The Texas Non-Bubble

Mike Konczal serves up some interesting graphs on the Texas economy. One important element he flags relates to jobs and the debt burden. Texas managed to go through the past decade with no housing bubble, and a limited increase in housing-related debt. This served the state a great deal in avoiding foreclosure and a subsequent “balance sheet” recession driven by households aiming for deleverage. Mike offers this commentary on how Texas did that:

Fisher states that a free regulatory environment is causing this growth, but the rather strong regulations on the mortgage market and growth in the housing stock are more likely the factors in preventing the build-up of housing debt that in turn isn’t holding back the economy. There are strong regulations on the housing market, especially in terms of housing equity loans that in turn make it harder to bid up values.

Well, why did Texas avoid a bubble? Mike flags consumer regulation. But I’d also point to lax local zoning and land use regulations.

The chief restriction on home equity loans in Texas is that they cannot exceed 80% of the market value of the home — essentially requiring all borrowers to have some sort of equity. Cash out refinances were restricted in the same manner. Requiring that homeowners place a sufficient amount as a downpayment, and restricting people from using equity gains as collateral to acquire new debt, substantially reduced speculation and cash outs.

But it’s something of an open question as to how much this reduced price fluctuation. Certainly, requiring sizable downpayments lowered the plausible group of buyers in a given property. However, the restriction on refinancing was probably a factor reducing leverage more than increasing price. Ie, it prevented existing homeowners from doubling down on home prices by acquiring more debt. Certainly, the option to extract future equity may have enticed buyers in other states. But limiting future equity extraction may or may not have been a small factor in actually inducing higher prices.

By contrast, there are good theoretical reasons to focus on housing restrictions. Paul Krugman argued all the way back in 2005 that house price appreciation seemed to be much higher in areas where geographic and zoning restrictions lowered the available supply of housing. Since then, Ed Glaeser and co-authors have written a paper arguing that price increases in housing were driven most strongly in areas where housing supply was relatively fixed.

This makes a lot of sense from a demand-supply framework. Where supply is flexible; builders respond to greater demand for housing by building more houses, so prices remain flat. Where supply is inflexible, increases in housing demand largely translate into increases in prices, not increases in the number of houses built. Even if the increase in housing demand comes from speculators who place little money down and expect to extract future equity from their houses; as long as builders can keep building this increase in demand will not translate into an increase in prices. You need both an increase in demand, as well as inflexible supply to generate an increase in housing prices.

The national data backs this idea up well enough, but there are two big stumbling blocks: basically Las Vegas and Phoenix. The housing market in these areas saw huge price increases, but the thinking is that land policy should have been fairly flexible here. If you look at both markets specifically though, the real problem may also have been inflexible housing supply:

In Nevada, something like 85% of all land is federally owned, including a lot of the land in the neighborhood of Las Vegas, and overseen by the Bureau of Land Management. A local journalist at the Nevada News & Views, Mike Chamberlain, has repeatedly emphasized the role of government ownership of land in building up the bubble. A federal law in 1998 split land sale proceeds with local governments, which gave local authorities strong incentives to try to bid up land sales. As this Economist article mentioned, other local housing participants in 2005 thought the government was far too stingy in releasing land at a suitable pace. At the very least, there are good reasons to think that not all of the land outside Las Vegas was free for development.

Phoenix is also wrongly classified as freely developable state. Rather, beginning in 1998, the state opted for a “growth management” policy limiting land use. Similar to Las Vegas, land outside of Phoenix land was held by the government, which limited sales to maximize revenues. This link from Demographia (honestly not sure how I ran across this, so perhaps take with a grain of salt) argues in Maricopa county, home to Phoenix, agricultural land was selling for a fraction of development land. The problem wasn’t a land shortage per se, so much as a segmented real estate market in which agricultural land was not easily convertible into housing. Wendell Cox at New Geography argues:

Building is largely impossible on the "abundance of land" surrounding Las Vegas and Phoenix. Las Vegas and Phoenix have virtual urban growth boundaries, formed by encircling federal and state lands. These are fairly tight boundaries, especially in view of the huge growth these areas have experienced. There are programs to auction off some of this land to developers and the price escalation during the bubble in the two metropolitan areas shows how a scarcity of land from government ownership produces the same higher prices as an urban growth boundary...

In Las Vegas, house prices escalated approximately 85% relative to incomes between 2002 and 2006. Coincidentally, over the same period, federal government land auctions prices for urban fringe land rose from a modest $50,000 per acre in 2001-2, to $229,000 in 2003-4 and $284,000 at the peak of the housing bubble (2005-6). Similarly, Phoenix house prices rose nearly as much as Las Vegas, while the rate of increase per acre in Phoenix land auctions rose nearly as much as in Las Vegas.

Somewhat conspiatorially, a similar situation prevailed in Spain. An Economist article has noted that building on vacant land required local governments to extend town limits, and entitled them to 10% of development land (which town governments then sold for revenue). I find it suspicious that three of the biggest housing bubble markets in the world in the last decade were characterized by these sorts of crony capitalist land ownership rules. It’s easy to imagine how governments could limit the sales in these auctions to artificially constrain supply and encourage price inflation.

I think all of this is at least circumstantial evidence to think that local zoning and housing policy may have played a role in preventing a housing bubble in Texas. There are other factors at play too — Texas has high property taxes, further limiting speculation, and it tends to draw its migrants from states in the Midwest, which also saw low property price appreciation. By contrast, Nevada and Arizona saw a lot of migrants from California (cashing in on previous house appreciation), while Florida had a lot of migrants from pricey New York.

Still, there’s no reason we can’t follow both the consumer regulation and the lax zoning. Texas’ housing policy involves “regulations,” but ought be relatively palatable for regulation-distrusting libertarians and others to swallow. There aren’t strict mandates on what or where to build, but simply sensible rules requiring that homeowners keep sufficient collateral in their homes. This seems reasonable enough. Not to get too into the politics of this, but the chief opposition to collateral requirements tends to come from progressive community activists worried that downpayments punish wealth-poor families.

Meanwhile, the loose regulations on housing seem to do a great deal of good in preventing price bubbles from building up as well. Those, too, seem reasonable. There’s no reason not to adopt both sets of policies throughout the nation. That would lower rents, limit speculation, and likely lower house price volatility. It’s too bad Rick Perry isn’t running on that platform.

The Rentier Class and Monetary Policy

Reihan Salam flags this bit from J.P. Morgan report on why there has been so much resistance to the Fed’s actions:

To understand why, consider Mr and Mrs James Rentier (a), an apocryphal family in their early 50’s living in upstate New York. The Rentiers are middle income: $80,000 in adjusted gross income, 3 children and $300,000 in savings after setting aside 10% of their income over the last 30 years. Over time, as they aged and given their limited safety net, they shifted their investments into cash and short term fixed income. The current tax system is friendly to the Rentiers; at their income level, after standard deductions, available child tax credits and the payroll tax holiday, their fully-loaded effective tax rate is around 14.5%. But now consider the impact of QE (quantitative easing) on this family. Money market yields, in a normal cycle, are ~ 2% over core inflation; that would be around 3.5% today Zerophilia deprives this family of ~$8,200 per year in after-tax interest income. How substantial is that? Let’s normalize interest rates, and then compute the increase in effective tax rates that results in the same amount of after-tax income the Rentiers have today. As shown below, the punitive impact of QE on this family is the same as raising effective tax rates by one third. These are the unintended consequences of QE: a wealth transfer froms avers to the over-leveraged, and perhaps, to owners of stocks, although this latter channel isn’t working that well. Note: this is before considering the impact of rising commodity prices on the Rentiers (the Fed rejects the notion that QE affects commodities).

The implication here is that all monetary policy doe is lower interest rates, serving as an implicit tax on the holders of capital. One hears a lot of this talk, and it’s worth wondering why there seems to be so much political backlash against federal reserve easing actions.

The key here though is that this analysis narrowly focuses on the short-term impacts of easing against the broader impacts. In the short term, more easing (say, in the form of further quantitative easing) may well lower long-run interest rates (the liquidity effect). But in the long run, easing serves to increase total nominal spending, and so expectations of future inflation. This is the Fischer effect, and it works to raise long-run interest rates.

A lot of people seem to be upset right now that interest rates are low; but that’s not

solely a function of the Fed. The “natural” Wicksellian rate of interest is low due to a weak economy. Successfully targeting a future path of nominal spending higher than that expected today would lead to a robust economic recovery and higher inflation expectations — and so actually higher interest rates in the future. That’s why Milton Friedman identified low interest rates with tight, rather than loose, money.

So phrasing this issue as a “economic recovery on one hand, low rates on the other” dilemma is short-sighted. The path to both economic recovery and higher rates lies in more easing. And if you look internationally, the countries that have done the most to implement expansionary monetary policy have the higher interest rates. In Sweden, Lars Svensson has pioneered a variety of unorthodox monetary policy tools — including setting a negative interest rate on reserves, and robust quantitative easing. The result has been an economy that has recovered to a pre-crisis trend rate of growth:

That has provide the Swedish Central Bank with sufficient leeway to see rising interest rates, led by Central Bank rate hikes. By contrast, Japan has been far more reluctant to embrace an expansionary monetary policy in terms of raising its price level; and so has seen low interest rates for decades. It’s hard to think that Japan is a better place for rentiers than Sweden.

There’s been substantial discussion of how it is that people in the economy somehow don’t perceive this. Brad DeLong has argued that the Great Depression era rentier class was opposed to inflation as their profits were entirely insulated from the suffering of common folk. By his argument, people are sufficiently

It’s hard to know what to think about this. The rentier class in the Great Depression was also devastated by overall economic losses. A reluctance to embrace expansionary monetary policy in an environment of a persistent demand shortfall and very low inflation doesn’t seem to make too much private economic sense. One imagines that the rentier class is simply mistaken

The Buffett Op-Ed

Others have already tackled this Op-Ed by Warren Buffett, in which he basically calls for higher capital taxes. Buffett's argument revolves around fairness -- he doesn' t seem to be taxed very much on a personal basis relative to the administrative staff in his office (why he continues to have administrative staff is another story -- one imagines that he could just learn to use Google Calendar, email, and then fire everyone else). The take on the other side is that we ought to set taxes on capital and corporations in ways that make sense for society as a whole, not for reasons of fairness.

And Buffett is absolutely playing this for personal PR purposes -- the more he ostensibly calls for greater "sacrifices" from himself; the more he alleviates any potential sources of envy against his wealth. Buffett may well end up doing better in a world of higher capital taxes, which would place enormous burdens on his competitors. Add to that his own ideological biases, the fact that Buffett doesn't pay many taxes anyway due to the fact that he's donating the vast bulk of his wealth, etc. and you end up with a not-particularly compelling case.

But then you also have some seemingly factual howlers.

Some of us are investment managers who earn billions from our daily labors but are allowed to classify our income as “carried interest,” thereby getting a bargain 15 percent tax rate. Others own stock index futures for 10 minutes and have 60 percent of their gain taxed at 15 percent, as if they’d been long-term investors.

This doesn't seem right at all. I'm sympathetic to eliminating carried interest rules; but it just seems wrong as a factual matter to argue that short-term investment gains are taxed at the long-run rate for those institutions -- or so I glean from Avik Roy. See the new update.

Then there's this section, which is something that Buffett repeats over and over:

Last year my federal tax bill — the income tax I paid, as well as payroll taxes paid by me and on my behalf — was $6,938,744. That sounds like a lot of money. But what I paid was only 17.4 percent of my taxable income — and that’s actually a lower percentage than was paid by any of the other 20 people in our office. Their tax burdens ranged from 33 percent to 41 percent and averaged 36 percent.

Leave aside Buffett's estimation of his own tax liability, which primarily reflects capital gains. How are his other office employees taxed at those rates? After all, one only enters the 35% income tax bracket after $250,000; and even there the average tax liability of a person will be much lower (something like 27% in my calculation). Is his comparing his average tax liability with the marginal tax liability of his employees? In the past, he's frequently claimed to have a higher tax rate than his secretary making $60,000 a year. Yet the marginal tax rate for a single person with that income is 25%. That's of course higher than the 17% he quotes above; but is far lower than the range he provides there (with an average tax liability that is far lower too).

There's much more here that's absurd. For instance:

I didn’t refuse, nor did others. I have worked with investors for 60 years and I have yet to see anyone — not even when capital gains rates were 39.9 percent in 1976-77 — shy away from a sensible investment because of the tax rate on the potential gain. People invest to make money, and potential taxes have never scared them off.

Why don't we just go all the way up to a tax rate of 90% then if the tax rate doesn't matter? If you think it matters at 90% on some margin, who is to say it doesn't matter at 39.9%? Why on earth do we think that asking investors will yield better information than thinking through data or theory? There's just no reason to think that making lots of money endows someone with insight in public policy or a comparative advantage in Op-Ed writing.

Update: From James Choi, someone with an Adjustable Gross Income of ~$60,000 pays 12.9% of their taxable income as income tax, and 8.5% of their AGI as income tax. Sure, you can add in payroll taxes, etc. in here -- but it's difficult to see exactly where he's getting the "my secretary pays so much more in taxes than me" statistics from.

Update 2: Steve Waldman has more in the comments regarding the tax treatment of futures. Buffett was right about this and I was wrong. It's still somewhat misleading in the sense that it presents an extreme example of short-term trading, when only 10 percent of the gains accrued by partners are taxed overall at the short-term rate. The particular rule behind the mentioned 60/40 split seems reasonable. Buffett's real concern anyway is not with the long/short run taxation of capital; but with carried interest rules and capital taxes generally. And I'm somewhat with him on the carried interest rules.

Unemployment Insurance

Mike Konczal has a post examining Romney’s idea to establish personal unemployment insurance accounts, rather than universal unemployment insurance. This debate gets into the general difference between “liberal” and “neo-liberal” approaches to the welfare state - in which the liberal approach would have the government directly provision goods, and the neo-liberals prefer to set up market structures to handle insurance (with subsidies thrown in for the truly poor). I’m generally in favor of the neo-liberal option; but Mike has had a number of good posts outlining some powerful critiques.

In this case, Mike outlines some research by Raj Chetty showing that unemployment insurance (when given in the form of a lump grant) actually increases the duration that people take to find a job. This makes sense if you think that the unemployed might need more time to find a perfect fit. So the “moral hazard” aspects of unemployment insurance might not be a huge worry; as long as people are avoiding immediate employment with the aim of finding better employment.

I’m fan of Chetty’s research in general, and this study is pretty clever. But it's worth noting other studies have found different effects. For instance, this study by Krueger found that search intensity increases as unemployment benefits decrease; and search intensity increases as benefits are about to run out. That suggests that some sort of moral hazard aspect to unemployment uninsurance isn’t crazy. Chetty’s paper didn’t show that people who waited longer got better jobs — so we don’t know what the value of waiting for a better job is; or whether people really did wait longer with a lump-sum benefit for better jobs.

We also have the advantage of looking at an actual program of unemployment insurance accounts — Chile — which is in general a good advantage of a neo-liberal approach to the Welfare State (balanced budget with flexibility for the business cycle, private accounts for pensions, etc.). This article from VoxEU suggests that an unemployment insurance savings account raises job-finding rates.

Chile’s program combines regular contributions (“split” between employers and employees), along with a common fund partially funded by the government. Upon unemployment, people first draw down their own private account. The key picture is this:

People eligible for the Solidarity fund (ie, drawing down unemployment benefits they didn't pay for) find jobs at much slower rates initially. Meanwhile, among those with personal accounts -- the amount of funding didn't affect the rate at which people found jobs (suggesting that the liquidity effects Chetty focuses on weren't a huge factor, at least here).

There's not an immediate takeaway from this. The authors of that piece emphasize the ability for personal unemployment accounts in diminishing moral hazard and increasing employment. Contrary to that, it's possible that delaying employment led to better labor market outcomes - though we just don't have data on that. Also, you probably want to figure unemployment itself as a bad, and count shorter unemployment durations as a good thing.

Overall, I’d say that Chetty’s research — though interesting — isn’t the last word. His job duration is interesting, but evidence from search intensity suggests that there may be *some* moral hazard here (the Chetty paper had some role for that too). We still don’t know (or at least I don’t know) what the improvement in job quality is for people who take longer to find work. The evidence on an actual personal unemployment plan seems at least somewhat positive.

I do see one important benefit a shift to personal unemployment accounts would get us — it would depoliticize the unemployment insurance issue. Right now, we rely on Congress to go ahead an authorize additional duration for unemployment insurance every time we have a recession. Given that we lack a consensus on how much the government should actually spend or tax, this discussion gets wrapped up in that broader debate, and so you end up with some hostility to what should be a routine automatic stabilizer. If instead unemployment insurance was all handled by personal accounts, one imagines that this debate would go about differently. People would just have access to unemployment insurance and Congress would complain about other things. Seems like a pretty good tradeoff to me.

How Much Does China Contribute to the US Economy?

Via Paul Kedrosky, here is an informative Fed Letter:

Goods and services from China accounted for only 2.7% of U.S. personal consumption expenditures in 2010, of which less than half reflected the actual costs of Chinese imports. The rest went to U.S. businesses and workers transporting, selling, and marketing goods carrying the "Made in China" label. Although the fraction is higher when the imported content of goods made in the United States is considered, Chinese imports still make up only a small share of total U.S. consumer spending. This suggests that Chinese inflation will have little direct effect on U.S. consumer prices.

Even 1.35% of the US Economy is significant. But it's a vastly different picture than one gets in the popular media, where Chinese-made goods have seemingly entirely displaced all American production.

Dreaming of A World Without (Public) Debt

If there's one thing the S&P's debt downgrade reinforces -- it's that public debt is bad. It's bad for taxpayers and bad for stability of the financial system. Ideally, we need to get rid of all of it.

The case for debt as a bad for taxpayers is easy enough. We spent some $200 billion every year on net interest on debt, or roughly $2 trillion a decade -- for which taxpayers receive absolutely nothing at all in return. This interest expense wouldn't exist in a world of saner budgeting in which expenses equalled income over reasonable periods of time.

Then, there's the foregone capital gains on that as well. Gilts are tax-free. If we had no debt and investors held the same amount of debt in the form of private debt, the IRS would be receiving a sizable chunk of revenue a year.

In theory, debt financing makes sense if an entity is making some fundamental investment, for which future cash flows will finance future interest payments. But that's not how the government works -- we borrow from tomorrow to finance consumption today. We're paying billions of dollars extra because the folks in 2003 were too short-sighted to finance their consumption in 2003 rather than later. That's no good reason to pay billions in the form of interest payments and foregone capital gains income. Think of how much easier it would be to handle budget problems with that extra buffer. Instead, we're taking those interest payments and throwing those back on the credit card. We'll end up paying substantially more than one dollar in future taxes to finance one dollar of consumption.

Does getting rid of the debt altogether sound crazy? Australia has typically held basically no public debt over the business cycle. They have a little more today due to the financial crisis, but will in all probability wind that down back to basically zero.

Then, there are the warping knock-on effects that "safe" sovereign debt has on the entire financial system. As Perry Mehlring outlined in The New Lombard Street, the Fed was once optimized for a world where the entire system of payments and debt revolved around private debt. What we dub "quantitative easing" was once done sort of more routinely as the Fed manipulated the prices of privately issued debt in order to determine country-wide credit and money ability.

FDR's enormous deficits -- and the resulting stock of public debt -- changed that. The Fed altered its mandate to only mess with public debt, only recovering that old role during the financial crisis, when a zero-rate bound on short-term Treasury debt and broader financial problems brought about financial interventions into private debt. But had FDR not bothered with basically useless fiscal stimulus programs (ie, decided to follow his campaign pledges), and instead stuck with the monetary interventions that actually worked -- we could imagine an alternate central banking world in which shaping interest rate expectations on private debt would constitute the totality of Fed operations. That would have been a much more stable world to live in.

In particular, you don't have the nonsense of "safe" debts underpinning the architecture of the entire financial world. Gary Gorton talks about the creation of structured finance as a way to meet some "shortage" of safe assets provided by the government. I would instead say that the fallacy of assuming that safe assets exist is invariably the cause of financial crises. Rather than worrying about what a debt downgrade will do to the financial system - the goal should be to build a system with is tolerant to (normal! expected!) downgrades of certain types of debt. Rather than pricing everything on the basis of Treasuries, we could have a world where everything has an assumed credit risk, and people bear enough capital to handle expected credit shocks.

This doesn't say anything about the mechanism by which debt goes to zero - whether we get there by higher taxes or lower spending. Obviously, right now, that's hard to imagine. But Australia seems to have figured something out, and even countries like Sweden and Canada have made important steps in that direction. At least in terms of how to imagine debt, I think it's important to say, "piling up this much debt was a really bad idea we should reverse as soon as possible," rather than, "interest rates are low, so let's pile on as much more of this as possible." The price of debt tells us nothing about it's value.

Data Revisions and the Guns and Butter Model

Karl Smith has a request:

Has anyone run the guns a butter model on the last election with the new disposal income data? Supposedly the Dems lost an extra 20 seats in the House or so above what could be explained structurally. However, now that we know the structure of the economy was worse than the frontline data does that estimate still hold?

I haven’t run the numbers but I am guessing what looked to be policy backlash will vanish in the structural void with new estimates.

I decided to check this out. First, I went with Douglas Hibbs site, the original source of the "Guns and Butter" model. He had predicted that the Dems would win 211 seats, roughly an overestimate of 20 seats (relative to Democrat actual wins of 193). However, this estimate came with caveats:

In fact there is uncertainty about income growth during last quarter - the 2010q2. The personal income data for q2 posted by the Commerce Department's Bureau of Economic Analysis on 30 August 2010 are second estimates and they are subject to potentially large revisions later.

Of course, this is exactly what happened.

I decided to download his data and update the consumption statistics. I took the latest disposable per capita income, which have been revised going back to 2008Q1. I couldn't get the CPI data to match exactly, but this page seems to do well enough to deflate the numbers.

At this point, I decided to run the full model with the 2010 election as an additional data point. This is the relevant point to use in evaluating all of the data to use for future modeling; but it may overstate the fit exactly for 2010 slightly. Here's what I have:

The new prediction for 2010 is 202.5 seats. This overstates Dem gains about about 10 seats, but does cut the overstatement.

I wondered how much adding 2010 did on its own, so next I threw out the 2010 data, and fit the 2010 election based on previous election data, but current economic data: now, I get a Democrat prediction of 206 seats. Roughly, a fourth of the Democrat "underperformance" can be accounted for by economic conditions that were worse than thought at the time.

I'm not sold on this model -- with so few elections to go through, it seems likely that many elections will be "anomalies" ex ante and then rationalized ex post through the model (you can sort of see that here -- throwing in the new data lowers the rate of misfit for 2010). Plus there are the various structural reasons to mistrust any model like this - Andrew Gelman offers some comments here, and then there is the Lucas Critique.

But if you're looking for ways in which worse economic data should change your priors, here's one of them -- the Democrats faced a worse economic climate in 2010 than commonly realized, and their performance is more understandable as a result.

We Should Have Defaulted

Any particular reason why we had a market crash now? Wasn't the extension of the debt ceiling supposed to ward off a market collapse? Arnold Kling offers a contrarian take:

Apparently, the resolution of the debt ceiling restored the dollar's status as a safe haven in the eyes of the world's investors. That accelerated the flight from European sovereign debt and European banks. That in turn raised fears in financial markets, driving down stocks, including in the United States.

I think one can make a plausible argument that we would be better off continuing debt ceiling games in the US. It looks as if certain European countries -- the usual suspects of Italy, Greece, and Spain among them -- face self-fulfilling beliefs regarding the quality of their debt. They can survive only if investors continue to lend to them at low rates. There are multiple equilibria here -- either peripheral countries continue to borrow at cheap rates reflecting a low probability of default, or they borrow at high rates reflecting a high probability of default.

Which equilibria we are in is determined by the initial level of capital willing to invest in Europe versus America. As Kling points out, the resolution of "uncertainty" in the US shifted the balance in favor of the US, pushing Europe to the bad equilibrium, with internationally disastrous consequences. Of course, keeping America a risky destination for capital probably isn't the best long-term strategy. But perhaps a more stringent regime of capital flows could have alleviated some of the short-run European liquidity problems, buying time to deal with the solvency concerns.

Elsewhere, Ryan Avent offers a useful historical perspective comparing today with the 1930s. It is a useful analogy, one that largely fits the narrative I got from the excellent Wages of Destruction. The euro, in this reading, in some sense serves the same function as the Gold Standard did for European countries -- a straightjacket preventing adequate monetary easing in poorly functioning economies, who have contracted out the ability to ease and do not receive fiscal transfers from elsewhere.

Why the Focus on Government Spending?

Once, economists believed that fiscal stimulus was basically worthless, and monetary policy determined cyclical variations. For instance, here is Paul Krugman in 1997:

Indeed, if you want a simple model for predicting the unemployment rate in the United States over the next few years, here it is: It will be what Greenspan wants it to be, plus or minus a random error reflecting the fact that he is not quite God

Though I can't find it; I've seen a policy bit from Larry Summers dating from the '80s or so that was extremely dismissive of the possibility of any fiscal stimulus. This sort of general impulse had knock on effects on all sorts of other policy debates. For instance, future Obama Administration official Jason Furman argued in favor of Wal-Mart in a Slate debate, in which one of his points was:

I believe that Ben Bernanke and the Federal Reserve decide the total number of jobs nationwide.

The general idea was that -- let's hand off the task of aggregate demand management to the Fed, and then otherwise pursue as many pro-growth strategies as possible. Who cares if Wal-Mart costs a few jobs somewhere? The Fed will create them elsewhere. Who cares if free trade results in the loss of a few jobs in Ohio? We'll make enough money from positive-sum trade interactions to make the deal worthwhile, and possibly redistribute back to those newly unemployed. With a strong economy, hopefully they can be retrained and find new jobs.

One of the things that we've seen in the last few years is that this belief has broken down entirely. No one seems to believe that the Fed bears the brunt of the work in generating jobs; or that fiscal stimulus is a typically unworkable solution to economic woes. Instead, we've come to see the economy overall as "Y = C + I + G + X" and think "If government spending goes down even a little bit, the economy will grow unacceptably slowly." More generally, the sorts of positive-sum economic interactions we loved in the past are less popular, because any negative side effects they generate are seen as imposing unacceptable burdens on struggling folks.

And so you have various people complaining about what this debt deal or what future cuts will have on jobs. This is just a type of debate we never really had before now; in the early 2000s for instance, you had the Republicans proposing a "Keynesian" strategy of lower taxes, while Democrats opposed that. But the aggregate demand management aspect of those cuts was less important than their inherent value as tax cuts.

Opinions on the composition of government spending or taxes differ. We should, in theory, be able to have perfectly reasonable discussions about how much we ought to spend or tax without worrying inordinately about how those discussions affect the labor market. If a central bank is properly targeting inflation or the price level, it will lean against government spending in either direction, meaning that no level of government spending has any effect on the economy in aggregate. That way, we can spend all of our time arguing whether or not any particular spending or tax bill makes sense on its own merits. People back in the '90s and '80s had the right idea.

We've sort of stopping doing that. A strong goal on the left seems to be ensuring that government spending remains as high as possible; because otherwise that will ensure doom to a poorly functioning recovery. On the right, the goal too is to keep taxes as low as possible, because households too are struggling. Perfectly reasonable policy debates have become infected with the idea that the balance of public spending and taxation is the primary determinant of broader economic outcomes. So you can't argue in favor of any sort of spending cuts without being some kind of economic arsonist.

I suppose one critique of this is that given such a large output gap and a Fed unwilling to adopt price-level targeting, an inordinate focus on the total amount of government spending makes sense. My response is that it must surely be easier to have the Fed do now what it did during the '90s, so Krugman can again write about how the unemployment rate is set by the Fed, so politicians can spend and tax as they please.

There's the other critique I guess that monetary policy can't perform the same function now due to the zero rate bound, or weak banks, or struggling households. All I can say is: there is an enormous literature on monetary policy, and exactly none of it focuses on the barriers to monetary policy, as least as far as I know. None of it says, "monetary policy works if X, Y, and Z happen." Monetary policy just works, at least in theory.

In practice, we saw monetary policy drive the recovery in 1933 when FDR took the US off of the gold standard, in an environment in which we also were at a zero rate bound; faced weak banks; and financially indebted households. The initial reaction of the economy to the first round of quantitative easing under exactly these conditions was positive; as was the reaction in the second round. The only real counterpoint seems to be the case of Japan. Yet as Scott Sumner has mentioned repeatedly; the Japanese Central Bank really seems to behave as if it does like a zero percent rate of inflation, and QE has helped them maintain that.

But fine, suppose you say I'm crazy for focusing on monetary policy so much. What about other broader labor market policies? Garett Jones links to a paper on the German labor force experience, which basically finds that their flexible labor markets did a great deal to limit the employment impact of the Great Recession. Why isn't there a greater focus on generating specific policies to target unemployment, rather than worrying every time the government spends a penny less?

Guest-Blogging at The Agenda

The last week, I did some blogging at Reihan's blog. Here's a rundown:

Why the Slow Recovery? - Household balance sheets, not shadow banks, are responsible for the weak recovery.

Examining Geithner's Career - Geithner has failed upwards for over a decade now.

Metis and Salman Khan - This guy is amazing

An N-Shaped Kuznets Curve? - Differences in human capital determine differences in income now, not differences in industry

Mend the Ratings Agencies - Here's what to do about your irrational dislike of Moody's

The End of Administrative Assistants - We have fewer secretaries now, and I'm fine with that

Taxation is Theft - An exploration of what I call "Schumerism" -- the dependency of the middle class on government

Why Are Wages Nominally Inflexible?

Nominal wage inflexibility is the standard assumption in economics, and it drives many of the key results in macroeconomics. Fiscal and monetary stimulus, in particular, are frequently justified on the grounds that greater price inflation is needed to re-adjust real wages in a world where nominal wages can't go down.

Well, why not? Scanner data shows that goods prices are actually quite flexible even in the short-run, contrary to what a "menu cost" argument would have you believe. Financial prices of course adjust at the level of microseconds. So it's not that prices in general are inflexible downwards -- just wage prices.

Bryan Caplan raises this issue, arguing that workers who offer to work for less "sound weird." That sounds about right. But why? Here's what's going on on either side of the labor market relationship:

1. From the employees' point of view: they're aware that a situation with a lot of unemployment generates a market for lemons. The long-run unemployed tend to be different from those who are employed -- they may not even compete for the same jobs. Yet workers have much more private information on their own about their own capacities than employers.

So you have asymmetrical information. How do workers signal to employers that they really are more qualified than all those people in the unemployment rolls that really do lack skills? These sort of labor search questions are a bigger deal during a severe recession, in which you have a greater mix of people with and without usable skills, when you worry about the depreciation of human capital among the long-run unemployed, etc.

If you walk up to an employer and say, "I'll be willing to work for 10% off;" you basically signal to that employer that you are worth less than the other job-seekers queuing up at the door. If employers were able to perfectly measure skills, they might be willing to take a chance on you anyway knowing that they're either getting a good worker at a lower price, or at worst a worse worker at a dearer price. All they can see in reality is that you have some level of ability that's hard to measure -- but you apparently lack enough confidence in your own ability to get a job that you're willing to lower your wage. That's not a good signal. If you have access to many other job-seekers (say, it's a recession and many people are unemployed) it's easier to go for those workers.

2. From the employer's side, you worry about the morale and productivity among all of your current staff. It's very damaging to morale, it seems, to simply cut the wages of current workers -- perhaps they consume many commitment goods, and even small wage cuts result in costly cutbacks among the few categories of discretionary spending that workers have. Maybe they're just psychologically drawn to "make more" over time, and don't like going backwards.

Either way, you worry about the productivity of workers that you get pay on the cheap. Instead, you want to pay wages that are a little above the market wage to grab workers of slightly better quality. Perhaps you manufacture an O-Ring style product in which outstanding effort from all workers is essential to the final product. In that case, you really worry about the maximum productivity of your worst employee. Grabbing minor wage savings from a marginal employee is a second-order consideration relative to lowering company-wide productivity that can happen from offering even a few workers lower than market wages.

Again -- you're not going to be hiring the best workers at a lower wage. The best workers are confident that they can actually get a good wage. The information asymmetry problem here is tough, and prices here are used as signals more than incentives.

There's a huge literature on this subject I'm not familiar with, so I'm sure others have had similar thoughts. This is what I would look to though.

The Lucas Critique

One of the most powerful ideas in economics is the Lucas Critique. The notion is that statistical relationships estimated in historical data do not necessarily represent causal relationships manipulable by policymakers. It applied in particular force to the Phillips Curve, a connection that some researchers found between unemployment and inflation. According to this critique; simply observing that unemployment and inflation tend to move opposite one another does not mean that central bankers can push inflation higher at will and gain lower employment.

This was a powerful critique at the time, and has yet to penetrate a lot of economic talk. Here, for instance, is Christina Romer, former Chair of the CEA:

The real division is not about the acceptable level of inflation, but about its causes, and the dispute is limiting the Fed’s aid to the economic recovery. The debate is between what I would describe as empiricists and theorists.

Empiricists, as the name suggests, put most weight on the evidence. Empirical analysis shows that the main determinants of inflation are past inflation and unemployment. Inflation rises when unemployment is below normal and falls when it is above normal.

It seems that Romer is accepting not only the empirical Phillips Curve relationship, but also its causal ability to be used by central bankers. Not only is this her own opinion, but the view that ought to be held by "empiricists" who are rigorous in the way they face data, as opposed to those woolley-headed theorists.

Yet even the empirical relationship between unemployment and inflation has broken down in the past few decades. And even if one such relationship did exist, that would not necessarily provide a guide for monetary policy. I do agree that more monetary easing would be worthwhile, but this is a bad way argument in its favor.

On the other side, you have other individuals arguing against monetary easing on the grounds that higher structural unemployment makes monetary easing futile. Scott Sumner neatly addresses that argument:

For similar reasons there is no hard and fast distinction between cyclical and structural unemployment. For instance, if structural unemployment in American has risen closer to European levels, it may be partly due to the decision to extend unemployment insurance from 26 weeks to 99 weeks, and to increase the minimum wage by over 40% right before the recession. Does that mean that demand stimulus cannot lower unemployment? No, because the maximum length of unemployment insurance is itself an endogenous variable. If stimulus were to sharply boost aggregate demand it is quite likely that Congress would return the UI limit to 26 weeks, as it has during previous recoveries. For similar reasons, the real minimum wage would decline with more rapid growth in demand. Aggregate supply and demand are hopelessly entangled, a problem that many economists haven’t fully recognised.

Once again, some relationship we observe today ("there is more structural unemployment now") doesn't provide an unambiguous guide on what to do in the future.

Finally, here’s a recent example from India’s Economist Prime Minister, Manmohan Singh:

We are committed to a growth rate of 9 to 10 % per annum. Our savings rate is about 34 to 35 % of our GDP with an investment rate of 36 to 37 %. And with a capital output ratio of 4:1 we can manage to have a growth rate of 9%.

On the face of it, this is a reasonable statement. Savings do translate into investment closely enough (give or take foreign direct investment, cash stuffed under the mattress, etc.), and accumulated capital in the form of investment aids in future output growth. And, at any point in time, one can compute the ratio between capital and output as a ratio. That’s all true enough.

What’s disturbing is the manner in which Manmohan Singh apparently relies on the crutch of capital/output as a solid parameter to be manipulable by policy. This has been a consistent factor in his economic thinking for quite some time, and goes back to the assumptions of early Indian planners that the accumulation of capital alone would suffice for growth.

Well that wasn’t necessarily true in Nehru’s time and it's not true now. For instance, note as Yasheng Huang does that China is far less effective than India at translating savings into growth (the country also saves more in general). So this is not some fixed parameter set by immutable laws. Instead the capital/output ratio is highly responsive to the general policy environment and incentives faced by economic actors. In China, presumably what you have going on is a lower degree of allocative efficiency. Yet one might equally have concerns in the Indian context about the role of policy; with microeconomic problems of labor quality, health, land acquisition, general governance, labor laws, taxation, and so on and so forth. It is exactly in order to evade the government’s abysmal failure to tackle these existing and tangible problems that Manmohan Singh suggests that the problem of growth can be reduced to an arithmetic question of savings and investment. Yet that relationship may not hold up in the absence of additional reforms to improve governance and tackle the various other binding constraints that hold back growth. (oh, to be sure he mentions other steps to make sure this will happen; but if his proposals haven't taken off in the last seven years why would they take effect now?).

Let me put it this way — Tim Pawlenty recently received a lot of flack for suggesting that his economic policy would simply demand 5% growth for a decade. What if he had said instead; “I will push savings up to 20%; then since there is a 4:1 relationship between investment and growth we can expect 5% growth.” I think most people would find the idea a little nuts. Many misadventures in development economics have included failures where simply pumping in more capital didn't necessarily get you more growth in an arithmetic fashion. The root problem is that any current relationship between savings and growth doesn’t represent a causal relationship manipulable by policymakers. That’s the Lucas Critique in action.

Mortgage Modification and Strategic Behavior

I have a co-authored paper with Chris Mayer, Ed Morrison, and Tomasz Piskorski that is live on NBER:

We investigate whether homeowners respond strategically to news of mortgage modification programs. We exploit plausibly exogenous variation in modification policy induced by U.S. state government lawsuits against Countrywide Financial Corporation, which agreed to offer modifications to seriously delinquent borrowers with subprime mortgages throughout the country. Using a difference-in-difference framework, we find that Countrywide’s relative delinquency rate increased thirteen percent per month immediately after the program’s announcement. The borrowers whose estimated default rates increased the most in response to the program were those who appear to have been the least likely to default otherwise, including those with substantial liquidity available through credit cards and relatively low combined loan-to-value ratios. These results suggest that strategic behavior should be an important consideration in designing mortgage modification programs.

Adam Levitin has weighed in here, and David Henderson has done so here.

The Value of Marginal Education

There’s an ongoing debate at EconLog, Marginal Revolution, the New York Times and elsewhere over the value of additional education. No one doubts that education appears to be a valuable investment for students who pursue it. But it valuable for the marginal individual? Do we need public policy to steer more students through high school, College, and degrees beyond? Given the centrality of cognitive ability and human capital to economic output and general wellbeing, this has to rank as one of the more important economic questions out there.

Tyler Cowen refers us to some studies:

How much do returns to education differ across different natural experiment methods? To test this, we estimate the rate of return to schooling in Australia using two different instruments for schooling: month of birth and changes in compulsory schooling laws. With annual pre-tax income as our measure of income, we find that the naıve ordinary least squares (OLS) returns to an additional year of schooling is 13%. The month of birth IV approach gives an 8% rate of return to schooling, while using changes in compulsory schooling laws as an IV produces a 12% rate of return. We then compare our results with a third natural experiment: studies of Australian twins that have been conducted by other researchers. While these studies have tended to estimate a lower return to education than ours, we believe that this is primarily due to the better measurement of income and schooling in our data set. Australian twins studies are consistent with our findings insofar as they find little evidence of ability bias in the OLS rate of return to schooling. Together, the estimates suggest that between one-tenth and two-fifths of the OLS return to schooling is due to ability bias. The rate of return to education in Australia, corrected for ability bias, is around 10%, which is similar to the rate in Britain, Canada, the Netherlands, Norway and the United States.

These are all basically examples of an Instrumental Variable (IV) approach. Let’s take these one at a time. First, we have the month of birth evidence. Yet this is the classic example of a weak instrument, an issue which is well discussed elsewhere. The month or quarter of birth has a very weak impact on final educational outcomes, and parents with children born in different months are not identical either.

Next, there is the compulsory schooling evidence, that Arnold Kling actually takes on as well, though only in the US context. He observes that the variation across states in terms of when a student can legally graduate doesn’t seem to predict their actual graduation habits. This is basically also a weak instrument; at least in the case of the US.

Finally, we have the twins evidence. The idea here is to observe one twin going to College and compare her with her sister twin who did not go to College. The assumption is that these two individuals shared identical environmental background factors, and so any resulting differences can be causally attributed to the College attendance of one twin. While this is a clever trick, it requires you to believe that twins are interchangeable humans. What if a family can only afford to send one twin to College, and so they send their more able child? What about all sorts of cognitive and non-cognitive differences that come up between children growing up in the same house? What about the possibility of twin interactions? Though interesting and suggestive, I don’t believe this evidence to be causally definitive.

It’s easy enough to knock holes in any body of literature, even one (as here) which does purport to establish identification. So here’s some evidence that points in the other direction.

1. Cognitive abilities have limited scope for educational intervention in developed economies beyond age ~5.

The evidence of this actually comes from James Heckman. He argues that we simply do not have access to any educational treatment that can reliably boost IQ over an extended period of time. Even the lauded Head Start/Perry Preschool programs can't do that. And if spending tens of thousands of dollars per pupil on a pilot program can’t produce results, it’s difficult to imagine what would.

An education proponent could now say something like, “Fine, but cognitive skills aren’t everything. Heckman supports Head Start — because it boosts noncognitive skills like impulse control.” Suppose I even grant that point — though I note that these noncognitive skills are something like a black box. There’s defined entirely as a residual of what can’t be a cognitive skill, and are inferred largely on the basis of lower crime rates among treated populations.

But think about what that would mean. Everything we do in schools — the teaching, the homework, etc. — has limited value when it comes to actually improving mental functions. Rather, it may or may not be effective in domesticating children to functioning in a modern post-industrial economy. At the very least, that would suggest that education ought radically change its focus away from cognitive tasks towards those aspects of behavior modification. Maybe we’d get the same results as school from a program forcing children to dig holes every day and fill them back up. Also note that Heckman’s results on the payoffs of education based on these noncognitive skills is rapidly declining in age. Are Head Start, prenatal care, or child nutrition policies worthwhile? Very likely. What about pushing unprepared children to attend College? Less clear.

2. Other estimates of the marginal return to education are low.

Heckman has another paper with coauthors where he attempts more rigorously to estimate the marginal impact of more education — in particular, of more College. Even the Instrumental Variable estimates discussed above may be biased — as they measure the impact on individuals induced to have the treatment (ie, more education). This need not be the same population as those induced to have more education in response to some arbitrary policy change.

Instead, Heckman creates an estimate designed to get exactly at the impact of more College on outcomes. The basic logic of his approach is to find individuals who had a low ex ante likelihood of attending College, but who went anyway. These are a proxy of the individuals targeted by, say, a program to induce more people to attend College.

He argues:

For a sample of white males from the NLSY, we establish that marginal expansions in college attendance attract students with lower returns than those enjoyed by persons currently attending college. The contrast between what conventional IV measures and the marginal return to a policy can be stark. For example, while the conventional IV estimate is 0.0951, the estimated marginal return to a policy that expands each individual’s probability of attending college by the same proportion is only 0.0148. This policy induces students who should not attend college to attend it. Too many people go to college. [Emphasis added]

Note in particular that his estimates are consistent with high “IV” estimates — based on a set of instruments that he was able to use here. So even if the “identified” estimates based on the IV literature are correct, they do not necessarily serve as useful diagnostics on whether College expansion programs are worthwhile.

I’ll acknowledge that there’s substantial uncertainty about this question and much that we don’t know. I’m not particularly on one “side” in this debate. But this is such a difficult question to answer because people who seek more education would likely have done well anyway.

What I can say is that the most effective policy interventions here have little to do with simply broadening the access to education. All sorts of early child intervention techniques seem to yield positive results. A number of charter school/school choice/voucher experiments have resulted in institutional improvements in the quality of education while lowering the cost.

Right-Wing Keynesianism

There's an idea going around to offer a one-time tax holiday to multinational firms to encourage them to repatriate income. The US, somewhat absurdly, charges multinational firms domestic tax rates on income earned in other countries. This encourages companies to re-invest foreign profits overseas rather than repatriate that income domestically -- unless they receive a special tax break to do so.

The clear solution to this problem would be to move over to a territoriality-based tax system in which all taxes are levied depending on the tax rates prevailing in the country where the business is taking place. This would simplify the tax code; remove absurd barriers to capital returning home; and generally move to a globally harmonized system of corporate taxation.

A one-off exemption is a second-best attempt to deal with this problem. This poses a number of different problems -- in particular, businesses come to see these one-off exemptions as inevitable, and so stop repatriating profits in all other periods. This ends up "heightening the contradictions" in the corporate tax system, as it were, and ensures that exemptions become regularized.

The other chief complaint is that repatriated corporate profits don't go to productive purposes. This is the claim from Howard Gleckman at the Tax Policy center, who draws on research in the field. The paper he references finds that repatriated profits were largely dispersed to shareholders.

Here's the thing though -- those shareholders then went and did something with that money. Perhaps they reinvested in company shares; maybe they went and bought a yacht. In the case of your left-wing Keynesianism, you issue a bond for a dollar and then spend that dollar on some sector of the economy. That may not logically preclude an economic expansion, but you can see what the difficulty is. But in the case of this right-wing Keynesian policy; you do have a genuine influx of foreign cash into the economy. Perhaps corporations aren't the ones spending the money. But someone sure gets that money and spends it. To be sure, there is a parallel problem that a large enough capital influx will adjust exchange rates however.

In general; I'm increasingly skeptical of tests like the one in the paper I mentioned, where you have a specific experiment applied to some subgroup of the population and you try to learn about the response. Even if you get the identification right (and that paper spends a lot of time arguing that they have some); it's just difficult to extrapolate from there to think about what that might mean for an economy as a whole.

That makes me think this right-wing Keynesianism may be underrated. Moving to a better tax system is a win; and shifting cash domestically in the short-run may be a win too.