Recently in macroeconomics Category

Time to repost the most recent Deseret News article from yesterday.

As many observers expected the U.S. Federal Reserve began a new round of quantitative easing this fall in an attempt to stimulate the economy by increasing the supply of available money.  As I discussed at the beginning of August, there is no fundamental difference between quantitative easing and the Fed's normal open market operations.  In the latter case the Fed buys U.S. Treasury securities on the bond market and in the former case it buys other non-traditional financial assets.  In both cases, however, it pays for these purchases by creating money.

Ryan Decker is a former BYU student who worked for Kerk Phillips and me. He is now a PhD student at the University of Maryland and is on the research staff of the Center for Economic Studies at the Census Bureau. He posted this very interesting picture.

If you look at new firms, they are adding the most workers and shedding the least. But that is by definition. What is interesting is that it is the middle aged firms (Age 4) and the old firms (16+ years) that have been the source of the vast majority of the job losses over the last 5 years and in every economic downturn in the labor market back to 1988.

i-Side Economics

Ike Brannon pointed me to a great op-ed piece by Andy Kessler in the Wall Street Journal last Tuesday describing comparing the New Keynesian spending policies of the Obama administration over the last three years to what he calls "i-side economics" ("i stands for "investment"), which is just a clever rebranding of the supply-side economics. The idea is that taking government funds (that have to come from somewhere) and giving them to someone does not create anything. It is investment that creates value and permanent new jobs. Very nice piece.

Problems with Pay-as-you-go

From the Deseret News, July 16th

The U.S Social Security system is in big trouble.  While the trust fund balance today is just over two and half trillion dollars, this amounts to about four years of benefits payments.  And while the balance on the trust fund has been rising every year since the fund was created in 1987, it will not be long before demographics cause that trend to reverse.  We need to reform Social Security and the longer we wait, the bigger the burden of reform we become.

This article comes out in the Deseret News tomorrow morning.

The U.S. economy has been through several rough years, beginning with a severe recession in 2008 and an anemic recovery since.  The economy has actually been growing since June of 2009, but it hasn't felt like it to many Americans.  Jobs have been slow to recover compared to most postwar recessions.  Despite the weakness of the recovery, things are not as bleak as they seem.  The longer the recovery remains weak, the greater the potential for future economic growth.

What Causes Economic Growth?

Today's column from the Deseret News

This semester I have been teaching a class at BYU on economic growth.  One of the anticlimactic moments in the class comes near the end when I try to summarize the various theories and models of growth we have covered.  We try to determine by an appeal to the evidence which of these is the best explanation of observed growth patterns.  The bottom line is that we don't really know.

On Taxes

Published this week in the Deseret News.

Taxes are in the news these days.  Both Rick Santorum and Mitt Romney recently released tax plans as part of their campaigns for president.  And the Obama administration released a new budget proposal for the coming fiscal year that alters some key tax rates.

Taxes are important for a variety of reasons.  Few people enjoy paying them, but they are necessary if the government is going to, in the long run, pay for the goods and services it consumes along with the goods, services and transfer payments it provides to the public.

Did the 2009 Stimulus Package Work?

This article appeared in the Deseret News yesterday.

Congress passed the American Recovery and Reinvestment Act in February of 2009. If you will recall, at the time it was touted by its proponents as an economic treatment for the recession caused by the housing financial crisis that preceded it.

Why Jobs are Important

from Today's Deseret News:

The U.S. job market is showing signs of improvement if the latest data are accurate.  On Friday the U.S. Bureau of Labor Statistics reported that the unemployment rate has fallen to a three-year low of 8.5%.  Of particular note is that private sector employment was up more than expected in December.  Tall of this could just be a one-month data fluke, but it is also encouraging that the number of new jobless claims has been declining recently as well.

This article appears in print tomorrow, November 29th, 2011 in the Deseret News.

Several years ago I heard a joke about two macroeconomists who went hunting with a non-economist colleague.  As they tracked a deer up a slope and over the crest of a hill, they noticed it edge into a clearing, making a perfect silhouette on the horizon.  Within heartbeats of each other the two economists fired.  One missed by ten feet to the right and the other missed by ten feet to the left.  The deer ran off immediately, unharmed and the two men yelled in joy and began to hive five and slap each other on the back.  Their colleague asked how they could be so excited when they had both missed by a substantial margin.  They replied. "Yes, we missed.  But on average we hit him right between the eyes!"
This article is from the Deseret News on Nov. 14th

In the last article in this series, I talked about how economic stimulus is supposed to work.  The basic premise is that when the government spends more money on goods & services, they more than replace the spending that households would've done without the stimulus.  That is the marginal propensity to consume (MPC) of the government is higher than that of households.

Economist Robert Barro has argued for the past thirty years or so, that this simple story ignores important aspects of household reasoning.  Imagine for example, that the government decides to run a budget deficit by lowering taxes.  This should be stimulative, since it leaves more money in the hands of consumers, who will presumably spend at least some portion of it (based on their MPC).  Barro argues, however, that rational households will realize that cutting taxes today and leaving spending unchanged does not mean taxes can stay permanently lower.  Such a policy is unsustainable over a long period of time.  Forward looking households will realize that lowering taxes today means raising them in the future (holding government spending constant over time in our example).  As a result they have a lower tax burden today and higher taxes in the future.  Since most consumers prefer consumption that is smoothed out over time, rather than high consumption now and low consumption later, the best behavior is to save.  Barro showed that under certain circumstances households increase their savings by exactly the same amount as the government reduced their taxes.  This leaves consumption unchanged and hence gives not stimulus at all.

 Barro has termed this effect "Ricardian equivalence" based on work by David Ricardo in the 1800's. As mentioned, Ricardian equivalence holds only in certain circumstances.  First, all consumers need to be rational and forward looking.  If some consumers do not care about the future, they will view a drop in taxes today as an increase in spendable income and increase their consumption.  If some consumers do not expect to be alive when the tax increase occurs they will also be likely to increase their consumption.  In these cases, there will be a stimulative effect of cutting taxes, even when it must necessarily be a temporary cut. 

Similarly, if the government increases spending and does so by borrowing money, rational households will realize that even though taxes don' t rise today, they must eventually rise at some future date.  The further off into the future that date is expected to be, the greater the number of households that will expect to be dead when the increase hits.  And, hence, the greater the stimulus will be.

A perfect example of this effect occurred in 1992 when Presidents Bush used an executive order to reduce federal withholding of taxes from people's paychecks.  The order did not change their overall tax burden; the same amount of taxes was due on April 15th.  However because withholding was lower the expected payment (refund) in April was larger (smaller) than before the change.  Since almost everyone in the economy expected to be around when the tax bill came due, this is an almost perfect implementation of a policy subject to Ricardian equivalence.  The response was exactly what Barro predicted, consumers saved most of their withholding and the policy had virtually no effect on the macroeconomy.

Very few economists believe that Barro's strict version of Ricardian equivalence where stimulus spending has zero effect is correct.  Nonetheless, his point is well taken.  That is, the effects of a stimulus are likely to be much smaller than those predicted by standard Keynesian models.  The effects are also likely to be larger when the future burden of paying for the stimulus is paid by future generations.  Stimulus spending that is paid back in the near future is likely to have very small effects.

As citizens and voters we need to ask ourselves if the short-run gain from a meaningful economic stimulus is worth the cost it imposes on future citizens and voters.
This article appeared on Tuesday, November 1st in the Deseret News.

In February of 2009 congress passed and President Obama signed the American Recovery and Reinvestment Act.  At the time it carried an estimated price tag of $787 billion.  Commonly referred to as "the stimulus bill," it was intended to reinvigorate an economy battered by the subprime mortgage financial crisis.  In September of this year, President proposed the American Jobs Act, which is also intended to invigorate the economy and spur jobs creation.  Under this act an additional $447 billion will be spent, leading some people to refer to it as "Stimulus Jr."

How exactly is increased government spending supposed to stimulate the economy.  The basis for this prescription lies in a particular school of macroeconomic thought known as Keynesianism.  The name comes from the famous British economist, John Maynard Keynes.  When he came up with his theories Keynes had in mind an economy mired in recession or depression, as was the case around the world during the 1930s.  In this environment Keynes claimed that workers and firms stood ready and willing to produce goods at the prevailing prices, if only someone would buy them.  This is the description of a market surplus, which occurs in individual markets occasionally for a variety of reasons.  Keynes argued there was an economy-wide surplus of goods, not just a surplus in a few scattered markets.

Normally with surpluses markets respond by lowering prices to clear the market, so that all goods offered for sale are purchased.  Think of sales on day-old bread or DVDs in the discount rack and you get the right idea.  However, Keynesian theory postulates that prices are slow to adjust, particularly downward.  This is referred to as price "stickiness" and it implies that markets will remain in surplus for long periods of time.  In the long run prices will eventually fall and markets will clear, but as Keynes famously quipped once, "In the long run we are all dead."  Hence, we may be quite concerned about what happens in the short run while prices are not adjusting.

In this scenario the problem with the economy is coming from consumers on the demand side.  They are not spending enough to purchase all the goods offered for sale.  A Keynesian prescription is to let the government purchase goods and services instead.  In theory this increases the demand for goods.  Firms sell goods that would otherwise remain unsold or not even produced in the first place.  And workers go back to work producing those goods.

There are complications, however.  The government needs to get the money to pay for these purchases somehow.  If it raises taxes, and uses the increased revenue to buy goods, it is also lowering the income of the households and businesses it taxes.  As a result, they spend less even as the government spends more.  Whether this leads to a net increase in the demand for goods depends on whether those taxes reduce their consumption of goods by more or less than the government increases its consumption.  Economists call this the marginal propensity to consume or MPC and argue that the MPC of the government is close to 100% (at least for stimulus spending) while the MPC of consumers in less than that.   Hence, a stimulus increases government spending more than it depresses private spending and yields a net increase in demand.

If, however, the government pays for spending by running a deficit, private spending need not fall, because households are not taxed and need not reduce spending.  This reasoning is why the traditional Keynesian policy prescription is to stimulate via deficit spending in a recession.

Since Keynes, macroeconomic theorists have run across flaws in this reasoning, however.  For example, when the government runs a deficit, it borrows more money from the general public.  When domestic households lend to the government, they voluntarily reduce spending and buy government bonds instead.  Hence, deficit-financed stimulus looks very similar to tax-financed stimulus in its overall effects.

Another reason why stimulus spending may be less effective than Keynesian theory suggests is that the effects depend crucially on how the money is spent.  For example, older and younger people may have different MPCs.  The old have less of a savings motive than the young.  Indeed most retired workers are dissavers, withdrawing funds on net from savings accounts and pensions.  If a stimulus package reroutes money from the old to the young it can actually reduce demand.

Recent studies suggest that much of the money from the 2009 stimulus was transferred to state and local governments for local spending projects.  However, many of these governments had quite low MPCs and used these stimulus funds directly or indirectly to pay off or avoid debt.  In other words they saved the money rather than spent it.  This may be one reason the stimulus was so much less effective that its proponents believed it would be.

Additional problems with stimulus spending include the effect it has in the long-run on burdens of taxation and expectations of future taxes.  More on those issues will be forthcoming in a later column.

Rational Expectations?

This article came out in the Deseret News on Tuesday, October 18th.

Last Monday the Nobel prize in economics was awarded to Tom Sargent and Chris Sims.  Both are well-known macroeconomists and both have worked on economic issues relevant to the 2008 recession and recovery.

Forecasting the future of the economy is tricky business.  For one thing it is very complicated, with millions of goods and services changing hands.  Another reason is that it is subject to changes in the economic environment that are not economic in nature; weather and politics being two good examples.  Forecasting how the economy will behave requires simplifying models that capture most of its features without adding too much complexity.  Over the years, economists have developed increasingly sophisticated ways of doing this.

By way of analogy consider the portion of U.S. Highway 6 that runs between Spanish Fork and Price.  I drive this stretch of road on occasion on my way to the San Rafael Swell.  The road goes up Spanish Fork Canyon, over Soldier Summit, and down Price Canyon.  It is necessarily winding and steep in many places.  Suppose you were tasked with forecasting the fate of a convoy of vehicles traveling over this road.

A simple first stab at the problem might involve using elementary physics.  The vehicles have given weights, they travel at certain speeds over different portions of the road, the road's gradient and curvature are known.  Based on this information you could, with some effort, derive a forecast for the progress of the convoy.

However, to improve your forecast, you might also consider the weather.  Unfortunately, the weather is changeable.  You have a general idea of conditions, but the specifics at each point on the road are not known.  Furthermore, these conditions can change unexpectedly.  You need to make a best guess and factor this into your forecast.  You will also need to update it as the convoy progresses and available information changes.  The same principle applies to other factors like the mechanical condition of the vehicles, and the mental condition of the drivers.

When you make your forecast you realize that it is only a best guess.  It is subject to change due to factors that are difficult to predict.

If you had some control over the highway or the vehicles you might be able to reduce the chances of a serious slowdown or pileup.  Suppose you had a radio controller that could uniformly boost or reduce the amount of fuel all the vehicles consume.  If conditions looked dangerous you could dial down consumption of gas, slow the convoy down, and reduce the chances of something bad happening. 


This type of forecasting and policy recommendation corresponds roughly to state-of-the-art economic forecasting prior to the introduction of Rational Expectations theory thirty to forty years ago.  Tom Sargent was an important contributor to that literature.  Chris Sims' contribution was to develop statistical techniques that identify how economic variables influence each other as time progresses.

When you cut back gas consumption you assumed this would make the cars go slower.  However, drivers are not automatons and they adjust their driving behavior based on the conditions they observe.  They do this by gathering all the relevant information they can: direct observation of the road through the windows, listening to the radio, talking with other drivers on cell phones, etc.  When things look dangerous, they slow down on their own.  If you dial down the gasoline flow, drivers will simply push harder on the accelerator to compensate and will maintain the speed they think is best.  .  Ignoring the responses of the drivers (decision makers) in the convoy (economy) to your manipulation of the gas flow (economic policy) gives bad forecasts.  Good forecasts will incorporate these rational responses.

The 2008 financial crisis and recession have been held up by some people as evidence that Rational Expectations is incorrect.  If decision makers are gathering information and processing it effectively, how could they have missed the subprime meltdown?  Why did they ignore the warnings of those who were warning against just such a meltdown at the time?

Go back to the convoy.  Suppose you have a fellow forecaster who believes the brakes on a large semi-truck are about to fail.  As the convoy makes each turn along the route he announces over the radio to all concerned that the semi is about to run out of control, tip over, and cause a massive pileup.  However, for the first several turns the brakes hold and the convoy continues on unharmed.  Eventually, everyone discounts his predictions of doom.  If the brakes finally do fail, it comes as big surprise to almost everyone.  Why did drivers not foresee the crash?  Why did they ignore the voice on the radio?  Because the problem was small, subtle, not readily apparent to anyone but an expert, and the exact moment of failure was largely random.

The problem is not that the forecasting methodology is wrong.  Rather, it is that unexpected or difficult to predict events can in some circumstances have huge consequences.  They are easy to see in hindsight, but not so easy to see before they happen.  One message the Nobel committee sent was that rational expectations is still an important piece of economic theory.

Is another recession on the horizon?

This article appeared in the Deseret News on Tuesday, October 4th.

According to the National Bureau of Economic Research (NBER) our most recent U.S. recession began in December 2007 and ended 18 months later in June 2009.  There are no precise criteria for deciding when recessions begin and end.  Instead, the NBER uses a variety of economic data to reach a consensus on the dates.  The general idea is to look for turning points in economic activity.  A peak, when economic activity begins a sustained fall is the beginning of a recession.  A trough, when the economy stops shrinking and begins to expand again is the end.  One commonly used rule of thumb is that a recession is at least two quarters of falling inflation-adjusted gross domestic product (GDP), while a recovery is two quarters of rising GDP.

Not all recessions and recoveries are equal, however.  A downturn can be mild as the one from July 1990 to March 1991 was, when GDP fell by 1.3%.  Or it can be severe like the most recent one where GDP fell by 5.1% from peak to trough.  In addition, recoveries can be anemic or robust.  For example GDP grew almost 14% in the two years following the 1981-82 recession, while it has only grown 5% in the two years since the end of the last recession.

What exactly causes a recession is a matter of intense debate amongst macroeconomists.  It is likely that there are many causes.

Keynesian theories focus on the role that consumer confidence plays in recessions.  When consumers begin to feel pessimistic about the future, they will save more and spend less.  This leads to a decrease in demand for goods and services.  If the prices of goods are slow to adjust, this will, in turn, lead to a surplus of production and firms will begin to lay off workers.

New classical economic theories point to the role of technology.  When there is a drop in productivity, firms will be unable to produce as many goods as they could previously.  The drop in worker productivity leads firms to lay off workers and leads to a recession.  It also causes capital to be less productive and this leads to large drops in purchases of investment goods.  New classical economists realize that technology rarely decreases, but they point out that energy price increases and increases in taxes are often identical in terms of their effects on firms.

Financial crises can also cause recession if they have a major impact on the banking sector.  When banks are in financial trouble they are reluctant to lend to businesses, and many sectors of the economy rely on bank lending to cover up front costs.  Residential construction and shipbuilding are two good examples.  A loss of lending forces these firms to lay off workers since they cannot borrow the money to pay their wages.

Our most recent recession was caused primarily by the subprime mortgage financial crisis.  The resulting drop in consumer confidence was likely an important contributing factor.  The anemic recovery, however, is likely due to other causes.  One facet of recent recoveries has been the slow rebound in employment.  This is especially true of the past two years.  A great deal of this is due to government policy.  Increases in personal and corporate income taxes are very similar to drops in technology from the point of view of firms hiring workers.  It makes no difference to the firm if revenue is lost because the firm is less efficient than before or because the government takes more in taxes.  Expectations of increased taxes act as a powerful disincentive to businesses.  Since most business operators dislike dealing with uncertainty concerning the future business environment, even uncertainty about whether taxes will go up or not, can act as a drag on the economy.  The expectation of increased government regulation can also mimic a productivity drop.  When particular methods of production are banned or made more costly, this forces firms to adopt different production techniques that are likely less efficient (else the firm would already be using them).

Are we headed toward another recession soon?  It is difficult or impossible to say for certain.  Unpredictable future events will have bigger effects than anything foreseeable right now.  The unfolding sovereign debt crisis in Europe has the potential to stress the banking sector.  But a banking meltdown is not a foregone conclusion.  Increased taxes are a possibility, particularly with the increased attention the public and policymakers are placing on reigning in government deficits.  However, budgets can be balanced by cutting spending rather as well, so it is entirely possible that tax rates will not be raised.  The implementation of Obamacare has the potential to impose costly regulation on firms that would lead to a drop in productivity.

One thing that is certain is that there will be another recession sometime.  It may begin this year or we may be lucky enough to go a decade or more without one.  When making financial plans for the future it is always a good idea to remember that recessions are a recurring feature of the economy.

This article was published in the Deseret News on Tuesday, September 20th.

The Greek financial system is in big trouble right now.  The fundamental problem is that the Greek government has been on a bit of spending bender over the past few years and has borrowed a lot of money to pay for this, all of it denominated in euros.  It has become frighteningly clear that this level of debt is unsustainable and the Greek government needs truly radical fiscal reform to avoid defaulting on its outstanding debt.  Much of that debt is held in the form of Greek government bonds by Greek banks, but a large amount is also held by various financial institutions outside of Greece.

By itself this is not really a very interesting or important situation.  There are a large number of countries in the world and inevitably, some of them get into fiscal trouble.  Some sort of financial crisis of this sort happens on a fairly regular basis.  Greece is, however, a member of a monetary union.  And its financial health could have an effect on the financial health of other members of that union.

The euro is a unique currency because it is issued by a collection of sovereign states, rather than by a single country as is usually the case.  The currency was formally introduced into circulation in 2002 and replaced the national currencies of the participating countries.  Control of the euro money was given to the European Central  Bank (ECB), which was created with the sole purpose of managing the euro.   When the euro was created it was very clear that all member countries would be using a single currency and would therefore be unified monetarily.  It was not clear, however, how unified these countries would be in fiscal terms, however.  There is no governmental equivalent to the ECB.  There is a European parliament, but there is no central government with authority to tax and spend for the European Union as a whole.  Fiscal matters are, in theory, left entirely to the individual member countries. This means there is no natural central source of funds to "bail out" the Greek government.  The two bailout packages worked out so far have been hammered out via complex negotiations between Greece, the ECB, and other European governments.

Suppose Greece decides it is going to default on its government bonds.  Does this necessarily mean that the euro as a currency is in trouble?  Not necessarily.  In fact, if there is no expectation that Europe is a fiscally united, then there should be no issue at all.  Greek bonds, though denominated in the same currency as German bond, already pay higher interest rates due to their higher probability of default.  If the Greek government decides to default, things could get really bad for Greece, but it need not affect other European countries.  The fact that German and other European banks hold Greek government bonds could lead to increased stress on the banking sectors in those countries, but it need not lead to dissolution of the euro as a currency.

However, a problem does arise with one the way that Greece might choose to default on its debt.  Rather than default outright, the Greek government could choose to drop out of the euro zone and reintroduce their previous national currency, the drachma.  They could do this by initially trading all euro amounts in Greece one-for-one with drachma, for example, and legally rewriting all contracts in euro to contracts in drachma.  Then the Greek central bank could drastically increase the number of drachma in circulation and repay its nominal debt with this new money.  The result would be a devaluation of the drachma.  Greek assets would be worth less on the world market, just like a default, but a formal default would be avoided.  In effect, Greece would be solving its fiscal problems by imposing an inflation tax and at least some of the burden of that tax would fall on non-Greek holders of Greek government bonds.

Now suppose you had a time machine and knew for certain that this was going to happen on Dec. 31st 2011.  What should you do today?  You should sell any Greek assets you hold today to avoid the inevitable loss in their value when the drachma is devalued.  If you are a savvy investor you might take profits by short-selling Greek debt.  Even if you don't have the time machine and are uncertain what is going to happen, you might still find it prudent to sell.  When all or most investors do this, the result is a worsening of the financial crisis.

If investors feel that Greek devaluation is becoming more and more likely, it is only natural that they begin to look at other European countries with similar fiscal problems.  These countries include Ireland, Spain, Portugal, and perhaps even Italy & France.  If enough countries choose to withdraw and devalue their currencies - particularly if either of the latter two do - then the euro as a multinational currency will effectively be dead.

Greek fiscal problems don't automatically mean the euro is doomed, but it is very easy to see why policy makers in Europe and elsewhere are worried that events are moving in exactly that direction.

This article was published in the Deseret News on Tuesday, September 6th.

Money in most countries in the world is issued by a central bank that is granted the monopoly right to issue the nation's currency.  In the United States the central bank is actually a system of 12 regional banks that are controlled by the Federal Reserve Board of Governors in Washington, D.C.  The Federal Reserve System, or Fed, is legally a private enterprise and is owned by member commercial banks.  Effectively, however, the Fed is 4th branch of the government.

The members of the Fed's Board of Governors are all appointed by the President of the U.S.   One of these is selected every four years to serve as the Chairman of the Fed.  Currently the Chairman is Ben Bernanke, who served as a member of the Board under the previous Chairman, Alan Greenspan.  While the Fed is legally owned by the member commercial banks, these banks have little direct input into the governance of the Fed these days.  Member banks elect six of the nine members of each of the 12 regional Federal Reserve Banks board of directors.  This board of directors, in turn, selects a president to run the regional Fed.  In practice, the members of the board and the presidents are chosen in Washington by the Board of Governors.

The Federal Reserve has a great many duties.  It was created in 1914 primarily to serve as a lender of last resort and address a longstanding problem the U.S. had been experiencing with bank runs.  Prior to 1914 the U.S. had no central bank.  There was a brief period early in U.S. history where the First and Second Banks of the United States were chartered and then disbanded, but these banks served mainly as depository and lending institutions for the U.S. government and not as modern central banks.  During most of the 19th century and up through 1913, the U.S. had no central monetary authority that would step in and loan funds to banks that were hit with bank runs.  As a result the nation experienced periodic bank panics where runs would occur on several banks simultaneously and led to nationwide financial crises.  The Federal Reserve System was set up to help alleviate this problem.

The Fed has many other duties as well, including regulatory control over banking, facilitation of check clearing and interbank transfers, and maintaining accounts for many U.S. government agencies.  The most important role the Fed plays, however, is as a creator and controller of the U.S. money supply.

One of the reasons the Fed is structured as it is, is to insulate it from political pressure.  The Fed is largely independent of the Federal government.  Day-to-day operational control is in the hands of the Board of Governors and the governors are appointed to very long terms of 14 years.   If the Fed were more susceptible to political pressure from the president or congress they would be more likely to use monetary policy to finance government spending.

Over the years since 1914 there have been period calls by people to disband the Fed.  The main reason that this has never been done is because the alternative is undesirable.  If you are one of those who is not pleased with the way congress has handled the U.S. budget, imagine what things would be like if congress was also in charge of the money supply.  By insulating the Fed from political pressure, we are able to maintain a much lower rate of inflation than we would otherwise have.  If congress were to take direct control of the U.S. money supply you can be assured that they would quickly give in to the temptation of simply printing whatever money they needed for their desired level of spending.  Delegating control to a central bank that is insulated from political influence makes it difficult or impossible to give in to that temptation.

While having an independent central bank does alleviate some problems, it creates others.  One argument against a central bank is that it is undemocratic.  Monopoly control of the money supply is placed in the hands of officials who are not answerable directly to the public.  This often leads to the perception that the money supply is in the hands of special interests who do not have the best interests of the public in mind.  In some countries and in many historical cases this perception is justified.  It is not so justified in the case of the Fed.

There are alternatives to the Federal Reserve System that are democratic in nature but not prone to inflation.    For example, from 1716 to 1845 Scotland had a free banking system of sorts, where two competing central banks each issued currency.  More generally, free banking would allow commercial banks to issue whatever currency they desired and they could back this currency however they wished as long as the backing was truthfully disclosed. Competitive free banking would allow some banks to issue monies backed by gold or other commodities.  Consumers would be free to choose what type of money they wished to hold and sellers could choose what types of money they would accept as payment.  One interesting new technological option that has many of the aspects of free banking is BitCoin, an online payment system that settles payments on a peer-to-peer basis without using a bank or even a currency controlled by a central bank.

Free banking is unlikely to be adopted as official U.S. policy anytime in the near future.  In the meantime, the Fed will continue to control the supply of dollars.  Despite its shortcomings, the Fed is a much better arrangement that most of the alternatives.

Keynes v. Hayek Rap

Russ Robert's masterpiece:

Note the cameo by Mike Munger.

After getting a B.A. in economics from BYU in 1998, I went to work for Thredgold Economic Associates for two-and-a-half years. Jeff Thredgold took an unconventional route to becoming a Chief Economist for major banks. He came up as a bond portfolio manager. As such, I always felt like he had very good intuition for what was happening in markets on a day-to-day basis.

One of Jeff's most insightful arguments is one that he has been making for as long as I've known him. In this week's issue of his weekly economic newsletter, The TEA Leaf, Jeff drives the point home, yet again, in compelling fashion.

"What [Ron] Paul and other Fed critics don't understand is that the Federal Reserve has an overseer...something or someone IT has to answer to. That something is the American bond market."
Dan Hamermesh is currently visiting BYU as an invited seminar speaker. I was showing him my picture of the normalized peak plot of employment in the last 14 recessions, and he told me about another labor fact from this recession that astounded me. Look at the picture below of average duration of unemployment in the U.S. since 1947. The average unemployment duration for everyone who said they were unemployed in August 2009 was 25 weeks (nearly 6 months). Compare that to the average of about 15 weeks between 1976 and 1992. This is the 60-year record in the U.S.


Dilbert: Not sugar coated

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My 9-year-old son showed me this today, and we laughed our heads off together.

The most recent winner of the Nobel Prize in Economics and New York Times columnist, Paul Krugman, had an eight-page article a week-and-a-half ago in the New York Times magazine entitled, "How Did Economists Get It So Wrong?" In short (and in its best light), his article was a broad critique of macroeconomics of the last three decades and a call to a return of the macroeconomics of the early 1970s. One of my favorite economists, John Cochrane, who we have cited multiple times on this blog for his biting rebuttals to poorly argued attacks (post 1, post 2), issued another instant classic in his response to Paul Krugman's article. Below are some of the highlights.
Finn Kydland was awarded the Nobel Prize in Economics in 2004 with Ed Prescott for their contributions to dynamic macroeconomics. In Kydland's Nobel lecture, he mentioned a truth that every professor of undergraduate macroeconomics has struggled with. "In the past 20 years, the gap between research and textbooks has grown wider and wider." The economic models outlined in undergraduate macroeconomic textbooks have almost no resemblance to the models used in current research, and the difference is the treatment of decisions across time--dynamics.
Greg Mankiw posted this video sketch yesterday from The Daily Show on a major signal that the housing market has not yet stabilized. Hilarious! My favorite part is when Robert Shiller starts giving advice on how Geithner should redecorate his bathroom.

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Chinn on the State of Macro

Menzie Chinn had a great post a week-and-a-half ago addressing the hot topic of the state of macroeconomics. This is something that Jason and I have discussed as well (post 1, post 2, post 3). Chinn has some great analysis of why macro is still very relevant and informative despite many perceived failures in the press. His two main points that jumped out at me were the following:

1) The first dimension on which you should rate any macroeconomic (or any economic) research is "How good is the question?" This is something that was always driven home to me by my macroeconomic professors at the University of Texas. Chinn emphasizes that methodology should follow from the question, not vice versa.

2) "...[T]he supposed failure of macroeconomics is more the failure of macroeconomics as described in the popular press, rather than of the discipline itself...."
The Consumer Price Index (CPI) numbers for June were released today, and the initial press was that inflation was higher than expected. The inflation hawks would point to today's numbers as an indication that the massive injections of money by the Federal Reserve and Congress are starting to increase prices toward the great inflation they have been predicting. But don't go there so fast. Headline CPI inflation increased by 0.7% in June, the highest monthly increase since June 2008. However take a look at the figure below of the headline CPI percent change over the last 12 months.

My son found this for me in today's Sunday comics.

The U.S. CPI numbers came out today (see chart below). A lot of noise was made last week about inflation worries starting to surface in yields from the auctions of U.S. Treasuries. This WSJ piece from last Thursday posited that the higher yields might be signaling inflation in six-to-nine months. Jim Hamilton had a great analysis two weeks ago explaining why we should probably still be more worried about deflation than inflation. I had a post a few months ago debunking some of the inflation rhetoric from the far right. Below is a chart of the core CPI (overall prices minus food and energy) in terms of year-over-year percentage change. We're definitely not in high inflation territory yet.

The Cleveland Fed has put up a site that shows in glorious graphical detail how the Fed's new policy of quantitative easing has developed and grown over the last eight months. The light orange area in the graphic below represents traditional monetary policy. You can navigate through different date ranges and different detail views using menu bars across the top and left sides of the graph. They also include dowloadable source data, brief explanations of the data, as well as a link to a more detailed article.

Thanks to Mark Showalter for pointing me to this great resource, and thanks to the Cleveland Fed for the most simple, beautiful, and interactive display of economic data that I have seen yet. Here's to central bank transparency!


Ford tough, GM rough

With bankruptcy plans finally announced for GM today, I thought it would be nice to revisit a previous post. On December 20, 2008, I posted an article entitled, "Ford tough," in which I praised Ford's decision not to accept government bailout money. I said the following:

The proposed auto bailout has been one of the most discouraging pieces of government action since the beginning of our current financial crisis. Ford's decision to stick with the market is one of the silver linings in the ominous clouds of the global recession. Ford does, of course, run the risk of not beeing able to compete in the short-run with GM and Chrysler and their new influx of government cash. But that's not really where the competition is anyway. The real contest is to see which U.S. company will be able to compete with their Japanese counterparts. I think the market will look favorably on Ford's long-run positioning.

Just look at what has happened to the stock prices of Ford and GM since December 20, 2008. The market has spoken.

Back in March, I wrote a piece entitled, "Overall economy not as bad... relatively" in which I graphically compared the current U.S. recession with the previous 13 recessions including the Great Depression. In that post, I concluded that the recession at that time was not the biggest since the Great Depression. This current post presents updated graphics and provides evidence that this is now the biggest U.S. recession since the big one at the beginning of the 1930s.