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Articles filed under Economics

Do Job Creators Matter?

Adam Ozimek at Modeled Behavior has a really great post on this question. It is a reply to Paul Krugman’s argument that, basically, high-income people get back in compensation their total value creation for the entire economy. For example, if Steve Jobs made a gazillion dollars, that means he created a gazillion dollars of value, but took it all back as his compensation; therefore had Steve Jobs never existed, nobody else in the world would have been any worse off. This is a simplification, but one of the great things about the post is that Ozimek carefully pins down the reasonable interpretation of Krugman’s actual assertion by going back to Krugman’s textbook writing.

Krugman argues that if we accept the premise that people get their marginal product of labor back as compensation, then why not set marginal tax rates to the level that maximizes government revenue: 70%?

Ozimek’s simple, great thought-experiment in the post:

Consider, for instance, that if we suddenly kicked out the top 10% of high IQ people (or 10% most productive people, or 10% most creative people, or whatever) in the U.S.. It strikes me as fairly likely that the total output of the remaining 90% would go down. Krugman seems to argue that this would not be the case. But even if you disagree with me in the short run, in the long-run the productivity increasing innovations these people would have made won’t show up, and the rest of us would have lower productivity as a result.

Now, instead of kicking out the top 10% of workers, just make them work less as a result of high income taxes. See my concern?

Lowered incentives of job creators and other innovators should be considered as one of the likely downsides to higher taxes.

Note that if you don’t think this is true, then what business do we have subsidizing higher education? If workers capture the entirety of their higher productivity, then I don’t see who gains by giving young people money to go to college rather than just cash.

I’d only add one observation.

Krugman ends his piece with this:

My point, then, is that this claim — and the lionization of high earners as people who make a vast contribution to society — is not, in fact, something that comes out of the free-market economic principles these people claim to believe in. Even if you believe that the top 1% or better yet the top 0.1% are actually earning the money they make, what they contribute is what they get, and they deserve no special solicitude. [Bold added]

What’s so funny about this is that Krugman is arguing that “these people” (i.e., people like me who think that a 70% marginal tax rate is not necessarily a good idea for America as whole) base our beliefs about political economy on his textbooks. He is pointing out a contradiction that exists only in his mind. I don’t accept his pseudo-scientific claims to knowledge about the impacts of doubling our maximum tax rate; my “free-market economic principles” are in fact based in part on my beliefs about the inherent uncertainty of such predictions.

(Cross-posted to The Corner)

Ever Deeper Union, Now and Forever, World Without End

I haven’t really said much about the catastrophic debt crisis unfolding in Europe, other than to say that it would be really bad for America to play beggar-thy-neighbor when the whole continent is at real risk of pitching over into the drink, and to wonder why, if the Germans decide they don’t want to bail out Italy, the northern Italians should decide they want to do so (in other words: why is the Eurozone more likely to break up than the Italian state).

But what’s unfolding is enormously important, not only to the world’s short-term economic outlook (if Europe collapses into a depression, they’ll surely drag the rest of the world with them at least part-way down), but to pretty much every aspect of America’s foreign policy going forward.

First: background. The European Union, is, was, and always will be a primarily political project. The gains to be had from businesses no longer having to hedge a variety of small currencies were always small and are now really negligible. For both France and Germany, the central partners in the enterprise, it meant not only a kind of formal commitment to the notion that there would never again be a war between the two largest continental powers, it also meant playing a larger role in world affairs, and a massively larger role in continental affairs, than either country could on its own, in France’s case because it just wasn’t all that big anymore, in Germany’s because it was, well, Germany. These goals could only be achieved by a progressive deepening of the Union, from being a trade and customs union, through regulatory harmonization and a common currency, to a common foreign and defense policy and some degree of fiscal union. So long as Europe remained purely a collection of states, unable to act as a union, the fundamental political objectives of the European project were not achieved. And these objectives were the reason for the project in the first place.

For many other countries in Europe – and particularly for Britain, for whom it spelled the end of the traditional British foreign policy objective of avoiding any single power dominating the continent (and objective that, by the time the US-Soviet rivalry matured, to say nothing of once it had ended, was thoroughly obsolete, but still) – the prospect of ever-deeper-union presented a Hobson’s choice: join, and give up a measure of independence for some share of decisionmaking; or don’t join, and retain formal independence but be dependent, practically, on the decisions made by the rising power in Brussels. Different European states have chosen differently – which is both what one would expect and entirely appropriate.

For certain countries – Italy being the most important – with longstanding, shall we say, governance issues, the European project presented an additional opportunity: the opportunity to do an end-run around their own government. Back in the days of the Lira, Rome resorted to regular devaluations to compensate for its chronic over-indebtedness. This, in turn, meant that Italian debt always carried a higher interest rate than German debt – reflecting market expectations that the Lira would generally decline versus the Deutschmark. Joining the Euro, for Italy, meant paying lower – more like German – interest rates on their debt in the future. In exchange, Italy would simply have to gets its fiscal house in something resembling better order – less like Italy, more like Germany. Which it promised to do.

And which, to some extent, Italy did – at least in terms of the budget. But that hasn’t mattered in the current crisis. The current crisis started off being about a country – Greece – that borrowed fraudulently, actively lying about its budgetary situation. But it’s not about that anymore. Spain was in excellent budgetary shape before the crisis. Italy wasn’t in great shape by any means, but it was in better shape than was the historic norm – and the trend line was going the right way. The current crisis is due to the fact that no country in Europe has a central bank; none have the option of using unorthodox monetary policy to avoid slipping into another recession; and countries across Europe have been thrown into budgetary crises by the recession that followed the financial crisis. Radical austerity across the continent would trigger a new recession, which would worsen the budgetary situation. Within the existing framework of decisionmaking, there’s no way for Italy to solve its budgetary problems – which is why Italian bonds now trade at a much higher yield than German bonds, precisely what joining the Euro was supposed to prevent. And as market fears of a possible Italian default or a breakup of the Euro have gotten more serious, the crisis has spread to France, the Netherlands, and even Germany – because none of these countries will avoid catastrophe if the Euro collapses.

What’s going on now is, I believe, an extremely high-stakes game of chicken. The acute crisis could be resolved immediately if the ECB would simply agree to buy Italian bonds in sufficient quantities to drive Italian interest rates down to a sustainable level. A firm commitment of that sort, backed up by market intervention, should have the desired effect. In the absence of any change in the structure of decision-making in Europe, however, this would amount to writing Italy a blank check. Because for the commitment to be credible, it needs to be unconditional – the ECB can’t say, “we’ll buy bonds if Italy keeps its debt ratio below so-and-so” because then the market can wonder, “well, what if the recession gets worse, and tax receipts drop; or what if Italy’s politicians simply rescind some of the austerity measures passed, pocketing the ECB’s commitment and going back to business as usual – what then?” And once the market wonders that, credit spreads widen out again – and the ECB has to either take stronger action, and you begin a race to the bottom as other countries scramble to be less-responsible than Italy; or the ECB surrenders and we’re back where we are now, only worse.

For a credible intervention not to amount to a blank check, the market would need to be satisfied that there was a mechanism in place to ensure that Italy could not cash the blank check. In other words, Italy would have to surrender a pretty significant degree of control over its own budget. Whatever form such an arrangement might take – whether it was run through the ECB or through some more accountable branch of the European bureaucracy – it amounts to fiscal union.

This isn’t, of course, how anybody wanted to get here. But it is, in fact, where the people who championed the creation of the Euro wanted to go. Monetary union could only work in combination with fiscal union. The architects of Europe were never able to sell “Europe” as a concept to the various peoples of Europe – they have generally proceeded on the assumption that democratic accountability was an obstacle to be avoided rather than a goal to be achieved. It looks to me like that continues to be their preferred mode of operation, and that what the leaders of Europe are looking for is to be forced into fiscal union rather than assenting to it, and for that union to be accomplished through the least-accountable governmental bodies possible.

But that, I believe, is what this game of chicken is about: the terms of deeper union. What Italy – and, subsequently, the other nations of the Euro-zone – will have to give up in order to qualify for support by the ECB in a crisis.

At least I hope that’s the case. Because if it isn’t, and there isn’t a “yes” to be gotten to, then we can kiss the world economy goodbye.

As a post-script, let me say this. The United States has, from the beginning, approached Europe from the perspective that we prefer it to get broader rather than deeper. We don’t want a European army, or a common European foreign policy; we are not particularly interested in fiscal union or even in the common currency; but we definitely want Britain and Turkey and heck, Ukraine to be part of the European Union – we want the Union to be as diffuse as possible. This diffusion has made it progressively harder for the EU to actually do anything as a corporate body – which, I think, was a feature, not a bug, from the American perspective.

But I have always felt that this perspective was wrong – in terms of American and global interests, not just the interests of Europe. Nobody’s interests are served when the world’s largest economy is effectively ungoverned. And if America’s interests were profoundly threatened by the emergence of a functional Europe on the diplomatic stage, then we really have to question how we conceive of our interests – is it not enough that there is no power on Earth capable of standing up to us; must there be no power capable of standing beside us either? American interests would have been better served by advising the architects of Europe to pay attention to the democratic deficit, and to grow the EU only at such a pace as was consistent with the development of functional European institutions. Peripheral countries would always be free to join the customs union, to voluntarily harmonize various regulatory matters, to peg their currencies to the Euro, etc. – without submitting to being governed from Brussels. I don’t, frankly, understand why America has any interest in whether London or Ankara or Kiev do submit to such governance – nor, for that matter, Paris or Berlin, but if Paris and Berlin were dead-set on creating Europe then it is in our interest for Europe to function. Which required, and now requires more than ever, deeper union.

Conservative Institutions, Radical Circumstances

Following Matt Yglesias to his new digs, I see he hasn’t changed either his views on monetary policy or his views on correcting typos before he posts:

[I]t’s encouraging that the Federal Reserve’s Open Market Committee considered [NGDP level targeting] at their meeting early this month. Unfortunately, according to the minutes they rejected it for reasons that seem pretty shallow. . .

The claim that this would “heighten uncertainty” seems to me to be just flat-out wrong. Normally there’s very little uncertainty about the Fed’s attitude. Normally we’re close to full employment and close to the Fed’s inflation target. . . . Today, however, there’s a great deal of uncertainty. We’re close to the Fed’s inflation target but nowhere near full employment. If millions of currently jobless people return to daily commuting, that’s all but certain to push gasoline prices up. If millions of currently jobless people living with parents or siblings get jobs and move into places of their own, that’s all but certain to push rents up. If that happens will the Fed tighten money to curb the inflation, or will it tolerate the inflation as passing pain needed to return to full employment? Nobdoy really knows, so nobody dares expect growth. One of the great virtues of a move toward NGPD level targeting is precisely to provide certainty on this point. The Fed will tighten if and only if total economy-wide spending increases so fast as to push us above the desired trend level.

True – but trivial. If “uncertainty” in this trivial sense were the problem, the Fed could always eliminate it by simply saying: we will do “X” no matter what, whatever “X” might be. “We won’t tighten until measured inflation is above 3% for two consecutive quarters,” is clear. So is, “we won’t tighten until unemployment goes below 7%.” So is, “we are standing pat until inflation expectations as measured by TIPS spreads drop below 2%, at which point we will do additional quantitative easing until expectations go above 2%.” Any fixed, inflexible rule would eliminate uncertainty.

And it would also eliminate any policy flexibility. Indeed, it eliminates the need for having a Fed – you could just have a computer program setting monetary policy. The very fact that you have a group of people in a room deciding what the rule is going to be means that there can never, ever be a totally credible and inflexible rule of the sort that Yglesias imagines he wants. “We are now moving to NGDP level targeting” sounds pretty clear – but what if inflation expectations jump to 4% overnight and employment growth doesn’t show up immediately? Won’t that put a lot of pressure on the Fed to reverse course? Doesn’t everybody know that it would put a lot of pressure on the Fed to reverse course? Heck, if NGDP level targeting worked it should lead to a sharp rise in nominal interest rates on Federal debt – that would be the market pricing in an expectation of much higher nominal growth. But the immediate result of such a spike would be a sharp increase in the cost of rolling over Federal debt, which might well create strong political pressure for greater short-term budgetary discipline to avoid locking in a huge interest overhang for years to come. Which, in turn, would be contractionary if it actually happened, and didn’t just force the Fed to change policy directions.

The Fed is a big, important, highly conservative institution. Quite properly, it doesn’t change its policy framework easily. If it did, that would lead to a widespread loss of confidence in the Fed as an institution, which would mean any rule it adopted wouldn’t be terribly effective.

Now, the current circumstances are extraordinary. The Fed has responded to those extraordinary circumstances by signalling that it will do pretty much anything to avoid us tripping into a double-dip recession. They’ve declined to be more daring than that, and have basically begged the fiscal side to do more to help them out. That, in turn, implies that they would welcome fiscal action that improved the long-term real growth prospects of the economy. That could mean tax reform that reduced economically distorting deductions; it could mean a shift in spending priorities away from defense and health-care and towards investments in physical infrastructure and human capital; it could mean dozens of other things that the Federal government isn’t doing, that would give either monetary or fiscal policy more running room for straight-out Keynesian expansion without igniting fears of an inflationary spiral.

I find it really hard to blame the Fed for being minimally conservative – not being eager to change its entire framework for thinking about monetary policy – when the fiscal side can’t seem to do anything at all.

Now, none of that means that the Fed shouldn’t consider an NGDP level target. But I’d expect it to want to see a bit more of a “developing consensus” in the profession before making the jump, precisely because you can’t change frameworks very often and remain credible. And if a new consensus is developing, it’s in the very early stages of doing so.

Finally, just to recap, here are the important points I think NGDP targeting needs to address:

- I understand why one implication of an NGDP-level targeting is that a negative supply shock should lead to looser, not tighter, money, and that a positive supply shock should lead to tighter, not looser, money. That makes sense to me. If oil prices spike, that’s not going to trigger an inflationary spiral – it’s going to trigger an economic contraction. So we should loosen. If oil prices crater, that’s going to temporarily goose growth, but there’s no underlying improvement in productivity to make that sustainable; the right response isn’t to loosen in response to lower inflation, but to tighten in response to rising nominal growth. This is not the way the Fed reacts currently – in particular, it’s not how it reacted at the beginning of the financial crisis, when commodity prices spiked even as we started to slip into recession – and this is an area that, I think, deserves very close scrutiny by the Fed, and potentially a declaration of their intent in the event of a future spike in commodity prices.

- But I don’t understand why a sustainable increase in productivity should lead to tighter money. I don’t know how the Fed can know whether productivity “should” increase at 3% or 2% per year over a given decade. And I don’t understand why, effectively, lowering the inflation target when productivity growth is high and raising the inflation target when productivity growth is low makes any sense. I’m not saying outright that it doesn’t make sense. I’m saying I don’t understand the logic of it. Put another way: how do we know that the American economy “should” grow at 5% per year? Where did that 5% come from? Presumably from our historic experience of what stable growth looked like – low inflation, modest population growth, productivity growth in the 2%-3% range. But if either of the latter two variables change, it seems to me that the NGDP level target should change, because they are the “real” drivers of the “real” growth rate of the economy.

- I continue to worry that NGDP has been significantly more volatile than inflation expectations have been, and that therefore an NGDP level target would imply a much more volatile Fed policy. If the Fed is supposed to use medium-term NGDP expectations to guide policy, that means the Fed would loosen preemptively whenever the market predicted a recession. The best instrument for measuring future expectations of nominal GDP growth is probably yields on the 10-year bond. I’m pretty sure, though not certain, that the 10-year bond yield is more volatile than the TIPS spread. But that might reflect the fact that the Fed is actually trying to fix inflation expectations, and is not trying to fix the 10-year bond yield. In any event, this is another area that would deserve real analysis before the Fed made such a shift.

Back Off Man, We’re Scientists

In an editorial in Monday’s New York Times, Adam S. Posen, an American economist, and a member of the Monetary Policy Committee of the Bank of England, provides an excellent illustration of an economist asserting that his policy preferences are literally scientific truth:

Scientific research tells us that high blood pressure and cholesterol are associated with a higher risk of heart disease and stroke, and that certain prescription medications reduce cholesterol and blood pressure. Yes, it is difficult to prove directly that taking these medicines prevents heart disease and stroke, and taking them is no guarantee of health. But still we should take them, and our doctors should prescribe them if they are indicated. This is the same situation we are in now, with our economy’s financial circulation at risk, and quantitative easing the indicated medicine. [Bold added]

Only, it’s not quite “the same situation” at all.

The problem is that medical science has conducted randomized clinical trials that show precisely this link between cholesterol-reducing drugs and reductions in strokes and morbidity. For example, a 1999 meta-analysis of more than a dozen randomized experiments testing the effect of statins (cholesterol-lowering drugs), showed that that “on average one stroke is prevented for every 143 patients treated with statins over a 4-year period.”

Note that the first sentence of the Lancet paper describing one of the early experiments to establish the effect of a cholesterol-reducing drug on mortality is: “Drug therapy for hypercholesterolaemia has remained controversial mainly because of insufficient clinical trial evidence for improved survival.” Precisely the lack of such experimental evidence engendered a debate; resolution required experiments that established definitively the effects of the interventions.

We have nothing like this for quantitative easing. Lacking experimental evidence doesn’t mean that therefore we should not undertake quantitative easing, but the editorial is an attempt to browbeat opposition by appeal to a purported, but unsubstantiated, scientific authority.

(Cross-posted to The Corner)

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Question For People Who Know More About Italy Than I Do

Why are the odds on the breakup of the Euro zone rated so much higher than the odds of the breakup of Italy?

If you were a voter in Lombardy, why would you prefer to stay with an Italy in a tailspin that had been expelled from the Euro, rather than sticking with the Euro and letting the southerners fend for themselves?

And what ratio of debt-devolution to the regions of Italy would you guess is the indifference point for the median Italian voter – that is to say, how much of Italy’s sovereign debt would need to stay with Padania and how much with a rump non-Euro Italia for both north and south to say: breaking up on these terms is fair?

I ask this question because this, it seems to me, is the key difference between Italy and Spain, even more important than the atrocious personality of Silvio Berlusconi. Catalonia would be eminently viable separate from Spain, but it wouldn’t take most of the Spanish economy with it if it separated. The northern European reluctance to bail out southern Europe is replicated in northern Italy’s desire to stop having to bail out southern Italy. If the Euro is in danger of breaking up largely because Germany prefers that, and the chaos that would follow, to fiscal union and the resultant permanent drain on its treasury, why isn’t Italy in danger of breaking up for the same reason?

Just curious.

Preventing Deflation Should Be The Fed's Top Priority

A high percentage of my recent posts (scratch that; I have no recent posts – say a high percentage of my posts since the summer) have been devoted to voicing my skepticism that looser monetary policy can engineer a meaningful recovery. My own view is that what you’d get instead is new speculative bubbles and a new crisis.

But that doesn’t mean monetary policy should err on the side of tightness in all circumstances. And if we’re at a real risk of slipping into a new round of deflation we should be erring very heavily on the side of looser money. That’s particularly true because the situation with the Euro is sufficiently touchy that we could experience a sudden and substantial liquidity shock with very little warning.

Inflation is dangerous. Deflation is much more dangerous. The Fed should be signalling very clearly that they have the tools available to prevent deflation, that they are ready to use them, and that preventing deflation is their top priority, even if it means overshooting on in an inflationary direction.

So for the time being, the inflationists and I are on the same side. Hopefully, clear messaging and prompt action on the Fed’s part will do the trick, and in a quarter or two we can go back to arguing about how to generate a real, sustainable recovery.

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).

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