I’m spending too much time around economists

Well, actually I think the time is well-spent.  But it is funny how often economic thinking and concepts directly intrude on my thoughts the older I get and the more time I spend with economists in person and in print.  Two cases in point, both related to the concept of opportunity cost:

1.   I was stuck at the airport for much of last Saturday and so perused the magazine racks there at some length during breaks from the pain of trying to work in an airport chair.  At one point, my eyes wandered over to the newest edition of Psychology Today – a pretty awful magazine – and noticed the front cover advertising an article titled something like: Why Smart People Have Less Sex.  I instantly and without really thinking at all said to myself, “Well that must be due to their higher opportunity cost,” before I even processed anything on a more intellectual level or even picked up the magazine.  I decided to see if the article did touch on this (obvious) possible explanation and was disappointed during a quick perusal to see it wasn’t really discussed as an alternative in anything more than a cursory fashion.

2.  My eldest son was taking forever eating his dinner tonight so I tried to explain to him the concept of opportunity cost.  I was tired of just telling him to eat his supper and stop playing with his food, so I thought I’d try to rationalize with him once again.  I proceeded to teach him the phrase opportunity cost and how he should think about what fun he was foregoing by taking twice as long to eat as it should even allowing for enjoyable organic family conversation.  When I quizzed him about what this all meant, he responded such that he certainly knew what I was talking about.  I thought victory was at hand.  And then he proceeded to tell me that it was still so much fun to make his pasta into a ski jump – thus handing me a defeat in my quest to get him to eat faster than paint dries.  However, I was pleased that his internal economist is working quite well since he seemed to be calculating the trade-offs!

Note: I wrote this post before David Henderson said this earlier in the week about opportunity cost.  Worth a look.

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Uncertainty, the Small Investor, and Recovery

By now, we have all heard the basic argument that a core problem impeding recovery during the 1930s was the uncertainty created by public policy. In Robert Higgs’ words: “the New Deal prolonged the Great Depression by creating an extraordinarily high degree of regime uncertainty in he minds of investor.” New or anticipated taxes and regulations were at the heart of this uncertainty. And as Burton Folsom notes in a recent book: “Roosevelt’s special-interest spending created insatiable demands by almost all groups of voters for special subsidies. That, in itself, created regime uncertainty.”  Obviously, the subsidies were used as a tool of coalition building. But at the same time, they created questions for all: “where would the line be drawn? Who would get special taxpayer subsidies and who would not?” (New Deal or Raw Deal, 251).

Things have changed significantly since the 1930s. Government has more than doubled in size relative to GDP and many of the forms of spending that seemed so novel during the New Deal have become a central component of what many consider to be a minimally functional state.

Another thing that has changed: whereas during the 1930s, the pool of investors was largely limited to the wealthy. In the past quarter century, in contrast, a majority of Americans have stepped into the market, often through a 401(k) or an IRA.  We became a nation of investors.

To bring things full circle, I turn your attention to a piece by Graham Bowley in today’s NYTimes, “In Striking Shift, Small Investors Flee Stock Market.”

The lead: “Renewed economic uncertainty is testing Americans’ generation-long love affair with the stock market.”

“For a lot of ordinary people, the economic recovery does not feel real,” said Loren Fox, a senior analyst at Strategic Insight, a New York research and data firm. “People are not going to rush toward the stock market on a sustained basis until they feel more confident of employment growth and the sustainability of the economic recovery.”

This trend is being reinforced by baby boomers readjusting their portfolios away from equities and toward bond funds and the loss of real estate value (and hence a loss in the capacity to use the house as an ATM).

For decades, political scientists and economists have spoken of a political business cycle wherein elected officials goose the economy in the months leading up to an election to maximize their votes, leaving the long-term economic fallout until after the election. Now that nearly every man and woman is an investor, things may be more complicated. One must ask whether the efforts to prove that something is being done are convincing voters qua small investors that the future is quite uncertain, thereby having the unintended consequence of prolonging the recession?

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Recovery Summer Update: Wie geht’s?

With but a few weeks left in “Recovery Summer,” this past week was not what many would have hoped. On Tuesday, the Federal Reserve’s FOMC announced that “the pace of recovery in output and employment has slowed in recent months” and “the pace of economic recovery is likely to be more modest in the near term than had been anticipated.”  Conditions “are likely to warrant exceptionally low levels of the federal funds rate for an extended period.” The market responded to the Fed’s optimistic forecast much as one might have predicted.

The front page article in today’s NYT by  Graham Bowley and Christine Hauser provides a sobering description of where we are economically:

The optimism that had pervaded Wall Street only weeks ago has faded quickly. In its place is a growing realization of what many Americans have been feeling in their bones: this is not the economic recovery the nation had hoped for. While the economy is growing again, it is growing too slowly to create many jobs or to increase household incomes. Given the uneven rebound in the United States, and now signs that the world’s other economic engines are slowing, economists say Americans may confront high unemployment and lackluster growth for some time to come.

The Goldman Sachs Group added to the sense of malaise when it  informed its clients that there is a 25 to 30 percent chance that the U.S. economy will fall back into recession. (Bloomberg).

But wait…

While things are increasingly dismal in the US, there are rays of hope across the Atlantic…more precisely, in Germany.

As Roddy Thompson reports: “Germany posted Friday its best quarterly growth since reunification.” The growth rate between April and June was 2.2 percent, compared with 0.6 percent in the US. In the words of senior ING economist Carsten Brzeski,  Germany is “playing in a league of its own.” By any one’s account, an annualized rate of growth approaching 9 percent is quite impressive. Kay Murchie notes at the Financial Markets blog that the growth in Germany has been largely export driven: “Earlier this week, Germany’s federal statistics office reported exports grew 3.8% in June compared with May. On an annual basis, exports were 29% higher.”

According to the Economist blog, Free Exchange, the surge in exports is only part of the story. Growth must also be attributed “to investment by firms at home looking to upgrade and expand their capital stock to meet that demand.” German firms are not worried by

American complaints that Germany is living off the spending of others and adding little to global demand have much impact. There are some signs that Germany’s recovery is leading to more spending at home. The German statistical office said that consumer spending made a positive contribution to GDP. Some firms are already reporting skill shortages, which ought to be good for jobs, wages and (eventually) consumption. Even so, a more balanced recovery in Germany may yet be thwarted by fragile banks and by the inherent thrift of consumers.

Germany’s impressive growth must come as a surprise to the Obama administration. If you will recall, in the early days of “recovery summer,” the administration chastised the Germans at the G-20 for providing insufficient stimulus to domestic demand and relying too heavily on exports. Chancellor Angela Merkel rejected the administration’s advice. As Marcus Walker and Matthew Karnitschnig (WSJ) reported at the time, Merkel claimed that the core argument “that increased deficit spending promotes growth— doesn’t apply in Germany.”

Continuing to run big deficits could backfire here, she said, because of Germans’ angst over their aging society and rising public debt. Fear that the German welfare state could run out of money leads individuals to save their income as a precaution, she said. If Germany cuts its budget deficit instead, “then the citizen is more willing to spend money,” she said, “because he knows that he can count on the pension, health and elderly-care systems.”

So, lets sort this out: if the government reduces the budget deficit, citizens have greater faith in the future and, as a result, are more willing to spend? Fiscal stability creates a comparable faith for corporations, leading them to invest in their capital stock? And all of this promotes growth?

Wunderbar!

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Recovery Summer Update

The Summer Recovery Tour has just completed its scheduled stop at Yellowstone National Park, as the touching account on the White House Blog informs us.

Meanwhile…

• The Beige Book, released yesterday, “underscored the Fed’s view that the recovery, while still moving forward, is progressing at a slower pace than earlier in the year.” (BusinessWeek)
• James Bullard, president of the St. Louis Fed, warned yesterday “that the Fed’s current policies were putting the American economy at risk of becoming ‘enmeshed in a Japanese-style deflationary outcome within the next several years.” (NY Times)

If the AP survey  of economists is correct, VP Biden may have to extend the tour, since the real recovery summer may be  scheduled for 2010 2011…2015?

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Unemployment: the Shrinking Denominator

Well, the new jobs numbers were released today: nonfarm payroll employment fell by 125,000 in June. At the same time, the unemployment rate fell from 9.7 to 9.5 percent.

Before the celebrations begin (“Recovery Summer is underway! The unemployment rate fell!”) recall that the rate only reflects those who are in the labor force. According to the Bureau of Labor Statistics, the workforce shrunk by 652,000 between May and June. In other words, 652,000 were sufficiently discouraged to stop searching for a job (to simplify a bit: the denominator is shrinking faster than the numerator).

If the overall picture is grim, it is particularly dismal for African Americans (15.4 percent unemployment) and Hispanics (12.4 percent unemployment).

Senate Republicans have become born again fiscal conservatives on the issue of unemployment, refusing to support an extension of benefits as they depart Washington for an extended July 4th holiday. One wonders if this is a strategic blunder. See Megan McArdle’s recent post on this and the lively comments it generated.

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Recovery Summer

The Recovery Summer is well underway.

• Vice President Biden sought to rally the troops in the Milwaukee stop of his Recovery Summer tour by noting: “there’s no possibility to restore 8 million jobs lost in the Great Recession.”
• Today, a  sharp drop in the Conference Board’s Consumer Confidence Index have sent markets into a triple-digit loss.
• Paul Krugman (New York Times) opines “We are now, I fear, in the early stages of a third depression. It will probably look more like the Long Depression [following the Panic of 1873] than the much more severe Great Depression.”
• The National Journal reports that in public opinion, “the cement is hardening.” Based on its Congressional Connection poll, “the sputtering economy, the unchecked oil spill in the Gulf of Mexico, two wars and a rough-and-tumble campaign season continue to take a toll on the public’s confidence in the government.”

Meanwhile…

• As Congress pushes forward with the most significant financial reforms since the Great Depression, Dan Alamariu at Foreign Policy predicts ”The reforms currently debated in Congress represent only the opening salvo of a larger reform process that will take years to complete and whose outcome will be both unexpected and more stringent on financials than the currently debated legislation.”
• The White House continues to push ahead with discussions on climate change policy with a meeting scheduled for today. The Hill reports: “Tuesday’s meeting with Obama may lay the groundwork for Reid to craft a legislative strategy for trying to get 60 votes this year on an energy and climate plan.”

Although Krugman draws analogies between 2010 and 1933, things feel a bit more like 1937.

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Policy Differences Among Economists and “Disinterested Citizens”

Milton Friedman argued in 1953 (and again in 1967) that economic policy differences are rooted primarily in different views about the consequences of those policies — and that these disagreements could largely be eliminated by better positive economics (!).  Specifically, he wrote:

I venture the judgment, however, that currently in the Western world, and especially in the United States, differences about economic policy among disinterested citizens derive predominantly from different predictions about the economic consequences of taking action – differences that in principle can be eliminated by the progress of positive economics – rather than from fundamental differences in basic values, differences about which men can ultimately only fight.  (1953)

I have been much impressed, in the course of much controversy about issues of economic policy, that most differences in economic policy in the United States do not reflect differences in value judgments, but differences in positive economic analysis.  I have found time and again that in mixed company – that is, a company of economists and noneconomists such as is here today – the economists present, although initially one would tend to regard them as covering a wide range of political views, tend to form a coalition vis-a-vis the noneconomists, and, often much to their surprise, to find themselves on the same side.  (1967)

This is a highly problematic contention and something that not even his wife Rose was willing to accept.  Indeed, she thought nearly the opposite: “I have always been impressed by the ability to predict an economist’s positive views from my knowledge of his political orientation” (1998).*  

My view is that values and interests, not scientific understanding, are at the root of most political differences – and this holds for economists as much as for the rest of us.  Indeed, even when economists are in agreement on policy despite different political views, this is often because of a commonly shared fundamental agreement on values, namely a generally consequentialist – even utilitarian – ethical framework that itself is exogenous to economics as a science.  

It is worth nothing that Milton wavered later in life in his confidence in this earlier view, noting “I am much less confident now that I am right and she [Rose] is wrong than I was more than four decades ago when I wrote the methodology article…” (1998).    

* Rose’s view is very, very troubling since it would make scholarship merely an adjunct to politics rather than a neutral scientific enterprise that might or might not have policy implications. (It is worth explicitly pointing out that she implies the causal arrow is going from political orientation to economic view, rather than the other way around).

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Wanted: An economics of fear

During and after the financial panic of 2008, we were exposed to a host of economists trying to explain the market meltdown, what should be done about it, and how we might avoid repeating it. Some of the leading lights in the discipline weighed in on the market problems. Now we have a reform proposal working through Congress that my fellow Pileus bloggers have written intelligently about (see here, here, and here).

Opinions are wide-ranging. I might share some of my own soon. But what unites all the various economists is a complete and utter cluelessness on the most important variable in the economic meltdown: fear.

Stock markets have been falling and have been highly volatile recently, apparently over the debt crisis in Europe (though I have to say that most media explanations for why markets move the way they do in a given day are complete gibberish). I would not be surprised to see the market slide even further, erasing most or all of the big gains of the past year.

Nothing in traditional finance can say anything useful about fear, nor can the macroeconomists. Perhaps there is something in the “new behavioral finance,” but I’m not aware of anything.  Keynes talked about “animal spirits,” but did not have a systematic theory of fear. To say that people behave irrationally is not a theory. A theory of fear would tell us something about why, when, and how fear develops and how it can be contained or modified. Similarly, we would could use a theory of the exuberance which leads to bubbles in the first place. I don’t think anyone really has a clue.

When the housing bubble burst, a lot of institutions were left holding high number of “toxic assets,” which were mostly mortgage-backed securities. Their price went to essentially zero, even though I cannot conceive of any model that would say a bunch of bad loans should have a zero price (even a really, really bad batch—say one where 50% of the mortgages will default—should still be worth 50 cents on the dollar, shouldn’t it?). Thus, the market went from systematically overvaluing these securities to systematically undervaluing them. What model of investor behavior can explain both phenomena?

Now we have debt problems in a few small European economies. Investors are acting as if the value of that debt is going to zero, though it is hard to imagine a complete collapse of the government that results in any European country simply defaulting on all its debt, though it is possible to think of cases where debt would need to be restructured and bond-holders would lose some value (in fact, the EU should require that to happen, rather than just throwing more money at these irresponsible states). This nervousness, this fear, spills over into other bond markets and into equity markets, which threatens the economic recovery. Systematic fear can be as devastating to an economy as real shocks.

People say that we need to understand the causes of the financial meltdown before proposing solutions. I think there are commonsense reforms that can be made, but these mostly won’t get at the real problem: no one has a clue about how to regulate either exuberance or fear.

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Resource Curse: Fact or Myth?

The “resource curse” refers to a set of cross-national relationships between resource dependence on the one hand and economic growth and civil conflict on the other. Sachs and Warner were the first to document the negative relationship between resources and growth. The notion that countries blessed with abundant mineral resources tend to suffer slow economic growth was just counterintuitive enough to appeal to most economists, and the idea quickly became a piece of conventional wisdom.

Subsequent research delved deeper without questioning the basic relationship. Was all production of primary commodities associated with slower growth, or just mineral production? (Evidence suggested the latter.) What was the causal mechanism: “Dutch disease” via appreciation of the real exchange rate, a political economy explanation such as corruption or rent-seeking, or civil conflict? (Sachs and Warner argued for the first, Robinson, Torvik, Verdier, Moene, and colleagues argued for the second, and many political scientists and economists associated with the World Bank’s Economics of Conflict program argued for the last.)

The research on resources and civil war became a massive literature in its own right. Collier and Hoeffler kick-started the program in 1998 with their “rational rebel” model of civil war. For them, resources promoted conflict by rewarding looting. Fearon and Laitin found that oil exporters were more likely to see new civil wars. Some research also found a diamond curse in the 1990s, but Ross’ work has found that oil (especially onshore oil) is the only robust channel by which resources promote intrastate conflicts. To my knowledge, no one has yet quantified the deleterious consequences that resources have on growth via the oil-civil war link or determined whether there is a growth residual that civil war does not explain.

However, some of the latest research to come out is questioning the very basis of the resource curse, the cross-national negative partial correlation between resource dependence and economic growth. The criticisms of prior research have focused on measurement and modeling issues. Typically, resource dependence has been measured as resource exports divided by GDP. In the numerator, total resource production is not available for many country-years, and exports are therefore preferred. The main problem is that re-exportation of minerals is apparently counted in some datasets, and export of processed minerals (e.g., smelter production) is definitely included. What we ideally want is mine production of raw minerals. In the denominator, GDP is used rather than population in order to test the Dutch-disease, crowding-out argument. If resources are important relative to the economy, they may draw capital and labor out of more “productive” sectors that generate dynamic gains and drive up nontradables prices.

The problem is that an economy may develop resource dependence because of growth-retarding institutions that have persisted for a long time, institutions that discourage capital accumulation and the manufacturing and service sectors dependent on abundant physical and human capital, thus generating a negative partial correlation between resource dependence and growth that is spurious due to “endogeneity.” Endogeneity simply means that the errors in the growth model correlate with one of the regressors, in this case resource dependence.

To try to address this problem, Sachs and Warner included some geographic controls, on the assumption that geography would be the main omitted variable that could drive spurious results. However, they found no effects for their geography controls. Since then, we have discovered that geography as a determinant of growth has been vastly overrated. Once Acemoglu, Johnson, and Robinson include political institutions (instrumented by settler mortality rates) in their growth models of post-colonial countries, geography is no longer statistically significant. What this tells us is that endogeneity may still be a problem.

In two recent papers, Brunnschweiler and Bulte argue that resource dependence is a result of poor institutions and conflict, and that when instrumented, it no longer affects either economic growth or civil war. They report that a very broad measure of resource abundance (net present value of natural capital, including mineral, agricultural, and environmental assets) is positively related to growth and therefore indirectly related to less conflict risk (richer countries experience less civil war). Whether these new papers shake the conventional wisdom or not remains to be seen. Certainly, instruments can be questioned (presidentialism and trade/GDP play a prominent role, but these do not strike me as obvious choices), and their measure of resource abundance is fraught with measurement error, but at the moment, the evidence is not looking good for the conventional resource curse.

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Those looming deficits. Yawn.

Before I get voted off the island, let me say that I’m in favor of much smaller government, lower spending and lower taxes.  I’m also a supporter of reducing budget deficits.

That said, however, I cannot find a reason to get that worked up by the budget future of the U.S. or most developed countries.  I started thinking this way over 20 years ago when I was an undergraduate and Robert Barro came to campus to tell us that the trade deficit we were running at the time was not that big of a deal, nor was the budget deficit that the trade deficit was helping finance.  This was my first exposure to Ricardian equivalence, a concept that I still think is basically right.

Of course studying economics at Chicago didn’t really dissuade me from this view.  Our macro courses paid scant attention to government finance of any kind, and no one in Chicago (or elsewhere) was paying attention to fiscal stimulus or any other  Keynesian voodoo.  We studied real business cycle (RBC) models.  I never became a master of these models, nor did the hyper-technical, ethereal nature of these models seem to be something I would be interested in or something I would be good at.

But I did gain a sense of what was important in the macroeconomy: real things.  By this I mean machines, hours worked, human capital, technology, infrastructure, networks, relationships, and time.  Prices, deficits, interest rates, exchange rates—these are things determined in markets by the supply and demand for real things.  They are not in themselves real things.   [If you and I each sell each other one billion dollar bonds, are we both worse off or better off?]

The way to judge government spending is to determine whether we are spending money on things that have value (relative to opportunity costs), not how those expenditures are financed or how much money is being moved around and to whom.   Taking money from person A and giving it to Person B is just a transfer; it doesn’t have real consequences unless people start doing things with their real stuff to avoid those transfers, such as putting their capital in less productive uses in order to avoid taxes.

In a closed economy (which we are definitely not, but hold that thought for a moment), the idea that a society can live beyond its means is impossible.  We cannot borrow from our children’s future.  We can only borrow from the present.  People who buy those government bonds know that those bonds can only be paid back from future taxes.  This is the main idea behind Ricardian equivalence.  It doesn’t matter whether spending increases are financed by taxes or bonds.    If I want to buy a car, the important question is not whether I pay cash, or get a 4-year loan or a 6-year loan (assuming each option will leave me solvent).  The important question is whether I buy a Toyota or a Lexus.  I don’t want a Lexus government.  I want a Toyota government.  Policies that diminish productivity, reduce investments in technology and human capital, and lead individuals to divert real resources from productive uses to unproductive uses are the policies we need to be most concerned about—not how big the budget deficit is.

The humungous caveat to this analysis, however, is foreign debt.  We cannot borrow from future generations since they don’t exist, but we can borrow from the Chinese and other creditors.  This is a genuine concern, but not one that I am terribly worried about yet, at least in the short-term.   As long as people have faith in the US Government meeting its obligations (and every time there is a crisis, people flock to US Bonds), they have every incentive to keep those bonds.  A mass sell-off would only hurt the seller, since it would lower the price of bonds.

So let’s focus on what matters: what are we doing with our time, our talents, and our stuff—and how can we keep government away from it.

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The Paul Millsap of Economics?

Even though I’m in the office working on a Saturday, I had a colleague (and fellow Jazz fan, incidentally) come by and berate me for comparing the great Bill Russell to Paul Millsap. Now, I’m a huge fan of Millsap—look at Game 2 of this series; he was the most valuable player on the floor—so I don’t consider this an insult to Russell.  But I realize some people get upset by not giving the greats of the past their due.

My colleague characterized the Millsap/Russell comparison as saying that Adam Smith was not a great economist because he couldn’t compete with economists if he were alive today (at least not without a lot of new training).  Certainly one could make the case that Smith, the “father” of the discipline, was a great economist.  But what are we to do with him today?  My fellow blogger, Jim, is a Smith expert and has written extensively on him, so I have to be careful.

PhD students in economics these days rarely read Smith.  In fact a philosopher or political scientist, I would conjecture, is much more likely to have read Smith than an economist .  In economics, “history” is anything published more than 20 years ago, and anything published before the great general equilibrium papers (Arrow-Debreu, etc.) in the 1950s is just “history of thought,” and there are like 2 people in the nation that are writing dissertations on the history of thought and probably fewer economics departments who want to hire them.

For better or worse, economics is a cumulative discipline.  A big premium exists for being well-schooled in the state of the art, but not much career value in saying, “Jones is really just arguing what Adam Smith said in a less technical way.”  Those comments just elicit a collective yawn from the discipline.  Paul Samuelson gave a coherent mathematical structure to Marshall and other predecessors, and we have all moved on with that structure .  Smith, actually, can still be read today by economists because of the clarity of his writing, but people like Ricardo—immensely influential historically—are impenetrable and a waste of time.  Understanding Ricardian Equivalence is key if you are macro guy, but reading Ricardo is not.  There are great economists today (though very few under 60, I would guess) who are conversant with the old masters, but most of just fake it.  Give us an Adam Smith cheat sheet, and we are good to go.  From time to time I have read parts of the classics.  But every time I do, I conclude afresh that this is not a good use of my time.

Our philosopher friends and others look at us disdainfully for our ahistorical discipline.  But I say, give us some useful answers, or shut up.  Some disciplines are not cumulative, and I conjecture that is a mark of the immaturity and lack of progress in those disciplines (though sometimes lack of progress is a function of the inherent difficulty of the field).  Economics is a relatively young discipline, but a mature one because we don’t have to start at the beginning all the time.  The discipline itself has sifted through the past research and preserves what has utility (though I’m not saying some out-of-fashion ideas don’t deserve being resurrected).   The more a discipline looks to its history, the less it has to say of value in today’s world.  I don’t think any of the hard scientists are focused on the past.

Now sometimes we look to the past because disciplines have declined.  Who can argue that symphonic music, for instance, has improved in the last century?  We still listen to the classics not because we are awaiting for good music to be discovered, but because there was so little that was really good in the 20^th century.

In social science and the NBA, this is not the case.   I’d still take Paul Millsap.

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When the Obvious isn’t Obvious

For many observers, it seems obvious that the roots of the current recession lie in the crisis in the banking sector.  In the Economist’s Voice (a non-technical, yet academic, electronic journal), Robert Barbera attacks University of Chicago Economist Casey Mulligan and other real business cycle theorists for having a framework that cannot either predict or even describe important economic phenomena.

Barbera chides for Mulligan for predicting in the Fall of 2008 that we wouldn’t see large decreases in employment because of the weak linkage between the financial sector and the rest of the economy.  Mulligan argued, and still does, that gyrations in the financial sector are not closely linked to performance of the economy overall.  In other words, the obvious is not obvious.

In a sharp response, Mulligan correctly points out that Barbera’s critiques are not based on any theoretical critique of the large literature on this topic, but merely on Mulligan’s incorrect prediction.  Mulligan acknowledges he was wrong, but points out that that obvious story cannot easily account for two important facts.  First, that even though employment fell sharply, GDP and consumption did not.  Second, the massive infusion into the financial sector did relatively little to increase lending.  [It all seemed to go into the monetary base, which caused know-nothings like Glenn Beck to rant about how this was going to cause rapid inflation and financial catastrophe.]

Mulligan does have an alternative account of the current recession.  He thinks it was caused primarily by distortions in the labor market, namely three successive increases in the minimum wage and a mortgage modification program that was associated with an marginal tax rate of over 100%.  He does acknowledge that there might be monetary or capital sector stories that could be explored, but I find the labor market story intriguing.

I’m highly suspicious that the banking sector crisis was completely unrelated to the current recession (and I suspect Mulligan would allow for some role).  But, on the other hand, Mulligan’s argument is based on careful modeling, data analysis, and peer review.  Barbara’s argument is based on huffing and puffing about what is obvious.  Mulligan admits the full story isn’t known, but he is none to kind of the resurgence of Keynesian thinking in the public sector:

Recent events only reinforce the prescription that economic analysis should be rooted in incentives, not voodoo incantations of multipliers and contagion.  But the latter will continue to enjoy prominence in the political marketplace, where there’s nothing like telling taxpayers “Give me your money and, trust me, your gift will make you richer.”

Often when people say something is obvious it means they don’t have a good argument.

Addendum: One of the commentators below references the views of Scott Sumner, who always has intelligent things to say.  In particular, back when Paul Krugman was screeching that we simply HAD to have a giant stimulus because we were in a liquidity trap and therefore out of monetary tools, Sumner wrote a nice little piece in The Economist’s Voice arguing that of course we still had tools.  If you are interested, you can also read my little comment on Sumner and on Brad DeLong’s mischaracterization of our available policy options (DeLong argued that the only way to do deficit spending was to increase spending, neglecting to mention cutting taxes).  It is my simple-minded attempt to be a macroeconomist–something I will avoid in the future, except when blogging!

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Krugman’s Hackery on Deficit Hawkery

Just about everything Paul Krugman writes nowadays is in some way related to rationalizing the Obama deficits. Now, Krugman’s a smarter man than I, but I think it’s pretty clear that his partisanship drives his economic analysis these days, rather than the other way around.

Yesterday Krugman turned a case against the euro into a mind-boggling attempt to justify Greece’s fiscal shenanigans over the past few years:

Right now everyone is focused on public debt, which can make it seem as if this is a simple story of governments that couldn’t control their spending. But that’s only part of the story for Greece, much less for Portugal, and not at all the story for Spain.The fact is that three years ago none of the countries now in or near crisis seemed to be in deep fiscal trouble. Even Greece’s 2007 budget deficit was no higher, as a share of G.D.P., than the deficits the United States ran in the mid-1980s (morning in America!), while Spain actually ran a surplus.

So because the U.S. ran a budget deficit of about 5% of GDP when existing public debt was about 50% of GDP, that makes it OK for Greece to run a deficit of just under 5% of GDP when existing public debt was about 100% of GDP? As for Spain and Portugal, the rigidity of their labor markets contributes to unemployment – and in Spain the popping of an enormous housing bubble has intensified the effect. He continues:

The problem is that deflation — falling wages and prices — is always and everywhere a deeply painful process. It invariably involves a prolonged slump with high unemployment.

Oh really? Tell that to economists who study the classical gold standard. From about 1880 to 1914, prices dropped on average 2% per year, even as the Second Industrial Revolution motored on. And here comes the inevitable payoff:

The deficit hawks are already trying to appropriate the European crisis, presenting it as an object lesson in the evils of government red ink. What the crisis really demonstrates, however, is the dangers of putting yourself in a policy straitjacket. When they joined the euro, the governments of Greece, Portugal and Spain denied themselves the ability to do some bad things, like printing too much money; but they also denied themselves the ability to respond flexibly to events.

Because everything has to relate back to defending the U.S. government’s unconscionable fiscal excesses. If Krugman really thought monetary pump-priming is always necessary to get a local economy back on track, he would favor abolishing the dollar and breaking the U.S. up into optimal currency areas.

More to the point, Krugman’s (lack of) concern about budget deficits is strangely selective. Back in 2004, he castigated the Bush Administration for “enormous” budget deficits and “irresponsible” tax cuts. So much for the objectivity of the scholar.

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Industrial Firms Lobbying Against Financial Reform

The NYT has this story on how manufacturers, auto dealers, and the Chamber of Commerce are lobbying against the proposed derivatives exchanges and new consumer financial protection agency in the financial reform bill. It seems to me that they’re right to be concerned. Industrial firms, apart – apparently – from U.S.-owned automakers, are not treated as being “too big to fail” and do not face moral hazard incentives to invest in risky financial instruments. They’re simply trying to hedge against risk of price rises in their inputs. Cracking down on derivatives generally thus doesn’t make much sense. A properly tailored financial regulation bill would regulate banks and perhaps insurance companies specifically – the companies backed up by Federal Reserve lending, the Treasury’s implicit too big to fail guarantee, and deposit insurance.

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The Arizona Conundrum

I’m interested in people’s opinions on the new Arizona anti-immigration law.  I have a hard time coming to a consensus in my own mind about the immigration issue and laws like the one Arizona passed.

My civil libertarian mind hates the police state and harassment of anyone—citizen or otherwise.

My rule-of-law mind hates that we mostly look the other way when our immigration laws are flouted—not just by the immigrants crossing the border, but by businesses who hire them and by local governments who provide them sanctuary from the law.

My utilitarian economist mind realizes how essential low-wage immigrant labor is to our economy.  A sudden extraction of illegal immigrants (not that that is possible) would be disastrous, economically speaking.

My selfish elitist mind realizes that I am part of the socioeconomic class that benefits most from this immigrant labor, since I don’t face much wage competition from them (though American academics do face a lot of pressure from educated immigrants in both obtaining jobs and getting into graduate schools).

My partisan political mind understands the importance of the Latino vote in the future.  Even a small-brained Republican like George W. realized this and tried to avoid alienating Hispanics.  Of course even smaller-brained Republican Congressmen have succeeded in sticking a racist knife into the party’s future.  Democrats (who, ironically, rely much more on electoral support from the unskilled laborers who are the principal losers from illegal immigration) just get to sit back and laugh as the Republicans do themselves in.

My cosmopolitan egalitarian mind hates that ugly racism underlying the anti-immigration view and sees open immigration as lifting at least some people around the world out of poverty.

My Christian mind is cognizant that many of these illegal immigrants are surely among “the least of these” that Christ talked about when he said, “For I was an hungered and ye gave me meat: I was thirsty, and ye gave me drink: I was a stranger and ye took me in.” (Matt. 25:35)  I generally don’t like to use religious arguments as policy justifications, since the things that determine private morality often cannot justify public policy,  but I have to say these biblical verses definitely come to mind.

So what is a civil-liberatarian-rule-of-law-utilitarian-economist-selfish-elitest-Republican-cosmopolitan-egalitarian-Christian to do?

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Barro

I’m a political scientist.  Moreover, I’m a political scientist who loves history and values qualitative research methods (and not just the KKV way of doing things). 

But I find economists to be fascinating.  They have their problems, mind you, something I’ll likely write about in the future.  However, I seem to read more and more research done by economists every year – and not just on traditional economic matters. 

And here is an interesting interview with Robert Barro on “The Lessons of the Great Depression” that is still worth a read.   

Given we are all victims these days, I’ll blame Sven (my fellow Pileus and our only current economist by training).

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Krugman on Friedman on the Depression

I just recently came across this profile of Milton Friedman by Paul Krugman in the February 15, 2007 New York Review of Books. Krugman pays homage to Friedman’s research as a macroeconomist, including his and Schwartz’s Monetary History of the United States, best known for its explanation of the Great Depression as a monetary phenomenon. However, Krugman castigates Friedman for “intellectual dishonesty” in his popularizations.

On the Great Depression, the core of Krugman’s accusation is that Friedman claimed to have found that the Federal Reserve “caused” the Great Depression when the money supply collapsed by a third during 1931-33 due to bank failures. But, says Krugman, the fault in the Fed was not reducing the monetary base (they increased it), but instead failure to act. So it’s dishonest to claim that the Fed caused the Depression, when Friedman’s research actually demonstrates the case for more government intervention, not less.

I take the point, but it’s an unfair stretch to characterize Friedman’s interpretation as intellectually dishonest. After all, when public choice economists criticize government regulation on the grounds that such agencies are often “captured” by the interests they’re supposed to be regulating, no one would say it’s intellectually dishonest to oppose certain government regulations on those grounds. Similarly, one can legitimately oppose monetary discretion on the grounds that central banks will sometimes make catastrophic mistakes on the side of acting too hesitantly or timidly.

Second, as I recall Friedman and Schwartz’s original argument, they also argued that an alternative to rescuing the banks would be either deposit insurance or allowing solvent but illiquid banks to suspend payments to depositors, as had been the case prior to 1913. It was the combination of no deposit insurance, no bailouts, and the prohibition on suspension of payments that caused the catastrophe. Had that last government regulation not been in place, the U.S. Depression might not have turned out to be the worst slump in the industrialized world in the 1930s.

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The Left’s Misdiagnosis of U.S. Health Care

You’re unlikely to get a patient’s prescription right if you haven’t properly diagnosed the illness you’re trying to treat. Predictions both rosy, catastrophic, and everywhere in between have issued forth from supporters and opponents of the recent health care reform bill. The truth is that economics is not a precise, predictive science, and we simply don’t know what the medium-term consequences of the bill will be. But we do know that if the bill’s treatment of the ailing U.S. health care payment system is based on a faulty diagnosis, it is likely to fail. So let’s be good empiricists and look at the evidence: What is wrong with U.S. health care payment system, and are these problems rationally related to the solutions offered by supporters of a government regulatory takeover, whether Obamacare or something more radical like single payer? Virtually everyone agrees that rising health care costs are the main problem we need to address, but why are health costs rising so much?

Any argument for government intervention must depend on showing that any health care payment system suffers from market failure. Market failure comes in essentially two varieties: public goods and market power.*

Public goods are goods that have to be provided for “everyone” if they are provided to anyone. You can’t find ways to exclude non-payers – thus, strategic customers will not pay even if they want the good, and the good isn’t provided. Everyone is worse off. Public goods include externalities, the tragedy of the commons, etc. Is health insurance a public good? Probably not. The left’s main complaint about market-provided health insurance is that those who cannot pay are excluded from it. However, during the course of the health care debate, supporters of the Democrats’ plan argued that health insurance was a public good, mainly because people who do not have insurance can obtain emergency care anyway and impose costs on others (“uncompensated care”). Therefore, everyone would be better off if everyone were forced to obtain health insurance.

To this argument there are three main responses: 1) uncompensated care represents no more than 3% of health care expenditures, so it cannot be responsible for much of the escalation of health care costs; 2) the rational solution to uncompensated care is not forcing everyone to buy insurance, but forcing everyone who can pay to pay for the care that they actually receive, for instance through wage garnishments; 3) even if #1 weren’t true, and #2 weren’t feasible, at most this argument would justify forcing people to obtain coverage for emergency care, but Obamacare essentially prohibits high-deductible, emergency-only plans! (See also here.)

What about market power? Economic theory predicts that monopolies – and maybe oligopolies too – will raise prices to the consumer and reduce the quantity of service. Health care prices have risen, but is there any more direct evidence of market power in health insurance?

We can look at profits. Monopolies should be able to reap profits well above the norm for most industries, because they enjoy monopoly power only due to the inability of other firms to enter the market. According to Henry Aaron at the liberal Brookings Institution, “Insurance company profits in the large picture have very little to do with the overall rising cost of health care.” Insurance companies’ profit margins tend to be under 5%, right about average for the American economy as a whole. In most states (those that have not regulated the industry to the brink of expiry), the health insurance market is competitive.

So why have health insurance costs risen so much? Because health care costs have risen so much. What does Obamacare do about health care costs? Almost nothing. Instead, the bill forces insurance companies to take all comers (guaranteed issue), forbids them from pricing risk (community rating), and gives the federal government review over their prices (price controls). These policies might make sense if the main problem with U.S. health care were market power in the insurance market, but it isn’t, and so they don’t.

Obamacare makes no economic sense. It should be repealed and replaced with true, consumer-powered reform that will force doctors and hospitals to reduce their prices.

*Allow me to quickly dispense with a third set of problems that really don’t count as market failure, because they don’t actually lead to socially suboptimal outcomes in competitive markets. I’m referring to moral hazard and adverse selection, which afflict finance and insurance markets in general. When a person is insured against a risk, that person is more likely to engage in behavior likely to actualize that risk (moral hazard). When insurance is offered, more risky persons are more likely to seek it out (adverse selection). But all insurance and financial markets have ways of dealing with these problems, from credit checks to claims adjustment. If you really thought these were insuperable problems requiring massive federal intervention, then you would also advocate this same intervention in, say, auto and homeowners’ insurance. But no one does.

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