victims of it."

Matthew Yglesias » In Praise of TARP

TARP was a smashing success EXCEPT that its benefits were skewed towards the benefit of wealthy bank executives and shareholders. That is the big problem. That problem also creates the moral hazard that increases chances of a repeat of the same kind of crisis.

Matthew Yglesias » In Praise of TARP: "TARP, the Troubled Asset Relief Program, looks set to go down in history as one of the most unfairly maligned policy initiatives of all time. The government took hundreds of billion dollars, gave it to banksters, and in exchange all we got was this lousy$7 billion in profit. Which is to say that even if TARP had no positive impact on the economy whatsoever, it had a negative cost to taxpayers. How many programs can you say that about? And how many of them are toxically unpopular? ...TARP was both a good idea and nothing less than an exposure of the myth of the free market. There’s an idea out there about a free market that operates “naturally” and produces a certain distribution of wealth and income. Any further interventions into that marketplace to ensure that prosperity is broadly shared constitutes some kind of illegitimate “redistribution” of wealth and income from its natural state. This is not, however, an accurate description of how any economy featuring a modern banking system works. A world in which we simply didn’t have banking and finance would be, overall, a much poorer world. But a world with banking and finance requires various forms of management—monetary policy, regulation of the financial system, and intervention amidst panics and crises. TARP and the associated activities of the Federal Reserve were examples of such intervention and were good ideas. But they highlight that public policy decisions are integral to the creation and sustainment of modern capitalist economies. Under the circumstances, wise and moral policymakers will necessarily attempt to ensure that the prosperity they create is broadly shared by law-abiding members of the community.

Matthew Yglesias » Inflation Targeting vs Price Level Targeting

Matthew Yglesias » Inflation Targeting vs Price Level Targeting: "I want to try to keep doing posts that explain some basic monetary policy concepts, since I think these issues are important but most people aren’t very familiar with them. Today, let’s consider the difference between two kinds of targets a central bank can set for itself. One would be inflation targeting and the other would be price-level targeting. The inflation rate is the rate at which the price level increases, so these are similar ideas. Indeed, in a world of perfect execution they’d be equivalent. This is what the world looks like if the central bank is successfully hitting a two percent inflation target:

And here’s how things look if the central bank is successfully hitting a target for two percent growth in the price level:

It looks the same. Because these are the same thing. But it looks different if you factor in the inevitable occurrence of problems.

For example, suppose the economy has a sharp unexpected burst of deflation:

Here the blue line represents somewhat successful inflation rate targeting—after a few problems, the inflation rate regains stability at two percent. The green line, by contrast, represents somewhat successful price level targeting—after a few problems the price level catches up with its previous two percent annual growth path. That means a couple years of below-trend inflation are met with some years of faster-than-usual inflation to make up the lost ground. This is a subtle distinction, but for someone who signed a long-term contract denominated in nominal terms back in 2007, it has big implications for the financial state of things in 2011, 2012 and beyond.

The Slump Goes On: Why? | The New York Review of Books

The Slump Goes On: Why? | The New York Review of Books: "Books on the Great Recession are still pouring off the presses—but for the most part they are backward-looking, asking how we got into this mess rather than telling us how to get out. To be fair, many recent books do offer prescriptions about how to avoid the next bubble; but they don’t offer much guidance on the most pressing problem at hand, which is how to deal with the continuing consequences of the last one. ...In what follows, we’ll provide a relatively brief discussion of a much-belabored but still controversial subject: the origins of the 2008 crisis. We’ll then turn to the ongoing policy debates about the response to the crisis and its aftermath. Not to keep readers in suspense: we believe that the relative absence of proposals to deal with mass unemployment is a case of “self-induced paralysis”—a phrase that Federal Reserve Chairman Ben Bernanke used a decade ago, when he was a researcher criticizing policymakers from the outside. There is room for action, both monetary and fiscal. But politicians, government officials, and economists alike have suffered a failure of nerve—a failure for which millions of workers will pay a heavy price.

A Productivity Boom-in-Waiting? - Project Syndicate

A Productivity Boom-in-Waiting? - Project Syndicate: "In the US, there was zero growth in bank lending between 1933, the trough of the Depression, and 1937, the subsequent business-cycle peak. Investment suffered. Stocks of both equipment and structures were actually lower in 1941 than in 1929.

...The result was a disappointing, all-but-jobless recovery. In the US, unemployment was still 14% in 1937, four full years into the recovery, and in 1940, on the eve of the country’s entry into World War II.

But there was another side to this coin. Output expanded robustly after 1933. Between 1933 and 1937, the US economy grew by 8% a year. Between 1938 and 1941, growth averaged more than 10%.

Rapid output growth without equally rapid capital-stock or employment growth must have reflected rapid productivity growth. This is the paradox of the 1930’s. Despite being a period of chronic high unemployment, corporate bankruptcies, and continuing financial difficulties, the 1930’s recorded the fastest productivity growth of any decade in US history.

...As the economic historian Alexander Field has shown, many firms took the “down time” created by weak demand for their products to reorganize their operations. Factories that had previously used a single centralized power source installed more flexible small electric motors on the shop floor. Railways reorganized their operations to make more efficient use of both rolling stock and workers. More firms established modern personnel-management departments and in-house research labs.

...So, even if there are good reasons to expect a period of sub-par investment and employment growth, this need not translate into slow productivity or GDP growth.

Does The Money Have to Come From Somewhere?

Matthew Yglesias:

I recently unveiled my jobs program, namely that the government should spend a bunch of money to hire unemployed people to do some stuff. ...
This naturally prompted some smart-ass retorts about how the money has to come from somewhere. A fallacy that’s so commonsensical that even reasonable well-informed conservative economists sometimes fall into it. The problem, I think, is that because one of the functions of money is to serve as a unit of account we tend to measure wealth in terms of its dollar value, which leads people to confuse money and wealth. We say things like “Bill Gates has a lot more money than your average NBA player” when what we actually mean is that Bill Gates owns a ton of valuable Microsoft stock not that he carriers more cash around in his pockets or is pointlessly stockpiling billions of dollars in checking accounts. But valuable resources and money are actually different things.
To see the relevance of this, imagine what happens if you’ve got a country with full employment, and suddenly some guys show up with suitcases full of really good counterfeit money looking to buy stuff. Well, since people mistake the counterfeit for money, they’re happy to exchange goods and services for it. But the mere arrival of counterfeit hasn’t increased the quantity of goods and services the country can produce. The counterfeiters want a maid, so they need to find someone’s existing maid and offer her higher wages to go work for them. The counterfeiters buy some shoes, so there are fewer pairs of shoes for everyone else. What “has to come from somewhere” in this case isn’t the money (which is fake) it’s the maids and the shoes. There are only so many to go around.
But suppose the counterfeiters come to a country that’s fallen into recession? Here it’s a different situation. If they want to hire a maid, they can find one who was laid off a month ago. If they want to buy some shoes, this creates a very temporary shortage and the shoe-factory quickly un-cancels that extra shift. Then the guys at the shoe factory have higher wages and celebrate with a night out at the bar. Suddenly, the brewery needs more manpower and the bar needs to re-hire that waitress they had to let go. It’s the miracle of counterfeiting.
But still, that’s counterfeiting. We can’t just counterfeit. The money still has to come from somewhere, right? Well, yes, literally speaking any money spent doing anything has to have an origin. But the government can do something even better than counterfeit—it can create real money. And if banks are holding excess reserves, the government can adopt policies that discourage them from doing so. If banks aren’t holding excess reserves, the government can adopt policies that reduce the quantity of reserves they’re required to hold. And if people have money that’s just sitting around because they like safety and liquidity, the government can offer to sell them safe & liquid treasuries and then redeploy the money for other purposes.
Long-term economic prosperity is determined by how much value a country is capable of creating. America can create a lot more value per person than China can, and China can create a lot more value than India. But in the short-term, gaps can arise between what could be produced and what’s actually being produced. If that gap is small or nonexistent, efforts to “stimulate” production will lead to inflation or mere shifting of resources around. But if the gap is large, then policy needs to induce people who are currently not doing anything to start producing goods and services again. This requires money and the money does have to “come from somewhere” but it’s easy enough to obtain, and obtaining it can increase the overall quantity of wealth in the economy.

fiscal stimulus debt

NYTimes.com: "Whenever the issue of fiscal stimulus comes up, you can count on someone chiming in to say, “Only a moron could believe that the answer to a problem created by too much debt is to create even more debt.” It sounds plausible — but it misses the key point: there’s a fallacy of composition here. When everyone tries to pay off debt at the same time, the result is contraction and deflation, which ends up making the debt problem worse even if nominal debt falls. On the other hand, a strong fiscal stimulus, by expanding the economy and creating moderate inflation, can actually help resolve debt problems.

Let’s go to the tape here. Below are two time series. The first is total US debt from 1929 to 1948 — public plus private — in billions of dollars. The second is total debt as a percentage of GDP:

From 1929 to 1933, everyone was trying to pay down debt — and the debt/GDP ratio skyrocketed thanks to contraction and deflation. During and immediately after WWII, there was massive borrowing — but GDP grew faster than debt, and the debt burden ended up falling.

Yes, it seems paradoxical — but that’s the kind of world we’re living in. And the refusal of so many people to face up to the fact that we’re in a world where conventional rules don’t apply makes it likely that we’ll stay in that world for a long time come.

Update: Left scale for both series — debt in 1933 was $169 billion, and 299 percent of GDP.

Inflation, Deflation, Debt

Krugman: "even granted that inflation reduces the real liabilities of debtors, it also reduces the real assets of creditors. So why is there any benefit to the economy?

The answer is, I think, easier to understand by considering the reverse case: the problem of debt-deflation. Here a falling price level increases the real value of all debts — and Irving Fisher famously argued that this has a contractionary effect on the economy, possibly turning into a vicious circle. Why?

The answer is that on average, debtors are more likely to be constrained by their balance sheets than creditors. The 1929-33 plunge in prices made heavily mortgaged farmers poorer, while making wealthy people sitting on cash richer; but while the farmers were forced to slash spending to make their payments, the people sitting on cash merely had the option of spending more — an option many didn’t take. Or, to lapse into economese, the marginal propensity to spend out of wealth is surely higher for debtors than for creditors, so the redistribution of real wealth caused by deflation is contractionary. And conversely, redistribution through inflation raises overall demand.

Is the Fed Sadistic?

Kevin Drum, Mother Jones:

Arnold Kling [libertarian] on current Fed policy:

I call it neutron-bomb monetary policy. The banks are still standing, while the people are getting killed. I don't think that is the explicit intent of the Fed, but the structure of the organization makes it much more responsive to the thought process of bankers than to that of ordinary Americans.

Scott Sumner [conservative monetarist]:

Central bankers are a bunch of well-meaning (or at worst amoral) people who act like sadists because they have the wrong model in their heads....What the Fed considers normal, I consider sadistic. Not just this Fed, but earlier Fed’s, and foreign central banks as well. If I knew there was 10% unemployment, I couldn’t sleep at night knowing the markets were predicting only 1% inflation, whereas the target was 2%. I’d keep asking myself; “Why not do more stimulus? We’d improve both the unemployment and inflation situations at the same time.”

Andy Harless [pro-business conservative?]:

How does the Recession allow the government to bail out banks? With the recession going on, people are afraid to do anything risky with their assets, so they keep them deposited in banks, earning no interest. Banks can then invest these deposits in Treasury notes and credit the interest on those Treasury notes to their bottom line, thus improving their balance sheets.

...Now this bailout program is not without its risks. The biggest risk is that the economy will recover, which would be a disaster for the program....So the success of this bailout program depends on avoiding recovery, avoiding increases in inflation expectations, and avoiding major declines in Treasury note yields. Now do you understand why the Federal Reserve Bank presidents — representatives of the banking sector — are the most hawkish voices at the FOMC’s policy meetings?

And of course, Paul Krugman [liberal]:

Why are people who know better sugar-coating economic reality? The answer, I’m sorry to say, is that it’s all about evading responsibility.

In the case of the Fed, admitting that the economy isn’t recovering would put the institution under pressure to do more. And so far, at least, the Fed seems more afraid of the possible loss of face if it tries to help the economy and fails than it is of the costs to the American people if it does nothing, and settles for a recovery that isn’t.

The Fed has very few admirers anywhere on the ideological spectrum these days.

Unemployment Falls Through Economic Growth via Okun's Law

The middle of the depression had some of the fastest growth in US history!

Delong:

[T]he reason the unemployment rate was dropping from its high of 24%... was... serious real economic growth... five of the eight years from ’33 to ’40 [saw] real GDP [grow] by more than 8% a year!...

seven different theories of recession

Grasping Reality with Both Hands
Confront economists' theories of depressions and what (if anything) the government should do about them and you find yourself immediately confronted with what look to be at least seven different theories:

• Monetarism, the doctrine of Irving Fisher and Milton Friedman, that a depression is the result of the money stock falling too low, where the money stock is the economy's sum total of liquid assets that are generally accepted as and held in people's portfolios for the usefulness as means of payment.
  
• Wicksellianism, the doctrine of Swedish economist Knut Wicksell, that a depression happens when the workings of the banking system lead the market rate of interest to be above the natural rate of interest that balances the supply of funds saved and the demand for funds to finance business investment.
  
• Minskyism, the doctrines of Hyman Minsky--and also Walter Bagehot and Charles Kindleberger--that a depression happens because of a panic and a flight to quality, as everybody tries to sell their risky assets and cuts back on their spending in order to try to shift their portfolio in the direction of safe, high-quality assets--which, of course, everybody cannot all do at the same time.
  
• Austrianism, the doctrine that because of past irrational exuberance and over- or malinvestment, that there is nothing of social value a large chunk of the labor force can do other than sit on its hands unemployed and wait for circumstances to change and profitable employment opportunities to open up.
  
• Vulgar Keynsianism, the doctrine that depressions happen because something has reduced the flow of aggregate demand.
  
• Hickianism, something you have forgotten from intermediate macroeconomics courses of a decade or two ago that involves IS and LM curves, which is actually a combination of monetarism (LM) and Wicksellianism (IS).
  
• Post-Keynsianism, which seems to be a combination of Wicksellianism and Minskyism.

The Rise of Finance in America

Read this entire article. Highly recommended. Tells about the rise of finance and the political problems that brings.
The Quiet Coup - Magazine - The Atlantic:

"From 1973 to 1985, the financial sector never earned more than 16 percent of domestic corporate profits. In 1986, that figure reached 19 percent. In the 1990s, it oscillated between 21 percent and 30 percent, higher than it had ever been in the postwar period. This decade, it reached 41 percent. Pay rose just as dramatically. From 1948 to 1982, average compensation in the financial sector ranged between 99 percent and 108 percent of the average for all domestic private industries. From 1983, it shot upward, reaching 181 percent in 2007.

The great wealth that the financial sector created and concentrated gave bankers enormous political weight—a weight not seen in the U.S. since the era of J.P. Morgan (the man).

Three cheers for the death of old economics | Anatole Kaletsky - Times Online: "The dirty little secret of modern economics is that the models created by central banks and governments to manage the economy say almost nothing about finance. Policymakers who turned to academic economists for guidance in last year’s crisis were told in effect: “The situation you are dealing with is impossible: our theories prove that it simply cannot exist.”

The Future of Oil: Four Scenarios

Standard and Poor's

The Gulf goes dry
In this scenario, Iran closes the Strait of Hormuz to oil tankers. Oil prices spike sharply. World oil supplies would be cut by about 20%. World strategic petroleum reserves are tapped extensively, but even so, oil prices rise to $250 per barrel. The world economy moves into recession, on the order of the 1980-1982 downturn. The U.S. is the hardest hit of the major economies, with real GDP dropping 5.2% below the baseline in late 2007, implying a major recession, and the unemployment rate reaching 7%. Consumer price inflation hits 10% next year as oil prices soar. The impact on Europe is smaller, but because the Continent started with weaker growth, the recession is just as big. Japan has a recession of similar size.

Both in terms of the price effect and the supply impact, the models are being pushed well outside their historical range, and the dislocations could be even more painful than this projection implies. This is by no means a worst-case scenario but closer to a best case given the closure of the Strait. We think (and certainly hope) this is an unlikely scenario.

	2004	2005	2006	2007	2008
Real GDP (% chg.)	4.5	3.5	2.7	(1.6)	4.0
Consumer spending (% chg.)	3.7	3.5	2.0	(2.5)	2.7
CPI (% chg.)	2.7	3.4	4.1	9.6	0.2
Core CPI (% chg.)	1.8	2.2	2.6	4.2	4.1
Oil price (WTI) ($/barrel)	41.0	56.6	91.7	238.2	106.9
Unemployment rate (%)	5.5	5.1	4.9	6.7	7.0
S&P 500 index	1133	1207	1218	793	965

structural unemployment vs cyclical unemployment

Brad Delong:

Over at Slate, James Ledbetter says that he cannot referee between the two gangs of economists warring over the causes of high unemployment.

But he is wrong.

He can.

Here is how:

Suppose that you have not cyclical unemployment generated by a collapse in aggregate demand but structural unemployment generated by mismatch, suppose you have a situation in which the structure of demand by consumers is different from the jobs that workers are capable of filling. Suppose--this is Berkeley, after all--that we were in a nice equilibrium in which some workers were baristas making lattes and other workers were yoga instructors teaching classes and that all of a sudden we have had a big shift in demand: that consumers decide that they want few moments of wired, frenetic caffeination and more moments of inner peace.

What would we expect to find happening?

We would expect, first, coffee bars to stand empty as people hoarded their quarters for the next yoga lesson. We would expect coffee bars to fire baristas, and to close down. But we would also expect yoga studios to be crowded, and yoga instructors to be teaching extra classes, and working long hours, and raising their prices, and training ex-baristas to chant properly, do the downward-facing dog and the lizard, and teach others how to achieve inner peace.

The size and duration of the excess unemployment of ex-baristas might be substantial and long-lasting. It takes quite a while to retrain a barista as a yoga instructor. Those seeking training might have a difficult time getting the attention of and apprenticing themselves to the yoga instructors doing land-office business--given how mercenary and grasping and eager to catch the wave of the market we all know yoga instructors to be.

But depression in the coffee-bar sector and unemployment among ex-baristas would be balanced by exuberance in the yoga-studio sector, rising prices for yoga lessons, and long hours and high wages for yoga instructors.

That is what 'mismatch' structura unemployment looks like--one sector depressed with a lot of idle excess labor, a second sector booming with rising wages and prices.

Minneapolis Federal Reserve chair Kocherlakota seemed to believe that our unemployment is structural which would not be affected by Fed policy:

...it is hard to see how the Fed can do much to cure this problem [of unemployment] ...the Fed does not have a means to transform construction workers into manufacturing workers.

As Krugman noted:

...Kocherlakota would have us believe that there’s a big problem of mismatch because manufacturing is trying to hire, while construction has slumped. But here’s the employment reality:

Bureau of Labor Statistics

Manufacturing employment has slumped, not risen — in fact, it has fallen more than construction employment. The problem is lack of overall demand, not worker mismatch.

Benign Bubbles vs Mean Minsky Bubbles

Paul Krugman:

while bubbles are in general a bad thing, just how bad depends a lot on the context — in particular, whether the inflation of the bubble has been accompanied by a big increase in leverage on the part of those buying the inflated assets.

Consider the stock bubble of the late 1990s. It was crazy, and when it popped U.S. households suffered a capital loss of about $5 trillion. This was bad, and helped cause a recession. But it never rose to the level of economic catastrophe.

Similarly, the stock market crash of 1987 had almost zero impact on the economy. A decline in prices is usually a good thing, so the popping of a bubble can be beneficial. The world would be a worse place if tulips were still worth their weight in gold like they were during the great tulip bubble. The crash in oil prices in the 1980s was devastating to big exporters like the USSR and the Persian Gulf, but it was a boon the the world as a whole. The decline in housing prices should make life easier because everyone needs a home and now they are cheaper, but the artificial financial crunch due to leverage caused a much broader problem.

What was the difference? First, a lot of financial institutions — which are highly leveraged — were holding [housing] securities ... So the housing bust undermined the financial system in a way the stock bust never did.

Second, households also leveraged themselves up in the housing boom, in a way they for the most part didn’t with stocks (yes, there were people buying dotcoms on margin, but they were not typical). So the housing bust created a balance-sheet crisis for the household sector in a way that the dotcom bust didn’t.

... the bubbles we should fear are those that lead to leverage, and set us up for a Minsky moment.

Undoing Past Wrongs

Some people think that the current economic problems (housing bubble, etc) were caused by overly loose monetary policy and that the remedy is to tighten monetary policy now.  Loose monetary policy was probably one contributor to the housing bubble (although I don't blame it for the current recession), but tighter monetary policy won't fix the recession.  Even if it were a mistake, doing the opposite thing won't automatically fix anything.  If you injure a friend's foot with an axe while cutting firewood during a wilderness camping trip and it gets gangrene, the best way to save your friend may be to cut it off with the axe rather than to forswear axe use entirely and do without firewood for heat and cooking.  If you drive over a pedestrian, the solution is not to go into reverse and run back over them, but to take them forward to the hospital. 

In the current situation, nobody has an actual model of the economy that explains why higher interest rates (and lower inflation) would be beneficial and yet some  people are calling for it. 

Recessions in nominal vs in real GDP

Matthew Yglesias "A different way of looking at it is to think of the recessions in nominal terms. Here’s Nominal GDP from 1980 to 1985:

The double-dip was associated with some flattening of Nominal GDP growth, but the deviation isn’t gigantic. What’s more, the super-rapid “catch-up” growth in real output that led us out of the recession didn’t involve anything unusually looking in nominal terms relative to the pre-recession trend. What happened was that the composition of nominal growth switched to one that involved less inflation and more “real” growth.

Compare that to more recent events:

That’s an entirely different kettle of fish. In nominal terms, we experienced a dramatically bigger recession than happened in the early eighties. Normally people think of “real” GDP as more important (that’s why they call it real) but for many purposes nominal numbers are very meaningful. My mortgage payments are denominated in nominal terms, as are my cable & phone bills, my salary, and various other contracts I’m involved with. When a huge gap opens up between the actual and trend levels of nominal economic activity, that means the best-laid plans of firms and households are all thrown out of whack. This is probably a situation the Federal Reserve could ameliorate if they were willing to produce enough inflation to push the price level back into line with trend, but if they continue to insist on a policy of opportunistic disinflation the adjustments will take longer.

Who does the Fed work for?

Matthew Yglesias:
As you read about Kansas City Fed President Thomas Hoenig’s plan to increase the unemployment rate by pushing inflation even further down below target, it’s worth asking yourself “How does a person get to be President of the Kansas City Fed?” Well, you get picked by the Board of Directors. And who picks the Board? Local bankers, mostly:

Each Federal Reserve Bank has a nine-member board of directors: The member banks elect the three Class A and three Class B directors, and the Board of Governors appoints the three directors in Class C. Directors are chosen without discrimination as to race, creed, color, or national origin. The directors in each class serve staggered three-year terms.

Class A directors of each Reserve Bank represent the stockholding member banks of the Federal Reserve District. Class B and Class C directors represent the public and are chosen with due, but not exclusive, consideration to the interests of agriculture, commerce, industry, services, labor, and consumers; Class B and Class C directors may not be officers, directors, or employees of any bank. In addition, Class C directors may not be stockholders of any bank. The Board of Governors annually designates one Class C director at each District Bank as chair of the board of directors and another Class C director as deputy chair.

This system has never made any real sense. The Fed’s Open Market Committee is an important maker of public policy. There’s no reason private firms should have such a large role in its governance. But many aspects of Fed governance have escaped scrutiny in recent decades thanks to the perception that the Volcker, Greenspan, and Bernanke era Feds were doing a good job. Increasingly, however, it’s clear that the Fed is not doing a good job—it seems incapable of hitting its inflation target, for example— which should spark increased discussion of the matter.

The People Who Sell Their Forecasts to Paying Clients Believe the Stimulus Is Working - Grasping Reality with Both Hands

I don't know of any firms selling forecasts who think that fiscal stimulus programs don't work. Nor do I know of any real business cycle forecasters. Are there any?

The People Who Sell Their Forecasts to Paying Clients Believe the Stimulus Is Working - Grasping Reality with Both Hands: "Only those who make their nut one way or the other by pleasing Republicans claim that it isn't. Jackie Calmes and Michael Cooper are on the case:

Jackie Calmes and Michael Cooper: Now that unemployment has topped 10 percent, some liberal-leaning economists see confirmation of their warnings that the $787 billion stimulus package President Obama signed into law last February was way too small. The economy needs a second big infusion, they say. No, some conservative-leaning economists counter, we were right: The package has been wasteful, ineffectual and even harmful to the extent that it adds to the nation’s debt and crowds out private-sector borrowing.

These long-running arguments have flared now that the White House and Congressional leaders are talking about a new “jobs bill.” But with roughly a quarter of the stimulus money out the door after nine months, the accumulation of hard data and real-life experience has allowed more dispassionate analysts to reach a consensus that the stimulus package, messy as it is, is working. The legislation, a variety of economists say, is helping an economy in free fall a year ago to grow again and shed fewer jobs than it otherwise would...

- Sent using Google Toolbar"

Matthew Yglesias » The American Recovery and Reinvestment Act Cut Taxes Substantially

Matthew Yglesias » The American Recovery and Reinvestment Act Cut Taxes Substantially: "the main problem facing right-of-center and left-of-center proponents of fiscal stabilization alike, namely that the political mechanism of enacting discretionary stimulus through congress is extremely clumsy and leads to bad policy outcomes. The most helpful thing to do before the next downturn would be to establish in advance a reasonably streamlined way of preventing state and local government from hiking taxes and cutting services in the middle of a recession.

Super-Economy: Japan's problem is supply, not demand (updated)

Super-Economy: Japan's problem is supply, not demand (updated)
...Let's first look at the lost decade, 1991-2000. When the rest of the world was having rapid, IT-fueled growth, Japan was stagnating. Here are the growth rates in real GDP between 1991-2000:

For all the nice years Japan had 9.6% growth compared to 38.7% for the U.S and 22.7% for the EU.15. The U.S grew by an average of 3.7% per year, Japan only 1.0% per year.

But as most of you know Japan is undergoing a rapid demographic transition. The country was and is aging. Because the old and children cannot work, when we want to compare countries with very different demographic characteristics instead of calculating GDP per capita, it makes sense to calculate GDP per working age adult (people aged 15-65).

Whereas the number of potential workers in the U.S increased by 13% during Japans "lost decade" (1991-2000), and by 3% in for example France, the Japanese potential workforce actually shrank during these years. Adjusting for this, the growth in Japan was 9.8%, compared to 16.9% in Germany, 17.3% in France, 16.3% in Italy and 23.2% in the United States. The U.S grew by twice, not four times of Japan (remember that these were the best years of the U.S and the worst years of Japan).

The importance of the demographic transformation in Japan is even more clear if we include the entire 1990-2007 period.

In non-population adjusted figures, Japan's real GDP grew by 26% in total these years, the lowest in the OECD. In comparison the figures are 63% for the U.S and 44% for the EU.15.

But during this period the U.S saw it's potential labor force (the number of people between 15-65) increase by 23% and the EU.15 by 11%, while Japan had a decrease of 4%.

Between 1990-2007, GDP per working age adult increased by 31.8% in the United States, by 29.6% in EU.15 and by 31.0% in Japan. The figures are nearly identical!

Japan has simply not been growing slower than other advanced countries once we adjust for demographic change.


Also notice Italy (who does better than we think) and Ireland (who does worse, much of the growth was due to their young population).

Nor did productivity grow any slower in Japan than Europe.

The Triumph of the Stupidly Optimistic

The Triumph of the Stupidly Optimistic
How many jobs are there where being wrongly optimistic for ages gets you promoted? I offer you ... equity analysts, who have, on average, overestimated S&P 500 earnings by 2x for a generation.

A Cross Of Gold - Paul Krugman Blog - NYTimes.com

A Cross Of Gold - Paul Krugman Blog - NYTimes.com
I’d add another point: the 19th-century economy had much more flexible prices and wages than later came to be the case — not, primarily, because of different institutions, but because it was still largely an economy of small, self-employed farmers. More than half of US workers were in agriculture up until the 1880s. Peter Temin has told me — I can’t find it in a quick search — that the United States didn’t start having modern recessions, with large declines in real GDP, until the Panic of 1873; Britain started having them much earlier, because it became an industrial economy earlier.

High Income Disparity Leads to Low Savings Rates « naked capitalism

Citigroup Plutonomy reports in 2005 and 2006 by Ajay Kapur, Niall Macleod, and Narendra Singh as reported by Yves Smith:

In a plutonomy, the rich drop their savings rate, consume a larger fraction of their bloated, very large share of the economy. This behavior overshadows the decisions of everybody else. The behavior of the exceptionally rich drives the national numbers – the “appallingly low” overall savings rates, the “over-extended consumer”, and the “unsustainable” current accounts that
accompany this phenomenon….

Feeling wealthier, the rich decide to consume a part of their capital gains right away. In other words, they save less from their income, the wellknown
wealth effect. The key point though is that this new lower savings rate is applied
to their newer massive income. Remember they got a much bigger chunk of the
economy, that’s how it became a plutonomy. The consequent decline in absolute savings for them (and the country) is huge when this happens. They just account for too large a part of the national economy; even a small fall in their savings rate overwhelms the decisions of all the rest.

Yves here. This account rather cheerily dismisses the notion that there might be overextended consumers on the other end of the food chain. Unprecedented credit card delinquencies and mortgage defaults suggest otherwise. But behaviors on both ends of the income spectrum no doubt played into the low-savings dynamic: wealthy who spend heavily, and struggling average consumers who increasingly came to rely on borrowings to improve or merely maintain their lifestyle. And let us not forget: were encouraged to monetize their home equity, so they actually aped the behavior of their betters, treating appreciated assets as savings. Before you chide people who did that as profligate (naive might be a better characterization), recall that no one less than Ben Bernanke was untroubled by rising consumer debt levels because they also showed rising asset levels. Bernanke ignored the fact that debt needs to be serviced out of incomes, and households for the most part were not borrowing to acquire income-producing assets. So unless the rising tide of consumer debt was matched by rising incomes, this process was bound to come to an ugly end.

The US shows a negative relationship between income concentration and savings (data points 1929-2002, with 1940-1944 excluded, which is defensible, given widespread wartime rationing):

Canada shows the same downward sloping relationship, as does the UK (although the authors have to massage the data a bit more, with one downward sloping line for the period before 1990, with a shift for the 1990s period).