“California Dreaming”

Mike Kimel at Angry Bear writes: California v. Red States, What Causes Growth, and the Great Stagnation

Introduction:

Lately there has been a small cottage industry of California v. Texas comparisons, with California getting the apparent short end of the stick.  Heavily regulated, high tax, big gubmint California is the past, and freewheeling low tax small government Texas is the future, and among the pieces of evidence is people moving out of California and into Texas.  California has been the punching bag as long as I can remember.  Texas usually plays the role of the victor, but every so often another state is put up as the shining paragon.  Over the years I’ve seen California get the negative comparison treatment relative to Colorado (mostly in the 1980s), North Carolina (mostly in the 1990s), Tennessee (a few times over the decades), and even (lately) North Dakota. –

In the conclusion:

This post has several takeaways:

1. In the last four decades, economic growth has been faster in some red states like Texas, North Carolina and Colorado than in California

2. In the states in our sample, government spending (state, local and federal) tends to lead the economic conditions by four or more years.

3. States with the fastest economic growth (Texas, Colorado, North Carolina) also tended to have the fastest increases in government spending.

4.  State and local spending as a share of the economy has held more or less constant over the last four decades.

5.  Federal government spending as a share of the economy has been declining.

From (1) (2) and (3) the clear implication is that the red states grew more because they had the fastest increases in government spending.

But then (4) comes along and says that State and Local spending as a share of total spending has remained relatively constant. What I gather is that the states where overall spending grew more are the states which also had the highest real growth rates. After all, government is one of the components of spending and if the economy grows government spending grows with it. But that doesn´t mean (unless the share of government was increasing) that government spending is driving growth.

The chart below begins with the “Great Moderation”.

Kimel_1

In North Dakota government spending share has fallen considerably in the last few years. If North Dakota is growing more than California (in fact more than all the states in the sample) it is because private spending is more than offsetting the fall in government spending as a share of the economy. And that´s oil!

In several states more recently the share of government spending has increased to the upper bound in the sample. In California it has gone above the sample peak. In Colorado and Texas, on the other hand it has remained close to the lower bound in the sample.

Nominal spending (NGDP) at the state level is determined fundamentally by the conduct of national monetary policy (much like in the individual Eurozone countries). The panel shows how close to trend nominal spending has remained. That is measured by the NGDP Gap, the percent difference between actual spending and the trend level of spending. Note that there´s a close correspondence between the “gap” and the rate of unemployment.

Kimel_2

North Dakota is in a league of its own:

Kimel_3

If monetary policy is the same for all states, why should the spending gap and the correspondence of the gap with unemployment differ widely? Local factors that affect both the gap and unemployment may be important. One such factor is researched in this just released NBER paper: “UNEMPLOYMENT BENEFITS AND UNEMPLOYMENT IN THE GREAT RECESSION: THE ROLE OF MACRO EFFECTS”. In their conclusion they write:

One motivation for increasing unemployment benefit durations during the Great Recession, in addition to helping unemployed workers smooth their consumption, is to increase employment through its stimulative effect on local demand. Although we cannot do full justice to evaluating this effect given the methodology on which our analysis relies, our results nevertheless offer some insights. To the extent that the unemployed spend a significant fraction of their income in their home counties (in a form of e.g., rent payments or service purchases), the corresponding part of the stimulative effect is fully captured by our analysis.

Indeed, we find that border counties with longer benefit durations have much higher unemployment, despite the potential beneficial effects of spending. …We find, however, that an increase in unemployment due to benefit extensions is similar in magnitude to the decline of employment. Thus, the total effect on spending is ambiguous as extending benefits increase spending by the unemployed but at the same time decrease spending as fewer people are employed. The potential offsetting effect of lower employment due to higher benefits was also recognized by policymakers but considered – based on the micro studies discussed above – to be quantitatively very small. Our results of a sizeable macro effect leads us to expect that the stimulative effect of higher spending by the unemployed is largely offset by the dramatic negative effect on employment from the general equilibrium effect of benefit expansion on vacancy creation.

Note Mike Kimel graciously made his spreadsheet available

Idolized one day, demonized the next

It is a common occurrence with sports idols and some teen idols to be demonized in the next stage of their lives. But among Fed Chairmen, Greenspan surely gets the ‘honor’ of being the first.

A scathing review of Greenspan´s latest book – The Map and the Territory – by Steven Pearlstein has led to additional acid comments by, among others Paul Krugman and Brad Delong.

PK writes “The worst ex-central banker”. It´s not just about his post-Chairman performance:

The thing is, Greenspan isn’t just being a bad economist here, he’s being a bad person, refusing to accept responsibility for his errors in and out of office. And he’s still out there, doing his best to make the world a worse place.

Brad Delong goes so far as to recant his initial review of Greenspan´s 2007 “Age of Uncertainty”:

I said Greenspan had batted about 35 out of 36 at the Federal Reserve. Adding on what we now see with respect to financial deregulation, tolerance of fraud, and reactions to the Lesser Depression since he left the Board of Governors, I now see him as batting 35 out of 42 or so–and his mistakes appear of greater magnitude than his successors(!).

But all that´s not new. Five years ago I wrote a piece for Nouriel Roubini´s EconoMonitor entitled “Fallen Idol” where I conclude:

Unfortunately, Greenspan was not an effective advocate for his own defense during his Congressional testimony. He pinned the crisis on mortgage securitizers, risk modelers and lending institutions. But his defense was really quite easy. As his own defense counsel he would argue that the Fed´s mandate is to:

1.      Keep inflation low and stable and,

2.      Attain maximum employment (equivalently, keep growth close to potential)

And then show “defense exhibit #1” (and only) to Congress´s “jury” panel:

Fallen Idol

Q&A on monetary policy with David Beckworth

Interview with James Pethokoukis:

Beckworth examines the Federal Reserve and monetary policy through the lens of market monetarism, a 21st century update of the monetarist approach of Milton Friedman. Most folks who identify as market monetarists have been in favor of the Fed’s bond-buying, or “quantitative easing,” program. They don’t think it’s been executed perfectly, however. If the Fed’s actions had been accompanied by a stated intention to target the level of nominal GDP, there’s a strong case that QE could have been far smaller yet far more effective. Still, QE has likely helped the economy and thus been worth doing.

The aftermath of three famous stock market crashes

Scott Sumner has a post on the 26 year anniversary of the October 19 1987 stock market crash, dispelling some common held myths. Recently I did a post commenting on Roger Farmer´s view that the stock market crash of 2008 caused the Great Recession.

In this post I put the ‘famous three’ stock crashes together. One was followed by the Great Depression, another by the Great Recession while the 1987 crash was followed by a boom in real output.

Crash Anniversary_1

The stock market crash of 2008-09 was the biggest, with the other two crashes being commensurate. Why no “Great Depression” in 1987 and 2008? Maybe because during 2008.QII and 2010.Q1 NGDP dropped by much less than in 1929QII-1931QI and it rose strongly between 1987QII-1989QI.

Crash Anniversary_2

Funny how some get heated up if inflation is above target, but feel it´s OK when it is below!

David Smith writes: “THE INFLATION BALOON’S STILL UP IN BRITAIN”:

Britain has become, once more, a high-inflation(!) economy. Normally as a nation we like to top any European league. But when that league is for inflation rates across Europe, that is more than a little embarrassing.

New Eurostat figures, which the Labour party was quick to pick up on, show that last month Britain had the highest inflation rate in the European Union. Yes, of all 28 EU members states, Britain’s inflation rate was the highest.

Britain’s 2.7% rate last month was more than double the EU (1.3%) and eurozone (1.1%) averages. Previously high-inflation EU countries, which included Hungary, Poland, Romania and the Netherlands, have come back down to earth. While Britain’s rate is close to 3%, more than half of the members of the EU – 15 in all – have prices rising at an annual rate of 1% or less.

Now, who´s ‘suffering’ more: The UK or 15 of the EU members that have inflation below 1%?

The “too low for too long” hypothesis revisited

John Taylor writes:

In her  article “Alan Greenspan: What Went Wrong” in the Wall Street Journal Alexandra Wolfe considers whether monetary policy played a role in exacerbating the housing boom going into the financial crisis by holding interest rates “too low for too long.” I’ve argued that it did  (along with regulatory lapses) and wrote about it in a 2007 Jackson Hole paper.

Alan Greenspan disagrees with that paper, as Alexandra Wolfe reports, but she also reports that “Prof. Taylor stands by the paper in which he presented the idea. ‘The paper provided empirical evidence…that unusually low interest rates set by the Fed in 2003-2005 compared with policy decisions in the prior two decades exacerbated the housing boom,’ he wrote in an email. Other economists have corroborated the findings, he added, and ‘the results are quite robust.’”

I agree with Greenspan´s disagreement. The charts give a good visual of the process.

  1. House prices began to climb after mid-1997, all of six years before the so called “too low for too long” period.
  2. House prices took an almost imperceptible ‘breather’ during the 2001 recession and then resumed the upward trend at the same rate.
  3. They continued to climb after interest rates were increased starting in mid-2004

Too Low Too Long_1

Now, interest rates were not “too low” in 2002-04:

  1. Note that MP (monetary policy) was “easy” in 1998-99. That follows from the fact that NGDP was rising above trend, irrespective of the FF target rate being reduced (1998) or increased (1999)
  2. During 2001-03 MP was tight despite interest rates being reduced at an accelerated clip. Look at what was happening to NGDP.
  3. The introduction of “forward guidance” in August 2003 “loosened” monetary policy and NGDP started travelling back to trend.
  4. In 2007-08 MP was first ‘tight’ and then ‘exceedingly’ tight, despite the continued drop in the FF target rate.

Too Low Too Long_2

Bottom Line: Don´t look at interest rates to gauge the stance of monetary policy!

Update: Scott Sumner has a take

The unending search for ‘the’ reason

David Altig asks: “Why Was the Housing-Price Collapse So Painful? (And Why Is It Still?)”. 

His considerations:

Foresight about the disaster to come was not the primary reason this year’s Nobel Prize in economics went to Robert Shiller (jointly with Eugene Fama and Lars Hansen). But Professor Shiller’s early claim that a housing-price bubble was full on, and his prediction that trouble was a-comin’, is arguably the primary source of his claim to fame in the public sphere.

Several years down the road, the causes and effects of the housing-price run-up, collapse, and ensuing financial crisis are still under the microscope. Consider, for example, this opinion by Dean Baker, co-director of the Center for Economic and Policy Research:

…the downturn is not primarily a “financial crisis.” The story of the downturn is a simple story of a collapsed housing bubble. The $8 trillion housing bubble was driving demand in the U.S. economy in the last decade until it collapsed in 2007. When the bubble burst we lost more than 4 percentage points of GDP worth of demand due to a plunge in residential construction. We lost roughly the same amount of demand due to a falloff in consumption associated with the disappearance of $8 trillion in housing wealth.

The collapse of the bubble created a hole in annual demand equal to 8 percent of GDP, which would be $1.3 trillion in today’s economy. The central problem facing the U.S., the euro zone, and the U.K. was finding ways to fill this hole.

In part, Baker’s post relates to an ongoing pundit catfight, which Baker himself concedes is fairly uninteresting. As he says, “What matters is the underlying issues of economic policy.” Agreed, and in that light I am skeptical about dismissing the centrality of the financial crisis to the story of the downturn and, perhaps more important, to the tepid recovery that has followed.

At the end David Altig muses that:

A more systematic take comes from the Federal Reserve Board’s Matteo Iacoviello:

Empirically, housing wealth and consumption tend to move together: this could happen because some third factor moves both variables, or because there is a more direct effect going from one variable to the other. Studies based on time-series data, on panel data and on more detailed, recent micro data point suggest that a considerable portion of the effect of housing wealth on consumption reflects the influence of changes in housing wealth on borrowing against such wealth.

That sounds like a financial problem to me and, in the spirit of Baker’s plea that it is the policy that matters, this distinction is more than semantic. The policy implications of an economic shock that alters the capacity to engage in borrowing and lending are not necessarily the same as those that result from a straightforward decline in wealth.

Having said that, it is not so clear how the policy implications are different. One possibility is that diminished access to credit markets also weakens policy-transmission mechanisms, calling for even more aggressive demand-oriented “pump-priming” policies of the sort Dean Baker advocates.

So as not to let any alternative off the table, Altig ‘goes Austrian’:

But it is also possible that we have entered a period of deep structural repair that only time (and not merely government stimulus) can (or should) engineer: deleveraging and balance sheet repair, sectoral resource reallocation, new consumption habits, new business models driven by both market and regulatory imperatives, you name it.

In my view, it’s not yet clear which policy approach is closest to optimal. But I am fairly well convinced that good judgment will require us to think of the past decade as the financial event it was, and in many ways still is.

So there are several theories (or alternative explanations). But a more general explanation – one that ‘contains’ both the “wealth-loss” explanation and the “altered capacity to engage in borrowing and lending” explanation was not considered. The “missing” explanation is that monetary policy failed miserably in providing an environment of nominal stability. Also, while nominal stability remained more or less intact, “sectoral reallocation” proceeded ‘naturally’.

The charts show that it was only after nominal income collapsed that the real economy (reflected in the unemployment rate) tanked. Note also that by that time housing wealth had already been ‘crushed’ and problems in financial institutions had surfaced long before, being made more acute with the complete loss of nominal stability after mid-2008.

Altig

And why is it still painful? The reason, which follows from my ‘explanation’, is that nominal spending (income or NGDP) is still way below any reasonable level. Again, more than anything else, that explains the dearth of progress made in a host of metrics.

In a recent post David Beckworth writes: “My Supply-Side Senses Are Starting to Tingle”, and shows that while until recently the biggest problem revealed by surveys of small businesses was “lack of sales” (demand), that has now been surpassed by concerns with “regulation” (affecting supply). I commented:

David, that´s almost the natural consequence of a deep and protracted demand slump. At a minimum, governments itch to legislate a recovery. The unintended consequence is that it works in reverse!

If true, prospects are quickly dimming!

John Williams longs for the ‘good ol´days’

He says:

Some of the most prominent parts of the current monetary policy tool kit will likely be retired when the Federal Reserve s able to raise short term interest rates above their current zero percent level, Federal Reserve Bank of San Francisco President John Williams said Friday.

Speaking at a conference held by the National Bureau of Economic Research in Boston, Mr. Williams praised the effectiveness of the tools the central bank has adopted since it could cut its traditional monetary policy level, the overnight fed funds rate, effectively to zero. He said he believed the Fed’s bond buying activities, as well as its efforts to offer guidance about the future path of monetary policy, have all done a lot for the economy.

But bond buying, and things like job and inflation thresholds that give clues to when the Fed might raise rates, still have enough uncertainty about them that they should be reserved for extraordinary times.

Given this understanding and the predictability of the effects of conventional policy, the short-term interest rate remains the best primary tool for future monetary policy,” Mr. Williams said in the text of his speech.

Yeah, for all the good “the best primary tool” did back in 2007/08 (or even in 2001/03)! Fed presidents and governors have to learn that monetary policy is not well approximated by interest rate policy.

No wonder the economy tanked in 2008

Daniel Thornton is an old member of the Fed research staff, having been active at the St Louis Fed for more than 30 years. So if he says:

“… the Federal Reserve has never used a policy rule, and there is no evidence that any other central bank has either.”

I have no reason to doubt him (although I do).

His opening paragraph is disheartening:

Old debates about the use of rules versus discretion for conducting monetary policy and the efficacy of nominal gross domestic product (GDP) targeting have recently returned to the forefront of monetary policy discussions. The economics profession has largely sided with rules over discretion, while the debate about nominal GDP targeting continues. However, despite the support among economists for policy rules, transcripts of the Federal Open Market Committee (FOMC) meetings suggest that the Federal Reserve has never used a policy rule, and there is no evidence that any other central bank has either. On the surface, a nominal GDP-targeting rule would seem easier to agree on and, hence, more likely to be adopted. However, this essay discusses reasons policymakers have not used policy rules and are unlikely to target nominal GDP.

Targets can be implicit. The fact that the Fed had no stated target (for example a 2% inflation target) does not mean it acted with unbounded discretion.

It is more or less accepted that in the early 1990s the Fed brought inflation down to an ‘acceptable’ (close to 2%) level (remember the talk about opportunistic disinflation at the time?). So we can think (and analysts did) that 2% was the inflation that the Fed (implicitly) targeted. But as the charts show, we could also think that the Fed was targeting the price level (PLT) along the 2% trend or even that the Fed was targeting NGDP along a 5.4% trend (in fact this was amply discussed in the December 1992 FOMC meeting). In any case, from 1992 to 2005 all these were observationally equivalent (see Nick Rowe with regards to Canada)

From that point, mostly due to Chinese growth, commodity and oil prices took off. To the US and many other countries that configured a negative supply shock. In that case, according to the dynamic AS/AD model, prices rise above trend and real output falls below trend (those points are signaled in the charts by fat arrows).

Note that for a while (until early 2008) NGDP was kept close to trend and the economy was doing a great job absorbing the fall in house prices and the negative impact this had on the financial sector. Unemployment, for example, remained low.

Being a die-hard inflation targeter, Bernanke saw the rise in prices and decided ‘to do something about it’. He was not acting with discretion, just following his own implicit rule of acting so as to keep headline inflation around 2%. Interestingly, when oil prices went up in 2004/05, Greenspan let people know he would pursue an “appropriate monetary policy”. Maybe that´s discretion, or maybe he figured that keeping NGDP on an even keel was the right “rule” to follow.

Discretion

So bad things happened not because the Fed acted with “discretion” but because it became “fanatic” about the wrong “target” at the wrong time!

Where is EZ inflation going?

First to zero and then deflation? Maybe not but the situation is dire. In the region as a whole inflation is just 1.1%, just over half the “target”. In other countries, such as Spain, it is rapidly converging on zero! But no matter, it is only slightly below target in Germany.

EZ Inflation_1

 

EZ Inflation_2

 

EZ Inflation_3

And this is what the one size fits all monetary policy has achieved. Overall, nominal spending is way below any reasonable ‘desired level’. Again, Germany is the exception, while Spain is ‘deeply buried’.

EZ Inflation_4

Real growth is nowhere to be seen. Even mighty Germany is barely keeping her nose above water. Meanwhile the “south”, with Spain as ‘representative agent’, has been in recession continuously for the past five years.

EZ Inflation_5

And nothing will change Germany´s mantra that “austerity is the only cure”! With inflation disappearing and real growth significantly negative, no more “austerity” will be possible.