Bernanke and Blinders: Making Distinctions Between Inflation and Relative Price Change

There were two articles in the Wall Street Journal on Monday about inflation. The articles raise many questions but central to them is the definition of inflation and what policymakers can do about it.

Most of us who are over 50 know what a colonoscopy is. Of course, we know it primarily from the user’s end – and by that you also know what I mean. But (and I do mean butt) most of us know very little about it from the doctor’s perspective. And while we might read the latest medical web sites, we really don’t have the training to understand all that is going on while we lay there on a cold bed with insufficient coverage of our precious parts.

Inflation is a word that most of us know. We feel the impact of inflation when our local grocer raises the price of bread and when a gallon of gas costs more than a double JD on the rocks. And we are constantly reminded about inflation since governments collect facts about price change and the press takes great glee in spreading the news each month. Then we hear that the Fed absolutely hates inflation almost as much as I hate anchovies and we feel somewhat relieved to know that Ben Bernanke and his colleagues are actively watching the numbers and are ready to attack like a head-butt in a Jets game.

Confusion may arise because inflation has two definitions. The first definition has to do with measurement. A price index is an average of prices. Some prices go up. Some prices go down. But the price index averages the ups and downs of all the items and calculates one number describing price change of all the items in the index. Food might be going up by 2% and horse shoes might be going down by 1%. The index doesn’t much care about individual changes because it averages them all together. Most price indexes are weighted – meaning they count some price changes more than others depending on how important the item is. We spend a lot more money on food than on horse shoes – so food prices are more heavily weighted or count more in the price index.

When we take into account all price changes in an index we get one number. For example, the consumer price index might be 202 this month. Perhaps it was 200 last month. So we would say that consumer prices rose by one percent (from 200 to 202). Or we would say that the inflation rate was 1% this month.

Okay – so the first definition of inflation is a measurement – it is the percentage change of a price index. This measure helps us to understand how far our income is going with respect to a particular basket or bundle of goods and services. Naturally when this measurement is high in a given time period, we don’t like it since it is telling us that our income is not stretching as far as it used to.

The big question is why this measurement of inflation matters for macro or for the Fed. So let’s wake up, do a few pushups, and move on to the second definition of inflation – macro inflation.

Recall that macro is about the national economy or the big picture. Macro is about aggregate supply and demand (If you don’t understand these concepts then I would suggest you go back and read all 60-something posts in my blog. Then you will be REALLY confused, give up, and go back to reading fun stuff.)

The Fed has no magic tool to impact the price of a specific single good or service. If food prices are misbehaving and causing the overall index to increase a lot, the Fed has no food price hammer to knock it back down. The Fed only has an aggregate demand hammer. Using traditional monetary policy to attack food prices would be notoriously inefficient since they would be using a macro tool that impacts ALL PRICES to whack away at food. The Fed’s tools are much better suited to times when the price index is rising because many or most of the items in the price index are rising (or falling) at excessive rates. This discussion gives us to ways to interpret a rise in the price index:

(1)   If it is being caused by only a small number of items, we call this RELATIVE PRICE CHANGE

(2)   If it is caused by many or most of the items rising, then we call that MACRO INFLATION

The hullabaloo in the papers recently is confusing because it is mostly screaming RELATIVE PRICE CHANGE and then wondering what the Fed is going to do about it. The Fed should, I believe, do nothing. Like a horse leading a carriage down a busy street, the Fed should be wearing blinders so it doesn’t get spooked by every little noise that signals a movement in prices.

So here is the fun part. While it is true that the Fed should not be tightening monetary policy because of recent changes in measured inflation – it should be tightening it because of other reasons. First, as the economy continues to improve banks will return to lending and spending and inflation will start to accelerate. Second, there is some risk that the Fed will wait too long to tighten the money supply and an inflation problem would be harder to douse once ingrained. Third, the combination of relative price change and a worry that the Fed will wait too long to address rising inflation can lead to a RISE IN INFLATIONARY EXPECTATIONS.  Fourth, a rise in inflationary expectations today causes behaviors that push up macro inflation today – as workers and other suppliers begin to press for their own wage and price increases. These behaviors are not only bad for inflation but they erode firm profits and could lead to a slowing of output and employment.

In summary – while current changes in the price index are not signaling higher macro inflation today there is, nevertheless, every reason to ask the Fed to immediately begin to lean against inflation. Without a quick return to a normal monetary policy we have the very real risk of a bout of stagflation similar to the kinds we experienced in the 1970s wherein both unemployment and inflation were rising. The only antidote was a virtual squashing of demand by the Fed late in the decade that sent interest rates above 20%. Let’s not go there again please. 

Angel Wings, three mumus, sweat pants, and Monetary Policy in 2011

When do you throw the angel wings away? My Dad threw me into Venetian Pool and told me to start swimming or I would sink to the bottom of the pool like a box of two week old Twinkies. Actually the water in the children’s pool at Coral Gables’ most unique swimming hole was only about two feet deep so my Dad wasn’t as callous as my sentence alluded.  Other parents purchased angel wings for their darlings. The angel wings hold the child on top of the water as they learn techniques of swimming – like moving your arms and legs in a manner that keep you on top of the water. They are a great idea. Once the kid masters the basic idea of swimming without fear of drowning, she can dispense with the wings and get on with trying to beat Mark Spitz’s records. The challenge comes with the more timid kids who are never quite sure their parents weren’t hiding in one of Venetian Pool’s dark and romantic caves making out. These kids were reluctant to give up the security of their angel wings and clearly jeopardized their ability to swim the English Channel. Their parents were faced with a dilemma. If we take the wings away our kid will NEVER learn to swim. If we don’t take the wings away our kid will NEVER learn to swim.

Martin Wolf and Ben Bernanke think that we are all reluctant kids who need our binkies or was that angel wings? Anyway M&B have been arguing of late that it is much too soon to start withdrawing monetary stimulus from the US and European economies. So I ask the question – will withdrawing stimulus now prevent us from ever swimming the English Channel? Or for you non-swimmers, will withdrawing monetary stimulus now mean that the economy will not recover? Or….tada…..will not withdrawing now imply the economy will not recover?

I think a clear and public plan to begin to withdraw the monetary stimulus is necessary right now. Waiting is foolish and will cost us. The reason is simple and relates to the angel wing example. Waiting creates self-defeating habits that are VERY difficult to reverse. Worse yet, reversing the policy too late creates unnecessary hardships. Okay – so let me dive into the deep end and splash around a bit. Sorry. I promise to not discuss angel wings one more time. But if you have never seen Venetian Pool in Coral Gables you REALLY have to see it.

M&B are like caring parents for more than 600 million people. They see an economy in the midst of a recovery, albeit one with less than hoped for employment increases. They see the risks surrounding another economic slowdown and do not want to contribute to an even longer and weaker recovery. Who can fault them for that? I guess I can or I wouldn’t be sitting here typing on a perfectly good day. It seems to me that postponing the inevitable puts central banks into a very bad position. Here is why. First, most of us know that the US economy will move closer to full capacity. At that time the Fed and ECB will need to generate more normal interest rates well above 0.25%.

Second, based on M&B’s unwillingness to raise the policy rate and tighten money after 6 quarters into a recovery, this raises the question as to when they will. Saying NO today means they are raising uncertainty for all of us. We know it is going to come but when? That matters to a lot of people.

Third, while we know it is prudent to raise rates at some point, how do we know they won’t raise them after inflation and inflation expectations have already firmed? Is it possible that we could be another 4-6 quarters down the road and still have a higher than desired unemployment rate yet inflation already starting to boil?  Will M&B continue to stall then? What exactly will it take to get them to remove the stimulus?  

Fourth, if inflation gets ingrained and rises above the Fed’s target this will surely cause longer-term interest rates to skyrocket. Even if the Fed stalls for a while longer – long-term rates will rise with or without a tighter Fed policy. This spike in interest rates without policy will be bad for the economy and the unemployment rate. If inflation jumps again and the Fed is finally impelled to reverse engines and raise interest rates—this could cause long-term rates to rise even higher. Remember 1979/80? Ugh.

But M&B promise to withdraw the stimulus right when it is needed. At the perfect moment when the economy is strong enough and inflation has not yet become ingrained in expectations, they will magically start the withdrawal. They want to do it this way to minimize the risk of hurting the economy with tight money. That is one risk. But what I am suggesting is that they are not considering the other side of the risk equation. History shows us that economic and political forces make it very difficult to identify the perfect time and that central banks often wait too late.  There is no such thing as just-in-time monetary policy and arriving too late has been shown to have disastrous effects.

 It is sort of like postponing a diet. You need to start right after Thanksgiving but you wait until after Christmas. Then you postpone to after New Year’s. But that would ruin your enjoyment of the bowl games. Okay – so you finally start the diet after the Super Bowl. At that point you need to lose a ton of weight plus you need to buy three mumus, four sets of sweat pants, and a small tent.  

Why I Want to Turn my Digital TV into a Hat Rack

Here’s a spout. Rose and Merlin were brother and sister. Rose played soccer and generally liked math. Merlin played in the orchestra and loved to photograph orchids. They hardly agreed on anything. Their arguments often got heated.  Rose would say – “you are mean and you called Daddy a monster.” Merlin would retort – “you are a pig and Mommy loves me more than you.” One day they were confronted by an evil visitor from outer space who threatened their very existence.  They were both worried but instead of working together to overwhelm the predator they took the occasion to yell at each other one more time. Rose started –“ if you had washed the dishes last night as required, none of this would have ever happened. “Merlin quipped, yes, but you are fat and ugly.” Rose and Merlin were never seen again.

So you are saying – Larry has clearly gone off the deep end. People have been saying that a long time so there must be another reason for me writing the above paragraph.

I am writing this paragraph after reading and re-reading my own words below and realizing it is possible for people to get the wrong idea – the opposite of what I am trying to say. The bottom line is that we have VERY challenging issues to deal with in the USA.  These are made even harder by a divided government. It is tempting to up the rhetoric but that might make it even harder to find solutions for security, defense, employment, health care and other pressing issues. The below spout is not meant to single out any one side or person.  As most parents find themselves saying – “I don’t care which one of you did it – you both can go to your rooms and right now!”  I am not taking sides here. Both sides can hate me equally!

I am REALLY irritated by the political fighting concerning the Tucson massacre of this past weekend. Some people are being somewhat careful with their words. Some are not. Let’s face it – some people on the left are using this shooting as a way to point a mean finger at their adversaries. They associate what is so far being called a crime by a deranged shooter with statements made by politicians on the right. In private people are saying what they really feel and they are even more ugly and vindictive about their political enemies. I don’t like to use the term political enemy but when I hear the adjectives some people use I cannot help but classify their categorizations of those with differences in political opinions as enemies. Of course, some of those on the right are not exactly making things better as they defend themselves and counter attack.

This is crazy. How many days will we spend listening to talking heads discuss whether or not the deranged killer was motivated by right-wing politicians? How much time will we waste hearing our right-wing friends defend themselves and counter attack and name-call their detractors?

Not all of the discussion is wrong headed if it seeks to protect better politicians and the rest of us from crazies and others who seek to hurt us individually or collectively.

But come on – most of what I am seeing and hearing is not directed that way. Here is what I don’t understand and what I am spouting about.

First, what religion or spiritual body of thought supports this mean-spirited talk?  

Second, why are they wasting our time with useless diatribes? Do we not have real and urgent problems to deal with?

Third, are our politicians so tired of battling the real and tough issues that they find it easier to lob stupid bombs at each other?  

Fourth, do these talking heads have some real data or information that has uncovered a plot by right-wingers to use weapons and other means of violence to take over America?

Fifth, have left wingers never advocated violence against the rich, big corporations, or the powerful?

Sixth, are there not always fringe persons in our free society who seek to incite fear, hurt, and kill the rest of us?

Seventh, would we not all be better off if we worked together to protect us from these crazies?

Rose and Merlin are fictitious people and the story about them is silly. But why do we act like them? The USA allows freedom of speech and we have a right to say intelligent and stupid things. Neither the left nor the right has a corner on the stupid statements. I just wish the rest of us weren’t so often brought into it. What irony. Now that I finally purchased a digital TV I find myself wanting to use it as a hat rack. 

2011 Kickoff

If you are like me you have probably already seen enough college football to last you until next Fall. But then, not many people would admit to being like me so let’s switch our attention to Brett Favre’s sexual exploits. That’s not what I meant. I meant Roethlisberger’s sex habits. No that’s not what I meant.

At this point you have either gone bowling or you are actually reading in excitement. So let me take advantage and switch to the economy and its performance in 2011. I am writing this on January 4^th so not much of 2011 is in evidence but I have noticed that the stock market has been very happy. That makes us retirees and hopeful retirees very happy. But will the fun continue?

That’s the $64,000 question and if that doesn’t date me then holy cow, what else could Edith? Those of you with short-term memories will remember that last year around this time we were very optimistic about the US economy but by spring and the unfolding of too much negative information about gyros and other Grecian statistics, we were wondering if we were in for a double dip – meaning that the US economy would fall from Grace and re-enter purgatory or even worse, you would receive a four-day visit from your closest relatives.

It took a while to climb out of that worrisome economic hole but here were again waiting for another Super Bowl and wondering if the economy will resume a clip fast enough to make a dent in the unemployment rate.   Macro is a great tool but being a practitioner of it doesn’t mean that I can forecast the economy for the rest of 2011. It is too bad that professional talking heads and journalists don’t have some humility because they get us all revved up for nothing but their own fame and wealth. They don’t know any more than we do but they sure look solemn and professional when they tell us about the future.

So if you have nothing better to do let me spend a little time explaining why I am generally optimistic but why I am not betting Betty’s Genesis on any particular outcome. What I do below is to explain why I think we might continue to recover but why there remain challenges that will impact the path of recovery. First, it seems to me that time has helped to heal the economy. While the stimulus policies helped to prevent a more severe downturn the main benefit is that the economy has mostly run its downward course. You don’t spend 10 years in rehab every time you get sick. The economy was not permanently injured by the factors that came together in 2007and thereafter to generate the recession.  The economy got punched and we adjusted to the punch. It was a hard punch so it took a while to digest. The good news is that we are on the mend.  The worst is over. The patient is on an upswing. But let’s not get too crazy.

Second, we still have some lingering problems. For example, housing experts believe that the foreclosure issue is still with us in 2011 (and beyond) and that means that housing prices may have to adjust downward another time or two. Most reports, I believe, see this as an orderly process. I interpret this to mean that housing news is 2011 won’t be good but it won’t interrupt too much the faster growth coming from other sectors of the economy.  I would expand this line of reasoning to include the broader financial system. While regulations have not addressed our problems adequately (too big to fail is one) I think time has helped to resolve the worst problems and debts are being worked off in the private sector.  As long as we don’t learn really bad unexpected news from housing or the financial sector, these sectors will only provide a small drag as we go forward.  Of course, that is one risk factor. If there are new unpleasant discoveries in the financial and housing sectors, then anything could happen.

Third, the big news item right now concerns US government debt and what our leaders in the government are going to do about it. There is the political silliness about extended the debt ceiling. Ignore that. We will not reneg on our national debt and everyone knows that. You guys have really fat wallets and the government has the ability to create infinite amounts of tax revenue at any time. So stop with that nonsense. What does matter is how we deal with reducing the debt. We REALLY need to have a plan and we have one brought forth by a commission at the end of 2010. The plan does not have to create extreme austerity forever and it does not need to create any real austerity until several years hence. But it does need to have an explicit and impossible to wiggle out of plan that reaches into the future. It must have credibility to bring government debt-to-GDP ratios back down to long-term averages.  Should our leaders legislate such a plan in the next few weeks that event will help the economy grow stronger now. Without it, we will lumber forward on the edge of a knife blade until the bond vigilantes get tired of harassing others.

Fourth – whether you call them bond vigilantes or simply grandma and grandpa – any hint of a significant resumption of the disastrous spending and saving performances of either our private or government sectors is going to lead to a economic calamity. Just like your child, presently a freshman  at Spendthrift U who cannot be given your credit card in his second semester,  our nation will not be able to find anyone willing to take the risk of lending us money – that is, buying our stocks and bonds . This eventuality will have the effect of raising interest rates, reducing the values on the stock market, depreciating the dollar and generating very slow growth – if not another recession.

So there we are.  We could have a nice reasonable story for the continuation of the recovery. But there are critical factors which include, at minimum, continued improvements in national saving and no unexpected or severe deterioration in housing or financial markets. With luck we might even see the unemployment rate begin to fall.  There is no magic to getting the unemployment rate back to 5%. In fact, I am guessing that what we call the “natural rate of unemployment” has significantly increased since firms have now found ways to reduce the employment factor in production for three years. Even with a spurt of sales I doubt they will go back to employment levels of 2007.

With households and governments taking years restoring saving balances, economic growth should not be spectacular. That is, do not expect a typical fast-paced recovery now nor in the near future.  Reality suggests that once firms become even more confident and optimistic about the future both output and employment will grow – the GDP gap will shrink and the unemployment rate will fall. This confidence will result from more time passing and the absence of negative surprises. So a gradually improving economy is possible. But those negative surprises with respect to housing, finance, and government debt policies suggest the possibility of something worse.  Time is on our side. Let’s hope our new government in Washington has the sense to minimize and not aggravate those things which will put us in reverse. 

Happy New Year

Many people around the globe celebrated Christmas on Saturday and whether or not you are a Christian Christmas it is a big day for most of us. Those who like to shop love the opportunities December affords. Those who cherish the spiritual part and the giving can feel and share their love of God and their fellow man with great intensity. Those who enjoy parties will get plenty of time to revel and gain weight which they can dutifully plan to shed in the New Year. The rest of you will hopefully enjoy the beauty of winter and the anticipation about what 2011 will bring. Those of you on the East Coast may have enjoyed enough winter!

I am pleased to give you all a really big gift by taking this week off from venting my spleen in my blog. But I do want to thank-you for giving me the chance to spout off in 2010. As you know I retired from Indiana University last January and I was not very sure how the first year would go. As it turned out I got chances to teach for a couple of months in South Korea and Vietnam. Last January I was lucky to share some ideas about macro on a nice little island off the coast of Florida. These teaching experiences kept me connected to macro and teaching. But the blog was my constant companion over this year and it gave me impetus each week to keep up with the latest news and issues. As you know it was a year in which macro could have won an Emmy Award.  There was never a time when I sat at my computer wondering if there was something juicy to write about.

Writing helps me to think in a more organized way. It also helps me get things off my chest. I always feel a lot better when I post a message. I admit that it is a very selfish affair for me. I can only hope that you benefit from my macro-thoughts. For all that I leave you with my thanks and a brief personal message.

My family and especially my parents and spouse always saw and see the world through an optimistic prism. To them, the world’s glass (of JD) is always half full. They never met an enemy and usually interpret difference of opinion and argument as a result of the complexity and changing nature of most phenomena. We might think of an adversary as misguided or misinformed but mostly we believe the interactions with them make us better informed about our own judgments. How boring and cruel a world would be if we all shared the same opinions about everything!

No matter what I might say about an issue or a person or a political party I hope it is taken in this positive spirit. I will do my best in 2011 to respect those who hold different opinions but I hope I never shy away from what I consider to be the right and the wrong of a particular issue or policy. We humans have much more that binds us than divides us and I hope we realize that as we move into an exciting but potentially divisive year.

You might be curious who reads my blog. It is mostly insane people I know pretty well. They include my former students, my recent students in Seoul, Hanoi, and Sanibel Island, and many colleagues. But I also badger various relatives, friends, and neighbors who might have some interest in macro.  I connect with all these people through Google’s Blogspot, Facebook, Linked-In, and Twitter. I also send a personal email to 100 and something people.

Blogspot has a statistics option which lets me know information about those who read my posts. Here are a few facts:

• ·         Since June of 2010 I posted 64 articles on 21 different macro topics (you can see all the topics on the lower right corner of the home page if you scroll down)
• ·         I posted 11 articles on Macro Policy, 8 on Exchange Rates and Policy, 6 on Employment and Unemployment, and so on.
• ·         The most popular articles were Fairy Tales Can Come True (Aug 6), AT&T (July 4), the Myopic Squirrel (Sept 13), The G20 (Oct 28), and Lilliputians(Aug 23).
• ·         There have been approximately 4,000 pageviews – posts that have been read or at least opened
• ·         While 75%of these page views came from the USA, I seem to have readers in South Korea, the UK, Vietnam, Canada, India, China, Germany, Spain, France and Finland.
• ·         Almost half of you used IE to connect but 24% used Firefox and another 25% used either Chrome or Safari.

I look forward to more spouting in 2011! Best to you all.

Nobel Nonsense and President Obama

I was going to take the week off and send you a nice holiday message and then one of my colleagues sent me the link to a Paul Krugman article. I guess I will send you my holiday message later in the week. 

I don’t like to read Paul Krugman articles because it is bad for my blood pressure. This guy has a Nobel Prize in economics which makes you think he might really care about his science but instead he uses his elite position to be the spokes person for one extreme view of economics. With his behavior he gives a bad name to the science and it riles me a bit. I would think that even liberals would be embarrassed by some of his antics.

In “When Zombies Win” http://www.nytimes.com/2010/12/20/opinion/20krugman.html , Krugman uses colorful language to say basically two things. First, Obamanomics didn’t fail – the President simply didn’t try enough economic stimuli. He had the right idea -- he simply didn't do enough of it. Second, he says President Obama, unlike Reagan who stuck with his ideas, has been cast into a spell by conservative zombies and they are going to eat his brain and our economy with it. Really – this Nobel Award winner said that!

To prove that Obama’s stimulus package was too small, he says “government spending on goods and services grew more slowly than during the Bush years, hardly constitutes a test of Keynesian economics.” Wow – talk about a real economic scientist! He uses government spending on goods and services as the only real data pertinent to stimulus in the last two years. Dear Paul – what about government transfer spending? What about government bailouts? What about tax cuts? Does anyone really think he provides a full coffin of evidence about stimulus by measuring only GPGS? I am glad for any college student taking freshmen economics who would not give such an answer on his or her final exam.

Then Krugman says that conservatives are totally discredited because inflation and interest rates have not risen in response to the stimuli. I am guessing that few economists really predicted a rise in inflation BEFORE the economy started to recover in earnest.  Most of us believe that something called the GDP Gap needs to closed before inflation starts rising. We also would not see interest rates rising until the paranoia about slow growth significantly reduced the demand for government bonds. Krugman turned a very legitimate worry or concern about stimulus causing higher inflation and interest rates into a forecast – and one that all his adversaries must have agreed with.  Talk about creating a straw man!  He also says that disinflation continues. Technically, that means that the inflation rate continues to fall.  Does he provide a shred of data or evidence? How much did the inflation rate fall in the last, say six months? Three months?

That Obama had the audacity to praise Ronald Reagan and admitted that some austerity is necessary for historically high levels of deficits and debt, make the President Zombie prey.  Those nasty Republicans made him say “Uncle” and now, according to Krugman, he can never oppose their incessant demands for ghoulish austere economics.

Krugman cites Ireland as an example of why austerity policy is bad. I guess that is the sum total of his knowledge about austerity and the experiences of no other countries matter. I would hope that no freshman university student would write such flimsy answers to important questions. Of course, if you happen to be Irish then you might want to reserve judgment about what did or didn’t help the Irish find their way out of their very tough present economic condition.  

Like Krugman, I don’t like the way Obama supported a tax plan that goes in the wrong direction. As I wrote last week, this won’t create enough stimuli to reduce the rate of unemployment. But Krugman wants more stimuli and that’s where he and I part ways. The US economy is gagging on past stimulus and will eventually swallow and digest it all. At that time the economy will grow – especially if we quickly introduce a fiscal restructuring that deals with future deficits and debt. Krugman might call that austerity but I call it common sense. 

Shakespeare 's Comedy Plays Out in the US Government

On Sunday I watched CNN until I thought I was going to choke from excessive theatre. If Shakespeare was alive he would have applauded loudly at the farce we call Washington. I am not sure which play the current cast of characters would best fit – A Comedy of Errors or All’s Well that Ends Well? I won’t say a lot more about these plays since I read the Clift Notes versions at best as a freshman at George Tech in 1911 and don’t want to give away my total lack of understanding of the arts.

But you have to admit without actually being a Buddhist monk that these politicians are missing the big picture. No matter how you look at this thing what was once billed as a renewal of the Bush tax cuts is now the world’s most laden Christmas Tree. The unfolding legislation is a really bad deal for all of us. Yet the stage production repeated with excruciating analysis by the press and Internet conveys how and why it is of the utmost urgency. I don’t agree.

As many of the Ds and Rs and journalists hold hands and sing one more kumbaya we are lulled into a warm sensation that this compromise bill is going to stave off a double dip recession and be just what Dr. House ordered to reduce the unemployment rate.  But are we really holding their feet to the fire? Will the bill do what we hope? Here are some things to think about.

•      The bill, even with all the new ornaments they are adding, will amount to a very small stimulus. It mostly keeps tax rates the same in 2011 as they were in 2010? How is that a stimulus? How is that going to significantly reduce the unemployment rate?
•     The bill in any manifestation will definitely add to the government deficits in coming years. These additions to an already bloated government debt pile certainty leads to even more uncertainty about interest rates and the soundness of federal, state, and local governments. Of course, you can translate that business uncertainty into a virtual certainty that you, I, and Mr. Jones are going to pay higher taxes at some point in the future. 
•      This bill does absolutely nothing to reduce the explicit and implicit debt obligations coming from Social Security, Medicare, and Medicaid. And it does nothing to reduce or control healthcare costs for those who actually pay for their healthcare.
•      Have you heard of bond vigilantes? This terminology is a colorful description of the people and institutions that make their living trading bonds. Call them geeks or greedy they have the tools and rights to decide when bonds are no longer a good deal. Most of us buy bonds and hold them to maturity. But sometimes we decide to sell them before maturity and it is these bond dealers who form a market so we can do that. We like them when they buy the bonds we no longer want so that we can buy villas on the Croatian coast. Anyway, as the US debt gets a big as Roseanne Barr’s belly, we recognize that there are way too many bonds out there and this should lead to a fall in the price of bonds. Knowing that – a lot of us want to sell these bonds before they lose too much of their value and the bond vigilantes are leading the charge with their faithful dog, Rin Tin Tin. No offense to Lassie. As bonds become as cheap as kimche in Korea, the returns on the bonds soar. Another way of saying this – it takes a much higher interest rate return to get people to hold all this kimche. Viola (or to you unsophisticated people who cannot spell in European, Walah) – the higher interest rates then act as an impediment to people who want to buy new houses and firms who want to buy new equipment. It generally slows things down.

So let’s summarize the above. This new legislation will not be a big enough stimulus; it will make the US debt larger; it will create more uncertainty; it will raise interest rates; and it will reduce spending on housing and investment. Hmmm.

You might be fuming at this point and say, LARRY, IF WE DO NOT PASS THIS BILL WE WILL GO DIRECTLY INTO A DOUBLE DIP recession. The capital letters implies that you are yelling at me or that you hit the Caps Lock key by accident. It is taken for granted by EVERYONE that if we let tax rates rise in the coming year that we will go directly without collecting $200 dollars to the square titled “Recession”.  So I have two things to say about that. First, this is not 2007 and we are not in free fall. While the economy is not growing as fast as we would like right now, it is growing and we are not in the same kind of panic situation as we were a couple of years ago. We do not need desperate policies. There are plenty of green shoots showing that the US economy is improving and as I have said in many past posts – we need to heal the housing markets and financial problems before the economy really picks up. This recent legislation does nothing directly to heal housing or finance. As I said above, passage of this bill does very little while creating very large risks.

Second, I am not advocating doing nothing. In fact, I would go along with some well-placed stimulus as long as it was coupled with Angelina Jolie.  That’s not right. I mean so long as some stimulus was coupled with a plan for long-run fiscal balance. I don’t need the long-run plan to start impacting us today. Too much austerity right this minute might not be good. But I do need the Plan to be legislated tomorrow with its first real impacts starting a few years from now. By legislating a plan today with impacts starting tomorrow – means we all can start planning today. That longer-term plan could have some elements of very short-term stimulus within it. But the longer term plan must show how we are going to pay for it in the future.

A good friend of mine had knee replacement surgery last week. He needed some pain medicine to get through the first week of recovery but soon he can get by without it. He knows that he has ahead of him several weeks of lingering pain and tough rehabilitation. By any definition, that plan for rehabilitation is tough and nothing to look forward to. But he knows that it is the only way to a recovery that allows him full use of his knee and leg. We in the USA can pretend that we don’t need a rehab plan yet, but the truth is that our government is giving us pain pills and are afraid to have us think about the future. We are better and tougher than that. We need better leadership and we need to make sure they know that. It is easy for them to legislate another round of morphine. Let’s not let them do that without also being very clear about what we need to grow again. 

The Fiscal Circus Has Two Rings

Now that Congress is making a little traction with a framework for fiscal policy, let’s not get carried away with dangerous partial solutions. It is one thing to keep the patient out of pain with an injection – it is quite another thing to apply the remedy to his problem. So let’s not get so excited about the easy part until we see the rest of it.

Any good circus has more than one ring.  In Ring 1 we have Congress working on an extension of the Bush tax cuts beyond 2010. That’s akin to a shot for the pain. In Ring 2 we have the serious stuff – a solution to fix our debt problems and therein address unemployment and economic growth.  It seems strange that the public has been so divided about Ring 1 since it is the easy one. Both democrats and republicans have joined hands in a holiday chorus and are singing a Hail Mary designed to focus on a possible deficiency of aggregate demand in the short-run. They had their little spats. The Ds don’t like it when stimulus includes the behaviors of high income earners – while the Rs don’t like the stimulus coming largely from the lower ends of the income scale. But let’s face it – they both get to go play on the monkey bars and jungle gyms at recess if they pass something before January 1. The public is going to shower them with love and kisses for saving our nation from a tax increase in a slow growth period with high and stubborn unemployment.  So it is unsurprising that they will find a consensus on the Bush Tax Cuts.

I am not against Ring 1 and am not against the general notion of keeping tax rates low right now. But I do see this as akin to a good dose of Demerol with no surgeon in sight. Ring 1 is okay so long as there is real action in Ring 2. This conclusion is based on one simple point – the Ring 1 solution will do little to reduce the unemployment rate without a satisfactory solution from Ring 2. Ring 2 contained the National Commission on Fiscal Responsibility and Reform. It went home with a few trout in the boat but not enough to start a real fish fry in Congress. It is true that 60% of the members of the commission voted yes to the spirit of a feasible but imperfect compromise law to attack our escalating government fiscal woes, but that wasn’t a strong and clear enough message.  Ring 2 is in limbo right now. The surgeon is not to be found.  Even if the Commission failed to get the required number of votes, it is still possible that the President and Congress can continue the work in Ring 2. So all is not lost.

While all is not lost, nothing yet is gained from a compromise in Ring 1. After all – in reality an agreement to leave the tax cuts in place for next year or beyond is simply a vote for NO CHANGE. The agreement keeps taxes from rising by keeping them the same as where they were in 2010. If we want 2011 to be better than 2010 then it takes some change. So the big question is – what needs to be changed?

Bernanke, Geithner, and many others still believe that the earth is flat. Oops, I mean they still believe that the problem with the US economy is deficient spending. So the kinds of change they are promoting in Ring 1 are fiscal and monetary policies that would stimulate more household spending.  They also believe that the economy has been very unfair to the average person so their preference is to help people with middle or lower incomes spend more. They don’t want to help Gazillionaires.

Another group sees it differently believing that aggregate demand is deficient because firms are hiring too few workers despite some signs of economic revival. Until firms start hiring more, no amount of stimulus is going to be effective. So all we need to do is figure out why firms are so reluctant to hire.  Or in other words, despite the fact that output has gone up in the last five quarters, employment has barely budged.  Why are firms not hiring? Without a significant resumption of hiring stimulus cannot work. First, the unemployed have few resources to spend. Second, even the employed people are reluctant to spend because until hiring picks up they are not sure that they won’t be the next to move to the unemployed pool.

Consider what happens when you hire a new permanent worker. First, the person must be trained. Second, the firm makes an implicit if not explicit contract to continue employment. If nothing else there is a goodwill gesture made on the part of both parties. Third, the firm will increase what it pays into the state unemployment pool. Fourth it will add to the payroll tax paid. Fifth the firm will probably incur expenditure for various benefits – including healthcare and pension. These are not entered into lightly.

Consider the alternative to hiring an additional new worker. Don’t hire anyone! When sales pick up it is possible to work the existing workforce harder. The firm can expect more output during the regular day or it can pay more for overtime. The company might also think harder about how to employ its workers. It might be possible to change its business practices in such a way that the same amount of labor can accomplish more in a given day. Clearly there are financial incentives for firms to not hire more workers. Buying a machine that makes existing workers more productive means not having to pay additional payroll taxes, healthcare benefits, pension benefits, etc.

So why would firms hire more? I love this question because it gets to the heart of economics since it is all about marginal benefits and marginal costs. According to marginal analysis, you hire another worker when the marginal benefit to the firm of one more worker exceeds the extra costs of one more worker. That is, the firm hires more if the increased employment increases its profits.

In a capitalistic system, firms are free to make hiring decisions and they generally hire more to capture higher profits. The government policy question, then, is as follows. If you want more spending, you need more employment. If you want more employment firms need to expect higher profits. Sales are expanding now so you would think that this would lead to higher profits. While profits are rising now the question is for how long? Firms would like some certainty that the recent short-term profits will not vanish as soon as they arrived.

And this is why Ring 2 is so important. To create the increased profit certainty that firms require will take increased attention to the things that might threaten future profits. Historically high government deficits and debt are real threats and all the current fuss over government instability in Europe points to how corrosive this can be. Government could go a long way to reducing profit uncertainty by crafting a solution for the government fiscal mess. This, of course, brings together the recent explosions of debt caused by stimulus legislation, health care, and by the ongoing and fully expected fiscal requirements of Social Security, Medicare, and Medicaid.  It is one thing to make a decision about the future of the Bush tax cuts – it is quite another thing to help firms better understand the tax and other regulatory impacts on them of dealing with the next 20 years of fiscal challenges.

Until you solve Ring 2 we will get no bang from Ring 1. Until you solve Ring 2 you get no decrease in profit uncertainty and no real commitment to hiring. Take no pride in a solution to the Bush tax cut extension until they get on with the real business of government. 

A Keynesian Wolf misleads about the Euro

I thought I had finally settled the debate about the euro crisis with my last post (ha ha) and then along comes this piece by Martin Wolf in the Financial Times (December 1, 2010). http://www.ft.com/cms/s/0/259c645e-fcbb-11df-bfdd-00144feab49a.html#axzz16y45YdFO

My previous post argued that the euro might depreciate more but it would surely not implode. Wolf is a great writer and I usually like to disagree with him because he is a not-so-closeted Keynesian and I am neither closeted nor Keynesian. This article irks me more than his usual writing because it epitomizes really good analysis based on a really wrong premise. His article illustrates what is wrong with much of what is written these days and helps me try to live up to my goal for this blog – to spout off.

The title of Wolf’s article is “Why the Irish crisis is a huge test for the eurozone” and he concludes that by joining the eurozone, a country consigns itself to credit crises. His words of advice to countries that give up their own currencies to be part of something like a eurozone, “… be careful what you wish for: credit crises would replace currency crises – and these are likely to be even worse.” 

He has an elegant explanation for all that. He begins with the premise that it is inevitable that countries with “divergencies in relative costs” would have international trade imbalances. That is, without flexible exchange rates a country with a bump in relative costs would soon find itself less competitive and would soon have a structural trade deficit. A depreciated currency could have come to the rescue and offset the cost change and restore its competitiveness. Sans an exchange rate depreciation in countries like Greece and Ireland, each would be stuck with a trade deficit implying a need to borrow from abroad to finance their trade deficits. This means a larger foreign debt and should a country have trouble meeting the debt at some point – wham bam thank-you mam – a credit crisis would occur. Then –oh my goodness – national prices would fall worsening the credit crisis – and that makes it much worse than a currency crisis might have been (if the country had its own exchange rate).

Since you know I love to use analogies – Wolf’s point is like saying that you can solve the morning after problem for the drunk by taking aspirin instead of Ibuprofen. We can spend until hell freezes over debating which drug is more effective for a hangover (I prefer a nice strong Bloody Mary myself). We might even find that one of them is better for hangovers. But the only real solution for a hangover is to not drink so much and to not dance to 1970s disco music like John Travolta wrapped in colorful beads with a lampshade on your head. My point is that Wolf is writing about “effect and effect” rather than “cause and effect”. His defect is in his focus on effects without causes. He shifts our attention away from the real problems to a choice of medications.

When this very intelligent man analyzes the issue of the euro, why does he not once – not one single time – does he not go back to the idea he starts with – the cause of it all – the change in relative prices? Why – because he is a closet Keynesian. They usually ignore the original problem. They see any problem as an excuse or some clever ploy to get the government involved by spending more. After all – there are so many things the government could be doing if they just spent more!

If a rise in relative costs and prices causes a country to lose competitiveness – I ask – then why cannot this country work directly on reducing its relative costs and prices? Would it be impolite to even ask this question?  If a country is made more vulnerable because its households go on a spending spree and forget to save; if a country’s government goes on an economic development spending binge that reduces national saving available to corporations; if a country’s companies get lazy and don’t invest in the right technologies or products – in all these cases its competitiveness will be reduced. But notice that in all these examples of cost disadvantage there is a direct cause that could be directly addressed if politicians had the cough-cough sincere interest or kahunas to investigate. But that is too hard for them to do. All that discussion of details might not fit on the teleprompter. Rather than take a real educational and leadership role about a complicated problem – it is much easier to advocate a policy to increase government or household spending.

In this particular case Wolf is blaming the problem on a single currency. If the poor babies only had their currencies back then the boo boo would go away. NO IT WOULDN’T AND READING ANOTHER CHAPTER OF DR. SUESS WON’T HELP IT GO AWAY. If those weakened countries had their currencies back their exchange values would plummet towards zero and contribute to a generally hysterical situation. The rapidly declining currencies would lead to large and rapid outflows of portfolio and real capital. Declining currency values would make it more impossible to pay off their debts.  Maybe you have read about past currencies crises? They do happen – and it seems to me they happen a lot more often than credit crises.

But I don’t want to get sucked into Wolf’s trap. It isn’t about the currencies. It is all about the CAUSES of competitiveness changes. If countries lose competitiveness for fundamental reasons then their leaders ought to decide what those reasons are and address them. Debating whether European nations would be better off with or without the euro misses the target, misleads, and misdirects our energy. Policymakers should not be discussing a euro break-up. They should be discussing the regulatory, housing, financial, spending, and saving practices that led to their current predicaments. If leaders don’t get this right then they ought to be replaced. I hope our own policymakers in the USA get this message too or 2012 could be really interesting.  

The Euro -- Breaking Up is Hard to Do

Many of the international monetary experts are weighing in on the future of the euro.  While I might not be an international monetary expert I do need weighing, so here goes. There is little reason for the euro to implode, for Spain to leave the euro, or for there to be separate clubs for euro-weak and euro-strong countries. While the euro might weaken more in the near future I think it will remain the currency of at least 16 countries for the foreseeable future. I agree with Neil Sedaka's 1962 tune from the good old days -- Breaking Up Is Hard To Do. 

Notice that when a hurricane devastated much of Louisiana, that state was not kicked out of the dollar alliance of 50 states plus others. That was true even though it might have helped folks in New Orleans if they had their own currency and it depreciated a bunch. Just think of all the Japanese tourists with their Nikons who might have been able to afford a neat trip to Patty Obrien’s, including a swamp boat ride and all the ‘Gator-filled Po-Boys they could suck down. Of course, let’s not forget a midnight beignet at the Café Du Monde.  But I digress.

You might retort that Louisiana is part of country called the USA and Greece, Ireland, Spain, and Portugal are part of a monetary union called the Eurozone. To be part of this monetary union all 16 members of the Eurozone signed a treaty in Maastricht that is a very formal document with pretty lettering and no smiley faces. I agree that it doesn’t have the force of statehood but it clearly is not trivial – and was not entered into lightly. All members of the Treaty drank copious amounts of Belgian coffee with delicious French pastries over many years and I am guessing that on more than one occasion a German official pointed out after one-too-many Schnapps that all members were not created equal.  Clearly they spoke of contingencies and escape mechanisms.

But even if they didn’t and some of what has transpired in the way of country debts and economic contractions was not expected, there is still little reason to break up the Eurozone. At least until recently there was a line-up of countries that wanted into this elite club – and for good reason. The Eurozone did what it was expected to do – it removed a major irritant from international trade between a growing number of European countries whose economies were becoming much for economically integrated. I am among millions of travelers who remember how stupid and irritating it seemed, when traveling around Europe, to have separate little piles of lira, pesetas, deutsche marks, etc. To businesses, this inconvenience was multiplied into unnecessary transactions costs. Of course, when these European currencies were sometimes changing in uncertain ways this really hurt business planning and it made a lot of sense to eliminate that risk by adopting one common currency. Wow! How cool can you get! As there is still much integration to unfold in Europe, these benefits will continue to hold and grow.

There is much more to the benefits of the euro – and countries like Greece, Ireland, Spain and Portugal reaped some of them more than others. Clearly from the standpoint of currency credibility these four and some of the other members gained when they gave up currencies with bad reputations for one that seemed a much better bet for the future.

Still you might say, wouldn’t the weaker countries benefit if they could depreciate their own currencies? And the answer is probably not.  All countries have policies tools to help when things go wrong – monetary, fiscal, immigration, financial regulation, and many more. While it is true that exchange rate management can be a powerful tool for a country, there are many countries that never use it. Many prefer to peg to the dollar or some other currency or bundles of currencies. Many simply do not believe it is wise to try to fine-tune their economy with the exchange rate.  So it is not a universally accepted best-policy. Whatever could be accomplished by depreciating their currencies in the current crisis could be managed with other traditional policies.

And one could argue that such exchange rate management policies or dirty floats come with great risk. There are numerous recent historical examples where speculators or hedge funds have caused devastating impacts on countries that waited to use depreciation as a tool of macroeconomic or trade policy. Right now the euro is taking a little beating from the markets – but certainly nothing like non-Eurozone countries have experienced in the last couple of years. I doubt that Ireland, Spain or Portugal would be better off with their own currencies depreciating by the likes of 50% right now!

And then there is the case of the strong countries, like Germany. Why not boot the scofflaws? Why should German citizens bear part of the brunt of weaknesses in neighboring countries? For one thing, Germany, France or the other stronger countries cannot really escape the fate of their weaker trading partners because of interdependencies. While the euro might be stronger today with a smaller club, contagion would still impact a wider group of countries whose economies are linked. Clearly the banks of the stronger countries hold the liabilities of the weaker ones. Business firms engage in cross-border trades in myriad ways. If Spain, for example, applies a fiscal remedy that slows economic growth in that country, clearly with or without the exchange rate impacts, this slower growth will spill over into its European trading partners. This is the price one pays for economic integration. If you want to receive the benefits of the relationships then you sometimes have to suffer through the costs – whether they come through exchange rate effects or not.  Furthermore, just because weaker countries might be asked to leave the Eurozone, they would still be members of the European Union. The EU might, in that case, be involved with policies to bailout or otherwise assist the weaker members.

In short, the benefits of the euro continue and neither the weaker nor the stronger countries will be better off by reducing the number of countries participating in the Eurozone. The best bet is that the Europeans will do what they often do – eat more croissants with that wonderful Spanish ham and debate until well into the night over cognac and brandy. The EU started a long time ago. The Eurozone is newer but has already endured much. In all, European countries show an ability and readiness to hash it all out and move forward. I bet they will continue to do the same now.  Don’t look for any pesetas anytime soon. 

Blinder makes Monetary Policy on the Moon

I eased off the topic of Quantitative Easing (QE) until now because there was so much being written about it. But then all this stuff about Prince William and Princess Kate hit the news and I realized two things. First, I am getting really old. Wasn’t Prince William playing in his crib last year? Second, you people need a little diversion from the Royal Family. And then to top things off Alan Blinder, a former Fed vice chairman, called QE2 a “garden variety monetary policy.”

Wow. Professor Blinder must be growing his artichokes on the moon if he calls QE2 garden variety. It is true that the Fed always does monetary policy by buying government bonds and by trying to influence interest rates. The buying of the government bonds washes the banks with new increased liquidity and reduces the pressure on the cost of bank borrowing. The general idea is that if the cost of bank funds decreases then banks will be willing to reduce interest rates on loans. The story continues – and then goldilocks lived happily ever after. Err, I mean the story goes that firms see lower interest rates and they jump in their Fords and drive down to the carry out window and borrow tons of money and spend it on new machines and workers. 

While I make a little fun with the story, the truth is that this sometimes works. The truth also contains the fact that most of the Fed's buying of government bonds is in bonds of short maturities. Therefore most of the direct impacts on interest rates occur at the short end of the term structure – on bonds that mature in two years or less. Of course, they hope that the reduction in short-term rates would bring about a decline in longer- term rates as well. To have the full or complete impact the story wants to have all rates decline. 

The above is garden variety monetary policy on planet Earth.

So what is different about QE2? First, it was invented in places like Japan and now the US where short-term interest rates are virtually zero so that the above story is no longer relevant. The Fed cannot reduce short-term interest rates and the cost of bank funds. So they decided that if they are going to make Mad Money (the TV show) on a regular basis they better come up with something cool and novel. If Nancy Pelosi cannot save the US economy, then maybe the Fed can.

Second, the Fed realized that even though they were able to drive short-term interest rates to zero (ta da!) rates on longer term assets were not coming down as much or as fast as they wanted. After all, to have the largest impact on spending it is important to impact loans with longer maturities. So QE is different – since it worries less about short-term rates and forcing even larger amounts of unused reserves on banks – and more on directly influencing long-term interest rates. While this has been tried by the Fed in the distant past, it is NOT DOING MONETARY POLICY AS USUAL.  And, of course, you wouldn’t have thousands of articles being written about QE if it were business as usual. 

Policy conservatives have plenty to chew on. QE and QE2 represent a broadening of the Fed’s tools or perhaps even its mandates. If policy conservatives want the Fed to focus its energies more narrowly (aiming only at inflation), then they are not going to sit around smelling incense as the Fed gets more active.  Moreover, policy conservatives might point out that QE1 already stuffed plenty of money into pillows and adding a second round is only asking for trouble. Professor Blinder can show you overhead slides of how easily it is to pull money back out of those pillows when necessary but what he can’t easily show you is how difficult that plan is to put in place in the real world right here on Earth.

Third, the difference in QE2 also relates to the business environment. Keynes convinced most of us that monetary policy is NOT the best tool to use when the recession is deep and when confidence is failing. Keynes and his legion of legally-obtained medical marijuana smokers have a preference for fiscal policy. Read recent articles by Krugman and Stiglitz to see why some activists prefer fiscal to monetary policy today. While you should not count QE2 out until the bell rings, it does not surprise me that most long-term interest rates rose – did not fall – once the Fed got serious about some of the details of QE2. As Keynes might say today, the Fed‘s flailing attempt to do something is doing nothing but creating a higher risk environment. Alan Blinder and some current Fed officials can say all they want – but markets are smarter than that. QE2 is not a good policy for the Earth at this time.

Voodoo Economics, Part 2

In my last post – Voodoo economics – I hit my page limit before I got to any real specifics. I laid out a rationale for why demand-side policy probably was largely spent and gave some background on supply-side policy. The main point is that supply-side policy has a checkered reputation that is mostly undeserved. It is pretty easy to dispense with the charges that it won’t work or that it is trickery. The more difficult aspect is that supply-side policy generally works BECAUSE IT STARTS by impacting rich folks and business firms.  But what matters most is where it ENDS – so let me get on with that point.

If you are imbued with equity and making sure that all people are always treated equally then you may find supply-side policy offensive. If you HATE capitalism and think that most capitalist policies are part of a great hoax that perpetuates current power and wealth, then you are probably not going to trust supply-side policy. If you are simply hoping to find a policy that will help us permanently exit this horrible recession and slow growth period, then you will want some assurance that any policy will do what it is supposed to do – create more economic prosperity and jobs. So where is the beef (or tofu for my vegetarian friends)?

Keep in mind that every policy is uncertain and risky. The Fed’s new quantitative easing policy is hotly debated. Another round of short-run government stimulus is no slam dunk and has its supporters and detractors. Supply-side policies are no different so let’s not read what I say here as blue-sky advocacy.  In my previous post I made the point that supply-side policy works because it directly impacts those who do the hiring and produce the output. The supply-side policy is directly aimed at business firms’ bottom lines. The basic intuition is that if policy can somehow make business executives more optimistic about their future revenues and costs, then they will be more willing to make capital investments and hire more workers.

Of course, like all policies, supply-side policy has its own moral hazards and unintended consequences. So we shouldn’t throw the baby out with the dirty bath water. Whatever advantages are given to companies and high income investors, attention must be paid to how they will translate into jobs and economic growth. I have said many times that I am neither a democrat nor a republican. Adam Smith was very clear that while he favored letting the invisible hand work, that firms are just as capable of corruption and waste as governments. While supply-side immediate impacts must be directed to firms and higher income investors – the true value of this approach is in its ultimate impacts in terms of higher output, more employment, and higher incomes.

What I didn’t do in the last post is to discuss the many ways this can be done. Notice that even among supply-siders there can be very different preferences for specific policies. Much depends on what you think is the biggest problem – what is making firms less willing to use their piles of cash today? What is making them less willing to make capital investments? Why don’t they hire more workers?

For starters, imagine one group of supply-siders who believe the economy is on the mend. They believe that we got hit by an economic firestorm that rocked our economic foundations but that the resilience of the economy provided the foundation for recovery and the policies of the last two years did not prevent some early healing. These supply-siders point to various green shoots or data that show promise of a continued recovery. Their supply-side recommendation might be – Don’t rock the boat! They might advise the government to create as little change as possible.  Just let the economy continue to heal. Firms will jump in as soon as they are surer that this recovery really has legs.

Of course, another group of supply-siders might believe that government policy was too aggressive and that we have created a very risky business environment typified by too much government debt. We all have seen some really worrisome estimates of future debt burdens. They bring up scenarios in which the US becomes the disdain of world investors causing a plummeting dollar, declining stock prices, and rapidly rising interest rates. It is not a pretty picture. These supply-siders believe that you can reduce the risky environment by paying attention to imbalances in the balance sheet of the Fed and the large liabilities of the government. Firms will not hire workers in sufficient numbers until they believe government debt and Fed policy are under control. Their supply-side policy means significant changes in the government budget and Fed policy.

Other supply-siders worry about international competitiveness. They worry about a government that seems to give lip service to free trade and a strong currency but whose real actions seem to put off the real decisions about trade or they lead to a declining value of the dollar. Whether it was the recent Asian Summit or the G20 meetings, the US was able to accomplish little. We have stalled so long on bilateral free trade agreements that our potential partners now seem to be the ones dragging their feet. The US harps on about China’s currency when most people agree that the US is equally culpable. Geithner blames the recent spectacular declines in the dollar on a reversal of safe monies. But what does he think caused the “new” view that the US is an unsafe place to invest? Keep in mind that while dollar declines might help exporters – they do very little to improve the competitiveness of US importers and they accelerate the desire of foreign investors to move their money out of the US. If you were a foreign investor, would you really want to receive your future return in dollars that are worth 15% less?  Real free trade and a real strong dollar are not easy to buy today. But they are an indispensible part of a strong and viable supply sector. 

Most discussions of trade end up with a story about saving. We all know by now that the US saves too little – and therefore our imports end up rising faster than our exports. This implies a need to borrow from the rest of the world – and we do. It is pretty clear that we in the US need to save more and our trading partners could save a little less. But who does saving in the US? Short answer – rich people and companies! The only real way to increase saving in amounts that matter is to increase the reward to saving. A Fed policy aimed at zero interest rates does nothing to help! A threatened increase in income tax rates and capital gains tax rates does nothing but reduce the incentive to save. Opponents of lowering these rates always point to the disproportionate benefits that would go to rich people. But notice that their focus is on the immediate impacts. Instead they should trust that a country with normal or strong saving more easily channels resources for innovation and labor productivity without having to borrow from abroad. Saving is the key to economic growth and rising incomes.  The ultimate effect is the one we should be focusing on today.  Thus some supply-siders advocate lower tax rates for companies and households regardless of income.

I am getting too wordy again and I have only discussed four examples of supply-side policies. I don’t want to promise a Voodoo 3. There are so many other great topics to be talking about!

So let me just summarize the rest briefly. Another approach to supply-side policy focuses on the reward to produce and the reward to work. While the US used to have a reputation of a country with a small government and low taxes, this is no longer the case.  Whether it is taxes on energy or regulations that require firms to guarantee health care or be greener it is no secret that firms feel increasingly burdened by government. Given the inertia of the government, firms are also increasingly uncertain as to how these new regulations and taxes will impact their future net revenues.  Add to that a worry that current unflattering attitudes toward the rich and corporations raise expectations about higher taxes on the incomes of companies and high income individuals. A supply-side approach recognizes how counterproductive this environment is to economic growth and employment.

Several leaders of the Democratic Party have very recently pointed out that postponing increased tax rates for the rich is the fair thing to do. They also are holding social security out of any discussions of how to solve long-term government debt challenges. Again, the issue is fairness. But what does fairness mean? I really doubt that dragging our feet on needed policies for economic growth is going to have an impact on the rich or the poor. The rich will take care of themselves at the country’s peril. The problem of poverty has little to do with marginal tax rate changes and everything to do with very long-term factors involving sociology, education, and training.  All government policies should not be held hostage to fairness. The fair thing to do is to take a very comprehensive and realistic view of poverty in the US – and then do something about it. 

Supply-side policies deserve a good look. There are many ways to skin this cat. But we won’t get to the first step if we can’t get beyond the Voodoo. 

Voodoo Economics, A Trojan Horse, and Trickle Down: Is it time to give the supply-side a try?

In Econ 101 we learn that economics is all about supply and demand. I was recently in South Korea where flooding caused by a typhoon virtually destroyed the cabbage crop. While Bugs Bunny would be quite upset about such an event it was even more important and upsetting for Koreans whose main dish, kimchi, is largely composed of cabbage. Kimchi is eaten at least once a day by many Koreans. Most Koreans have two refrigerators – one for all their other food and the other just for kimchi. I do not hide the fact that I love kimchi as much or more than most Koreans and I have several shirt stains to prove my devotion to the wonderful dish.

It was no surprise to anyone when the price of kimchi rose by 600% this summer. Why? Because of supply and demand. While the demand for kimchi had remained largely unchanged by the typhoon the supply had been reduced by the bucket-full.  As such grocery stores and restaurants bid up the price of this very scarce commodity as they tried to fulfill the usual wants of their customers. The market result was a much higher price. As kimchi came into Korea from abroad and the supply began to recover, the price of kimchi peaked and then started downward.

As the US Congress reconvenes as lame ducks and then for real in 2011, we should remember that government has policy tools that can be aimed directly at demand, supply, or both. But as the title of this message suggests, any member of the US government who recommends a supply-side policy will have to get over huge political obstacles. When George Bush Sr. was competing with Ronald Reagan to get the Republican presidential nomination in 1980, he labeled Reagan’s policy Voodoo Economics. The implication was that Reagan was trying to foist magic on the American public. Supply-side economics was also referred to as a Trojan Horse implying this policy was a trick on the American people. Finally, supply-side economics is alleged to be a tool to help the rich at the expense of the poor – meaning that the real benefits go to rich people and companies and all we can do is hope for some benefits to trickle down to the poor and middle class.

In short – supply-side policies are thought to be magic, a cheap trick, and a tool to steal from the poor and give to the rich. That’s hardly a resounding vote of confidence. It is no wonder politicians do not want to stand up and be counted for a supply-side approach. But I will argue below that the supply-side reputation is better than the title suggests and supply-side policy is just about perfect for our challenges today.

Let’s begin by quickly defining the supply-side. Economics concludes that while society will want and express a demand for food, autos, appliances and multi-colored condoms, it takes business firms to produce them. When we study demand we focus on the factors that determine what households want to purchase. But when we analyze supply, we emphasize the ability and motivations of business firms to produce those products. Supply does not get created magically. Firms must put together resources – like raw materials, intermediate assemblies, labor, machines, factories, and energy – if they are to bring the right goods to market at a competitive price.

If President Obama wants to improve the climate for production and employment, then he has choices. A demand-side approach focuses on the consuming household.  He can recommend tax reductions and subsidies to induce households to spend. He can use government legislation to direct the government’s awesome machinery to spend more. When we talk about a “stimulus package” we are usually thinking about how the government can create more demand in the economy. Despite all the controversy right now, it is true to say that sometimes these demand-side remedies work. The government stimulates demand and firms respond like Pavlov’s famous dog – demand increases and firms produce more. To produce more they often hire more workers.

But right now at the end of 2010, it isn’t perfectly clear if the demand stimulus choice is the best one. We saw what happened when cash for clunkers expired. In a previous post I explained that households are repaying debt or are otherwise saving. Given the remaining uncertainty about the economic recovery it seems wiser for them to be saving and not spending. Of course, business firms are watching all this and are not about to risk their capital to produce more until they are more certain that any demand increases are going to have some staying power.  That leaves the government’s direct spending on the economy. But even here we learned how disingenuous Congress can be. So called shovel-ready projects were about as ready as a Medicare patient at a high-jump competition. Government largess was aimed at a multitude of Democratic pet peeves. We learned that the political process can be very slow and unreliable when it comes to quickly generating more demand for goods and services. Yet it was perfect at increasing government debt.

The second choice available to President Obama is a supply-side policy. Supply-side economics was boosted when Jean-Baptiste Say ( Say’s Law) declared that “supply creates its own demand”.  The general meaning of this statement is that factors which cause permanent changes in society’s capacity to produce often lead to conditions (e.g. falling prices) which raise the level of demand to the higher amount of supply. Most economists today use Say’s Law to guide their analyses and forecasts of long-run economic growth. These forecasts have no role for demand and totally explain long-run changes in economic growth with two factors: labor supply and productivity growth.  The upshot of economic growth theory is that strong growth will occur only if and when labor supply and labor productivity growth permits it. Persistent economic growth is the only way to have persistent and permanent increases in employment.

Today our demographics indicate there is very little potential to increase economic growth and employment through faster labor supply growth. Our baby boomers (hurrah) are retiring and there is only so much that can be done through immigration or inducements to remain in the labor force.  So that leaves labor productivity as the only real route to stronger economic growth and employment.  How does a government formulate policy to achieve stronger labor productivity growth? First, the government needs to recognize that innovation and higher productivity are the keys to business success – firms with higher productivity compete better. So the firms are willing partners in any policy that improves labor productivity.  Second, the government must realize that productivity enhancements are expensive and often require firms raising large amounts of capital. Third, firms will not take these large risks without believing that they will pay off – and create excellent returns to the owners and stockholders. Fourth, these payoffs relate very much to two key factors in the business environment – expected future revenues and costs.

In a nutshell – supply-side policy needs to create optimism and clarity among business firms about future profits. This optimism is necessary for the capital investments that will lead to higher economic growth and employment. Any policies that promise restrained business costs and more certain long-run revenues and after-tax profits are what we need right now. These policies are what we call supply-side policies.

Is this magic? Ask China and the dozens of other countries that have implemented similar supply-side policies if they have worked.

Is this a trick? The above discussion explains why the supply-side approach should work.  While this approach might not work, it clearly has a strong rationale for why it should be effective. This is no Trojan Horse.

Is this trickle-down? It is no act of deception to recognize that supply-side policy generally aims its most immediate impacts on business firms and wealthier people.  How much of the benefits are absorbed by the poor or the middle class is definitely a legitimate question. My reading of economic history is that the only real way to permanently raise the standard of living in a country is through long-term economic growth.  Schemes to redistribute income or to equalize incomes can be effective only in an environment of growth. 

Demand-side policy is very risky right now. It might not work. Worse yet, it might create higher uncertainty about the long-run future of America as it raises US debt, worries our trading partners, and opens up concern about when and by how much the future stimulus will be withdrawn.  It is time to give supply-side policy another look.

There is a lot more to say about this issue. Hopefully this is a start to a good discussion. Let me know what you think.

Misunderstanding Changes in US Competitiveness -- Miss Piggy and US Imports

Recent government releases of trade data have Americans concerned. The monthly trade deficit increase in July and was approximately $10 billion higher than in July of 2009. It got even larger in August and September 2010. The National Income and Products Accounts definition of the goods and services trade deficit found the deficit had increased to an annualized  -$515 billion in the third quarter of 2010 -- $124 billion larger than it was in the third quarter of 2009. (Data are real, annualized) 

The data speaks for itself but the press and politicians have generated only misinterpretation and confusion.  As usual – they are more concerned about winning friends and votes than they are about faithful interpretation.  A worsened trade deficit is nothing to be happy about – but there is much more to this picture. The graph below has annualized quarterly real net exports of goods and services (annualized exports of goods and services minus annualized imports of goods and services) for all quarters between 1995 and the third quarter of 2010. The most noticeable aspects of the graph are the deterioration of net exports between 1995 and 2005 and the subsequence reversal in trend starting in late 2006. The eyeball easily sees that NET EXPORTS ARE IMPROVING.  

 http://research.stlouisfed.org/fred2/graph/?id=NETEXC       

While it is true that there was a deterioration in a few quarters since late 2006, the overwhelming story is the improvement. But as I will explain below, the recent improvement in net exports has very little to do with US trade competitiveness and should not be interpreted as a return to normal. It has more to do with large and erratic quarterly swings in our appetite for foreign goods. Inasmuch, there is little that policymakers can or should react to from these recent quarterly changes. Clearly, the one-quarter data does not suggest a need to cajole China or anyone else.

While it is true that the one-quarter change of -$106 billion in 2010 QII looks large, it does not necessarily bode ill. We have to wait and see. In fact, a closer look at the quarterly net export changes reveals a very large increase in quarterly variability since 2006 – the standard deviation was approximately $50 billion per quarter. That means that the large one-quarter change of - $111 billion in 2010 QII was within 2 standard deviations of the mean change since 2006 of $17 billion.  This means that $111 billion falls within the 95% confidence interval and therefore is not an unlikely outcome.  With this kind of volatility it would not be surprising to see net exports improve by $111 billion in 2010 QIV.

A second issue is the erroneous interpretation. When we read that net exports are deteriorating we question the ability of US firms to compete globally. While net export changes are the result of changes in both exports AND imports – we often focus only on the export side. The misleading interpretation is the conclusion that if net exports are worsening, then it must be because US firms cannot compete anymore. Or perhaps it means that China is an unfair trader – slapping egregious import tariffs on our goods or manipulating its currency. Clearly there must be some unfair practices in China and abroad or our US companies would do better. If we are having trouble selling goods abroad, the story goes, then this is hurting our recovery from the recession and is having a negative impact on workers who produce exports. Let’s face it – it’s a chilling story and it gives our politicians a way to ride in on their silvery steeds and save the day against those unfair and mean enemies.

Of course, none of this is true insofar as recent events are concerned.  US exports increased by $225 billion in the last five quarters – an increase of more than 15% in real terms. Exports increased in every one of those five quarters and by amounts ranging from $20 to $84 billion per quarter.  If anything – it has been these increases in exports that have sustained the US economy and prevented job growth from being even worse!

It turns out, however, of you want to talk about US Net Exports for the entire time period and the key sub-periods – the trade story is about IMPORTS not exports. The below chart – if it is readable on the blog – shows the quarterly changes in exports (blue diamond) and imports (red squares) since 1995. 

http://research.stlouisfed.org/fred2/graph/?id=EXPGSC1,IMPGSC1,#

Here’s is what we should notice –

First, in the vast majority of quarters from 1995 to 2005 – the imports are above the exports – meaning that no matter how much exports increased in a particular quarter – imports increased by more. We can really suck in foreign goods!

Second, in the time period directly afterward 2005 – the changes in imports declined and then went negative. As the recession approached and worsened and US incomes decreased – we quit spending. We stopped buying all goods – both domestically produced and imported.  Export changes also shriveled but by less than the imports. So net exports improved! So for a while we see net exports improving not so much because US firms were more competitive in global markets – but because the US was hurting and our populations was buying less.

Third, in the final five quarters – 2009 QIII to 2010 QIII – we see the US economy starting to recover and our appetite for goods returning. Despite the large and positive swing in exports – imports started rising even more and the trade deficit worsened in 2010.

Fourth – looking at the chart you see that these recent changes in imports are probably unsustainable – since they are well out of line with the past history of import changes. The export recovery seems much more sustainable.

In summary, recent changes in net exports tell us less about changing competitiveness of US firms and more about the appetites of US consumers and firms.  Increased volatility of net exports warns us not to make too much of one-quarter changes of the recent past and coming future. If we want to restore the US to balanced trade, the data suggests we should think more about how and why US households and firms increasingly look abroad for their purchases.  If foreigners are so willing to buy US goods – why aren’t we? Pointing the finger at China might not be so smart. Our world exports are doing well.