Fiscal Discipline Now Rather Than Later

Cartoon by Jim Gibson

Great news! The US government budget deficit is smaller than we expected. Now we don’t have to worry about that pesky thing. According to the Congressional Budget Office (CBO) we can expect the US budget deficit for 2013 to weigh in at only $642 billion. That amounts to 4% of the nation’s GDP. That is $200 billion less than expected just a few months ago. Get out the Swisher Sweets and Bud Light – it is time to celebrate.

That really is good news. What is not so good news is that more and more we are hearing that this improvement means we can forget about working on our government debt problems. Before this news was known various economists were reluctant to deal with the national debt problem because such a policy might weaken our economy and prevent a full recovery. Now that the major scare seems to be over, these people are emboldened and louder than ever. But they have it backwards. The recent budgetary progress means it will be even easier to solve our economic problems because we are that much closer to removing the negative impacts of the government on the economy.

Joe, the 5 foot 3 inch 400 pound 14 year old exclaims to his mom – I only gained 20 pounds this year. That’s great honey let’s celebrate by eating a fried potato farm.  That’s pretty much what these people are saying about the debt. A $642 billion deficit in one year means we ADD another $642 billion to our huge government debt. Adding $642 billion instead of $842 billion is definitely a good thing – but it does nothing to reduce the swollen debt. It simply makes it bigger at a slightly slower pace.  But notice that when you are at $642 billion it makes it easier to get to $442 billion…and then to $222 billion. This is the time to keep plugging away at the problem. It is not the time to smoke a cigar and hope good things keep happening.

The CBO’s figures show that the net federal debt which was at a bloated 66.8% of GDP in 2012 will rise to 68.8% this year and then to 69.9% in 2014. More typically this debt was about 35% of the economy before the crisis hit. So let’s say the debt load doubled in about five years. Even with very optimistic assumptions, the CBO sees the debt load at about 66% in 10 years (2023). It is like admitting that after averaging a svelte 200 pounds for much of your life, you have now ballooned to 400 pounds. You now have a 10-year plan to get back down to 375! What a joke. How stupid do they think we are? Don’t answer that.

Can I really make comparisons with overweight people and the government debt? Of course I can. While it is not easy or trivial to decide an optimal country debt load it is very difficult to deny that a country that usually runs debt loads of 35% is not in some way harmed by debt loads of twice that amount. Some experts say that the debt explosion was caused by a weak economy. But notice that the CBO has the debt load at 66% in 2023. They do not believe the economy will be weak for 10 years. It is not the economy that is causing the debt. It is government’s inability to govern that is causing this drag on the economy. Call this drag crowding out or simply call it risk aversion. Either way, too much debt is slowing us down and hurting the average citizen.

One more point that supports a more aggressive approach gets to the idea of jeopardy. Our President moans on camera about our inability to help flood victims one day; tornado victims another day; and Boston bombing victims yet another day. We should all be frustrated about the fact that there are important unmet needs that turn up every day. Your kid needs new braces for her teeth. Sorry honey, we just bought a car we can’t afford and the monthly payments mean we have to wait to get your teeth straightened. Obama cannot complain he doesn’t have enough money to help tornado victims at the same time he supports programs that keep our debt at no less than 66% of GDP for the next 10 years. If you want to be able to help in an emergency then you need an emergency fund. There is no emergency fund because we will spend this year $642 billion more than the government collects.

All of this is made worst by the fact that we know that interest rates are going to rise from their very low levels. This is important for many reasons but a primary consideration is that as interest rates rise we will pay more interest expense on the national debt. With the value of the debt rising AND interest rates rising – interest expense will be a larger and larger component of government spending. Interest expense cannot be cut. It must be paid. This makes cutting the annual deficit and the total debt even harder. It makes helping tornado victims harder.

The worry warts tell us that any attempts to reduce the deficit through policy will be more than the economy can handle. They compare a possible US plan to balance the budget to draconian efforts in Europe that have been blamed on much slower growth in that part of the world.   But we don’t have to do anything extreme with taxes and spending that would send us careening into another recession. We have seen numerous proposals floated that have teeth but which only gradually bring back fiscal discipline. But it is difficult to talk rationally about a national debt management plan when even the smallest unexpected reduction in the deficits leads to demands for more government stimulus. We now have a window of opportunity to restore competitiveness to our US economy. Having a larger national debt is not the route to that competitiveness.

Krugman versus Reinhart & Rogoff

Cartoon by Jim Gibson

Imagine the bar fight when Danny accused Mike of not being a scientist. You aren’t a scientist – nah nah nah. Yea, but your mom wears combat boots. It sounds pretty stupid – and sounds even stupider when Economist Krugman dukes it out with colleagues Reinhart and Rogoff.  I am guessing they are not having lunch together at the faculty table. Is Macroeconomics a science? Are these guys scientists? And why does it matter? In brief I would say yes, yes, and because we think it matters even if it doesn’t.

Wikipedia says a science is “a systematic enterprise that builds and organizes knowledge in the form of testable hypotheses and predictions about the universe…refers to a body of knowledge itself, of the type that can be rationally explained and reliably applied.”

For those of you not sufficiently trained in globbygook, just about anything fits this definition of a science if it is trying to “figure-out” something. Your two-year old puts your best carving knife into the light socket and you explain to him that there is something called ‘lectricity and note that the knife will take the ‘lectricity out of the wall and into your body and it will hurt.  You might not know it but you are acting as a physicist and you are using a body of knowledge called physics. Physics explains why the electricity will go into your body and harm you. Hundreds of other kids have already tested the hypothesis and laid a solid empirical foundation to support the theory. Pretty cool – physics is obviously a real science.

But so is macroeconomics. I can’t tell you how many hours I spent theorizing about econ stuff and how many more hours I spent running little experiments that end up either supporting or not supporting hypotheses.  For my doctoral dissertation I had a theory that said that Nixon’s Wage and Price Controls of the early 1970s would reduce inflation only if they reduced inflationary expectations. I spent about a year drinking JD and formulating a model, gathering data, and then running a bunch of statistical tests that might reject or not reject my theory.  To be scientific you need to start with a problem that you want to explain, have an explanation, and then try to put your explanation to the test. If your explanation fails the test, then you move on to sales or painting. If your explanation does not fail the test, then you hold on to it for a while – a least until someone has a better explanation than yours. It is like being a sheriff in the cowboy days of the Old West. You were sheriff until someone came along who was faster at the draw. Truth, like sheriffs, evolves. 

If you are still awake, you might retort that while economists pretend to do all that stuff, they are not REAL scientists like physicists and geneticists and sexologists. And for that opinion, you would be wrong. Why? Because Wikipedia cannot be wrong.  Look again at the definition of a science and you will see that the only real criterion is that you are trying to test your hypotheses. There is no single criterion that says whether your test is strong enough.  There is no single test of a theory being “good enough.”  You are the sheriff until someone beats you to the draw.

You might be surprised but if you think about it, it isn’t so strange. Take meteorology.  There are some things these weather people know and get right every single time. If a cloud reaches a saturation point then it is very likely to rain soon. But if you ever lived in Florida during hurricane season you know that there are some things that meteorologists almost never get right. Where exactly will the full force of a hurricane hit Sanibel Island? When will it arrive? How long will it stay there? These are very critical and important questions. Meteorology has a lot of good theories and they have put these theories to the test many times – but they still don’t succeed much when it comes to the most important questions.  Geneticists know a cell deformity or marker when they see one. But they still do not know when or if YOU will get pancreatic cancer. Other medical sciences can treat the symptoms of your cold but they cannot stop millions of people catching colds every year. 

Every science is the same. There are no REAL sciences. You either use the scientific method to advance knowledge or don't. Every science has things it can easily explain and other things it cannot. Let’s face it we have contrasting theories with respect to every aspect of our life. Should we floss or gargle? Take vitamins? Use synthetic oil in your car? Should I have my prostate checked every year? Who was better the Beatles or the Stones?

I am not belittling science. There is much we know. I am just making the point that there is much we don’t know. The low-hanging fruit is gone and every science is in the process of discovering new and important things. In that discovery process there are always competing models, competing scientists, and competing opinions. This is true in macroeconomics and it is true in physics.

So what’s the rub with respect to macro? The answer is that there is room for difference of opinion in some very important areas. Think of what we are trying to accomplish with policy. It looks easy on a power point slide – but how do we REALLY get the US economy to grow faster? Note that whatever policy we deliver, it will involve the actions and reactions of firms and households, spenders and savers, investors, domestic citizens and foreigners, and so on. Psychology and expectations will always be at work. The ages of the population this year and next will impact how policies create changes in behavior. It is a wonder that we ever get this question right. What size ark should we build when the floods come? I am guessing we could get some very different answers to that question too.

What galls me is not that economists get things wrong and not that they disagree about policy. What galls me is when they do not even try to act like scientists. Not checking data that supports a very strong policy position is poor science. Shooting from the hip without any real attempt to utilize a large body of information and data is likewise unforgivable. Arguing in voices that sound more like competitors in divorce court does nothing but reduce the confidence that people have in macro science. Economists need to put on their big-boy pants and quit acting like children. There will always be politics and ideology. The best economists will try their hardest to be above that fray. 

Pop-Up Inflation

Cartoon by Jim Gibson

In my last post I worried that inflation is coming back and likened Fed policy to – frying pan, fire, frying pan. In writing that I admit that trends showed there was some room for the inflation rate to fall further and I don’t have a good prediction for when inflation will rise again. The importance of this is that important people keep putting pressure on the Fed to keep the pedal to the metal. Any deviation from this monetary flooding is met with fear. Last week Bernanke happened to mention that the Fed was thinking about reversing policy – and the markets immediately went into the tank.

It is interesting that the markets are testing the Fed. The markets seem to love all that money. But that doesn’t mean it is good for Main Street or for employment. A recent article by Andy Kessler (Wall Street Journal, the Fed Squeezes the Shadow Banking System, May 23, 2013, page A17) explains that the Fed has robbed the private sectors of a lot of government bonds and mortgage-backed securities. All this stuff is sitting in the Fed’s vaults and is not being used as collateral for the private sector’s loans. I love Kessler’s line, “In other words the Fed’s policy – to stimulate lending and the economy by buying Treasurys…is creating a shortage of safe collateral, the very thing needed to create credit…”

James Bullard of the St. Louis Fed is worried that inflation is too low and he wants the Fed to keep stimulating the economy. As Kessler says, that is strangling the economy. Worse yet, the risk of a giant pop gets larger and larger the more money is out there. Bernanke is afraid to remove even a dime of it because of the market’s reactions. It is like promising to go on a diet tomorrow. Really, I have a headache today but I will start it tomorrow. Image how the financial markets are going to react when he finally has to remove some money from the system.

Back to this disinflation thing. It is easy to see why the US inflation rate is not going to increase in the next few months. The most obvious factor is slower expected growth in Europe, China, Japan, and most of the world outside of the US. World economic growth spills over into US markets for good reasons. First, when those countries stagnate they buy fewer of our goods. Thus US export sales decrease. Second, as money moves out of those countries and into ours, this has the effect of raising the value of the dollar. The higher value of the dollar dents exports further but it also makes imports cost less. Both factors push US inflation and inflationary expectations downward.  In my last posting I showed a strong medium-term downward trend in inflation. Clearly both medium- and short-term trends are pushing inflation expectations downward. That means less upward pressure on wages and the prices of various other inputs to the production process.

So long as world economic growth is restrained, it is hard to imagine the US inflation rate soaring back this summer. But damaging risk remains. Many people who worry about global warming admit that temperatures have not been rising in the last decade. But they look beyond all that and focus on what happens if you don’t combat warming immediately.  They are alarmed. Well I am alarmed about inflation coming back and putting us back into another deep recession. Europe will not be in a recession forever. China will find a way to grow faster. Japan may figure out its problems. The US is seeing wealth rise as stock and housing prices return to stable values. Many emerging nations are devaluing and restructuring.

No, these problems do not have to be solved soon or at one time. The way our financial markets work is through bits and pieces of information that begin to form a mosaic. When the image of a stronger world economy starts to emerge it won’t take long for inflationary expectations to rise. It is like the jack-in-the-box – you turn and turn and turn the crank but Jack stays in the box – at least until that critical moment. Jack-in-the-box is fun but not when the Fed is at the crank. If the Fed has not done a thing to impede rising inflationary expectations, we can expect a quick return trip from the frying pan to the fire. And it won’t be pleasant. They can take some of the sting out by starting the process now. 

Inflation History Lesson: From the frying pan to the fire and back again

Cartoon By Jim Gibson

Inflation is back in the news. While there are a few folks worried about rising inflation much of the energy has been focused on it falling (often called disinflation). The latest news on inflation in April showed it negative, -0.4% in April after -0.2% in March (a negative inflation rate means prices are falling and is often called deflation). Consumers generally like inflation to fall, so this is good news for them. It was also cheered by asset holders because lower inflation means the Fed has more room to pump up the economy. Of course, if disinflation or deflation continues, many will take this as a sign that the economy is once again going into a recession. And that is not good news.

So here we are. As usual we have a difference of opinion. Some experts are worried about the inflation rate rising while others are worried it is going to fall. While the past is never a perfect guide for tomorrow, it doesn’t hurt to review what the data shows us. And what the data shows is disconcerting. While inflation may well fall more in the near future there is every reason to bet it will come back with a vengeance. This data came from Fred at the St. Louis Fed. Fred is a handy-dandy free data and graph service. http://research.stlouisfed.org/fred2/

The graph below plots annual values of two measures of US inflation from 1959 to present. One measure is based on the well-known Consumer Price Index for All Urban Consumers. The second one is drawn from the less-well-known Personal Consumption Expenditures Deflator Excluding Food and Energy. Inflation rates are created by taking annual percentage changes in these indexes. Because these index names are long and ugly I am going to called them Steve (blue line in the chart) (like in Steve Martin who is wild and Crazy) and Angela (red line in the chart) (as in Angela Merkel who is not wild and crazy).

Steve inflation is published by the US Labor Department and is based on surveys of prices paid by the typical urban consumer. Steve inflation often swings wildly because food and energy are important parts of Steve and these prices can gyrate like Britney Spears after a night on the town. For example the graph shows Steve inflation rising to about 14% in 1979 only to fall back to about 3% within a few years. Much of that was attributed to food and energy. Not that food and energy prices don’t affect consumers – but they do distort what is happening to the prices of what most of the consumers buy. 

That is why I added Angela inflation – she is constructed and published by the US Commerce Department as a tool to deflate personal consumer spending. Angela is a little more boring because the Commerce Department has removed those pesky food and energy prices from this version of the PCE deflator. (This index also makes an attempt to remove some of the bias caused by Steve’s assumption that people do not economize on goods and services whose prices are rising the fastest.)

So that’s Steve inflation and Angela inflation. A quick look at the chart shows that Steve swings around like a young lady at a ho-down in Arkansas. Angela is more conservative and I must conclude – much more refined and reliable. Some might say that Angela is smoother! But notice too that Angela and Steve have the same general tendencies or trends. So while they might disagree on the extent of inflation during a particular year or two – they both agree on the general direction of inflation. Notice that from 1959 to 1979 they both were rising and thereafter falling. You might say that the most current trend of inflation was to flatten at a little less than 2.5% starting in about 1990.

Apparently what goes up must come down. As we think about where we are today and what will come tomorrow it is good to see these trends. But they are only part of the story. For example, you might want to extend the downward trend since 1979 into the future. That would argue against a quick return to higher inflation. Then again, you might think that 15 years of falling inflation is long enough for the trend and therefore you might want to predict a reversal of trend. In that case you are worried about rising inflation.

There is more to see in this graph. Notice the vertical shaded areas – they depict recessions. We have had eight recessions since 1959. After seven of those eight recessions the inflation rate fell. That makes economic sense. Recessions are times when buyers slow their purchases and firms find it more difficult to sell goods. They often discount their prices to get rid of excess inventories. These disinflation periods following recessions can be very shallow and short (e.g. after the 1970 recession) or they can be much longer and more pronounced (e.g. after the 1980 recession). After the 1990 recession the inflation rate fell for almost 10 years.

Now look at inflation behavior before each recession. In all the recessions except for 1982, the inflation rate was rising before the recession started. In all those cases you had sharp changes in Fed policy – increasing interest rates to try to cool off the inflationary economy. But as soon as the recession was evident, the Fed reversed engines and reduced interest rates. In one sense the policies worked – you can see that inflation did fall. But the unintended consequence of the tight money policy was a recession.

So what do we have? We have inflation rising followed by tight money followed by inflation falling followed by loose money followed by rising inflation. This cycle goes on and on. The prudent thing would be to bring monetary policy back to neutrality once the worst of the recession is over. Why? To answer that question we have to look into what caused the pesky inflation to begin with. The graph shows that food and energy prices must have had some impact driving overall inflation upwards – especially in the 1970s. But food and energy prices do not explain the upward thrust of inflation that occurred in in the late 1980s, late 1990s, and then again after the turn of the century.

Fed policy had very much to do with driving inflation periods higher after those recessions. This belief is based on policy data. I used the level of the federal funds rate (ffr) as my measure of monetary policy. When the Fed wants to tighten policy they raise their goal for ffr; when they want to loosen money they reduce the ffr. So here is what I found:

·        The 1982 recession ended in November 1982. The ffr went from 15.1% in early 1981 to 6.6% in March of 1988. In other words – the Fed kept monetary policy very loose more than six years after the end of the recession.

·        The 1990/91 recession ended in March of 1991. The first quarter of 1989 had a ffr of 9.8%. It was reduced until February of 1994 to the point where it was 3.3%. Again the ffr was kept very low until three years after the end of the recession.

·        The 2001 recession ended in November of that year. The ffr was about 6.5% at the end of 2000 and continued down to 1.8% until November of 2004 – three years after the end of the recession.

·        Finally the 2008/2009 recession ended in June of 2009. The ffr started at 5.3% in mid-2007. It started down and has remained at 0.25% as of today. Today is now four years after the recession. It is unclear when the Fed will again begin the raise rates.

What is the history lesson? The Fed is an aggressive agent for monetary policy. It strikes hard at rising inflation and tries to offset recessions. But it also has a tendency to be very late when it comes to withdrawing monetary stimulus after recessions end. After the last four recessions, the Fed was late when it came to leaving the dance. They left four years late! They are still dancing some four years after the last recession.

Why not stay at the dance? The answer is in the data. Monetary policy eventually revs up the economic engine. Recessions do not last forever and the economy returns to strength. Always worried they didn’t do enough, the Fed keeps the stimulus going for too long and the result is – higher inflation and then a need to fight inflation again. And then another recession.

To my scientific friends – I know a graph or two does not constitute real scientific proof  of anything. Someone else might be able to manipulate data that shows a fuzzier result. But I have been reading the literature and watching the economy for decades. I don’t think you can deny the fact that the Fed can best be described by the old adage -- from the frying pan into the fire and back again. It is time for the fed to reduce monetary stimulus and forestall the usual recession-inflation-recession nightmare.

Error Correction: Wolf's Howl is Off-Tune

Tuesday I posted an article that had two main points -- (1) Germany's improvements in exports did not, as Wolf argued, have any strong negative impact on the exports of other EU countries. (2) The main slowdown in demand in Europe came from capital spending and not from overall domestic demand. I concluded that Wolf's continued emphasis on stimulus spending was wrong-headed since the main problem in Europe seems to come from one sector -- capital spending.

In looking at my spreadsheets again, I found errors in the part that measures changes in capital spending. These errors do not change the above conclusions -- but since technically I wrongly quoted some numbers. I decided I needed to come clean!

In the article I said that capital spending had decreased in all EU countries. The numbers were very strong -- for example I erroneously said that overall EU capital spending had decreased by 90%. My corrected numbers show that EU spending on capital declined by 4% and that 14 of these countries exhibited declines ranging from -66% for Ireland to -1% for Latvia.

While these errors are important, they do not detract significantly from my conclusions.Consumer spending and export sales were very strong among the EU countries between 2006 and 2012.  The main spending sector contributing to slower growth in the EU was capital spending. The problem is not overall aggregate demand -- the problem is no real solutions for financial and housing problems.

I feel better now. Thanks.

Wolf's Howl is Off-tune:Data Shows Why Macro Stimulus Can't Work

Martin Wolf continues his Keynesian tirade in the Financial Times, “The German model is not for export,” May 8, 2013, page 7. As in the US, a policy debate rages on in Europe as predictions call for impending slower economic growth.  Germany and a few other European countries push austerity.  So Wolf has to beat the Keynesian spending drum even louder to get a hearing for his stimulus advocacy. In this article Wolfe says that much of Europe is doomed to a protracted era of slow growth because Germany and the IMF are encouraging European countries to emulate Germany. Of course it would be difficult for most countries to mirror one of the world’s strongest export champions and so Wolf worries that Europe is in for big trouble.

I have written about the counter-productive results of more stimulus when debts are huge and I won’t repeat all that here. Today I take Wolf to task over misinterpreting the current economic situation in Europe. Wolf says that Germany has been able to replace declining domestic demand by producing more external or foreign sales. He says this causes a big problem for the other European countries because Germany’s surpluses translate into trade deficits among the rest. He says a combination of weak domestic plus weak external spending is killing European countries. I show below that Wolf’s assessment is not the case. Worse, the data shows vividly why more macro stimulus cannot be the answer to our slow growth woes. 

I went to Eurostat – a great place to look at macroeconomic data for the EU countries. http://epp.eurostat.ec.europa.eu/portal/page/portal/eurostat/home/  I look at GDP data as a way to see how EU countries have fared since the crisis hit. More specifically I examine key spending data. I looked at changes in the data between 2006 and 2012. In 2006 the EU economy was chugging along before the financial crisis hit and spread. Let’s call that the “before” photo. Sort of like the picture of Terry Bradshaw before he went on his diet. 2012 is the after shot – after the recession and after the economy had several years to recover. Terry says he lost 40 pounds. What happened to the EU?

I first looked at consumer spending. From reading Wolf you might think it had declined – or it was still struggling. If we look at all 27 EU countries together, the total growth of consumer spending increased by about 12%. Germany did a little better – about 14%.  But Germany was among the worst countries. 20 EU countries did better than the EU average. Slovakia led the group with an increase of 61% in consumer spending. Among this group of 20 countries having stronger than 20% increases in consumer spending were Switzerland, Bulgaria, Norway, Poland, and Lithuania. Of course, there were several countries with dismal domestic consumption spending and those included the usual suspects – Iceland, Ireland, Greece, UK, and Portugal. As a benchmark, US consumption grew by about 17% from 2006 to 2012.

What about Germany’s great trade splurge? Germany’s export sales increased by 29% from 2006 to 2012. That was stronger than its domestic consumer spending growth but clearly short of the US export growth of 45%. The overall EU’s export growth was about 24% but 21 EU countries had export sales growth faster than the EU average and 16 of those exceeded Germany’s rate. Slovakia managed an 82% increase in export sales. If most EU countries had bad trade deficit outcomes as Wolf alleged, it was because of their even stronger growth of imports. That means domestic spending must have been increasing – that is, Europeans were consuming more at home – some of the products were produced at home while others were brought in from abroad. That doesn’t sound like deficient domestic demand to me.

So why are these EU countries having such a bad time? The answer which Wolf never discusses is in what the EU calls fixed capital expenditures or what is sometimes called gross private domestic investment. Fixed capital includes domestic spending on plant, equipment, housing, etc. This spending category is interesting. Germany’s fixed capital was 91% lower in 2012 than it was in 2006. For the whole EU the number was -90%. For the USA it was -77%. EVERY EU country showed negative change in fixed capital spending from 2006 to 2012. The worst performance was from Greece (-115%) and the best from Sweden (-63%). If anything has not recovered in the world economy it is business spending on plant and equipment and national spending on housing.

Wolf is so wrapped up in Keynesian macroeconomic stabilization policy that he can’t even see that the main problem with slow growth and a return to stability in the EU and the US is mostly located in one single part of GDP. There is no real export issue and there is no consumer spending issue. The issue is that no country has sufficiently addressed the things that caused the crisis to begin – the housing and financial crises. People are not buying homes and firms are not borrowing to expand. It is pretty simple. The FED and ECB flooded the world with liquidity and drove interest rates to nothing. 

The US government introduced historical levels of fiscal stimulus. Yet we in the US are not growing much faster than our European counterparts.  More stimulus from monetary or fiscal policy means unsustainable debt and financial bubbles. Yet Wolf and other liberals continue to want more of the same. The data suggest that what we need is what we needed from the beginning – a satisfactory response to housing and financial problems. Yet most experts continue to admit after half a decade that they still have not brought forth anything to tackle excessive risk, too-big-to-fail, transparency, and various other elements of the housing/financial crises. I guess it is easier to cry Wolf (for more stimulus).

Cartoons

Dear friends,

I want to thank my college buddy Jim Gibson for adding a cartoon to this week’s blog post. Jim played defensive tackle for Bobby Dodd at Georgia Tech in the 1960s but was even more well known for the cartoons he posted on the football bulletin board. The coaches loved being lampooned by Jim. Jim also was recently given credit for the Georgia Tech logo he designed almost 50 years ago that is still in use today. Go Tech! Hopefully Jim will draw more cartoons for us in the future. 

Global Economic Growth: the Pause that Refreshes?

Any athlete knows there are times in a contest when you rest. A marathoner can’t sprint the last mile if she tries to sprint all the miles. The sprint takes it out of you. The world economy was on a sprint before the last crisis hit. The downturn didn’t hit all places at the same time – but a look at world growth in 2005 and 2006 looks like a global economic sprint. Some policymakers long for a return to those heady days. I try to explain below why a fast return may not be the best approach to sustainable gains and lower unemployment.

The average annual growth rate of the world's advanced economies (35 countries labeled so by the IMF) from 1995 to 2004 was a modest 2.8 percent. The median growth rate of the real GDP of these economies  was 3.9 percent in 2006. In 2006 the top 17 countries had real GDP growth rates ranging from 3.9 percent to 10.1 percent. IMF projections for 2014 have the top 17 countries growing anywhere from 1.6 percent to 5.5 percent. (The data and the list of countries can be found in table A2. Advanced Economies: Real GDP and Total Domestic Spending  http://www.imf.org/external/pubs/ft/weo/2013/01/pdf/tables.pdf )

Clearly 2006 was a very strong period of world economic growth. The strong growth was shared across most countries. The recession stopped all that with no change in world growth  in 2008 and a contraction of 3.5 percent in 2009. World growth returned to positive but averaged only 1.4 percent per year between 2011 and 2012.  We are clearly still far off the torrid growth pace of 2006. With respect to these 35 countries the great majority will be nowhere near their 2006 paces even by 2018. The IMF forecasts the following real GDP growth relative to the strong growth of 2005 and 2006:

•   4 countries will return to past high growth by or before 2014: US, Australia, Japan, Norway
•   6 countries will return to strong growth by 2018: Germany, France, Greece, Portugal, UK, Taiwan
•   25 countries will not return to strong growth rates by 2018.
•   Some 12 years beyond 2006, only 10 countries are predicted to return to strong economic growth. Some of the 25 countries on the list that will not repeat past strong growth include Italy, the Netherlands, Canada, South Korea, Iceland, Estonia, Singapore, Czech Republic, and Hong Kong.

For people in many of these countries, this slow growth is not desirable. Unemployment is too high and many business firms are having trouble staying afloat. Interest rates are low preventing savers from reaching their investment goals. Houses remain empty or unsold and excess capacity deteriorates. Countries have large debts that limit their use of traditional fiscal policies. The negatives are stark and frustrating.

But there may be a silver lining. Like a pause in the runner’s pace, this growth respite is not all bad. To understand this we look back at the 2005/2006 period’s strong growth. With so many countries growing so quickly at the same time, we placed impossible demands on world commodities markets. To produce so much economic output for the world takes inputs. Output requires energy, steel, aluminum, copper, rubber, and many more commodities. Demand for food commodities also spiked. Bringing all this together we saw commodities prices ebb by 2002 and then increase dramatically thereafter until falling sharply in the middle of the global recession.

The prices of many commodities doubled (or more than doubled) in the run-up after 2002. While the global recession caused a temporary hiatus in inflation the subsequent economic recovery witnessed a return to strong commodity price growth. Recent pessimism about economic growth in Europe and China has taken some steam out of commodities but with the US, China, and many other emerging countries showing resilience, commodity demand and commodity prices are ready to resume a rapid upward clip. The only real thing that will forestall them is a more gradual return to stronger growth among the leading countries.

A quicker turnaround in world growth sounds good on the surface but if it brings with it another bout of extreme commodity price inflation, it is doubtful that firms will be able sustain a stronger pace of output in the face of rapidly increasing business costs. We see now how uncertainty about rising medical costs and taxes puts a lid on hiring – another bout of rising commodity prices would just add to that.

It seems perverse but right now good economic news is not necessarily unqualified good news. We want to finish the race in first place. Running too hard right now is not the way to do it. It might be frustrating watching some runners catch up, but we need to have some patience and some trust that the tortoise might again beat that pesky hare.

Quit Yellen and Start Jellin’

If Ben Bernanke steps down next year as Chairman of the Fed, his successor might be Janet Yellen. A lot was written about her last week. The following Yellen quote from a recent speech was highlighted in several articles,

"With unemployment so far from its longer-run normal level, I believe progress on reducing unemployment should take center stage for the [Federal Open Market Committee], even if maintaining that progress might result in inflation slightly and temporarily exceeding 2 percent."

This seemingly innocuous statement deserves more attention, especially since until 1978 the Fed had a singular mandate – to use its tools to pursue price stability.  The European Central bank (ECB) also has a similar singular mandate. But the Humphrey-Hawkins Act of 1978 created a dual mandate for the Fed – including price stability and full employment as its two key goals.

While Yellen’s above quote sounds reasonable there are some who acknowledge that until 2008, the Fed acted as if it still operated largely with a single price stability mandate. Attaining full employment was a secondary objective at least until recently. Fiscal Policy was thought to be the more appropriate means to deal with employment and economic growth. There are some who believe that Yellen and some others on the board would like to permanently create more balance between the two goals – raising the stature of employment and growth in the Fed’s work. Yellen will hoist full employment above price stability for the foreseeable future.

It is understandable that national interest should be concerned about employment and economic growth. It seems reasonable to want to aim all our policy guns at this plague. But many things that seem reasonable on the surface sometimes seem dead wrong after looking into them more closely. So that’s what I want to pursue here. As you will see below, I conclude that changing the Fed’s objective to favor employment would be very risky, inefficient, and wasteful. So let’s get started.

First, note that we believed in a single price stability mandate for the US Fed for about 60 years. The ECB insisted on this single mandate and despite what appears to be some wavering recently, the ECB continues with it. There must be some strong reasoning behind the Fed focusing on price stability.

Second, recall that John M. Keynes invented something called the liquidity trap. Modern Keynesians dispensed with this extreme behavioral assumption but maintained models that always had a preference for fiscal over monetary policy as it had to do with affecting real variables like employment and output. So Keynesians didn’t think much about using monetary policy to control employment and output.

Third, Monetarists challenged Keynesians by admitting that in the short-run, monetary policy could have a very large impact on employment and output. But Monetarists insisted that these impacts were possible only if the stimulus policy was unexpected – it had to be a surprise to be effective.  In the longer-term, the effects would dissipate as the impact was fully understood. So-called Neo-Keynesians agreed that such monetary surprises had only a short-term impact. Both groups of economists agreed that part of the undoing of the short-term impacts was eventual increasing inflation and interest rates.

Fourth, much of the discussion today assumes that there is no need to worry about the Fed’s recent and future monetary explosion having an upward impact on inflation and interest rates. But history is clearly rife with examples of inflation catching up when least expected. Policymakers have been caught many times with their guards down. Inflation was not there and then it was, like magic.

Inflation is like a fire. I once had a small fire in one pot on my stove. I could not believe how quickly it spread. Once inflation spreads, the FED acts quickly to eradicate it. Episodes of extreme fed tightening have led to either pronounced decreases in economic growth or absolute reductions in output. When the fire spreads you have to bring out the big hoses – and this pretty much ruins the kitchen – until you have time to rebuild. The below link takes you to a discussion where the author points out several, dismal time periods following tight money – 1956, 1960, 1968, 1973, 1978, 1980, 1989, and 2000 http://www.econbrowser.com/archives/2006/02/should_the_fed.html

The Fed swears it will do better this time. It will know when to pull out the money in a reasonable way that does not disturb the economy. History is not on the Fed’s side. If you believe the Fed I have a fire insurance plan to sell you.

Fifth, Yellen and others are making us all take a very clear risk. Is it worth it? They say – okay, it is possible that focusing on employment today will bring more inflation sometime in the future.  But they believe that this risk looks like chicken-feed compared to the pains of the unemployed today. But again, they do not fully explain the problems of inflation. As I said above, when inflation comes it might first rise slowly and to levels that are only a little above the 2-3% range.  But experience in other countries and the US shows that once inflation starts rising it is very hard to contain. That is why countries try so hard to maintain price stability. Turkey, Brazil, and Israel are countries that experienced inflation rates above 100% per year in the recent past. Talk to someone who lived in those countries and you know why people prefer price stability.

You believe it can’t happen here and now. But notice that hyperinflation has to start somewhere. It starts at 3% and then spreads from there. And by the way it usually got going because governments could not constrain their spending and the central bank monetized and compounded these political errors.

When inflation does get started it messes everything up – workers often get higher wages but since inflation rises faster than their incomes they get lost in the dust. Interest rates rise and make creditors feel richer until they find out that prices rose faster than investment income. People spend much too much of their productive time learning how to protect their money balances as they buy cuckoo clocks and other collectibles instead of bonds and stocks and real estate. Firms prefer producing later because prices will be higher than they are today.

In short, using monetary expansion is a very risky way to target employment and economic growth. It might work for a little while but the Fed and the rest of us know that sustainable increases in the economy are not going to come until the nation’s real problems are attended to. The US faces many threats to employment and output including housing, financial, demographic, global competition, and more. The more we fiddle with expansionary monetary policy the more we raise the risk of slower growth and divert attention from the real solutions. My advice – quit Yellen and start jellin’. 

Why We Are Lousy Investors by Guest Blogger Robert Klemkosky

 We have known for a long time that greed and fear play a prominent role in investors’ decisions. A mix of both is healthy for the markets; greed makes us strive for higher returns, which also entails higher risk, and fear makes us avoid excess risks or reckless risks. The trouble starts when greed or fear gets out of control. Too much greed and asset prices go up too much and bubbles form, such as technology stocks in 1996-2000. Too much fear and selling occurs and asset prices plunge. Of the two, fear can be a more powerful force than greed because it can turn into a panic and result in a financial pandemic such as what just occurred in 2008 with stock prices and the credit markets.

In reality, investors should follow the advice of Warren Buffett and buy on fear and sell on greed. But emotions and psychology prevent most investors from doing that consistently. Investors do the wrong thing at major turning points in the market, such as buying record amounts of mutual fund shares at market peaks (first quarter of 2000) and selling record amounts of mutual fund shares at market bottoms (fourth quarter of 2002). And selling stocks at the bottom of the bear market in March 2009 only to see the stock market go up 100 percent in the next nine months.

We all like to think of ourselves as rational and logical, but there is much evidence that we are far from national and logical when making investment decisions. Behavioral finance is a discipline that analyzes how our emotional inclinations and psychological biases affect and influence our investment decisions, both as individuals and collectively.

Overconfidence is one of the major biases that affects investment decisions. We consistently overestimate our knowledge, skills and abilities. We have illusions of control even if events are more random. We overestimate the precision of information and underestimate risks. If we have been successful, we have a tendency to become more overconfident and take on more risk. So don’t always assume that you have better knowledge and skills than others and don’t ever equate stock market performance during a bull market with investor IQ.

There is also a disposition effect in that investors have an aversion to losses. They hate losses about twice as much as they like gains, and will take risks to avoid losses but not gains. One result is that investors sell winners and keep losers, exactly the opposite of what they should do, especially for tax purposes. Investors  hate to admit mistakes which include stock market losses, so there is also regret aversion.

Investors have a tendency to extrapolate the past, especially the recent past. The human mind is not good at figuring out the probabilities of future events, so the easiest thing to do is assume past trends will continue. We expect bull markets to continue as well as bear markets. We select stock or funds that have done well in the past, expecting that performance to continue in the future. We miss major turning points in the market.

Investors have beliefs and convictions about stocks and the market. When presented with information, they have a tendency to accept or listen only to information that confirms and supports their beliefs and filters out information that conflicts with their beliefs and experiences. The rational thing to do would be to seek out information that does not support our beliefs and convictions. This is referred to as confirmation bias.

When we look back, things seems much more obvious and we delude ourselves into thinking that events were predictable and we had the foresight to make those predictions. In other words, we forget our original forecasts or thinking and use the outcome as if it was our original forecast. We think events that happened were predictable and events that didn’t happen were unlikely. It’s  why we take credit for our successes and blame others for our failures.

Lemmings are rodents that would follow each other over a cliff to their deaths. Their behavior explains a lot about investor behavior and is sometimes called herd mentality. Investors are very comfortable going along with everyone else which is usually what happens in bull and bear markets. It seems investors get greedy together or get fearful together, which is why we have the bull and bear markets.

People feel comfortable investing in companies they work for or companies in their locale. It’s a reason why investors are underrepresented in stocks outside their country. But what happened at Enron, Lehman Brothers and other companies shows the risk of investing in company stock to the detriment of a diversified portfolio. We also become very loyal and attached to a stock that, for example, has performed well and has made us a successful investor. So investors have a tendency to ride it up and ride it down. They forget that a stock doesn’t love them and doesn’t even know they own it.

Individuals have a money illusion bias in that they don’t factor inflation into long-term financial decisions, such as providing college educations for their children or retirement. At 4 percent inflation, money loses half its value in approximately 10 years, and goods and services cost about 50 percent more in nominal terms. People also underestimate the power of compounding. If you invest $1000 at 6 percent for 30 years, you have wealth of $5144 at the end of the period. If you take on a little more risk and invest at 8 percent, you nearly double your ending wealth, $10,002, versus investing at 6 percent.

Understanding the basic concepts of behavioral finance will make us better investors. We don’t need a degree in psychology to use the concepts of behavioral finance successfully. Being cognizant of the behavioral biases and not succumbing to emotions, especially fear and greed, will go a long way toward better investment performance.

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Chained CPI -- Much Ado About Nothing

A lot is being said about President Obama’s brave gesture to control entitlement spending in his new budget for 2014.  He is apparently compromising by agreeing to change the cost-of-living adjustment for social security benefits. He says we can save some money by using a chained price index instead of a wage earner index. I thought it was illegal these days to put wage earners in chains, but maybe I don’t understand this whole thing.

The President’s proposal, according to my absolutely perfect estimates, will save Social Security (SS) approximately $2.7 billion per year. Keep in mind that our current annual government spending is closing in on $4 trillion. You don’t have to be a math major to realize how small $2.7 billion is compared to $4 trillion. Graphics can sometimes work. Imagine Dolly Parton’s bra. That’s what the government spends each year. Now imagine…Never mind. You know what I mean.

The Labor Department has data on price indexes so I compared the chained price index (CPI-C) values to those published for the Urban Wage Earners Price Index (CPI-W). We don’t actually know what inflation will be in the future but if it is anything like it was in the past, then we can make estimates of the effect of the new index. The CPI-W is what is now used to adjust social security payments for inflation each year. The President wants to replace it with the CPI-C. Comparison data is available from 2000 to 2012 on the BLS website. Using the price index data I calculated two annual inflation rates for each year from 2001 to 2012.

Guess what I found? Guess Again. Isn’t this fun! Anyway, the differences between the inflation rates of CPI-C and CPI-W didn’t add up to a hill of beans. In 2004 the average SS recipient would have lost $15 if the government had used the CPI-C instead of the traditional CPI-W. Seriously – that’s about a buck a month. 2010 would have been the worst year for social security recipients – they would have lost $94 that year if the CPI-C had been in place in that year or just a little more than $8 per month (a pack of Marlboro?)

If we add up over all 12 years from 2000 to 2012 I find that President Obama’s huge concession would reduce the SS benefits of the average recipient by a little more than $513 (in 2013 prices). During those 12 years this person would have received more than $168,000 from SS. The proposed approach will have cost them $513. Please! You people talking about the President’s brazen compromise, please think about these numbers. He is causing almost no harm to SS recipients and he is doing absolutely nothing to resolve the national deficit and debt problem.

Why do we see such big numbers reported in the news? The answer is that they are projecting changes for the future. They do not know what the future inflation rate will be so they are making forecasts. One thing is for sure about the future – they are projecting that inflation will increase. So when they estimate that the impact on us will be something like $130 billion in the future, they are basing this number on a lot of inflation in the next decade. $130 billion received in say 2023 will be based on people having MUCH HIGHER incomes and social security benefits. Comparing $130 billion a year to current budget numbers is the old Apples and Oranges trick. This trick is meant to scare you.

One more point. There is nothing to guarantee that this proposed change to a chained index will always save the government money relative to a fixed-weight wage earner index. It is true that a chained index allows for the calculated price level to incorporate buyer’s adjustments away from the highest priced goods. But the truth is that people do not always behave that way. If during a particular year we have people gravitating to very popular but higher prices goods, then the chain index will show a HIGHER inflation rate than the CPI-W. 

Maybe the president should stop looking for things that are politically pleasing and focus on the real business of budgets and compromises. As for you – like good consumers everywhere you can beat the system.  Recall that the CPI is an average of prices paid by the “average” household. Don’t be average! You can make your future SS dollars go farther if you work hard at being a good buyer. If the price of orange juice is going up, then just drink more drinks whose prices are not going up. Try a nice tall glass of JD!

Snowstorms, Windshield Wipers, and Employment

After last week’s employment rate announcements, the US stock market took a big dive. Many words were written about the dire information in the report.  The report published by the Bureau of Labor Statistics consisted of about 20 short paragraphs accompanied by about 30 data tables and can be found at http://www.bls.gov/news.release/empsit.nr0.htm

I am sure that people thousands of miles away from the US will be impacted by the reactions to this report. Bus drivers in Delhi will be discussing the terrible situation in US labor markets. Angry teens in Bangladesh will set a few Russian Ladas on fire to show solidarity with union members in Wisconsin.  You get the picture – information moves fast and at long distance in 2013.

Except for the back of my father’s large and muscular hand, nothing came fast when I was a kid. I recall television advertisements that allowed me to send a few cents to someone somewhere and in return I would get a toy submarine. If you put baking soda in that toy submarine it would submerge in your bath tub just like a real submarine. Anyway, I can remember that it took weeks if not months for that stupid toy submarine to show up in my mailbox at 3170 Oak Avenue. I would check the mailbox every day! Girls were slower back then as well but that is another story. You get the picture. Children were supposed to learn patience.

The question is whether we are better off or not with all this speed today. I’d like to move on to phones and texting but let’s stay with the employment release of last week. The key message of this release is that while payroll employment increased in March, it did not increase enough to provide further evidence of a stronger economy. That is, the 88,000 increase in employment was a big disappointment. But was it really?

First, keep in mind that monthly employment changes are typically small. The total number of people employed in the USA in February of 2013 was about 135 million. So the percentage increase of 88,000 in March employment was about 0.65% (=.0065). If I lost 0.65% of my body weight I would lose about one tenth of one pound. Woowee.  Anyway, notice that even if the employment change had been more like 300,000 new jobs in March that performance would only amount to a tiny percentage increase. What matters more is the future course of employment changes. At 300,000 new jobs per month for a whole year – employment would increase by 3.6 million or by about 2.6% for 2013. That would be pretty nice. So far in the three months of 2013 employment has increased by an average of 168,000 per month. At that rate we might get 2 million jobs for the year for an increase of about 1.5%. To conclude this first point – the 88,000 was nothing to write home about – but what matters less is one month and what matters more is the future trajectory. The first quarter is not where we want it but by no means should we be burning our bras and/or jock straps.

Second, what does the 88,000 increase tell us? The answer is “not much.” Suppose you are like me and your weight varies a lot. So let’ suppose my typical weight change is about plus or minus 50 pounds per month. One month I gain 60 pounds. The next month I lose 40 pounds. Suppose I tell you I gained 55 pounds in March. Is that evidence that I am going to gain a ton of weight in April? In May? It does not. My weight swings a lot from month to month. The typical upswing or downswing is around 50. It would take a much larger swing in one month for you to bet on me gaining again and again. Of course, you’d bet more money if you saw me gaining more than 50 pounds each month for several months.

A statistical analysis of the payroll employment figure shows very high variability from month to month – to the tune of about 90,000 workers. Next to that the 88,000 means very little. It tells us nothing about the future.

In summary, the one month change of 88,000 is not only tiny but it is not statistically large enough to suggest anything is happening in the way of a trend. I can tell you that jobs have increased by about 504,000 in 2013 and in the 12 months between March of 2012 and 2013 the increase in payroll employment has been 1.9 million. The more data we have, the more complete the picture becomes. Yet the market knew most of that before Friday morning and the market seemed to go crazy because of the 88,000 announcement. Even the local Bloomington Herald Times had many articles analyzing last month’s dismal number.

Why does a seemingly meaningless number get so much attention? Aside from the fact that the news media has to sell information, my guess is that we get all this drama because we demand it. And we demand it these days because the future is so uncertain. Will we have a double dip recession? Is the economy on the mend and about to grow quickly? Does the economy have several years of slow growth ahead? If we knew the answer to these questions, we could plan our lives better and perhaps more profitably.

This uncertainty theme hits home if you think about driving in a snow storm on a road that you don’t know well. You do know that there are many twists and turns in the road. But with the snow, you cannot see more than a few inches ahead of your windshield. In such a situation, you are staring intently ahead and every time you see a change in the scenery, you are ready to begin turning the steering wheel in one direction or the other. Turning too slowly means you might miss the turn. Of course turning because of a false signal means you quickly steer the other way. You are on top of the situation and you watch everything that moves! You adjust quickly. Sometimes the information is correct and sometimes it is not. But you are watching every change as if your life depended on it.

Our deeply uncertain economic times are like such a snow storm. Each time an economic number comes out we react to it as if it had great content for the future. When we discover it had no such content, then we react to that discovery.  Telling the government to slow its delivery of monthly news is like asking for your windshield wipers to quit working. Ignoring highly erratic data is like driving straight ahead on a curvy road. Since there is always uncertainty about the future, we are stuck with living through a roller coaster ride of economic news. But with uncertainty heightened as it is today the roller coaster is no less than the infamous Kingda Ka.

One more point.  We learned nothing new about employment in March of 2013. The economy and employment continue to be deeply affected by very long-term factors (e.g. demographics, industrialization, globalization, government policy and regulation) and dealing with the aftermath of a deep and prolonged global financial crisis. Few spots in the world are growing rapidly and despite a lot of policy experimentation, both Republicans and Democrats are going to be disappointed if they are hoping to see anything but lackluster growth for the time being. Even if we got a huge spike in employment in April or May it won’t mean much of anything insofar as the big picture is concerned.

By the way, I am happy to report that I have not changed my tune in the last three years – in March of 2010 I said we would not have any real growth until we overcame three problems. My reading today is that we have made some progress on only one of the three and thus we are firmly stuck in economic purgatory. See my post – The Whack-A-Mole Recovery…. http://larrydavidsonspoutsoff.blogspot.com/2010/03/whack-mole-recovery-or-good-news-is-bad.html

Davidsonian Economics and the Death of Macro

Macro was born and it is in the process of dying. I am not being melodramatic. Lots of things have finite life cycles. Take the hula hoop. It was great while it lasted and back surgeons are still raking in the dough as a result of it. But it is now hard to find a hula hoop. The death of macro is not necessarily a negative thing -- I would call it evolutionary. It came, it served, and then it outlived its usefulness. I will argue below that we will replace it with something I humbly call Davidsonian Economics. I am really crappy at naming things so if you are among the first 10,000 people to write back with a better name I will give you 79% of my future royalties.

To explain the process and what this means to us requires me to write a little about the evolution of macro ideas. I am going to try to do this in two ways. For normal humans I am going to summarize the main points and use a lot of bolding and underlining. Soon you can go off to your regular routine – e.g. kissing the dog and petting the wife. For those of you afflicted with bottomless boredom and something akin to a PhD, I will drone on with details until you are ready to rent the full library of Fidel Castro’s speeches.

First, the brief summary and by brief I mean less than 743 paragraphs. Great ideas always stem from real human problems. When I grew up polio was a disease that affected too many people. Scientists then found a cure and mankind was made immeasurable better. The results are not always so clear for social sciences – but during and after the Great Depression a lot of people wanted to try to “cure” us of future depressions and recessions. John Maynard Keynes was one of those people.  His work was carried on by economists we call Keynesians.

Today we are faced with the lingering impacts of a Great Financial Crisis and World Recession– and many great minds are trying to find a cure for the latest social science disease – slow economic growth. So if you believe what I write below then you have become a Davidsonian – and we will have started a new economics we will call the Davidsonian School of Thought. Our colors will be Cream and Crimson and our favorite liquor will be of course JD. I hope to add some cheerleaders soon. Now to the evolution we call macro...

Before the 1930s – No Macro – Adam Smith’s “invisible hand” cured most economic disturbances; economic growth theory focused on supply factors. Neither monetary nor fiscal policy was used to offset short-term recessions. Monetary policy was geared to keeping prices stable in the long-run.

1960s Keynesians said workers were slow to discover rising prices and could be “fooled” into supplying more labor whenever asked. Governments could fool firms into thinking prices and profits would rise when government stimulated demand. An increase in government spending or a reduction in income tax rates would, therefore, lead to more demand for goods and services and firms would produce more goods and services. Workers would find out later that their wage increase didn’t buy more goods and services as they discovered the higher prices of goods and services. By then the recession was healed. Keynesians preferred fiscal policy over monetary policy.

1970s Neo-Keynesians and Monetarists saw the Stagflation of the 1970s and emphasized what happened when workers caught on to the policy-demand-inflation game. After a period of rising demand and economic growth, workers would want bigger wage increases and this led to another recession – but this time with higher inflation. Ugh. Stimulus worked as long as you could fool the workers about the cost of living. These economists saw the risks involved with macro policy but gave it a green light so long as policymakers didn’t get carried away.

1980s Rational Expectations believed that workers, after living through inflation and stagflation, would be better at incorporating inflation expectations into their current wage bargains. Thus they were harder to fool. This took the bang out of the ability of government to stimulate the economy with fiscal or monetary policy. If policymakers were not careful, a stimulus would have little to no effect on employment and output.

1980s and Beyond Neo-Supply-siders seeing that the impact of demand-based stimulus policy had peaked started focusing on using policies that directly impacted the decision to employ workers and produce more output. While supply-side policies do not adversely affect inflation they do often appear to worsen the income distribution. Politically supply-side policies are a little like gun confiscation advocates in Nevada.

2013 and Davidsonians find us with a new behavioral assumption – that politicians are dumber than rocks and cannot be trusted to fashion a successful economic program. Despite really strong (as in kimchi) economic demand stimulus, the US economy continues to clank along at school-zone speeds. Even the mention of new expanded stimulus programs sends shock waves over national debt reaching crisis proportions. Such policies immediately create uncertainty and very conservative behaviors on the part of workers and firms. 

Notice that if you are not asleep yet we have gone full circle in the last 75 years from a time when we had no demand policies; to when they were lauded; to a precautionary phase; to no impact; to finally a stage of perverse impact. That puts us back to where we were before the 1930s.

We are back to something more like the Classical Theory. The only way to improve employment and economic growth is to restore competition and remove regulations that prevent wages and prices from clearing markets.  Today Keynesian stimulus programs reduce confidence and need to be replaced by financial and aggregate supply policies that raise confidence and reward firms that improve productivity and control costs. The days of fooling firms and workers is over. There is no magic wand. You can't get something for nothing. Cyprus reminds us all one more time of the dangers to debt. What makes the economy grow has never changed -- entrepreneurs and businesses need to innovate and take risk. We need an environment that rewards and facilitates that process.