Monday, December 31, 2012

President rejects his bipartisan commission

The fiscal deal struck last night makes one thing clear: President Obama must have really hated the recommendations of the bipartisan Bowles-Simpson commission that he appointed. The commission said that we needed to reform entitlement programs to rein in spending and that increased tax revenue should come in the form of base broadening and lower marginal tax rates. The deal appears to offer no entitlement reforms, no tax reform, and higher marginal tax rates. After all the public discussion over the past couple years of what a good fiscal reform would look like, it is hard to imagine a deal that would be less responsive to the ideas of bipartisan policy wonks.

The Neverending Quest for a More Redistributionist Tax System

I just listened to President Obama's latest remarks on fiscal policy.  This passage caught my attention:
I want to make clear that any agreement we have to deal with these automatic spending cuts that are being threatened for next month, those also have to be balanced, because, remember, my principle always has been let’s do things in a balanced, responsible way. And that means the revenues have to be part of the equation in turning off the sequester and eliminating these automatic spending cuts, as well as spending cuts.

Now, the same is true for any future deficit agreement. Obviously we’re going to have to do more to reduce our debt and our deficit. I’m willing to do more, but it’s going to have to be balanced. We’re going to have do it in a balanced responsible way.

For example, I’m willing to reduce our government’s Medicare bills by finding new ways to reduce the cost of health care in this country. That’s something that we all should agree on. We want to make sure that Medicare is there for future generations. But the current trajectory of health care costs has gone up so high, we’ve got to find ways to make sure that it’s sustainable.

But that kind of reform has to go hand and hand with doing some more work to reform our tax code, so that wealthy individuals, the biggest corporations, can’t take advantage of loopholes and deductions that aren’t available to most of the folks standing up here; aren’t available to most Americans.

So there is still more work to be done in the tax code to make it fair, even as we’re also looking at how we can strengthen something like Medicare.

Translation: The deal we are about to strike will raise taxes on the rich. But the fiscal imbalances we face will remain unsustainably large.  So I will ask for more tax increases on the rich later.

Friday, December 28, 2012

Theater Recommendation

For those in the Boston area: Yesterday, my family and I enjoyed one of our Christmas presents from Santa and went to the new production of the musical Pippin at the American Repertory Theater in Cambridge. I recall seeing the original Broadway production in the 1970s when I was in high school and liking the play then. I went to see it yesterday with a bit of trepidation, wondering whether my sensibilities had changed too much over the past four decades for me to still enjoy it. But the play did not disappoint, not even one bit. This new production is absolutely terrific: great acting, music, dancing, and even acrobatics. Everyone had a blast, from my teenage sons to my 85-year-old mother.

The play's run lasts until January 20. Go see it if you can.

Thursday, December 27, 2012

Glaeser on Disability

Ed considers what might be behind this fact:
Thirty years ago, there was a 40-to-1 ratio between the total labor force and those workers receiving Social Security disability payments. Today that ratio is less than 18-to-1.

Monday, December 24, 2012

A Reading for Christmas

My favorite Christmas-themed economics article is this one by Steve Landsburg. From 2004, but truly timeless.

A Krugman Puzzler

I often disagree with Paul Krugman, but I usually understand him.  Lately, however, I have been puzzled about his view of the bond market.  In a recent post, he takes President Obama to task for believing that the failure to deal with our long-term fiscal imbalance might cause a spike in interest rates:
America can’t run out of cash (except politically, if Congress refuses to raise the debt ceiling); it basically can’t experience an interest rate spike unless people see an increased chance of economic recovery and hence a rise in short-term rates. And the people who have been predicting an interest rate spike any day now for four years shouldn’t have any credibility at this point.

But back in 2003, when the fiscal imbalance was much smaller, he wrote:
With war looming, it's time to be prepared. So last week I switched to a fixed-rate mortgage. It means higher monthly payments, but I'm terrified about what will happen to interest rates once financial markets wake up to the implications of skyrocketing budget deficits.... 
How will the train wreck play itself out? Maybe a future administration will use butterfly ballots to disenfranchise retirees, making it possible to slash Social Security and Medicare. Or maybe a repentant Rush Limbaugh will lead the drive to raise taxes on the rich. But my prediction is that politicians will eventually be tempted to resolve the crisis the way irresponsible governments usually do: by printing money, both to pay current bills and to inflate away debt. 
And as that temptation becomes obvious, interest rates will soar. It won't happen right away. With the economy stalling and the stock market plunging, short-term rates are probably headed down, not up, in the next few months, and mortgage rates may not have hit bottom yet. But unless we slide into Japanese-style deflation, there are much higher interest rates in our future. 
I think that the main thing keeping long-term interest rates low right now is cognitive dissonance. Even though the business community is starting to get scared -- the ultra-establishment Committee for Economic Development now warns that ''a fiscal crisis threatens our future standard of living'' -- investors still can't believe that the leaders of the United States are acting like the rulers of a banana republic. But I've done the math, and reached my own conclusions -- and I've locked in my rate.
I am having trouble reconciling these points of views.  Has Paul changed his mind since 2003 about how the bond market works?  Or are circumstances different now?  If anything, I would have thought that the fiscal situation is more dire now and so the logic from 2003 would apply with more force.  I am puzzled.

Update: Several people have emailed me possible resolutions of the puzzle, but none is really satisfying.

One group of emailers says that things are different now because we are in a liquidity trap.  But back in 2003 the federal funds rate was at about 1 percent, so we were very close to the zero lower bound.

Another group of emailers says that Paul has admitted that his 2003 forecast was mistaken.  But that is not the issue.  Of course, we can look back and say it was mistaken.  No big deal.  Any economist who has ever made a forecast has made some mistaken forecasts.  The puzzle to me is how Paul can act so certain that the outcome he viewed as likely in 2003 is now beyond the realm of the plausible, even though the fiscal imbalances are much larger.

By the way, my column coming out in Sunday's NY Times touches on these issues, which is why the puzzle came to mind.

Thursday, December 20, 2012


Like most of you, I've been thinking about guns for the last few days. As economists, what do we have to say about gun control? Though this article is not about the economics of the problem, it has something to say about the practicalities of regulation. Regulating guns through the U.S. Consumer and Product Safety Commission is a start, and using some of the strategies that were used against tobacco is another useful step.

What's the problem here? People buy guns for three reasons: (i) they want to shoot animals with them; (ii) they want to shoot people with them; (iii) they want to threaten people with them. There are externalities. Gun manufacturers and retailers profit from the sale of guns. The people who buy the guns and use them seem to enjoy having them. But there are third parties who suffer. People shooting at animals can hit people. People who buy guns intending to protect themselves may shoot people who in fact intend no harm. People may temporarily feel compelled to harm others, and want an efficient instrument to do it with.

There are also information problems. It may be difficult to determine who is a hunter, who is temporarily not in their right mind, and who wants to put a loaded weapon in the bedside table.

What do economists know? We know something about information problems, and we know something about mitigating externalities. Let's think first about the information problems. Here, we know that we can make some headway by regulating the market so that it becomes segmented, with these different types of people self-selecting. This one is pretty obvious, and is a standard part of the conversation. Guns for hunting do not need to be automatic or semi-automatic, they do not need to have large magazines, and they do not have to be small. If hunting weapons do not have these properties, who would want to buy them for other purposes?

On the externality problem, we can be more inventive. A standard tool for dealing with externalities is the Pigouvian tax. Tax the source of the bad externality, and you get less of it. How big should the tax be? An unusual problem here is that the size of the externality is random - every gun is not going to injure or kill someone. There's also an inherent moral hazard problem, in that the size of the externality depends on the care taken by the gunowner. Did he or she properly train himself or herself? Did they store their weapon to decrease the chance of an accident?

What's the value of a life? I think when economists ask that question, lay people are offended. I'm thinking about it now, and I'm offended too. If someone offered me $5 million for my cat, let alone another human being, I wouldn't take it.

In any case, the Pigouvian tax we would need to correct the externality should be a large one, and it could generate a lot of revenue. If there are 300 million guns in the United States, and we impose a tax of $3600 per gun on the current stock, we would eliminate the federal government deficit. But $3600 is coming nowhere close to the potential damage that a single weapon could cause. A potential solution would be to have a gun-purchaser post collateral - several million dollars in assets - that could be confiscated in the event that the gun resulted in injury or loss of life. This has the added benefit of mitigating the moral hazard problem - the collateral is lost whether the damage is "accidental" or caused by, for example, someone who steals the gun.

Of course, once we start thinking about the size of the tax (or collateral) needed to correct the inefficiency that exists here, we'll probably come to the conclusion that it is more efficient just to ban particular weapons and ammunition at the point of manufacture. I think our legislators should take that as far as it goes.

Addendum: See this related piece by Louis Johnston.

The Confused and the Confusing

I don't know why, but I find Paul Krugman's behavior interesting. Here's his reply to my previous post. This is typically the way he does it. For some reason Noah Smith is always the conduit.

The first thing to note is this:
For newbies: saltwater is the kind of macro practiced at MIT, some of Harvard, Princeton, etc., macro that still finds Keynesian ideas useful and argues that monetary and fiscal policy can be effective; freshwater is Chicago, Minnesota, etc. insisting that business cycles are optimal responses to real shocks.
This is not actually a message for newbies. Krugman seems to be hoping that these "newbies" are Rip Van Winkles who have been asleep for 30 years rather than 20. Or maybe he thinks that repeating this enough will make it true. From my previous post:
What are "freshwater" and "saltwater" macro? No idea. In Paul Krugman's own department at Princeton, Richard Rogerson, who was a student of Ed Prescott's, resides with Nobu Kiyotaki, who was a student (or at least a coauthor) of Olivier Blanchard's. There are other macroeconomists there with PhDs from Chicago, Minnesota, and MIT. What school of thought drives that place? Beats me.
If Krugman can't figure out what is going on in his own department, do you think you can trust him to take the pulse of the profession?

A second thing:
So yes, the equations in one of Mike Woodford’s papers look a lot like the equations coming out of Chicago or Minneapolis. And a few years ago it was possible to delude oneself into believing that this represented a true convergence of thought.
There's much more to it than equations. Here's an example. In fall 2008, I went to this conference at the Federal Reserve Bank of Minneapolis. What was it about? Monetary Policy and Financial Frictions. That's in the middle of the crisis, and it was certainly topical. I didn't see anyone there obsessing about TFP shocks. People came from across the country - Princeton, Chicago, MIT, Northwestern, Stanford, Columbia, etc.

One paper I saw was Mike Woodford's work with Curdia. Woodford/Curdia start with a basic NK framework and add a financial friction, in part by introducing some heterogeneity to generate borrowing and lending. When I first saw the program, I was wondering why Andy Atkeson was discussing the paper. I wouldn't have thought that Andy knows much about NK models. Wrong. Actually, what Mike was doing uses some ideas from the market segmentation literature that Andy has done work in. There was basically a set of shared ideas, techniques, and tricks for getting the job done. Cross-fertilization! Market segmentation is about studying the distributional effects of monetary policy - a nonneutrality of money. Mike works in models where the nonneutrality generally comes from price stickiness. Andy was a Sargent student at Stanford. His first job was at Chicago, and he is now at UCLA. Mike at one time also worked at Chicago, and he was at Princeton, then Columbia.

Here's something I could have said:
I’m not saying that the NK approach is necessarily right; but it’s a serious intellectual effort, undertaken by people who thought they were part of an open professional dialogue.
So Krugman and I have something we can agree on.

Krugman seems to want us to be at each others' throats. Only he can tell us why.

Monday, December 17, 2012


I thought I would offer some light entertainment today. This Paul Krugman post struck me as perhaps more deranged than usuual on the topic of macroeconomists.

Here are the two closing paragraphs, to give you the idea:
In fact, the freshwater side wasn’t listening at all, as evidenced by the way 80-year-old fallacies cropped up as soon as an actual policy response to crisis was on the table; and as for changing views in response to facts, well, we all know how that has gone.

The state of macro is, in fact, rotten, and will remain so until the cult that has taken over half the field is somehow dislodged.
Like most of the macroeconomists I know and talk to, I try to keep up with my field, and with what is going on in the rest of economics. That's a hard thing to do of course. It burns all the time that is left after teaching students, trying to do one's own research, and doing whatever else we need to do to get on with life.

It doesn't surprise me that Paul Krugman isn't up on what is going on in macroeconomic research. Why should we expect him to go to macro conferences, spend time in seminars, and talk to his colleagues at Princeton? He has plenty on his plate, what with delivering two NYT columns per week, blogging, talking to pundits, and giving speeches. But if he's not up on the field, what purpose does it serve to make up outlandish stuff for people to read? Maybe this just motivates the Krugman base. I have no idea.

Some of the following ideas you can find in other forms if you search my archive, but these things bear repeating once in a while.

This is actually a relatively tranquil time in the field of macroeconomics. Most of us now speak the same language, and communication is good. I don't see the kind of animosity in the profession that existed, for example, between James Tobin and Milton Friedman in the 1960s, or between the Minnesota school and everyone else in the 1970s and early 1980s. People disagree about issues and science, of course, and they spend their time in seminar rooms and at conferences getting pretty heated about economics. But I think the level of mutual respect is actually relatively high. There seem to be more serious disputes, for example, between structural and astructural labor economists than among macroeconomists.

Back in the day, there was a revolution in macro, beginning with the Phelps volume, and Lucas's "Expectations and the Neutrality of Money." At the time, this revolution was widely-misperceived as a fundamentally conservative movement. It was actually a nerd revolution. The people who led it were an inarticulate and socially awkward bunch who were not let into (or were kicked out of) the Ivy League. They had to persevere outside of the mainstream, in underdog places like Carnegie-Mellon, Rochester, and the University of Minnesota, not to mention the Federal Reserve Bank of Minneapolis.

What these people had on their side were mathematics, econometrics, and most of all the power of economic theory. There was nothing weird about what these nerds were doing - they were simply applying received theory to problems in macroeconomics. Why could that be thought of as offensive?

Since the 1970s, it is hard to identify a field called macroeconomics. People who call themselves macroeconomists have adopted ideas from game theory, mechanism design, general equilibrium theory, finance, information economics, etc. to study problems of interest to policymakers and the public at large. Sometimes it's hard to tell a macroeconomist from a labor economist, from someone working on industrial organization problems. What are "freshwater" and "saltwater" macro? No idea. In Paul Krugman's own department at Princeton, Richard Rogerson, who was a student of Ed Prescott's, resides with Nobu Kiyotaki, who was a student (or at least a coauthor) of Olivier Blanchard's. There are other macroeconomists there with PhDs from Chicago, Minnesota, and MIT. What school of thought drives that place? Beats me.

The truth is that we have all moved on from the macro world of the 1970s. Methods that seemed revolutionary in 1972 are the methods everyone in the profession uses now. The nerds who had trouble getting their papers published in 1972 went on to run journals and professional organizations, and to win Nobel prizes. This isn't some "cult that has taken over half the field," it's the whole ball of wax. Rotten? No way!

Economic science does an excellent job of displacing bad ideas with good ones. It's happening every day. For every person who places obstacles in the way of good science to protect his or her turf, there are five more who are willing to publish innovative papers in good journals, and to promote revolutionary ideas that might be destructive for the powers-that-be. The state of macro is sound - not that we have solved all the problems in the world, or don't need a good revolution.

A Cartoon for the Pigou Club

Asness on Buffett

Warren may be a great investor, but he really doesn't cut it as a policy wonk.

Thursday, December 13, 2012

Interpreting the Fed

My friend and sometime coauthor Larry Ball sends me his quick analysis of the Federal Reserve's recent announcement:

I think the FOMC announcement is big news: for the first time, the Fed clearly says it will be more dovish in the future than the pre-crisis Taylor Rule (TR) dicates.

In my estimation, the pre-crisis TR is something like the following for the real interest rate r:

r = 2.0 - (1.5)(u-u*) + (0.5)(pi-2.0).

Let’s say u* is still 5.0. Then if u=6.5 and pi=2.5, the TR says r = 0, which implies the nominal interest rate is i = 2.5. Yet the Fed says that i will still be zero!

Some argue that u* has risen above 5.0. That would raise the i implied by the TR, strengthening the conclusion that the Fed’s new rule is more dovish than the TR.

Some argue that r* [the constant term in the TR] has fallen from 2.0 to 1.0. I doubt it, but even with that change, the TR still implies i = 1.5. My conclusion about dovishness is robust.

This deviation from the TR has not happened since the TR was discovered. In particular, the Fed was NOT more dovish than the TR in 2003. I believe the numbers for 2003 are roughly u=6.0, u*=5.0, and pi=1.0. For the TR shown above, the 2003 numbers imply r =0 and i=1.0, which is about the same as the actual i.

It is not clear whether the Fed’s announcement of future dovishness will have significant effects today. The efficacy of announcements about future monetary policy is unproven.

Wednesday, December 12, 2012

Why We Shouldn't Feel Well-Guided

Today's FOMC statement was as expected on the quantitative easing (QE) side of policy. The Fed will continue to purchase $40 billion in mortgage-backed securities (MBS) per month, and will be purchasing $45 billion per month in long Treasury securities outright, rather than swapping short Treasuries for long ones.

There were some surprises (for me) in the change in forward guidance. Let's see what the statement says, so we can parse it:
the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored. The Committee views these thresholds as consistent with its earlier date-based guidance. In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.
The first part of this, is a trigger at at a 6.5% unemployment rate. Actually, it's not a trigger, as the 6.5% unemployment rate is just a necessary condition for tightening. The second part - the inflation trigger - is pretty weird. A second necessary condition for tightening is an inflation forecast -one to two years ahead - that exceeds 2.5%. Note the following:

(i) The FOMC is going to ignore actual inflation. Apparently that's irrelevant.
(ii) Whose forecast is this? You know whose. It's the Fed's own forecast. If you're paying attention to the Fed's forecasts, you'll understand that they basically make it up so that it's consistent with their own policy.

We're also told that inflation expectations becoming unanchored would be grounds for tightening. What is that supposed to mean? Then we're told that, of course, the Fed will look at everything, just as it always does.

If the goal was to provide a more precise statement about what will trigger a tightening of policy in the future, the FOMC has failed dismally. This statement is more vague than the last one, in October, which contained a calendar date.

What about policy after liftoff? We're told that the committee"...will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent." I'm worried that this is balanced like Fox News. The last reference to "balanced approach" I saw was in a speech by Janet Yellen. The balanced approach, as far as I can tell, represents a marked change in monetary policy, toward an activist approach rooted in the belief that short-run non-neutralities of money are a very big deal. The Fed has just told us that they care a lot less about inflation. They're losing sight of what their job is.

Option C

In the negotiations over the fiscal cliff, many people think the House Republicans are in a tough spot.  The logic is that they have little leverage, because they face only two choices:

A. Concede to most of the president's demands.
B. Take the economy over the cliff, and get blamed for it.

As a result, the logic goes, they will end up doing A, because B is so much worse.

Keith Hennessey points out that there is also option C: Extend the tax cuts, except at the top, for one year. Apparently (and I was not aware of this), Senate Democrats passed a bill doing exactly this back in July.  If the House passes it now, it goes to the President's desk, and he would have a hard time vetoing it.

This is not great policy, as it sets up another fiscal cliff one year from now, and it does not address all the spending cuts that are part of the fiscal cliff.  But from the Republicans' point of view, it may be better than either A or B.  Keith argues that the ability of Speaker Boehner to fall back on this option should give him more bargaining power as he negotiates with the president.  That is, because the president won't like option C either, the possibility that it could occur may make him more willing to compromise.  From the president's perspective, it is better to make concessions today than having to do this whole fiscal-cliff thing again a year from now.

Tuesday, December 11, 2012

Fed Update

The FOMC is meeting today and tomorrow. What is on its collective mind? There are two issues which are likely to be on the agenda relating, respectively, to the two legs of the Fed's current unconventional policy actions: quantitative easing and forward guidance.

Quantitative Easing
The Fed's "operation twist" will end at the end of this month. Recall that this asset swap program began in September 2011, and was extended in June of this year. The program involves sales of Treasury securities with remaining maturities of 3 years and less in exchange for Treasury securities with remaining maturities 6 years or more. Those swaps have been proceeding at a rate of $45 billion per month. Even if the Fed wanted to continue that program, it would not be feasible, as the short-term Treasury securities on the Fed's balance sheet are all but depleted.

Since September, the Fed has been purchasing $40 billion in mortgage-backed securities (MBS) per month - the "QE3" program. This is also an asset swap, but in this case a swap of reserves for MBS. QE3 is an open-ended program, which will continue under conditions stated, for example, in the last FOMC statement:
If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.
My best guess is that the committee will not think of the new information received since the last meeting as indicating "substantial" improvement in the labor market, and they will be looking to keep their policy stance the "same" as it was at the last meeting. But they can't do that, as it's impossible to continue the twist asset swap. What's the next best thing? Well, if you believe that QE works to actually ease something, as the FOMC certainly does, then you should also think that there is little difference between swapping short Treasuries for long Treasuries and swapping reserves for long Treasuries. What you should expect to see is a QE4 program involving purchases of $40 billion in MBS per month and $45 billion in long Treasuries per month. In terms of total purchases, that's a little larger than QE2, which involved purchases of about $75 billion per month (all Treasuries). The Fed could of course buy more than $40 billion in MBS per month, but that would signal a change, and they're not likely to do it (I'm not sure about the feasibility either - how big is that market?).

Some concerns:
1)The Treasury and the Fed are clearly thinking about debt management in completely different ways. As for example James Hamilton and David Beckworth have pointed out, the Treasury has been systematically increasing the average maturity of the outstanding government debt in the hands of the public, while the Fed is systematically reducing it. The Treasury might be thinking that it can save a huge amount on debt service in the future by, for example, locking in a 30-year borrowing rate of 2.84%. The Treasury seems to think it is looking after us by lengthening the average maturity of government debt, lowering borrowing costs, and presumably lowering our future tax burden. But the Fed thinks that we get more real economic activity (temporarily, permanently?) if the average maturity of government debt is lower. The Fed also thinks it is looking out for us. Maybe Ben Bernanke should walk down the street and try to sort this out with Tim Geithner (or his successor).
2)Short of a theory of QE - or more generally a serious theory of the term structure of interest rates - no one has a clue what the effects are, if any. Until someone suggests something better, the best guess is that QE is irrelevant. Any effects you think you are seeing are either coming from somewhere else, or have to do with what QE signals for the future policy rate. The good news is that, if it's irrelevant, it doesn't do any harm. But if the FOMC thinks it works when it doesn't, that could be a problem, in that negative QE does not tighten, just as positive QE does not ease.

Forward Guidance
This is where the big change in policy is likely to occur. In public statements, various Fed presidents have been honing a policy rule that involves quantitative triggers. Until now, the FOMC's forward guidance statements have included a calendar date for "liftoff" - the date at which the Fed's policy rate (the interest rate on reserves currently, given the large stock of reserves outstanding) rises above 0.25%. The last FOMC statement says that date is "likely" to be mid-2015.

After living with calendar dates in the forward guidance language since August 2011, FOMC members now appear to think they are a bad idea. Why? The Fed generally likes the idea of forward guidance, as it is another tool the Fed thinks it can use when it is up against the zero lower bound. Support for the idea comes from New Keynesians - Woodford et al. - and New Keynesian models. But Woodford is on record as thinking that a calendar date is a bad idea. One may think that extending the liftoff date will be more accommodative, as this increases anticipated inflation and lowers the real rate of interest, but extending the liftoff date also conveys pessimism.

The triggers for liftoff typically take the following form. The policy rate should stay at 0.25% until one of two things happen: (i) the inflation rate rises above x%; (ii) the unemployment rate falls below y%. Most of the public debate currently seems to be over what x and y should be. x is typically in the range 2.5 to 3.0, and y is typically 5.5 to 7.0. The argument for triggers is that a calendar date can lead to policy errors, or negates the intent of the policy. If the Fed commits to the calendar date, it risks waiting too long to tighten, or it tightens too soon. But if the Fed appears willing to move the calendar date in response to new information, the forward guidance becomes meaningless. With triggers, the FOMC can state the policy once, commit to it, and move forward.

Here are the problems with triggers:
(1)To be well-understood, the triggers need to be specified in a very simple form. As such it seems as likely that the Fed will make a policy error if it commits to a trigger as if it commits to a calendar date. The unemployment rate seems as good a variable as any to capture what is going on in the real economy, but as such it's pretty bad. It's hardly a sufficient statistic for everything the Fed should be concerned with.
(2)This is a bad precedent to set, for two reasons. First, the Fed should not be setting numerical targets for anything related to the real side of the dual mandate. As is well-known, the effect of monetary policy on real economic activity is transient, and the transmission process poorly understood. It would be foolish to pretend that we know what the level of aggregate economic activity should be, or that the Fed knows how to get there. Second, once you convince people that triggers are a good idea in this "unusual" circumstance, those same people will wonder what makes other circumstances "normal." Why not just write down a Taylor rule for the Fed, and send the FOMC home? Again, our knowledge of how the economy works, and what future contingencies await us, is so bad that it seems optimal, at least to me, that the Fed make it up as it goes along.

My overriding concern is that the Fed's unconventional policy moves - one on top of the other - are digging a deep hole that it will find it difficult to get out of. Of course, Ben Bernanke seems likely to leave at the end of his term in about a year's time, so it won't be his problem.

The Poverty Trap in France

From Forbes:
Let’s take an unemployed mother living alone with two children between six and 10 years old. In 2010, there were 284,445 French families in this situation that were on welfare.
This mother will be given the “Active Solidarity Income.” Since she has two children, the amount will be $1,100. If she is renting an apartment with a $650 rent, she will be given the “Housing Customized Aid,” amounting to $620. Then she will receive “Family Allowances,” which amounts to another $160. Finally, let’s add the payment known as “Allowance for the start of the school year,” which is $750 once a year, or $62.50 per month. (She might even benefit from other aids, but these are the most common.) She will be given a total of $1,942.50 per month.
Now imagine that this mother has found work and will be paid the “legal minimum wage,” which amounts to $1,820 gross—or $1,430 after taxes. Since she would be earning $1,430, she will no longer receive the “Active Solidarity income.” Her “Housing Customized Aid” will be lowered to $460, but she will still be given “Family Allowances” and the “Allowance for the start of the school year.” Therefore, her total income will amount to $2,112.50....
For this mother of two, working again will bring her family an additional income of only $170. Moreover, this $170 is likely to be lost in the cost of transportation to work, since the cost of gas in France is $7 per gallon. In any case, such a small amount of money is not an incentive to go back to work. Between staying home and working, the choice is simple: welfare is a better deal.

Make Your Own Deficit-Reduction Plan

The Wall Street Journal's interactive graphic lets you choose from a menu of options.

Sunday, December 9, 2012

Gaps and Triangles

James Tobin once said:
It takes a heap of Harberger triangles to fill an Okun gap.
Gregory Mankiw once discussed gaps versus triangles in the context of fiscal policy issues (the 2009 stimulus package). According to Mankiw, Keynesians think of Harberger triangles as small potatoes, and output gaps as large potatoes; non-Keynesians think the opposite. That's certainly consistent with Paul Krugman's view of the world. Krugman quotes Tobin in his post, and states:’s a more general observation that even bad microeconomic policies, which lead to substantial distortions in the use of resources, have a hard time doing remotely as much damage as a severe economic slump, which doesn’t misallocate resources — it simply wastes them.

What's a Harberger triangle? It's a partial equilibrium measure of the welfare loss from a distortion - a tax or monopoly power for example. Total welfare from the production and consumption of a given good or service can be measured as consumer surplus plus producer surplus, which is the area under the demand curve minus the area under the supply curve, calculated given the quantity traded in the market. Total welfare is maximized at the competitive equilibrium quantity and price, but a proportional tax, for example, reduces the quantity traded, and the welfare loss (when we include the revenue generated from the tax) is a triangle - indeed a Harberger triangle.

In the 1950s, Harberger measured the welfare loss from monopoly in the United States, essentially by adding up these triangles for monopolized industries. He came up with a small number - about 0.1% of GDP. Thus, if we were to use Harberger's methods to add up the heap of Harberger triangles arising from tax distortions, monopoly, various trade restrictions, and other synthetic obstacles to exchange, the welfare loss we obtain should be small.

Are output gaps large? Certainly Paul Krugman thinks so.
Right now the U.S. economy is operating something like 6 percent below capacity.
A 6% output gap is what you get if you use the Congressional Budget Office's (CBO's) measure of potential output. The chart shows this measure, along with actual real GDP. Suppose we take the CBO output gap of 6% of GDP as an accurate measure of what could be achieved if the fiscal and monetary authorities in the United States behaved appropriately. Also suppose that 0.1% is a good part of the heap of Harberger triangles in existence in the US economy. Then, indeed, the heap of triangles looks trivial relative to the gap.

But this isn't as obvious as it might look to some of you. Let's go back to Tobin's article ("How Dead is Keynes?"), where the quote comes from, and try to figure out what he was trying to say. Perhaps surprisingly, he wasn't comparing the welfare cost of business cycles to the welfare costs of "micro" distortions. In his article, Tobin said that 1977 policymakers were between the rock and the hard place. To achieve disinflation would require some sacrifice in terms of lost output. But further monetary accommodation would just lead to self-fulfilling increases in inflation. According to Tobin, "the way out, the only way out, is incomes policy." Then he states:
Most of you will, I'm sure, have no idea what "incomes policy" is, and that's a wonderful thing. "Incomes policy" sounds innocuous. What could be wrong with a government policy that looks after our incomes, presumably making them larger? Well, incomes policy is actually wage and price controls. In the pre-Volcker era, wage-price controls were very much on the table as a means for controlling inflation. Wage and price controls were introduced by the Nixon administration, and were in effect from 1971 to 1974 in the United States. I had the misfortune to live through the era of the Anti-Inflation Board in Canada, 1975-1978. The key achievement of Milton Friedman and the Old Monetarists was to convince everyone that inflation control is the job of the central bank. It's hard to find anyone today who disagrees with that view, and I think that's a good.

The funny, and I think key, point comes out of Tobin's confusion about gaps and triangles. Relative to what he's discussing, the gap and the triangles are actually exactly the same thing. Early in his paper, Tobin discusses the "central propositions" of Keynes's General Theory. To start:
So, inefficiencies arise because prices and wages are not at their market-clearing values, and quantities traded are demand-determined. In this context, how would we measure the efficiency loss in a particular market? Guess what, it's a Harberger triangle. The inefficiencies Tobin envisions arising from wage and price controls arise from what? From wages and prices that deviate from their market clearing values. What's the efficiency loss? It's a Harberger triangle. It takes a heap of Harberger triangles to fill a heap of Harberger triangles.

If I were a hardcore Keynesian - New, Old, whatever - how would I measure the costs of business cycles? Well, to start, I would accept Tobin's first central proposition from the General Theory. Inefficiencies arise because wages and prices are misaligned. To calculate welfare losses I would add up Harberger triangles across markets. The inefficiencies that arise in New Keynesian models are indeed identical to the ones which would be generated by a set of good-specific taxes.

What's the conclusion? Keynesians - Paul Krugman in particular - can't have it both ways. Macro does not "trump" micro. This is a no-trump world. If I argue that Keynesian sticky wage/price distortions are large, and that tax distortions are small, that's a contradiction.

But it's not a contradiction to say that sticky wage/price distortions are small, and other inefficiencies that we face are large. Is 6% of GDP a serious measure of the current effects of sticky wage/price distortions? Of course not. Read this document and see if you think the CBO measures potential output the way any sensible macroeconomist would measure it. Yikes. I don't think so.

There are of course plenty of models around now that take wage and price stickiness seriously, and also contain a multitude of shocks that allow those models to fit the data. Christiano/Eichenbaum/Evans is one of those. It seems straightforward to take a model like that, turn off the wage/price rigidity, compare business cycles without the wage/price rigidity to those with it, and ask what the agents in the model would pay to live without the wage-price rigidity (this is with monetary and fiscal policies that are not correcting the inefficiencies). I don't know if that has ever been done.

We could think of such an experiment as giving us an upper bound on the welfare loss from wage/price rigidity. There are plenty of reasons to think that standard New Keynesian models exaggerate the effects of wage/price stickiness. For example, Calvo pricing is suspect. If the losses from wage/price rigidity are such a big deal, there are large surpluses left on the table that inventive buyers and sellers of labor, goods, and services, would be happy to have.

So, there are good reasons to think that the welfare losses from wage/price rigidity are small. There is also plenty of evidence that other inefficiencies matter a great deal. This paper by Hsieh and Klenow shows how the misallocation of resources in China and India is a big deal - for aggregate TFP (total factor productivity) and GDP. There is an upcoming special issue of the Review of Economic Dynamics on misallocation and productivity. This includes a paper by Greenwood, Sanchez, and Wang, showing that financial misallocation can be big-time. In the United States, we have experienced a decade where resources were apparently reallocated, inefficiently, to the housing and mortgage markets, with disastrous results. We understand more about that episode than we used to, but we have a lot to learn. What people should come to terms with, is that wage and price rigidity likely had little to do with that experience, and the sooner economists recognize that, the more progress we'll make.

Fiscal Cliff Fact of the Day

As reported in the NY Times:
Even if Republicans were to agree to Mr. Obama’s core demand — that the top marginal income rates return to the Clinton-era levels of 36 percent and 39.6 percent after Dec. 31, rather than stay at the Bush-era rates of 33 percent and 35 percent — the additional revenue would be only about a quarter of the $1.6 trillion that Mr. Obama wants to collect over 10 years.

Wednesday, December 5, 2012

An Unfortunate Broken Promise

Back in 2008, when President Obama was running for his first term, he promised to be a post-partisan leader.  While a Democrat, he said he would accept good ideas when they came from Republicans.  At the time, I believed him, at least to some degree.  And I wrote about it in this NY Times column.

Sadly, I was wrong.  The short version of the story is this: As a candidate, President Obama campaigned on a platform of raising taxes on the rich.  Yet he and his economic advisers also said they wanted to raise dividend taxes only slightly, from 15 to 20 percent.  For reasons I explained in the Times article, keeping dividend taxes low was a position bolstered by good economics. Now, however, the president wants to raise dividend taxes to ordinary income tax rates (plus, for high-income taxpayers, the new tax of 3.8 percent that is part of the Obamacare legislation).

To put it another way, he campaigned as a moderate, willing to concede that the other party had some good ideas on tax policy.  Once in office, he gave up on those ideas.

A similar thing happened with Bowles-Simpson.  During his first term, he appointed a bipartisan panel, which concluded we could address our long-term fiscal problem with lower tax rates and a broader tax base.  Now, the President goes around the country lambasting that approach.

Reasonable people can disagree about whether President Obama is a good or bad president.  But the claim that he has tried to transcend partisanship and find a middle ground is just impossible to square with the facts.

Monday, December 3, 2012

A Reading for the Pigou Club

From The New Yorker.  One disappointing quotation:
"We would never propose a carbon tax, and have no intention of proposing one," [White House spokesman Jay] Carney told reporters.

Some Advice on Tax Planning

I don't normally give advice on personal finances, but in light of the fiscal situation we are facing, I will pass along one tidbit.  Consider converting some of your retirement savings into a Roth IRA. Over the past few years, I have converted all that I can, which is about half of my retirement savings. 

To make the best of a Roth conversion, you need liquid assets outside of retirement accounts to pay the resulting tax liability.  But if you can do this, you will shelter more of your savings from capital taxation, and you will avoid required minimum distributions when you turn 70 1/2, which means tax-free accumulation for a longer period of time.

To read more about this option, click here.

Saturday, December 1, 2012

Why the President is Not So Keen on Just Limiting Deductions

From the White House blog.  Bottom line: If you apply a $25,000 deduction cap only to households with income above $250K, phase in the cap gradually as income rises above $250K, and exclude charitible giving from the cap, you increase revenue by only $450 billion over ten years.