An ongoing review of politics and culture

Crime Shouldn't Pay; Working Should

The American Conservative has an interesting cover story by the always intriguing Ron Unz, which you might have skipped because of the terrible title.

That title is: “Immigration, the Republicans and the End of White America.”

Now, you’d think that, with such a title, the article would be about how awful immigration is because it’s leading to the end of white America and of the Republican Party (the presumed protectors of white America). But that’s not the article’s point at all. Rather, Unz’s argument is that “white America,” if it isn’t a thing of the past already, is going to be one in the near future no matter what; the demographic change, good or bad, is already baked in. Campaigns based on outright demonization of immigrants, whether or not they are morally wrong, are a practical mistake, because they will solidify the perception that the GOP is a white ethnic party.

However, Unz goes on, mass immigration is a problem because, by keeping wages persistently low at the lower end of the scale, it is leading to an economically more stratified society, which may be a bad thing in its own right but also leads to persistent economic and political problems.

Unz’s solution, therefore, is to tackle the problem from the other end. Rather than try to restrict immigration, legislate a rise in wages. With a national minimum wage in the $10-12 range, the jobs that currently go to low-skilled immigrants from much poorer countries would go one of three places: either overseas (where they might wind up employing the same people in their home countries), or away altogether (substituting capital for labor through innovation), or to natives willing to do the work if it paid a more reasonable wage. Enforcement would still be an issue, of course, but the constellation of interests in favor of “enforce minimum wage laws” would be much stronger than that in favor of “enforce immigration laws.” Labor unions that are ambivalent about mass immigration (immigration holds down wages, but increases the number of public-sector jobs) would be unequivocally in favor of enforcing minimum wage laws. Hispanic politicians, who generally favor a high-immigration regime, also favor a regime that is more friendly to poor immigrants once they are here, and that leaves them less-subject to economic exploitation. They would certainly also be on the “enforce the minimum wage” side of the fence. And so forth.

I think Unz’s argument merits real consideration. It’s very much in the same universe as two reform proposals that I’ve long found attractive: replacing some or all of the payroll tax with a value-added tax, and replacing the existing patchwork system of visas with a simple auction, the proceeds of the auction going to offset the costs that areas with high levels of immigration bear due to rapid population growth (and, in particular, rapid growth in the relatively poorer segment of the population). The payroll tax is no big deal for a large employer, but it’s a meaningful burden on, for example, household employers, and creates an incentive to hire people off the books – which, in turn, is easier to do if the employees aren’t here legally. A VAT would bring those wages (when they are consumed) under the tax umbrella without creating a disincentive to employment; some kind of payroll-tax exemption for very small employers, meanwhile, would eliminate the incentive to hire illegal immigrants for these jobs.

My other proposal, a visa auction, would open the “front door” of legal immigration (the process for getting a visa to work at a large firm would become trivial; instead of hiring a lawyer, taking out ads, and bearing the costs of endless bureaucratic delays, you’d just pay the cost of the visa and be done with it) while simultaneously aligning forces correctly for closing the “back door” of illegal immigration (someone who employed an illegal immigrant would be illegally depriving the government of revenue; the IRS is very good at catching and punishing people who do that). Moreover, the auction would bring in revenue, which would not only offset the social costs of immigration but would create an incentive to open the “front door” to the optimally-wide level (if we could bring in billions of dollars per year by increasing the number of visas, Congress – and the electorate – might feel differently about the subject than now, when costs are socialized and benefits are largely privatized). Finally, you’d expect a visa auction to uptier the average skill level of the immigrant population relative to the current system of making it very difficult to hire skilled immigrants on the books, and relatively easy to hire unskilled immigrant laborers off the books.

A higher national minimum wage would be complementary to these kinds of reforms. Yes, it would impose a burden on very small employers – but if you also eliminated the payroll tax for such employers, the net effect might not be so significant. A visa auction system would be vulnerable to parochial lobbying by, for example, agribusiness seeking special “seasonal” visas at a lower price. But if the minimum wage were hiked as well, those employers would have to lobby for an exemption to the minimum wage as well – a taller political order. The difficulty of that lobbying effort might be enough to tip the balance in favor of restructuring their enterprises to work within the law rather than trying to change or evade the law so their operations can continue as currently structured.

Wouldn’t raising the minimum wage increase unemployment? Isn’t that a terrible idea right now? Well, maybe, but not necessarily. Businesses that had to pay a higher minimum wage would have to do one of the following things: (1) raise prices to compensate; (2) apply capital in innovative new ways to reduce the need for the job and/or make the job more productive, so it “earns” a higher real wage; or (3) shut down or relocate operations. If the inflationists are right, and what we need is coordinated expectations of higher nominal prices, then (1) is exactly what we need in our current economic circumstances. If I’m right, and what we need is coordinated expectations of higher real wages, then (2) is exactly what we need in our current economic circumstances. To the extent that (3) means that instead of people coming from Mexico, capital flows to Mexico and the people stay there, then a reduction in the growth of the American workforce doesn’t lead to higher American unemployment. And to the extent that (3) means that smaller operations simply go out of business, we should think about offsets to prevent that happening (such as payroll tax relief).

But I’d also turn the question around. Does anyone think that unemployment would drop significantly if nominal wages at the low end of the wage scale dropped suddenly? If the inflationists are right, we need real wages to drop to get out of the recession, but that’s across the board – a very different proposition from saying that declining real wages at the low end of the spectrum are beneficial. The opposite, in fact, may be true. Deflation benefits creditors at the expense of debtors. Debtors are, generally, the folks to the left of the median in terms of wages. So if those wages come under pressure, but wages at the other end, where the creditors are, remain stable, then you’re exacerbating the effects of deflation, not counteracting them.

I’m not so much endorsing Unz’s specific proposal – or even my own ideas – so much as saying that we should be thinking about the problem in terms of the title of this post. Crime shouldn’t pay. Working should. The best way to make that true isn’t to build a huge punitive infrastructure organized around stopping some people from working (an infrastructure which is then only applied fitfully and inconsistently, as any punitive infrastructure will be when you’re dealing with a large class of lawbreakers). It’s to align incentives properly. Make breaking the law more expensive. Make following the law more remunerative. And align the law more sensibly with what’s good, in general, for those from whom the law’s authority ultimately derives.

Back To The Future: Healthcare Edition

Health care really isn’t my issue, but I’m going to wade into it anyway. This weekend, Matt Yglesias (probably my favorite blogger to argue with) said:

I think that too often people’s pet concerns about health care costs point to things that increase the level of health care spending rather than the high growth rate of health care spending.

Think about the market for cars. Cars are pretty expensive. They’re sold at a wide variety of price points. And quality-adjusted prices for cars don’t show any noteworthy crazy trends. Now suppose the government made cars tax deductible, what would happen? Well I assume that at the margin people would start buying more expensive cars. So for a few years, car spending as a share of GDP would accelerate. But pretty soon the American automobile fleet would have turned over and the acceleration would stop. The subsidy, in other words, provides a one-off boost to automobile spending but it doesn’t do anything to change the underlying cost structure of the system.

Health care, I think, is like that. But what’s really distressing people about health care isn’t the absolute level of spending, it’s the very rapid pace at which prices are rising.

Except that, if we look at spending on an internationally comparative basis, and look at percentage changes here and elsewhere, they aren’t rising very rapidly here. From 2002 to 2008, US per-capital health-care spending grew a bit faster than five and a half percent a year. That puts us in the middle of the pack of industrialized countries; Dutch spending grew nearly 7% per year, Canadian spending more than 5.7% per year, and UK spending more than 7%; by contrast, French spending grew less than 4.5% per year and Swiss spending grew a bit more than 5%. A similar picture obtains if you look back at the previous six-year period; American health-care spending per-capita grew a bit under 6% per year in that period, a slower rate of growth than the Dutch, British, Danes or Swedes, but faster than the French or Swiss, much faster than the Germans, and slightly faster than the Canadians.

The problem is not primarily the high growth rate of our health-care spending; the problem is precisely the high level of our health-care spending. Which in turn means that a growth rate that looks reasonable when compared internationally is unsustainable in terms of the bite it takes out of the domestic economy.

We got into this mess primarily because our per-capita health-care spending growth rate didn’t slow as quickly as our peer countries. Back in 1972, American health care was already dramatically more expensive on a per-capita basis than the British system, which operates very differently. But it was only modestly more expensive than Danish, Swedish, Canadian, German or Swiss health care. And health care expenditures were rising across the board in this period. From 1972 to 1978, American health care expenditures per-capita grew by a bit over 12% per year. But German per-capita expenses went up by 14%. British per-capita expenses went up by just under 12%. French per-capita expenses went up by over 13%. Swiss expenses went up by 11.3%. And this was the era of double-digit inflation; similar increases in prices and wages in all sorts of sectors were normal.

The problem is that America maintained a very high rate of growth in per-capita health care expenses well into the 1980s, well after inflation in general was tamed, and didn’t bring our growth rates down to internationally comparable levels until the 1990s. From 1978 to 1984, America’s per-capita health-care expenses grew nearly 12%, versus a bit over 8% for the Netherlands and a bit over 9% for Germany. In the next six-year period, America’s expenses grew over 9%, versus less than 7.5% for the Netherlands and a bit over 5% for Germany. Similar comparisons obtain with Switzerland, Canada, Belgium, the UK, France. It was in the 1980s that American health care went from being modestly more expensive than other wealthy countries with mixed public-private systems, to being wildly more expensive than other wealthy countries with mixed public-private systems.

Because we’re growing off such a high cost base, even as we have dramatically reduced the rate of growth of per-capita health-care expenditures the absolute bite we’re taking out of GDP is getting out of hand. From 1978 to 1990, German heath-care expenses as a percent of GDP did not change; they were 8.4% at the start of that period and 8.3% at the end. During the same period, American health care expenses as a percentage of GDP went from 8.4% – the same as Germany – to 12.4%, a nearly 50% increase in relative share of GDP. From 1990 to 2008, German health-care expenses have increased from 8.3% to 10.7%. Looked at one way, that’s a 2.4% increase – looked at another way, that’s a 29% increase in relative share. During that same period, American health care costs went from 12.4% of GDP to 16.4% – a 4% increase. But that’s only a 32% increase in relative share – very comparable to Germany. The high cost base means that internationally comparable growth rates in health care expenses, measured either in per-capita terms or as percent of GDP, are unsustainable for the United States.

To solve our health care problem, we have to do one of three things that no other developed country is doing.

- Either we have to grow nominal GDP much more rapidly than other developed countries while holding health-care cost inflation down to levels comparable to other developed countries.

- Or we have to slow health-care cost growth to rates much lower than those achieved by our peer countries, and keep those growth rates low for an extended period, without, in the process, sacrificing growth in nominal GDP.

- Or we have to take a one-time axe to health-care costs in some fashion so that we can, from that point, grow from a more manageable base.

I think any of these is a tall order for reformers of either the right or the left. Not because the reforms are poorly designed, but because restructuring more than 15% of the economy is hard, and when that restructuring has to be led by the government it’s even harder, because there are a lot of ways to put pressure on the government not to do it. If we could switch to the Canadian system tomorrow, and thereby achieve Canadian levels of cost control, this would not solve our problems. We would not only have to switch to the Canadian system, but then use the government’s monopsody power much more aggressively than the Canadian government has to. Static international comparisons – we spend twice as much per capita or as a percent of GDP as this or that country, without getting better health-care outcomes – are probably not as relevant for figuring out where to go as elucidating the levers that would make it possible to get from here to there. Because whatever happened in the 1980s happened. We can’t go back and make it un-happen.

Diverting Money Into Speculation is Contractionary, Now Or Later

Fed Chairman Yglesias says:

I’m going to have the Federal Reserve purchase lots of stuff, with the quantities of the stuff, the nature of the stuff purchased, and the timing of the purchases done at my discretion. And I’m going to keep doing it until unemployment is down to 6.5 percent or so unless core inflation gets over 5 percent. If core inflation goes over five percent, then I’ll conclude that my estimate [of what constitutes full employment] was off and we need to reconsider. But as long as inflation is below 5 percent and unemployment is above 6.5 percent, my conclusion will be that the Fed needs to buy more stuff and buying more stuff is exactly what we’ll be doing.

Then what happens? It’s like FDR and the gold standard redux. A minority of rich businessmen will think to themselves that this is a great idea, and revise upwards the quantity of potential customers for their products or services in the medium term and start investing to hire workers and equipment while idle resources are still cheap and plentiful. The majority of rich businessmen will think to themselves that this guy is an insane socialist who’s going to produce runaway inflation, and will start ditching cash and low-yield dollar-denominated financial instruments in favor of some mix of foreign currencies, commodities, and concrete assets like bigger houses and fancier yachts. Both the majority who think I’m an idiot and the minority who think I’m a genius will be taking steps that boost real output.

I want to poke some holes in the notion that the actions of the majority in this hypothetical will assist in the recovery.

Let’s take an extreme scenario: the majority takes all their money out of circulation and puts it into gold. Gold’s the classic inflation hedge. Why shouldn’t they buy gold if they think the dollar is going to be debased? Obviously, gold isn’t going to absorb 100% of the cash currently in low-yielding financial instruments – but what if it did? What would be the economic consequences?

Well, that money would now be out of circulation. The Federal Reserve would have added a certain amount of money to the economy, by buying a variety of debt instruments. The sellers of those instruments, instead of putting the proceeds of their sales to work generating employment and income, stuffed it in a shiny yellow mattress. The Fed has expanded its balance sheet without boosting the economy in any way – but the market is aware of this expanded balance sheet, and aware that, eventually, it has to be unwound. And thus the net effect is contractionary.

As I say, this won’t actually happen. So what if some of the money goes into other assets that are likely to perform well in an inflationary climate – oil, say. Will that boost economic activity? Quite the contrary. Because of America’s dependence on oil as an economic input, a speculation-driven spike in oil prices would be an immediate negative shock to the economy. Now, if the rise in prices was driven by higher end-user demand, it might boost more investment in things like refining capacity. But if it’s driven by inflation concerns, not so much. You might still get an increase in extraction efforts, and some increase in employment as a consequence. But mostly not; oil prices are high enough already that there’s a lot of investment going on in this area. Incremental increases in the price of oil would probably just be a tax on productive activity that uses oil as an input, distributed into the coffers of entities who already own or lease oil properties. Again, the net effect is contractionary.

What about land? Surely increases in the price of land would be a good thing; after all, the collapse in the housing market is what got us into this mess in the first place. Well, don’t be so quick. Yes, an increase in land prices would help alleviate the problem of so many underwater mortgages. But expensive housing is, all else being equal, a drag on economic activity, a barrier to establishing a household. Yglesias himself has pointed out that the insane housing boom of the 2000s was mostly a boom in land prices; the boom in housing construction was well within historic norms (albeit building went quite nuts in specific regions like California’s Inland Empire and south Florida). In current conditions, reflating the housing bubble will alleviate the debt overhang, but it’ll leave us with a new problem: housing prices that are out of line with reasonable expectation for future wages, which would either imply another crash in the future (which would precipitate another recession) or a long-term economic drag. Because the bottom line is: land as such doesn’t generate much economic activity. As they say: we aren’t making more of it. So rises in land prices, unlike rises in the price of, say, automobiles, don’t create an incentive to produce more land more cheaply.

So how can speculative bubbles be expansionary? Why did we see strong NGDP growth in the middle of the 2000s, when this was substantially underwritten by the housing bubble? Well, because higher prices made it possible for incumbents to spend their increase in paper wealth through debt, and the combination of low interest rates, poor credit standards and exotic products made it possible to increase debt at little or no increase in the cost of debt service, at least for the short term (many of these exotic products raised the service cost substantially down the road). This produces a short-term increase in demand, but it’s borrowed from the future. Now, that’s fine – if you’re borrowing to increase your earnings capacity in the future. Then you come out ahead. But that’s not what we were doing in the 2000s.

The crash and subsequent recession are a consequence of the false growth of the 2000s. To the extent that monetary expansion fails to create real economic activity, but instead fuels speculation, it’s creating new economic problems. Those problems might be immediate – if they amount to alternative forms of money stuffed in mattresses – or they might take a while to manifest – if we dig our way out of our problem by reflating the housing bubble, for example, then we’ll have the bubble to deal with.

Chairman Yglesias, in other words, could, by pursuing an inflationary strategy, actually push the NAIRU up even as he pushes unemployment down. Instead of 4% inflation and 6.5% unemployment, he could wind up with 5% inflation and 8% unemployment. And then he has a problem.

I don’t know how much of the monetary stimulus will “leak” into this kind of unproductive speculative activity, and neither does he. Some of it will. If very little does, then the Yglesias strategy will work. If lots of it does, it’ll backfire – badly. But I do think it’s a mistake to be sanguine that whatever the holders of cash do in response to rising inflation expectations will assist in the economic recovery.

And that’s why I keep coming back to the need to tackle the structural problems in the economy. Among other things, tackling these will make monetary stimulus more effective – because they will provide a rationale for diverting money into productive activity rather than into speculation.

Mike Konczal Makes Cool Venn Diagrams

Check ‘em out.

Based on what I’ve written before, I agree with some combination of the lower-right segments of both the demand-side and supply-side charts: I think we need to tackle the overhang of consumer debt directly (rather than by trying to reinflate the housing bubble through monetary policy) and I think we need to take actions to improve labor productivity, which means putting people directly back to work (nobody is less productive than somebody unemployed), investing in human and physical capital, and identifying ways to reduce friction in the labor market (some of which will mean changing or even increasing the way government intervenes – for example, in the health insurance market – and some of which will mean the opposite, reducing regulations of various sorts).

I’m more skeptical of the top side of the demand-side chart (what we need is more inflation) and much more skeptical of the left side of the supply-side chart (basically, explanations that blame the Obama Administration’s responses for increasing “uncertainty”).

Rules Are Good But Monetary Policy Is Hard

This is perhaps a long-winded way of saying that I now think Scott Sumner and David Beckworth have been right all along and we need to ditch talking about “inflation” in favor of something that means “nominal GDP.” I think “total spending” may be the right turn of phrase.

I’m glad Matt Yglesias has declared himself on this point, so I now know what position I’m arguing with when I argue with him.

My reasons for hesitancy about endorsing nominal GDP as the target for monetary policy remain the same:

- It’s a fairly radical departure from established practice (although an interesting one!).

- It perversely “punishes” spurts in productivity (which increase real growth) with higher interest rates, and “rewards” drops in productivity (which reduce real growth) with lower interest rates; similarly, it calls for looser money when there’s a commodity-related inflationary shock (such as an oil spike) because such shocks reduce NGDP growth even though they (temporarily) increase inflation – and for tighter money when the opposite happens.

- It implies either very volatile interest rates (as expectations for NGDP are more volatile than inflation expectations), or unrealistically good forecasting of NGDP, or overly slow responses (we didn’t realize how badly NGDP had dropped in the recent recession until well after the Fed acted). Scott Sumner thinks that a robust NGDP futures market could give the Fed the tool it needs to see changes in expectations swiftly, and respond accurately. I’m more skeptical; the stock market is a pretty good proxy for such a market, and the stock market predicted (as the saying goes) twelve of the last five recessions. People seem comfortable with TIPS as a guide to inflation expectations, but again: inflation expectations have been less volatile than nominal GDP growth expectations.

My hesitancy about “catch-up” spending growth is something I’ve also articulated before: I don’t think there is a symmetry here. I haven’t heard Yglesias say that one problem with the 1980s is that interest rates were consistently too low, and that we needed to keep nominal spending well below 5% for a period to “catch up” with the fact that we had such high nominal spending in the 1970s.

But I don’t feel the need to present a strenuous objection to an NGDP rule. It’s a rule. If I understand right, Scott Sumner thinks it was effectively the rule being followed under the Greenspan Fed in the 1990s, though Greenspan never formally adopted a rule of any kind. Then again, Taylor thinks Greenspan was following his rule. So during the most successful period of central bank management in recent history – we got stable growth, low inflation, and an unemployment rate down to levels not seen since the early 1960s – we don’t know what rule was being followed. Which – maybe – suggests that underlying economic conditions were favorable enough that monetary policy was simply easier in the 1990s than it had been before or would be subsequently.

Which is a big part of why I am resisting the call to focus so much on monetary policy as the solution to our current economic problems.

And About Those Structural Imbalances

I think Matt Yglesias is closing in on a crucial difference between two sides in this debate about how to get out of our current economic mess, a difference that doesn’t divide neatly along a right-versus-left axis.

On the one hand are people who say: we’re in a funk because of a massive hit to aggregate demand. What caused that hit – presumably the massive financial crisis triggered by the fall in housing prices – is less important than the fact of the hit. Monetary policy has the tools to reduce the attractiveness of holding money. If money is less attractive, then goods and services become relatively more attractive, so aggregate demand goes up. So the Fed should use those tools to dig us all the way out of the recession, all the way back to full employment. Then we can talk about structural stuff, ways to make the economy more efficient as well as ways to better distribute the gains from increased efficiency.

On the other hand are people who say: we’re in a funk because of a massive hit to aggregate demand, but the cause of that hit needs to be fully understood so that we can solve the problem correctly. The proximate cause of the hit to demand was the banking crisis. The proximate cause of the banking crisis was a drop in housing values. But the broader cause of the crisis was that consumption growth in the 2000s was overwhelmingly driven by rising consumer debt. Consumer debt was rising because wages were not keeping up with the rising cost of living. The large gains in global productivity in the 2000s, to the extent that they accrued to the United States, were captured as what amount to rents by the health and financial sectors.

Yglesias says:

The way this story goes is that we had steady productivity gains going back 10-15 years, related both to Asian manufacturing and to technological change. This freed up workers to go do other things. But instead of putting the workers to productive uses, they went off to toil in an unsustainable boom in housebuilding. When this boom collapsed, what we were left with was not 1-2 years of productivity growth but an entire decade’s worth of displaced labor. The entire growth experience of the aughts wasn’t so much wiped out in the recession as revealed to have been an illusion in the first place. Now we need to essentially start over, and restructure the American economy to find useful ways to employ people.

But the illusion wasn’t that we engaged in a binge of housebuilding. It’s that we engineered a massive speculative bubble in land, and then borrowed against those appreciated values to finance current consumption. That was the illusion.

The structural change that didn’t happen was moving American labor up the value chain so that American workers (not just Chinese workers) were seeing rising productivity, which would be more likely to drive rising American wages, and combating the financialization of American industry that wasn’t just driving more income into the hands of the already wealthy but, more specifically, seeing finance capture a larger and larger percentage of aggregate American profits.

Both of these are hard tasks. China still has a whole lot of low-hanging fruit to pluck. (As do India, Indonesia, Vietnam, Brazil, Turkey, Nigeria . . . it’s a big world out there.) Their productivity gains are doing wonderful things for world wealth, but China is going to capture the lion’s share of those gains. And the impact on the United States and other developed countries will be brutal if we don’t figure out how to make our service sectors more productive and move up the value chain ahead of these rising economic powers. And financialization is easy to diagnose but difficult to combat in a world of globalized finance. The countries that have done the best at it are relatively small economies (like Canada) that aren’t particularly good models for a country like the United States.

These problems, already manifesting themselves in the 1990s, were completely unaddressed in the 2000s. If anything, they were exacerbated. But we still saw a recovery in demand because of rising housing values.

That was the illusion. When the illusion went away, ordinary Americans experienced a sharp shock to their expectations of future wealth. In aggregate, they did not believe they could consume at the level that they had been – because their previous consumption was financed by debt backed by an asset that was now depreciating, not appreciating.

To combat the recession, yes, we need to avoid falling into outright deflation. But once we’ve achieved price stability, monetary policy has done its job. And that won’t solve the whole problem. It didn’t after the last, much milder recession – inflation was already picking up in 2004, and yet unemployment had barely budged. What brought down unemployment after that was the debt-fueled rise in consumption. That’s the experience we don’t want to repeat.

The amount of inflation it would take to get out from under the mountain of consumer debt we have accumulated is not to be contemplated. The amount of savings it would take is similarly not to be contemplated; that huge spike in savings is what is prolonging the recession. To get out from under the debt will require clearing the market, which in turn means government intervention in the housing finance market. Those tools exist; we should use them, even if it means we have to bail out the banks again.

But we’d still have to convince people that they can rationally expect higher wages in the future. And I really do believe that the only way to do this is to tackle some of the structural problems in our economy as outlined above. I’m open to what are considered right-wing and what are considered left-wing approaches to achieving those goals – as, I believe, is the Obama Administration, though I don’t think they’ve put a whole lot of energy behind any of them.

That’s the fundamental divide between myself and those who advocate a policy of “boost aggregate demand now and worry about the fundamentals later.” I think we need to understand why we had such a big hit to aggregate demand in order to boost it without causing a bigger problem down the road. It’s not a left-versus-right debate. I count on my side of the debate Jeffrey Sachs, Paul Volcker, Joseph Stiglitz and, it appears, President Barack Obama. If anything, it’s mainly a debate within the left.

Another Post About Monetary Policy

Just to clarify my views a little more, the following policies are not equivalent to each other:

1. There should be no discretionary monetary policy; currency should consist of or be backed explicitly by assets such as precious metals.

2. Monetary policy should exclusively be concerned with combating inflation; recessions are caused by structural changes in the economy, and monetary policy should ignore them.

3. Monetary policy should be concerned with price stability – defined as a low rate of inflation to stay above the zero bound below which conventional monetary policy doesn’t really work. When inflation gets too low, the central bank should create more money; when it gets too high, it should take money out of circulation. Outright deflation, meanwhile, should be fought aggressively with every tool at the central bank’s disposal. This goal – stable, low inflation – is what produces the best results in terms of long term growth, and is therefore also the best way for the central bank to deliver on its mandate to achieve full employment in addition to price stability.

4. Monetary policy should be concerned with price stability, but this should be understood as price stability over a period of time, such as a decade. If inflation has been too low for a period, the central bank should aim for higher inflation to “catch up” with where the price level would have been with stable inflation. Presumably, if inflation has been too high for a period, the central bank should aim for lower than usual inflation to catch up (catch down?) with where the price level would have been in the absence of the inflationary period.

5. Monetary policy should balance the goal of price stability with the goal of maintaining low unemployment. The central bank should keep an eye on both indicators; when unemployment is very low, that should motivate the central bank to have a lower inflation target; and when unemployment is high, that should motivate the central bank to have a higher inflation target. Anything less than full employment should be understood as a prima facie indicator that inflation is too low.

6. Monetary policy should not target inflation or unemployment but rather aggregate spending or nominal GDP. When nominal GDP drops below target, whether due to a drop in real growth or a drop in inflation, the central bank should ease; when nominal GDP rises above the target, whether due to a rise in real growth or a rise in inflation, the central bank should ease. The implications, among other things, are that a rise in productivity growth should make the central bank more vigilant about inflation, and that external shocks (such as spikes in commodity prices) that produce more inflation should prompt the central bank to ease, rather than tighten (since they actually cause a drop in NGDP – the hit to real growth more than offsets the spike in inflation).

In this space, I’ve been arguing for proposition #3.

Proposition #1 is, in my view, a position held only by cranks.

Proposition #2 appears to be the position held by a number of GOP politicians, including Governor Perry. I haven’t heard anybody who is actually involved in monetary policy or who is a professional economist advocate this position. If Austrian school economists believe that deflation isn’t a monetary phenomenon, then I stand corrected. In any event, I reject this proposition completely.

Proposition #3 is what I would call a conventional conservative monetary policy view. I’d count most versions of the Taylor Rule as falling within this rubric, notwithstanding the fact that the output gap is a factor in some versions of said rule. I’d also say that arguments about whether or not to have an explicit inflation target, and whether that target should be 1% or 2% or 3% in general (the goal being to have inflation be as low as possible without significant risk of dropping below zero), also fall within this rubric. I don’t think I’ve really made arguments in favor of or against a particular inflation target, or whether inflation targeting is the best way to achieve the goal of price stability.

Proposition #4 I object to mostly on the grounds that, in practice, it would be asymmetric. You could have catch-up inflation, but never catch-up deflation (the latter would be too economically destructive). Because of this, I suspect that in practice it would result in higher inflation on average than the stated target. This, in turn, would undermine confidence in the ability of the central bank to maintain stable prices, and you could wind up in a rising spiral of inflationary expectations.

Proposition #5 sounds to me like a recipe for a back-to-the-70s inflationary spiral. What Paul Volcker was warning about in his recent Op Ed. In my preferred terms, inflation above some low and stable number negatively impacts real growth. Since the goal is to get nominal growth (aggregate spending, aggregate demand) up, this negative feedback means that you need more inflation than you would think to get the result you want. This higher inflation then becomes permanent – if you tried to return to price stability, you’d hit an economy with already low real growth rates with a recession. So, anyway, I’m strongly opposed to this proposition, just as I am strongly opposed to Propositions 1 and 2.

Proposition #6 is the intriguing hobby horse of Scott Sumner and is certainly worth exploring. I’ve raised my concerns about it with him before – nominal GDP is more volatile than inflation expectations, so this would mean monetary policy would become more volatile; moreover, precisely because it’s more volatile, it’s harder to predict, so you might get it more wrong than traditional monetary policy does; finally, it seems to demand perverse actions like “punishing” higher productivity with higher interest rates and “rewarding” drops in productivity with lower interest rates, and it would mean reading commodity price signals in the opposite way that they are usually read (higher commodity prices would mean a hit to real growth, and so would prompt easing rather than tightening). I guess I really hope some small economy adopts this policy so we could study a real-world example, but it feels kind of a radical experiment for a major economy like the United States or the EU.

I’m laying out all these alternatives because the advocates of greater easing have generally been wildly inconsistent about the rationale for greater easing which, I think, has hurt their case. The strongest case for another round of quantitative easing is that we are at greater risk now of renewed deflation than a rise in inflation. I think a very good case can be made for that proposition. (My main response would be that the major reason why we are at risk of deflation is the situation in the Euro-zone, and that unilateral easing by the United States could well exacerbate that situation. But if we really are at risk of renewed deflation, it wouldn’t be hard to convince me that we need a new round of QE.)

And sometimes advocates of greater easing make that case. Or, sometimes they make the case that we could have looser monetary policy without sparking inflation. I take that to be a version of the “we’re at risk for deflation” case: nominal prices and wages haven’t fallen yet – but they will if the economy doesn’t pick up soon to support them at current levels.

But sometimes they make the case for one of the other propositions above, either 4 or 5 or 6. And I can’t stress enough that these are inconsistent views.

Pundits and politicians have the luxury of saying “we need more inflation” without actually articulating a more general monetary policy. But central banks do not. If the advocates of higher inflation don’t pick an actual policy, and accept its implications for different economic conditions, then effectively they are advocating Proposition #5: let inflation rise until unemployment falls below some target level. Since I believe that’s a policy that’s proved catastrophic before, I have to push back.

In general, it’s a good idea to have as many arguments in your quiver as possible. So I understand the impulse to argue in the alternative: we need higher inflation because a 2% target is too close to the zero bound, or because we need to catch up to make up for past deflation, or because we’re at risk of falling into deflation again, or because we should be targeting NGDP and not inflation in the first place, or because unemployment is a bigger problem now than inflation is. Whatever rationale you like: so long as we get higher inflation.

But precisely because these positions are inconsistent, and would therefore mean different behavior in different economic conditions, even if they all agree right now, the central bank cannot adopt them all. They cannot argue in the alternative. They have to have a rule. And if you’re trying to influence the thinking of the central bank, it might make sense not to argue in the alternative in this way, but rather to argue for a position that the bank could actually adopt.

And this applies in spades to the other side of the aisle. So let me just say that letter GOP congressional leaders wrote to the Fed is simply outrageous. Outrageous, that is, if you think the Fed should actually be independent of political influence. It is as nakedly partisan a move as Nixon’s infamous deal with Arthur Burns#.

I sincerely hope nobody thinks I’ve been expressing skepticism about outright advocacy of higher inflation as the solution to the long employment recession because I want President Obama to fail to be reelected. I voted for him last time, and I’m more likely than not going to vote for him again. And, moreover, it seems to me that President Obama agrees with my view on the very question we’re discussing – namely, whether we need to address the long-term growth prospects of the economy to actually solve the short-term unemployment problem, as opposed to the whole problem being “monetary policy is too tight.” So why wouldn’t I support him?

I just wish he were doing more about those long-term growth prospects.

Zero Taxes

A lot of economists believe that we’re in a demand-side recession and that a good idea to do fix that would be to do fiscal stimulus. Stimulus spending has some problems, however: for various regulatory reasons it’s hard to do quickly, which is important for stimulus (see e.g. Megan McArdle here on the Obama jobs plan), hard to do effectively (i.e. in a way that will get people to spend money, and preferably with a high multiplier), and some people fear there’s a risk the spending could become a permanent baseline instead of a temporary increase.

So here’s a modest proposal: why not abolish all taxes, for a year?

To be sure, this isn’t something, say, Argentina can do, but it’s certainly something the United States can do, because it holds the world’s reserve currency and so can fund any level of deficit indefinitely. So why not 100% deficit?

I think it’s hard to argue this wouldn’t be stimulative. A lot of people would bring a lot of taxable things forward so as not to get them taxed the year after but I view this as a feature, not a bug. It might cause some inflation, but again, in the current predicament — feature, not bug. It would get US companies to repatriate their cash.

Obviously this would increase the debt, but would it increase it by really that much? I haven’t run the math, but if this stimulus succeeds in kick-starting growth (and if it doesn’t, nothing will), there’s a plausible scenario in which the long run the US would accumulate less debt than in a lost decade scenario.

Jeffrey Sachs: Welcome To the Hard-Money Paleo-Liberal Club

Jeffrey Sachs:

As the US shed manufacturing jobs in the 1980s and 1990s, the Federal Government and Federal Reserve tried to compensate by boosting jobs in construction and other sectors shielded from international competition (so-called non-traded sectors). The Fed cut interest rates and the White House and Congress promoted housing finance, including through reckless deregulation and irresponsible behavior by government-backed entities like Fannie Mae. These efforts produced a temporary boom in housing, followed by the bust in 2008.

Matt Yglesias’s response:

There was, obviously, a huge boom in the price of land in the United States of America during this period. But was there really an extraordinary boom in housebuilding?

At the height of the “boom” we were adding units about as quickly as we were adding them in the late 1970s, when the total population was smaller and China’s “opening up” was just a glimmer of an idea of a possibility. If the Federal Reserve was trying to engineer a homebuilding boom it didn’t really work.

Hmmm. So, after the dot-com bust and the subsequent recession, instead of looking for ways to increase the long-term growth rate of the economy (whether by making the tax code or the regulations more efficient, or through an increase in public investments in physical infrastructure and human capital), the Bush Administration and Greenspan Fed relied on easier money – monetary easing by the Fed and an increase in housing lending – to provide stimulus.

And not only did we not get a sustainable recovery across the board, according to Yglesias we didn’t even get (in aggregate) massive overinvestment in the housing sector (though we certainly did get ludicrous overinvestment in certain areas, like California’s Inland Empire and southern Florida). Instead, what we mostly got was a speculative bubble.

So the solution to our current recession must be Yglesias’s preferred policy of increased monetary stimulus. Because that’ll definitely lead to a sustained increase in aggregate demand, rather than another speculative bubble.

And Yglesias, if I understand him correctly, has argued that since the late-1980s monetary policy has been too tight, the evidence being that unemployment has remained stubbornly higher for longer after recessions and that we’ve had only one period of sustained wage growth (the late 1990s). So maybe the problem with the economy in the 1990s and 2000s was insufficiently large speculative bubbles.

Meanwhile, count Jeffrey Sachs as another liberal skeptic, along with Joseph Stiglitz, of the reigning liberal economic paradigm.

Me, Inc.

Megan McArdle and Arnold Kling (two bloggers who are very helpful in understanding the actual economy where we now live, by the way) make the point that life can be good when you have a comfortable job, but it’s dangerous, because it is likely to go away. Here’s Kling:

A job seeker is looking for something for a well-defined job. But the trend seems to be that if a job can be defined, it can be automated or outsourced.

The marginal product of people who need well-defined jobs is declining. The marginal product of people who can thrive in less structured environments is increasing.

The way I have put this is that workers in our economy are in a race between development of as-yet-non-commoditized cognitive capabilities on one hand, and wage reductions as capabilities are commoditized through technological advances (broadly defined) on the other. This has been going on for a long, long time, but it does seem to be speeding up – why?

I think there are several non-mutually-exclusive causes:

1. Information technology. Moore’s Law is creating the kind of advances in information storage, processing and transmission that automate knowledge work in the way that technologies 50 – 150 years ago were automating physical labor. Market research managers, journalists, software engineers, and most of the people they know, are now being subjected to this unpleasant process. As a practical example, the Internet has automated out of existence much of the labor that journalists, librarians, many middle managers in corporations and others used to do. The term we normally use to describe this (when it is not happening to us) is “productivity growth.”

2. Globalization. The decreasing relevance of large-scale war under Pax Americana combined with the economic re-emergence of Western Europe and Japan by the 1970s, and the Asian heartland more recently, have created trans-national labor pools through a mix of outsourcing, immigration, and importing labor content via shipped manufactured goods. We move the stuff, the jobs or the people; but, in all cases, labor in Indiana increasingly competes with labor in India. Ceteris paribus, this creates upward pressure on wages for the most skilled, and downward pressure on wages for the less skilled.

3. The market for corporate control. Starting with the leverage buyout movement of the 1980s, U.S., and later European, companies became more aggressive about seeking shareholder value through automation, outsourcing, and just stopping doing things that did not generate returns above cost of capital. The underlying causes were technology change and globalization, combined with a flexible American political economy which made the best of a worsening situation.

4. The death of the “Detroit model”. The comatose state of the whole Big Auto, Big Steel and related industrial supply chain is a very important example of these effects, but was also accelerated by other contingent factors. Because of its size, this matters. American domestic production of oil peaked in 1971; oil imports doubled between 1970 and 1975; and OPEC was able to drive large price increases. This tended to disproportionately harm those industries that were the source of high-wage union jobs. Private sector unionization has withered across the economy as the bargaining power of industrial workers declined. In what is probably inextricably both cause and effect, “non-­distributive services” (finance, professional services, health care, and so on) became in 1970 a larger part of the private economy than goods-­producing industries. This shift to services tended to enhance the prospects of the cognitive elite at the expense of traditional industrial workers.

I think that what both McArdle and Kling are pointing to is less an aberration, than a return to what is a more natural situation. The comfortable post-WWII combination of high incomes plus stability is the anomaly.

Of course, what sticks out like a sore thumb in all of this is the position of public sector workers.

(Cross-posted to The Corner)

I Agree With Joseph Stiglitz

From his Politico piece dated yesterday:

Monetary policy, one of the main instruments for managing the macro-economy, has proved ineffective — and will likely continue to be. It’s a delusion to think it can get us out of the mess it helped create. We need to admit it to ourselves.

. . .

But how do we get America back to work now? The best way is to use this opportunity — with remarkably low long-term interest rates — to make long-term investments that America so badly needs in infrastructure, technology and education.

We should focus on investments that both yield high returns and are labor intensive. These complement private investments — they increase private returns and so simultaneously encourage the private sector.

. . .

There are things we can do beyond the budget. The government should have some influence over the banks, particularly given the enormous debt they owe us for their rescue. Carrots and sticks can encourage more lending to small- and medium-sized businesses and to restructure more mortgages. It is inexcusable that we have done so little to help homeowners, and as long as the foreclosures continue apace, the real estate market will continue to be weak.

These are, basically, the points I’ve been trying to make in this space over the past couple of days.

Stiglitz also makes some points about taxes that I agree with. I believe we need more revenue – but I want to see that incremental revenue raised in ways that make the tax code more efficient. So I favor reducing or eliminating certain tax expenditures (subsidies in the tax code) and raising taxes on activities with significant negative externalities. I’d support a lower-rates-and-broaden-the-base approach to corporate tax reform. I’m not even constitutionally opposed to modest upper-bracket tax hikes; I just don’t think that’s the be-all and end-all of tax reform.

In my dream world, the conservative faction would recognize the need for more tax revenue, and would be fighting to make sure incremental revenue was raised by increasing rather than reducing the efficiency of the code. In my dream world, the conservative faction would recognize the need for more investment in public goods that will increase productivity over the long term, as well as more efforts to tackle unemployment directly, and would focus on fighting the capture of these investments by special interests and winning efficiency-improving givebacks in exchange for agreeing to increase, not cut, domestic discretionary spending. (Give more aid to the states to retain teachers – but only if the states get something back from the public sector unions on benefits. Spend a trillion dollars on essential infrastructure – but get a temporary suspension of Davis Bacon rules. You get my drift.)

But that’s not the world we live in. So I wind up agreeing more with Joseph Stiglitz, a left-wing critic of the Obama Administration, than with anyone in the conservative faction.

And for that, no doubt, I’ll be attacked from the left because I don’t think monetary policy can do much more to get us out of this mess. Another point on which I agree with Joseph Stiglitz.

Casualties of Currency Wars

Oh, yeah: about those currency wars.

So, suppose the United States does what Switzerland just did, and announces that we’re simply going to print dollars until the dollar drops to, say, half a Euro in value.

What we’d be doing is seizing a larger share of world demand in exchange for making all our assets worth less. As such, you’d expect our action to be stimulative at home – but to result in contraction in the Euro zone.

In case you hadn’t noticed, the Euro zone isn’t doing terrible well itself these days. But the pain is not spread evenly. Germany is performing relatively well; it has higher unemployment than it used to (and still going up) but significantly lower than the situation in southern Europe. Italy and Spain, on the other hand, are going through a brutal contraction compounded by the requirements of governmental austerity. (And while Italy isn’t exactly a model citizen when it comes to government spending, it has done much better on that front in recent years than in much of its modern history – and Spain was in fact a model citizen.)

All of this is leading to substantial pressure on European institutions. A default in the periphery will inevitably lead to a massive recession across the continent and, indeed, worldwide. But a default is unavoidable without either substantially higher inflation, massive fiscal transfers from the center (mostly Germany) to the periphery, or some kind of debt forgiveness.

A substantial American devaluation would make all these pressures much worse. It is possible that, as the pressures reach intolerable levels, the various European polities will suddenly work out a viable solution that saves the Euro zone. In the same way, it is possible that a credible external threat will bring a group of squabbling countries together to unite against the common enemy.

But it’s also possible that it won’t. And if it doesn’t, then Europe goes over the cliff.

Normally, the risk with a currency war is competitive devaluations that lead to generally higher inflation, but with the added element of higher uncertainty about future exchange rates imposing a kind of transaction tax on international trade. If that were the only result, then we’d be back to our discussion about whether higher inflation as such is something we want.

But in the current environment, I think the risks are far more significant than that. A massive devaluation by the United States would basically be betting the world economy that the ECB will follow suit.

Even if they did, if I were a European policymaker, I would appreciate having an economic gun that size put to my head by their American allies.

Monetary Stimulus and Speculative Bubbles

Here’s the way the argument about monetary stimulus usually goes. A recession happens when too many people increase their savings at once. This takes money out of circulation, and this shortage of money produces additional, perverse incentives to hoard money. To break the cycle, you have to decrease the appeal of holding money – by producing inflation. Inflation causes money to lose value; the “safe” store of value is no longer safe. So the money goes back into circulation, to purchase goods and services, and a recovery ensues.

This, however, assumes that only cash and near-cash instruments can serve as stores of value. If you make cash less attractive to hold, but people remain pessimistic about their future prospects, they may not go out and spend. They may go searching for other stores of value that may be riskier than cash, but that are not subject to the dilutive effects of inflation: land, precious metals, etc.

These kinds of assets are substantially less-liquid than cash. But they are also substantially less-productive than other kinds of investments. Moving money from cash to speculation in land, for example, reduces the efficiency of the economy because cash can be more readily mobilized than land, and land – as such – doesn’t employ anybody or produce anything.

People and businesses are not hoarding cash because the returns on cash are so good. The returns on cash are terrible. That’s what it means to say that conventional monetary policy has run its course. Heck, at this point the returns on even longer term government debt are terrible; that suggests that unconventional monetary policy has fired a whole lot of bullets as well, without adequate effect.

The Fed could do more: expand the balance sheet even further, declare that it will continue to print money until unemployment drops to a certain level, etc. This might result in people reducing their savings, and increasing their spending in turn; it might result in businesses deploying their cash in productive investments rather than hoarding it. But it also might result in people taking their cash and buying physical gold; it might result in businesses shifting their cash balances into other currencies or putting a portion of it into instruments backed by physical commodities. Speculation-driven increases in the prices of food and energy – facilitated by cheap money and exacerbated by a declining dollar – might leave the average person in worse shape, financially, than before the additional monetary stimulus.

Moreover, speculative bubbles are economically destabilizing. The worst case scenario of continued monetary expansion is a modest increase in employment and a larger-than-expected spike in inflation, along with an outburst of speculative frenzy in the markets. The bubble would draw more and more resources out of the real economy into a relatively non-productive sector. Businesses would be reluctant to invest in such a volatile climate. Individuals would suffer from record high energy and food prices. And the Fed would be faced with a terrible choice of either sticking with the inflationary strategy – let’s assume unemployment is hovering around 8% at this point – in the face of all these warning signals, or throttling back, bursting the bubble, and throwing us into a new recession.

It’s not impossible. That scenario – collapsing dollar, weak and slow employment recovery, followed by a massive speculative bubble that wound up wrecking the real economy far worse than the prior recession – is exactly what happened in the 2000s. Because in that decade our government’s growth “strategy” consisted of war and encouraging people to sell each other houses at ever higher prices.

I understand the theory. I understand how it’s supposed to work, and that, all else being equal, there is a very clear relationship between inflation and employment. I have real questions about whether all else is equal in the real world.

The Storm Windows Non-Fallacy

Paul Krugman makes the case that environmental regulation – in a liquidity trap – could actually by stimulative:

As some of us keep trying to point out, the United States is in a liquidity trap: private spending is inadequate to achieve full employment, and with short-term interest rates close to zero, conventional monetary policy is exhausted.

This puts us in a world of topsy-turvy, in which many of the usual rules of economics cease to hold. Thrift leads to lower investment; wage cuts reduce employment; even higher productivity can be a bad thing. And the broken windows fallacy ceases to be a fallacy: something that forces firms to replace capital, even if that something seemingly makes them poorer, can stimulate spending and raise employment. Indeed, in the absence of effective policy, that’s how recovery eventually happens: as Keynes put it, a slump goes on until “the shortage of capital through use, decay and obsolescence” gets firms spending again to replace their plant and equipment.

And now you can see why tighter ozone regulation would actually have created jobs: it would have forced firms to spend on upgrading or replacing equipment, helping to boost demand.

Alex Tabarrok replies that this is akin to saying that actively going around breaking windows would be stimulative – the regulation is effectively a tax, and the tax will be anti-stimulative even if the actual purchases of equipment are stimulative.

I think it’s unfortunate that Krugman refers to the broken windows fallacy, because this isn’t a “broken” windows situation at all, where you’re destroying something in order to force someone to spend money to repair it. This is what you might call a “storm windows” situation – you’re ordering people to spend money to make what amounts to a capital improvement with a positive return (assuming you believe the ozone regulations will lead to better health and a more pleasant environment). Moreover, since the regulations impose a one-time cost on businesses to retrofit to comply with the regulation, they don’t, in fact, interfere with profit maximization – they are not the equivalent to an increase in taxes; they are equivalent to a one-time assessment. Again: like a storm window installation, not an increase in the rate of window breaking.

Now, obviously, things aren’t that simple. Not all businesses are flush with cash; some businesses could find ways to avoid the regulation by moving operations offshore; etc. Depending on the circumstances, these effects could be very small or very large. If you were worried about these effects, you’d provide an offsetting tax credit, and allow the deficit to grow slightly. Now instead of mobilizing the cash on corporate balance sheets directly, you’d be doing so indirectly – laundering it through the Treasury.

But again, my point is: the long-term returns from improved air quality matter to the decision. They are not incidental. If the government decided to stimulate demand by hiring one group of people to go around breaking windows and hiring another group to go around installing new windows equivalent to the old, participants in the non-window-breaking sectors of the economy would conclude that the government had gone mad; with no plausible ideas of how to stimulate the economy, it was reduced to complete absurdity, obvious waste. This perception would result in lower expectations for future growth, and this would lead to less investment, less employment, etc. And on net, the economy would be worse off. On the other hand, if the long-term returns are plausibly material, and perceived as such, then there’s every reason to expect that the regulation would be stimulative on net in this situation, precisely because there’s a glut of investable dollars (which is another way of saying there’s a perceived shortage of attractive investment opportunities).

Malinvestment and Recessions

Frequent commenter Pithlord asks a good question in the comments to my last post:

[M]arkets can be rational-but-wrong. But if that’s the case, and if the markets are revising their beliefs about future real productive capacity (as opposed to nominal demand), then there must have been some new piece of information in September 2008 that meant it was rational to revise expectations of future productive capacity downwards. A lot. I have trouble seeing what that piece of information would be.

That’s an extremely good question, and I’ll try to answer it as I see it. But first, I want to stress that I’m not an economist, and that I come at this with, basically, the instincts from my Wall Street career, as well as my strong inclination to believe that the people who run the Fed are not idiots. They may certainly be wrong – we’re very much in uncharted territory – but if the solution to our economic problems were obvious, and in their hands, then you need an explanation for why they are not pursuing that solution. They might be more willing to tolerate unemployment than someone else – they may have other priorities. But any dovish argument needs to grapple with those priorities. Simply asserting that there is no other side to the question – that it is obvious what is to be done, and it’s simply mysterious or evidence of malicious intent if the powers that be don’t do it – well, it’s just a poor mode of argumentation, it seems to me.

So, here’s how I look at it. I don’t believe the wealth effect is terribly significant. In general, people don’t spend (much) of rises in asset values, and they don’t save (much) more in response to asset price declines. That’s because most people don’t own much in the way of assets. Most people consume what they earn – or more. And the people who own assets don’t reallocate between savings and consumption that much in response to market fluctuations, even big ones. Markets fluctuate for all sorts of reasons; that’s why they say the stock market has predicted twelve of the last four recessions.

The kinds of market declines that presage recessions are ones related to the creation of large amounts of bad debt. When large amounts of debt go bad, it’s a problem in and of itself – money gets “stuck” cleaning up debt rather than being deployed more productively. But it’s also an indication that prior investment decisions – on a broad scale – were based on exceedingly faulty information about possible returns.

In the 2000s, we had reasonably good growth in consumption, and therefore reasonably good economic growth. But a huge percentage of this consumption was underwritten by rising housing values. The market behaved, for some time, as if either this would continue forever, or it would be eventually replaced by some other driver of consumption growth. When the housing market turned negative, the market initially treated this as a cyclical downturn – there would be less construction in the near future, so money would flow into other goods or services. But when the sheer scale of the bad debt became clear, that revealed two things. First, it revealed massive weaknesses in our financial system – which is what caused the financial panic. But it also caused a significant revision in expectations about how much consumption would grow in the future. The debt overhang was directly going to cause people to consume less as they saved to pay off their bad debts. But indirectly, it changed people’s expectations because the scale of the bad debt made people realize how much of the consumption growth of the 2000s was tied up in a rising housing market. Tied up, in other words, in an illusion, one that was not going to be repeated or easily replaced.

The mutual fund disclaimer says “past performance is not indicative of future results” but that’s all we have to go on in the real world. If past performance was good, we think future performance will be as well. If the past performance is revealed to have been not as good as previously thought, then future performance expectations will be revised sharply downward.

I actually saw this happen once before, on a much smaller scale, in the 2000 recession. I remember when the market’s perception changed from the notion that this was just a correction to the expectation that something was going to change in the real economy. We could have vaporized trillions on paper without any material consequence in the real world – as I say, I’m skeptical that the wealth effect is very large. But two high-profile bankruptcies changed the way the correction was perceived: Enron and Worldcom. Both were instances of fraudulent accounting. Even though both were large companies, their bankruptcies alone wouldn’t have been a big deal. But because their frauds were so longstanding, what the market understood was that these companies had not really been profitable for some time. Moreover, the market understood that other companies – their competitors – had invested heavily, with borrowed money, to copy these apparently moneymaking strategies that were now revealed to be fraudulent. All these other telecommunications and energy companies were now perceived to be at risk – projections for profit went out the window, and projections for bankruptcy replaced them. So, once again, what changed was expectations for how much return the economy was likely to produce. What had apparently been produced profitably in the past was revealed to be fraudulent – value-destroying rather than value-creating. That changed expectations for what might be produced in the future. On a much smaller scale, but a similar process.

The line between what I argued in my last post and what the inflation doves are arguing isn’t actually that sharp. I’m not denying that a rise in inflation would boost demand, all else being equal. I’m arguing that all else won’t be equal – that we need to worry about a rise in inflation resulting in a drop in real growth, via a variety of mechanisms. That would mean the boost to NGDP from an inflationary strategy would be lower than expected, which would lead to demand for more inflation. And the tradeoff gets worse the further down that road you go.

That’s why I’m biased toward a hard-money monetary policy – a policy that focuses on price stability (and yes, I think there’s a case for some degree of “catch up” given the deflation of 2009) rather than the dual mandate that the Fed formally operates under (though they don’t seem to be following it in practice, and haven’t been for some time) of achieving price stability and full employment. But the more important focuses should be twofold: on alleviating human misery by tackling unemployment directly, and on taking action on the supply side that would improve expectations regarding future growth. And I cannot stress enough that I believe there are lots of left-wing opportunities that properly should be classified as supply-side ones. For example: liquifying the housing market by some kind of debt cram-down.

We’re now actually overdue for a revival in construction. But it isn’t happening because the housing market has seized up due to bad mortgage debt. The amount of inflation it would take to solve that problem is terrifying – we don’t want to go there. But we could tackle the debt directly. I’d call that a supply-side action, government clearing away the dead wood so the economy can grow again – just like patents are a government-granted monopoly, the process of foreclosure is a creation of the legal system. The goal should be to get transactions happening again, and that requires cleaning up the mountain of bad debt, even if it means banks take another hit. Again: the focus should be on creating conditions that encourage wealth creation, not on preserving the position of incumbents. (Some people argue Japan couldn’t get out of its liquidity trap for years because it wouldn’t inflate the economy enough – I’m inclined to agree with those who argue that Japan couldn’t get out of its liquidity trap because it wasn’t willing to take on the incumbent banks, who would not write off their enormous portfolio of bad debt.)

Why Easier Money Is Not A Sufficient Answer to The Great Recession

I’ve been meaning to write something about this for some time. If I understand the case for monetary policy über alles, the argument runs roughly as follows. After the financial crisis of 2008, we saw a dramatic fall-off in consumer demand for goods and services, and a dramatic increase in demand for money – for safe stores of value. This produced the deep and long recession whose effects – particularly high unemployment – still plague us. The solution is to reduce demand for money by increasing expected inflation. If inflation expectations rise, people will be less willing to hold safe stores of value – because they will not be perceived as safe stores of value anymore. So, instead, they’ll spend their money on goods and services, or invest their money in ventures that produce a higher return. And either will produce a return to growth.

My problem with this story is it leaves out the why of the increase in demand for money. The implicit, unstated assumption behind the story is that there is some natural rate of real growth that everybody knows is achievable, and that therefore the sudden rise in demand for money reflects some kind of irrationality on the part of the participants in the economy. But I don’t think that’s the case. We don’t know what the “natural” rate of achievable real growth is. It seems to me that the story of the Great Recession is that people suddenly realized that the rise in consumption over the 2000s had been based on fantasy. Housing values would not go up forever, and people were consequently not as rich as they thought they were. More to the point: if the apparent increases in household wealth of the 2000s were revealed to be illusory, then expectations for future increases in wealth would have to be recalibrated as well. If we weren’t as rich as we thought we were in 2006, maybe we wouldn’t be as rich as we thought we’d be in 2016 either.

The recession, then, was caused by a rational drop in expectations for real growth. If real growth is projected to be poor, then it is rational to save more for rainy days, and to keep that savings in safe stores of value.

The problem, of course, is that this becomes a self-fulfilling prophecy. The question is whether the cycle can be broken merely by undermining faith in the safe store of value.

I don’t think so, because I think making money less safe will only encourage people to seek other sources of safety that appear money-like. These could, in fact, be highly risky – whether we’re talking about fake AAA securities or highly volatile commodities – but whether or not they prove to be as safe as hoped, a shift out of money and into these kinds of assets will not spur either aggregate demand or real growth. You might well get more inflation – indeed, I’d expect you would – but this would be offset by lower real growth.

Now, this might not be true for a smaller economy. A small economy can devalue its currency and thereby increase demand for other currencies without materially affecting the incentives for those currencies to devalue in turn. Such a small economy can, thereby, capture a greater share of global demand to offset the drop in domestic demand, and thereby prop up real growth at the cost of a one-time drop in everybody’s wealth. This is basically what Sweden did in the Great Recession. But a big economy like the United States can’t do this without creating enormous strains in other large economies. The likely result would be competitive devaluations that leave everyone basically where they were before – with higher inflation offset by lower real growth. And the strategy poses risks for smaller economies as well, if it becomes a habit. Countries that get a reputation for dealing with debt by repeated devaluations wind up paying very high interest rates even when times are good. These high rates, in turn, make robust real growth more difficult to achieve than in countries with better fiscal and monetary management. Pre-Euro Italy and pre-Lula Brazil are good examples.

That doesn’t mean that monetary policy has no role to play in keeping a major economy stable. It absolutely does. The role of sound monetary policy is to provide price stability. To keep inflation very low and positive. That’s precisely what the Fed has been trying to do – with considerable success – since Paul Volcker broke the back of double-digit inflation in the early 1980s. I’m not making the case against “fiat money” and for a gold standard – that would just mean yoking the economy to the vicissitudes of demand and supply in a random commodity, something that only has appeal in those circumstances where the monetary authorities stop doing their proper job. I’m making the case for doing that proper job: aiming for price stability.

In my view, therefore, the response to the short-term economic dislocation should be to focus on the long-term. Get long-term real growth expectations to rise, and the economy will recover as businesses react to take advantage of the opportunities afforded by that projected growth.

That’s not a right-wing view. It doesn’t mean that we should only respond by cutting marginal income tax rates, or even that we need to bring the deficit down. It means that we need to reorient our spending priorities around investments that will deliver for the long term – more investment in physical infrastructure and human capital, less investment in defense and current consumption. And it means we need to reorient our taxing priorities – eliminating economy-distorting tax expenditures, reducing taxes on employment, and increasing taxes on consumption. It may mean increasing government intervention in some areas – to restore confidence in the financial system, for example, or to liquify the housing market by getting rid of the burden of overhanging debt – and reducing it in others; patent and copyright reform, for example, should properly be understood as a species of deregulation, reducing the scope of government-granted monopolies. It means, in general, that we should be assessing changes in spending, taxes and regulation by what they will do to long-term expectations for real growth, and not what they’ll do for short-term demand.

The short-term focus, by contrast, should be on reducing human misery and preserving the value of human capital, while imposing the least drag on long-term economic performance. Since the Volcker recession, American employment recessions have been substantially longer-lived than recessions of comparable depth in the pre-Volcker period. This was true in 1990-1991, and again in 2000-2002, and again today. This may well be a side-effect of the successful efforts by the Fed to achieve price stability, and if so that’s still preferable to the pre-Volcker situation when unemployment and inflation both marched up in a saw-tooth pattern to successively higher peaks with each recession and recovery. But we don’t have to accept that situation as inevitable. We could tackle unemployment directly, whether through a German-style Kurzarbeit program or through Great Depression-style public employment schemes or through some other mechanism – or a combination thereof. The biggest initiative of the Obama Administration in this regard was the stimulus plan, which, by giving aid to the states, prevented massive public-sector layoffs. This was a good thing to do – but it wasn’t a fair thing to do, because it protected public employees but not the employees of private enterprises, and it provided that protection without any givebacks (on benefits or work rules, for example) that might have increased productivity in the public sector and thereby promoted long-term growth. And this, I believe, is the primary reason that the stimulus remains unpopular – not because people wanted teachers and firefighters laid off, but because people don’t like favoritism.

What I’m laying out is a case for what might be called hard-money paleo-liberalism: a state that invests in projects that are important to long-term growth (whether physical- or human-capital-related) but are too large or diffuse or uncertain to attract private sector investment, and that plays an important role in cushioning the effects of economic dislocation on those directly affected, but that pursues a monetary policy aimed at price stability rather than counter-cyclical stimulus.

The emerging conventional wisdom on the left is that the Obama Administration failed by not focusing more on short-term economic performance – getting more monetary stimulus (by packing the Fed with inflation doves) and/or more fiscal stimulus (by passing a larger or second stimulus bill of similar character to the first). Leaving aside whether the Administration could have achieved either posited goal, as well as whether the Administration could have known that more stimulus was necessary, my suggestion is that this is the wrong critique. The Obama Administration should be faulted – from the left – for not being sufficiently creative in tackling unemployment directly, for not leading an adequate reorientation of our national spending priorities, and for being insufficiently aggressive at tackling the structural problems in the housing and financial sectors that are holding back a resumption of growth. His policymaking has remained squarely within the neo-liberal consensus even as that consensus appears to have failed. But the one great achievement of the last 30 years was a monetary policy that worked. So it’s strange to see the continued support for that pillar be made the focus of what he’s done wrong.

Uncertainty and Investment

Matt Yglesias argues that regulatory uncertainty can deter investment.

Writing about a DC bar that had to close its doors because it couldn’t get a liquor license, he writes that this isn’t just bad because of the loss of economic activity from that one bar but also because it’s

a sign to would-be entrepreneurs everywhere that their potential investments are much riskier than a superficial read of market conditions would suggest.

Well, exactly.

I’ve been an entrepreneur, startup advisor and technology journalist, and I’ve always been surprised at how risk-averse venture capitalists seem. Isn’t the whole point of their job to take risks?

And yet most venture capitalists have very narrow sets of criteria under which they invest.

The answer is that risk isn’t unidimensional. Whenever you undertake something there are many factors that can go wrong. And it’s precisely by mitigating risks in most of these factors that you feel comfortable taking bigger risks along other factors.

So a VC will try to back a team that’s located in Silicon Valley, has the right pedigree, etc. and minimize all these other risks precisely because she’s taking a big risk on an untested product in an untested market.

To take another example, let’s say you’re a company that’s thinking about building and operating a bridge.

This type of investment typically entails spending a ton of money upfront, and then using money from toll fees and the like to recoup your investment over time. For these big types of projects, the time frame is generally measured in the decades. Usually these investments are leveraged: you borrow most of the money to build the bridge and then pay back interest out of the cashflow from the tolls.

That means you need to take into account not just how much it’ll cost to build the bridge and how many people will use it and how much you think they’ll pay (30 years from now!) but also things over which you have even less control like, say, interest rates and inflation.

Now let’s say you’re looking at two bridge projects, one in Germany and one in Argentina. Let’s say for the sake of argument that they are identical in terms of how much they’ll cost, how much you can expect to recoup (nominally), etc. What’s inflation going to be like in Argentina in 30 years? What about Germany?

Well, no one can say for sure. But one can guess. One can note that inflation has been pretty moderate in Germany for over 30 years. One can note that Germany’s political culture is hellbent on keeping inflation under control, even if this entails considerable other costs. One can note that Germany is in a region, Europe, that has had generally sound monetary policy and credible central banks.

Meanwhile, one can note that Argentina defaulted on its loans and dramatically devalued its currency a decade ago and that it hasn’t yet come to an agreement to the satisfaction of all its bondholders. One can note that not only is inflation rampant in Argentina right now but that the government is actively involved in denying the extent of the phenomenon, going so far as harassing analysts putting out inflation numbers that contradict the government’s figures.

Again, let’s say that on the “pure” business metrics, the two bridges are the same. Something tells me the bridge in Germany is going to get built, and the one in Argentina isn’t.

Of course, it’s possible that this is wrong. Maybe one day Germany decides to debase the euro to keep its exports competitive and hits onto an inflationary cycle that gets out of control. Maybe Argentina elects a former hard-left trade unionist who realizes that credibility with international investors will help regular people in Argentina and manages to keep Argentinian economic policy “orthodox.”

But right now, there’s just a lot more uncertainty associated with building a bridge in Argentina than in Germany, and this means that, ceteris paribus, Argentina will get less investment than Germany.

All of which is to say that, yes, regulatory uncertainty can and does indeed deter investment. And the key to grokking that is to understand that it’s precisely by making some criteria more certain that entrepreneurs and investors are freed to take more risks.

Certainly it doesn’t mean that there aren’t a lot of politicos BS-ing about this. It’s not an argument against all regulation (indeed in some cases good regulation is better than no regulation). And after taking the US federal government to the brink of default, the Republican Party is arguably the least well placed in talking about “certainty.”

But, “uncertainty” matters.

How France Must Save Itself And Thereby Save The World

At Business Insider, I put forward a plan for France to reform its economy, and thereby lead the Eurozone out of the doldrums and to the sunlit uplands of prosperity.

I encourage you to read it and share it.

Texas' policies attract people to move there but that doesn't mean the people who move there like Texas' policies

A puzzling post from Matt Yglesias.

Writing that Texas’ job growth is mainly due to population growth (it seems the picture is slightly more complex ), he writes:

A few people came up to me after the Cato event on Thursday night and said something like, you may be right but doesn’t the population boom show that people are voting with their feet for Texas-style public policy? … You can’t talk about revealed preferences without looking at prices. Notwithstanding the real estate crash, someone who bought a building in Williamsburg or Central Square or Logan Circle ten or fifteen years ago has done very well for himself. This would not be a million dollar house in Houston. In Brooklyn and Cambridge and DC we have “gentrification.” In Dallas they have population growth. There’s little net population increase in coastal states because THE RENT IS TOO DAMN HIGH (book forthcoming).

Right, but why is the rent too damn high in coastal states? As Ed Glaeser convincingly argues, and as I’m sure Matt knows, the rent is too damn high in coastal states because of policies enacted by these states that make construction hard, and thus reduce the housing supply, and thus drive up prices. Conversely, the rent is not too damn high in Texas because construction is relatively unregulated and so supply and demand match up (in both directions: Texas had a soft landing from the housing bubble).

Imagine, to take another Yglesias hobbyhorse, and I hope the subject of a forthcoming book from him, that all states except Massachusetts enacted very strict occupational licensing regimes for clowns. Plenty of clowns would presumably move to Massachusetts.

One person might say: “See? Massachusetts’ policies have enticed plenty of clowns to move there, which is good for consumer choice and the broader economy (and clowns).”

A second person might say: “Clowns didn’t move there because of policies, they moved there because it’s easier/cheaper to be a clown in Massachusetts.”

And the first person would say: “Well, exactly.”

Back before Deng’s reforms when plenty of communist Chinese tried to come to Hong Kong to make a better life, I’m pretty sure most of them weren’t readers of Hayek who had made an intellectual determination that central planning and collective ownership of the means of production was inferior to free markets and the rule of law. But it would still be fair to say that they were voting with their feet against communist policies.

Corporations are not people. They're persons.

There’s a bit of hoo-ha about Mitt Romney saying that “corporations are people.”

He was using shorthand to refer to the fact that taxes on corporations are ultimately borne by people (not just shareholders, by the way—workers and customers as well), which is absolutely correct.

Romney’s off the cuff statement has been used pretty unfairly to malign him.

This is because the phrase “corporations are people” has some political salience because of Supreme Court decisions that are purported to have granted special rights to corporations on the grounds that they are people.

There’s even a movement to amend the Constitution to say that corporations are not people.

This may just be the dumbest controversy EVER. It makes intelligent design look like the general theory of relativity. It’s like a controversy about whether the sun rises in the east.

Even the intelligent Jon Chait writes in defense of Romney “there is a controversy over whether corporations are people from the standpoint of law.” No there isn’t.

Understanding why corporations are not people, but persons, is easier with some grasp of law and history, but really, all it requires is knowledge of English and logic.

Corporations are persons.

What this means is that they’re recognized by the law as entities that can have a name, sue in court, be a party to contracts and have property.

Different types of persons have different types of rights, but these types of persons have only the rights that allow them to exist. Not the kind of “human rights” that fleshlings enjoy. (These non-people persons are referred to as “moral persons,” an even more misleading term, as opposed to “physical persons.”)

That’s it.

That’s it.

That corporations are persons does not mean that they are people, as a matter of law, language and logic. (Etymology, as often, helps: persona in Latin is the mask that actors would use in the ancient theater. Legal personality is thus the “mask” that either individual people or groups of people use to act in the legal arena. This is also why we have the word “persona” in English, which also refers figuratively to a mask.)

And if corporations are people, it means we’ve reinstated slavery, because corporations are bought, sold and even killed by their owners every day.

But there’s an even more profound reason why this non-controversy is stupid.

It’s not just that it’s an obvious fact that corporations are persons, not people, and that this, in itself, is utterly uncontroversial and of no notable policy consequence.

It’s that the doctrine of legal personality is one of the basic building blocks of civilization. It’s right up there with writing and indoor plumbing.

This is because without legal personality, it is not possible to have an institution that is distinct from the humans who make it up.

A state is a legal person. Without the concept of legal personality, any land and its inhabitants are the personal property of its ruler, as it was for much of human history. Even Robert Mugabe would not dare assert personal legal property over all of Zimbabwe.

It is quite simply one of the greatest achievements of civilization that we reached a level of sophistication high enough that we could not only conceive, but theorize and enforce the concept of an institution that is, actually, nothing but an abstract concept (there is no such thing as “Wal-Mart.” There are buildings and people and bank accounts, but “Wal-Mart” doesn’t exist. Except as a fiction. As a law professor of mine used to say “I’ve never had lunch with a corporation.”).

It’s not just a great achievement of civilization because it’s a beautiful concept. It’s a great achievement of civilization because without it all of civilization would collapse. Every collective human endeavor now includes the creation of non-people persons. Literally. Imagine what would happen if every corporation and state vanished overnight as a legal construct (but leaving all the buildings and stuff intact). Society. Would. Collapse.

Being opposed to the concept of corporations as persons, or not understanding why corporations are persons and why the fact that it is so is as problematic as the fact of the sun rising in the east, is frightening.

(Parenthetically: Why, then, the controversy around Supreme Court decisions? A few reasons.

(1. People are stupid.

(2. The omniscient and perfect Framers of the US Constitution neglected to distinguish in their text between the vulgar and legal meanings of the word “person”. For example, in the infamous Three-fifth Compromise, the “free persons” used for the purpose of the census do not include corporations. But in other stances of the use of “persons”, they might. But this is not a debate as to whether corporations are persons (they are) or people (they’re not), but a debate as to how to interpret the Framers’ sloppy English.)