Will help organize your thoughts

This guest post by Ilan Noy of the University of Hawaii at Econobrowser is a very useful first take on the possible macroeconomic  effects from the  earthquake/tsunami in Sendai  Japan:

In the last 14 months, we have seen a spate of very large earthquakes which began with the unprecedented devastation caused by the earthquake in Haiti (1/10/10) — the most destructive natural disaster in modern history (relative to national population), continued with the unusually strong earthquake in Chile (2/27/10), to the most recent events generated by the earthquake in Sendai, Japan.

The horrific toll of this disaster is not yet clear (both in terms of fatalities and physical damage) and the nuclear crisis triggered by this event is still unfolding. Econbrowser readers, however, are probably already asking what will be the likely economic impact of this disaster. Remarkably, in spite of a spate of catastrophic disasters in the last decade (the East Asian tsunami of 2004, the Kashmir earthquake of 2005, and the Sichuan earthquake in 2008 to name a few), we have a fairly limited knowledge of the likely macroeconomic impacts of these events.

Before discussing these impacts, however, it is useful to note that while the most widely used dataset on disasters (EM-DAT) shows that their incidence has been growing over time, this increase is probably driven by improved reporting of milder events; truly large events do not show a similar trend.

“Macro Prudential Policies” – The new “buzz word”

A few days ago I commented on Olivier Blanchard´s “guide to the conversation” that would take place at the IMF sponsored meeting.  Blanchard comes back with “9 tentative conclusions” from the meeting. Just one example:

4.  Macroeconomic policy has many targets and many instruments (that is, the tools we use or variables to implement policy). There are many examples of this that were discussed at the conference, but here are two.

  • Monetary policy has to go beyond inflation stability, adding output and financial stability to the list of targets, and adding macro-prudential measures to the list of instruments.
  • Fiscal policy is more than just “G minus T” and an associated “multiplier” (the proportion or factor by which changes in government spending or taxes affect other parts of the economy). There are potentially dozens of instruments, each with their own dynamic effects that depend on the state of the economy and other policies. Bob Solow made the point that reducing discussions about fiscal policy to what is the right multiplier does not do service to the issue

It gets all very complicated. I lost count of the number of possible “targets and instruments”. The new catch word is “Macro Prudential”. A conference about “it” has already taken place in China:

Macro-prudential conference in Shanghai

Recognizing the need to reach greater understanding about the potential roads to internationally-consistent and effective macro-prudential regulation—and in an effort to make sure that an appropriately broad range of views are taken into account—earlier this week, the Peoples’ Bank of China hosted an IMF-sponsored conference in Shanghai. The conference brought together central bankers and senior financial officials from Asia and around the world to examine and discuss key issues regarding macro-prudential policies. The conference, titled Macro-Prudential Policies: Asian Perspectives, allowed international participants as well as Fund staff attendees to benefit from the views of key Asian policymakers. And vice versa.

What are the aims?

At the conference, there was wide agreement that the first step in designing macro-prudential policies ought to be a convergence of views regarding the objectives of such policies.

Of course, the most basic objective is straightforward—to prevent a crisis like the one just experienced.

 This takes me back to 1997/98, when at the tail end of the Asia crisis the buzz word became “Redesigning the International Financial Architecture” (IFA), followed, obviously, by Conferences dedicated to the topic and a host of papers on the subject.

The principle is the same, only now under a different name! And don´t forget that for all the discussion on a new IFA, the Asia crisis was the seed of the so called international economic imbalances that are thought to be behind the present crisis!

But Blanchard indicates that economists should welcome all this because:

7.  Where do we go from here? In terms of research, the future is exciting. There are many topics on which we should work—namely macro issues with, as Joe Stiglitz said, the right micro foundations.

I would have thought this was the perfect time to shed worries about micro foundation for macro after 40 years of taking us nowhere.

History is in the eye of the beholder

Arnold Kling summarizes a seminar he organized on History and the Great Depression:

Over the weekend, I was at a seminar that I organized on the historical narrative of the Great Depression. Below the fold, I will summarize some things that came out of it. For me, the most interesting insights concern how historical narratives evolve over time to serve later purposes. One argument that was made, which I found persuasive, is that the history of the Great Depression that most of us grew up with was written to enhance the glow surrounding Roosevelt and to transfer that glow to subsequent Democrats, notably John Kennedy. Thus, what one might call the “Arthur Schlesinger version” became the standard narrative.

If nothing else, please read point (5) below on how folk macroeconomics and academic macroeconomics differ, and how this relates to the Great Depression.

What makes a Union hold together?

Mark Sadowski in a detailed comment to a recent post, ended saying: “It´s taken as gospel that the US is a better OCA (Optimal Currency Area) than the Eurozone. But is this really true? (This might make an interesting post)”.

His reaction was triggered by a post by Kash, which, in turn, picked up on a post by Gavyn Davies.

I must say that the OCA discussion was revived last year when the Eurozone crisis flared up with the Greek “blow-up”. This post by David Beckworth – and the links within – is a good reference to the debate. At the end of the post he writes:

I will go one further in this debate. It is not clear to me even now that all of the United States is an OCA. Do we really think Michigan and Texas over the past decade or so benefited from the same monetary policy? And do we think both states had an adequate amount of economic shock absorbers? Given the vast differences between these two states in their business cycles, diversification of industry, union influence, and wage stickiness it easy to wonder whether these states should belong to the same currency union. Yes, they have access to fiscal transfers, labor mobility is great (I myself left a job in Michigan for this one in Texas), culturally they are similar, and politically there is will for the dollar union. Still, given the disparate impact of U.S. monetary policy on different regions of the country one does wonder whether all the United States is truly an OCA.

In singling out Michigan and Texas, DB is following up on a much earlier post of his that discussed differential impacts of Monetary Policy:

The differential responses of these two states to the same monetary policy shock are striking. Texas is hardly affected relative to the steep downturn in Michigan. As noted above, these patterns fall more broadly into the regions of the United States with different sensitivities to the federal funds rate shocks. Our research confirms early studies that show these regional differences can be partly explained by the composition of output: those states with a relatively high share in manufacturing get hammered by a monetary policy shock while those states with relatively high shares in extractive industries fare much better. We also find that states with a relatively high share in the financial sector fare better as well. Finally, we find that states that have (1) a relatively high share of labor income compared to capital income and (2) a relatively high rate of unionization also get hammered by monetary policy shocks.

Conventional wisdom has it that to “qualify” as a OCA, there should be high business cycle correlation (symmetry of shocks) among members and individual members should possess “economic shock absorbers” – flexible wages & prices, labor market flexibility, labor mobility and a federal fiscal authority that coordinates fiscal transfers.

Figure 1 depicts this set-up for the Eurozone countries. The correlation between member counties and eurozone RGDP is straightforward. The shock absorber index is constructed from a simple average of an index of protection (rigidity) in the labor market (EPS index constructed by the OECD) and the inflation rate (as proxy for downward price rigidity).

The outcome is what was expected. Portugal and Greece are well within the OCA frontier. Spain and Ireland are polar opposites. Spain has a high business cycle correlation and low shock absorbing capabilities while Ireland shows the opposite characteristics.

Figure 2 shows the business cycle correlation of 8 US regions. Even though, as mentioned by DB above, there are differences in the shock absorbers of different states (maybe not so much when they are aggregated in regions), an index that quantifies these differences is not available. Nevertheless it is noticeable that the range of the variation in business cycle correlation is about the same among Eurozone countries and US regions.

Mark chose to compare the difference relative to trend among states. To keep the analysis consistent, I compare the business cycle correlation of individual states. This is depicted in figure 3, which classifies correlations as high (H,>0.8), medium (M, 0.50 – 0.79), low (L, 0 – 0.49) and negative (N). Here the differences are enormous, with five states showing negative BC correlations and another four registering low correlation!

Michigan (corr=0.85) and Texas (corr=0.69) are singled out in the picture. So, if as in DB´s example, Michigan and Texas make him wonder if the US is an OCA, what is implied by the differential between states above the 0.8 line and those below the 0.50 cut-off point? If the OCA “conditions” were in fact “necessary conditions”, the US should have “blown-up” as a Union a long time ago!

But we know it hasn´t. So why not? Maybe shared language, custom and culture in addition to a central government are more important than some economic indicator conditions. Those are exactly the conditions that the Eurozone countries do not possess.

Figure 4 shows another aspect that might be relevant for “binding the Union” together. The 6 largest states have about 42% of income (RGDP) and 41% of the population while the 6 smaller states have about 1.3% of income and 1.1% of the population.  Pretty equitable, no?

“Claws” shown

In the last few days we´ve witnessed a spat on the economic blogosphere. It all began with Tyler Cowen´s Sunday article for the NYT . In the article “Fiscal Illusion and How to Face It”, Tyler Cowen opens with:

FISCAL policy debates often focus on technocratic questions about how much money the government should spend and when, yet the actual course of events depends not on the experts but on politics. The more that our government runs up unfunded obligations and debt, the more we are setting a trap for ourselves.

Nothing wrong with that, except for the last two lines, which, for some, gave the impression that TC was pointing a finger at Obama. Brad DeLong was peeved and wrote:

Tyler Cowen writes a column that is both good and bad. It is good for what it says: it debunks fiscal illusions. It is bad for what it does not say, and for what it does not say it tends to deepen our political illusions. You see, for some reason Tyler Cowen does not mention the obvious solution at the ballot box to the very real fiscal illusion problems he writes about. If we simply stopped electing Republicans–if we simply elected presidents who would choose policies designed by the technocrats of the Clinton and Obama administrations and elected senators and representatives who voted for them–we would be absolutely fine.

Not surprisingly, Paul Krugman joins the fray, siding with DeLong and going further. He presents this graph

 and writes:

Brad DeLong is mad at Tyler Cowen, with reason — for Cowen writes about US fiscal irresponsibility, fairly sensibly, without mentioning the elephant, and I do mean elephant, in the room: the role of the post-Reagan GOP.

Look: until 1980 or so the United States generally paid its way; the ratio of debt to GDP generally fell over time. Then starve-the-beast came to power, and fiscal realism went away. That’s the story; anyone who glosses over that, who makes it a plague-on-both-houses issue or, worse, makes it seem as if Obama is the villain, is in an essential way misleading his readers.

OK. Let´s forget about the WWII debt unwinding and focus more closely on the period Krugman and DeLong are concerned – the post 1980 (Reagan) years. The figure shows that except for some of the Bush II years (incidentally, debt was relatively “well behaved”), the Democrats were very much involved in the process, sometimes “monopolistically” so. So Cowen would not be wrong to consider it a “plague-on-both-houses issue”.  

You could argue that Clinton (and his technocrats) was in “the right place at the right time”, being able to “enjoy” the “Peace Dividend”, which few (maybe Krugman) doubt was a Reagan “legacy”. 

DeLong and Krugman appear to be canvassing votes, with Krugman reinforcing DeLong´s “pro Democrats” arguments:

Democrats aren’t fiscal saints. But we have one party that has been generally responsible, and tries to pay for what it wants, and another party that consistently, deliberately, takes actions to increase deficits in the long term. Saying this may be shrill; but not saying it is being deceptive.

But Krugman is not one to let a “spat go to waste”, so he quickly comes back with more arguments against “conservatives” (that he identifies with Republicans). In commenting on Time Magazine´s choice of Blogs (where Krugman´s own got the top spot), he writes:

Some have asked if there aren’t conservative sites I read regularly. Well, no. I will read anything I’ve been informed about that’s either interesting or revealing; but I don’t know of any economics or politics sites on that side that regularly provide analysis or information I need to take seriously. I know we’re supposed to pretend that both sides always have a point; but the truth is that most of the time they don’t. The parties are not equally irresponsible; Rachel Maddow isn’t Glenn Beck; and a conservative blog, almost by definition, is a blog written by someone who chooses not to notice that asymmetry. And life is short …

The “not equally irresponsible” is a link to his previous “Turning a Blind Eye to the Obvious” post and, indirectly, to Tyler Cowen´s article, where it all began. That got a strong reaction from Scott Sumner (and enticed many comments):

You might ask whether I’m being a bit harsh calling him “ignorant.”  Actually, he’s the one who proudly flaunts his ignorance of conservative thought. 

I find that reading good liberal blogs like Krugman, DeLong, Thoma, Yglesias, etc, sharpens my arguments.  It forces me to reconsider things I took for granted.  I’d guess that when Krugman tells people at cocktail parties that the post-1980 trend of lower tax rates, deregulation, and privatization was a plot devised by racist Republicans, they all nod their heads in agreement.  If he occasionally read a conservative blog he might learn that all those trends occurred in almost every country throughout the world after 1980, usually much more so than in the US.

While the spat heats up, so do the debt and deficit. And as TC wrote in a later post:

If I called on President Obama to push for a budget deal, and I cite CAP in support, it was not to criticize the Democrats, or Obama (as DeLong and Krugman mysteriously suggested), but rather because I see him as by far the most influential player in this process.

Certainly a much more sensible attitude.

“Criminals at large”

The ECB did it in 2008 and is about to do it again! This piece from the WSJ explains:

Two of the European Central Bank‘s top officials signaled Tuesday that the bank may raise interest rates faster than ECB President Jean-Claude Trichet suggested last week, reinforcing market expectations that a new cycle of rate increases is on the way.

Axel Weber, whose unofficial reign as leader of the hawkish faction on the ECB’s governing council ends when he leaves the German central bank at the end of next month, told the subscription TV service Deutsches Anleger-Fernsehen that:

“Hitherto, it has seldom been the case that the risks of inflation were banished completely with one small interest rate step. There will be a normalization of interest rates,” Weber said.

Earlier in the day, Austrian National Bank head Ewald Nowotny, a more dovish member of the ECB’s council, had used the same word to describe the outlook for the bank’s policy.

“In the crisis we had very low inflation, and we are now in a different situation. I see it more as a normalization phase,” Nowotny said.

Apparently it´s all about Germany. Other countries are “The others” – they are all dead, just like in the Nicole Kidman film.

The ECB’s main refinancing rate, which has been at 1% since May 2009, is now less than half the rate of inflation in the euro zone, which stood at 2.4% in February. The economy, too, continues to improve, a 2.9% rise in German factory orders in January providing further evidence of a solid start to the year.

And the ECB thinks it´s all just a “poker game”, where “bluffing” is of the essence:

Jean-Claude Trichet has been careful not to commit to a series of hikes, but we believe that is what it will be,” said Michael Hart, director of currency strategy with the Roubini Global Economics think-tank in London. “The ECB is bluffing. We think the ECB will hike by a total of 75 basis points, probably by August.

“Appelez les gendarmes”!

“You say stop, I say go, go, go”…

Or is it a simple “good cop, bad cop” routine being played out for some obscure reason? This piece from the WSJ summarizes the story:

While Dallas Fed President Richard Fisher signaled higher oil prices may lead the central bank to roll back its huge monetary stimulus to prevent an inflation outbreak, Atlanta Fed chief Dennis Lockhart said more stimulus may be needed to avoid another recession.

The bad news is that the “bad cop” is a voting member of the FOMC this year, while the “good cop” will only vote next year, by which time he will likely have reverted to his preferred (bad cop) role!

If only Bernanke would not forget (again) his previous writings

“Find the thermostat”

Today the IMF is hosting a Conference, transmitted live, on Macro and Growth policies in the Wake of the Crisis. Olivier Blanchard, the IMF´s chief-economist wrote a “guide to the conversation”.

He first summarizes the framework and then puts forth some ideas for discussion. I´ll only discuss the first point of the framework and the first point of the ideas for discussion.

According to Blanchard the first point in the “framework” is summarized by the following:

  • The essential goal of monetary policy was low and stable inflation. The best way to achieve it was to follow an interest rate rule. If designed right, the rule was not only credible, but delivered stable inflation and ensured that output was as close as it could be to its potential.

Then, from the early 1980s on, macroeconomic fluctuations were increasingly muted, and the period became known as the “Great Moderation”. Then the crisis came. If nothing else, it forces us to do a wholesale reexamination of those principles. Here are some ideas to guide the conversation: The first of which is:

  • Economic imbalances: Achieving stable inflation is good, but we can now see it does not guarantee stable output. Before the crisis, steady output growth and stable inflation hid growing imbalances in the composition of output and in the balance sheets of households, firms, and financial institutions, as well as growing misalignments of asset prices. These imbalances ended up being very costly. The question now is how best to address such imbalances. Should we think of macroeconomic policy as having three legs—monetary, fiscal, and financial—each with separate authorities? Or should we think of extending both the mandate and the set of tools of monetary policy to cover both output and financial stability? And, if so, what tools do we have and how do we use them?

To begin with, the goal – low and stable inflation – is not well defined. There are several “inflations” and, as the example in figure 1 shows, they can be very different. The “interest rate rule” is also problematic because, like at present, it cannot fall below zero. In addition, the policy rate is not a good indicator of the stance of monetary policy.

Notwithstanding these caveats about the goal and instrument, the fact is that “from the early 1980s on, macroeconomic fluctuations were increasingly muted, and the period became known as the “Great Moderation”.

As Blanchard notes in the first point of his “guide to the conversation”, low and stable inflation does not guarantee stable output. So how come that for about 20 years the economy experienced falling and than stable inflation and stable output? It must be that, in practice, something else was happening, and that when this “something else” went away all “hell broke loose”. This conjecture also indicates that stability in output and inflation was not “hiding” growing imbalances.

Imbalances are always present in a dynamic economy. They are often the result of wrong incentives. It is not the case that macro “stability” fosters, or hides, imbalances, but that sudden instability make them worse and more difficult to redress.

In 2003, Friedman gave the simplest explanation for the “Great Moderation” with his “thermostat analogy”. In essence, the new found stability was the result of the Fed (and many other Central Banks) stabilizing nominal expenditures. In that case, from the QTM, according to which MV=PY, the Fed managed to offset changes in V with changes in M, keeping nominal expenditures, PY, reasonably stable. Note that PY or its growth rate (p+y), contemplates both inflation and real output growth, so that stabilizing nominal expenditures along a level growth path means stabilizing both inflation and output.

Figures 2 & 3 are alternative ways of depicting the economy during the last decades. We observe that up to late 2007, the Fed´s “thermostat” worked pretty well. There was a period of relative instability between 1998 and 2004, when the Fed failed in “calibrating the thermostat” adequately, first allowing the “temperature to rise excessively” and than to “drop by too much”. By 2005 the economy was back on track.

In a way the problem faced is simple. Get the economy back on a reasonable nominal spending growth path and use the “thermostat” to keep it there. Maintaining “inflation targeting” will not get the job done, functioning as a constraint on getting the economy back on track. In this set up, fiscal and financial policy are the province of other agencies.

Update: This post argues that Trichet is “out of his mind”!

Update 2: And this points to the fact that the “thermostat” in Europe is “only for Germany” (“Foutre les autres”)

Welcome back, NAIRU

The drop in the unemployment rate to just below 9% is, to some, a danger sign! The funniest comment I could find on the employment report released yesterday was this piece from the WSJ. The opening paragraph says it all:

The startlingly quick pace with which the unemployment rate has fallen is raising questions whether the labor market could soon reach levels that may start to generate inflation and alter the monetary policy outlook.

The NAIRU concept – a Phillips Curve offshoot – which indicates the rate of unemployment below which inflation takes off every once in a while comes back to haunt us. In the early 1990´s it was “common knowledge” that the NAIRU was in the 6%-6.5% range. When unemployment fell below 6% in 1994 (and inflation kept going down) it was revised to 5.5%. But the unemployment rate kept falling (reaching 3.8% in early 2000) and inflation didn´t rise. At that point the more perceptive analyst just gave up on the concept.

But it´s back in full force. From Merrill Lynch, quoted in the WSJ, we read that:

Bank of America Merrill Lynch chief economist Ethan Harris notes the drop in the unemployment rate seen over the last three months is the largest since the 1950s. “This is completely off the charts,” and “I just don’t think we can continue to drop this fast,” Harris said.

So let´s check what went on in the 1950´s. Figures 1 & 2 show periods in the 1950´s when unemployment dropped fast in a short period of time. It should be noted that these instances were associated with falls in labor force participation.

Figure 3 shows the same pattern for the present time.

Figure 4 shows that following the drop in labor force participation and the strong fall in unemployment in the last months of 1954, labor force participation went back up in the next several months and unemployment kept trending down.

And what happened to inflation over the whole period that unemployment was falling? As shown in figure 5 it remained inside negative territory!

Figure 6 shows that the level of unemployment is closely linked to the “distance” of nominal spending to its trend path in the 1950´s.

Figure 7 shows that the same pattern holds in more recent times.

In short, unemployment will fall, even if labor force participation goes up, if prospects for the economy improve. For that to happen (and persist) nominal spending has to converge to a “reasonable” trend path. Inflation should go up, converging to its “desired” level. But it´s nonsense to say, as emphasized in the WSJ piece, that the fall in unemployment is an indication that the Fed could tighten earlier than expected because of the many times discredited notion regarding a minimum level of unemployment below which inflation will take off.

Note: The NAIRU concept was “invented” in 1975 by Modigliani to help him convince the Fed that it could be expansionary because unemployment could fall quite a bit before it would increase inflation. We know what happened. Unemployment went up and so did inflation!