The Next Team

What would you call a group of economists who are skeptical of regulating mortgage markets, who think unemployment insurance and unions increase unemployment, who say that tax hikes retard economic growth, and who believe that the recovery from the Great Depression was a monetary phenomenon rather than the result of New Deal fiscal policy?

No, it is not a right-wing cabal. It's Team Obama.

Here's the evidence:

When Senator Christopher J. Dodd, Democrat of Connecticut, gave his opening statement last week at the hearings lambasting the rise of “risky exotic and subprime mortgages,” he was actually tapping into a very old vein of suspicion against innovations in the mortgage market.....Congress is contemplating a serious tightening of regulations to make the new forms of lending more difficult. New research from some of the leading housing economists in the country, however, examines the long history of mortgage market innovations and suggests that regulators should be mindful of the potential downside in tightening too much.

--Austan Goolsbee

Unemployment insurance also extends the time a person stays off the job. Clark and I estimated that the existence of unemployment insurance almost doubles the number of unemployment spells lasting more than three months. If unemployment insurance were eliminated, the unemployment rate would drop by more than half a percentage point, which means that the number of unemployed people would fall by about 750,000. This is all the more significant in light of the fact that less than half of the unemployed receive insurance benefits, largely because many have not worked enough to qualify.

Another cause of long-term unemployment is unionization. High union wages that exceed the competitive market rate are likely to cause job losses in the unionized sector of the economy. Also, those who lose high-wage union jobs are often reluctant to accept alternative low-wage employment. Between 1970 and 1985, for example, a state with a 20 percent unionization rate, approximately the average for the fifty states and the District of Columbia, experienced an unemployment rate that was 1.2 percentage points higher than that of a hypothetical state that had no unions.

--Larry Summers

Tax changes have very large effects on output. Our baseline specification suggests that an exogenous tax increase of one percent of GDP lowers real GDP by roughly three percent.

--Christina Romer (writing with husband David)

Given the key roles of monetary contraction and the gold standard in causing the Great Depression, it is not surprising that currency devaluations and monetary expansion became the leading sources of recovery throughout the world....the new spending programs initiated by the New Deal had little direct expansionary effect on the economy.

--Christina Romer

All points well taken. Indeed, quotations like these make me pleased with recent economic appointments. I just hope that the above lessons make their way into the President-elect's briefing memos and that he is persuaded by them.

These quotations also make me a bit surprised we have not heard more complaining from the left-wing of the Democratic party. But that may be still to come.

Job Market Signaling

Memo to new econ PhDs on the job market: Click here immediately to get some time-sensitive news from Al Roth's blog.

Everyone else: Ignore this post.

Lessons from the Crisis

As seen by Michael Spence.

Mike says a lot of smart stuff in this article. But this sentence seems to veer off in the wrong direction, or at the very least could be easily misinterpreted:

we need a commission of top industry professionals and academics to address the challenge of measuring and detecting systemic risk and provide the underpinning of an effective “early warning” system.

I see little hope of creating any kind of "early warning" system, if by that Mike means better forecasting. Crises like the current one are inherently unpredictable. If they were predictable, hedge funds and other money managers would not lose so much money during them.

True, a few people were sounding an alarm in advance of the current crisis: Nouriel Roubini, in particular, comes to mind. And a few hedge funds have made money during the crisis. Yet that fact is not very meaningful. Given the diversity of opinion at any point in time, someone will always look right ex post. The key question is whether the event is reliably predictable ex ante.

Policymakers at the Fed and Treasury cannot do better than rely on the consensus judgment of experts, and a couple years ago the consensus opinion was not predicting anything like what is now occurring. To suggest a regulatory system that gives an "early warning" is like saying we need to find a better crystal ball. Good luck with that.

In my view, the key to regulatory reform is not trying to predict the future with more accuracy but, instead, making the system more robust so that the economy functions better when the unpredictable inevitably occurs. In other words, our focus needs to be not on what will happen but on what might happen.

A Keynesian Moment

Click here to read my essay appearing in tomorrow's New York Times.

Stimulus for Skeptics

David Brooks channels Harvard's Michael Porter.

Moral Hazard

Time to Start Christmas Shopping

If you are looking for a gift for someone you think should learn a little economics, check out this new book by Nariman Behravesh. The book lives up to its subtitle: "A No-Nonsense, Non-Partisan Guide to Today’s Global Economic Debates."

Nariman Behravesh is chief economist at Global Insight, the economic analysis and forecasting firm that evolved from Otto Eckstein's DRI and Larry Klein's Wharton Econometrics. About thirty years ago, Nariman was my boss, when I spent a summer as an intern at the Congressional Budget Office. I learned a lot working for him, and now, through this book, many other people can as well.

As I post this, the book is number 41,218 in the Amazon sales ranking. I hope a little free advertising on this blog manages to improve that a bit. It deserves to be much higher.

Update, same day, about 15 hours later: The book is now up to number 998 at Amazon. A nice demonstration of the power of the blogosphere.

Reallocating Resources

Bob Crandall and Cliff Winston of Brookings opine on the problems facing the auto industry:

In our judgment, based on experience elsewhere in American industry, the most constructive role the government can play at this point is to provide a short-term infusion of capital with strict repayment rules that will essentially require the auto makers to sell off their assets to other, successful companies.

Who are the most exploited workers in the American economy?

The University of Chicago's Allen Sanderson has an answer.

Happy Thanksgiving!

Redefining "grownup" and "hack"

In a post about the Obama economic team titled The Grownups are Coming, Paul Krugman writes:

Seriously, isn’t it amazing just how impressive the people being named to key positions in the Obama administration seem? Bye-bye hacks and cronies, hello people who actually know what they’re doing.

Like Paul, I am impressed by the new economic team. I know best the three economists coming from academia--Larry Summers, Christy Romer, and Austan Goolsbee--and they are all first-rate. They are excellent choices.

But are they really in a different class than those in the previous administration? Based a standard ranking of economists' academic accomplishments as of October 2008, here is where these three stand (out of more than 18,000 economists), together with the rankings of all the CEA chairmen appointed by President Bush:

11. Larry Summers
21. Greg Mankiw
35. Ben Bernanke
99. Eddie Lazear
132. Glenn Hubbard
249. Harvey Rosen
391. Christy Romer
653. Austan Goolsbee

Judging by this objective criterion, it looks like the two adminstrations are drawing economists from roughly the same talent pool.

Of course, if one defines "grownup" as a person who agrees with Paul Krugman, and "hack" as a person who does not, then one might come to a different conclusion.

Cooley on Human Capital

NYU economist Tom Cooley wants to Prime The Pump With Education Spending.

My one addendum: As we're doing this, let's not forget to buy a lot of textbooks.

An Open Letter to the New President

From the greatest economist of the day.

NPR reads this blog

Listen to the evidence.

What's wrong with the efficient scale?

Reuters reports:

President-elect Barack Obama vowed on Tuesday to cut billions of dollars from wasteful government programs....An obvious example, Obama said, were reports of crop subsidies to farmers who make more than $2.5 million per year.

Like President-elect Obama (but unlike candidate Obama), I am all for getting rid of farm subsidies. But why would you want to use taxpayer funds to encourage large, efficient, profitable farms to break up into smaller, less efficient, less profitable farms? Isn't that precisely what you do if you maintain subsidies only for small farmers?

As all ec 10 students know, competitive markets push firms toward the efficient scale, defined as the level of production that minimizes average total cost. The low costs are in turn passed on to consumers in the form of low prices. These conclusions no longer hold true, however, if government policy tilts the playing field by rewarding small scale.

Update: Hal Varian's best-selling intermediate microeconomics textbook tells this story:

The Food Security Act of 1985 significantly restricted the payments to large farmers. As a result, the farmers broke up their holdings by leasing the land to local investors. The investors would acquire parcels large enough to take advantage of the subsidies, but too small to run into the restrictions aimed at large farmers. Once the land was acquired the investor would register it with a government program that would pay the investor not to plant the land. This practice became known as "farming the government.''...

Note that the ostensible goal of the program---restricting the amount of government subsidies paid to large farmers---has not been achieved.When the large farmers rent their land to small farmers, the market price of the rents depends on the generosity of the Federal subsidies.The higher the subsidies, the higher the equilibrium rent the large farmers receive. The benefits from the subsidy program still falls on those who initially own the land, since it is ultimately the value of what the land can earn---either from growing crops or farming the government---that determines its market value.

Thanks, Hal, for sending this in.

The Return of Larry

David Leonhardt on Larry Summers.

Income Elasticity of Mistress Demand

From the Wealth Report:

You know times are tough when the rich start cutting costs on their mistresses. According to a new survey by Prince & Assoc., more than 80% of multimillionaires who had extra-marital lovers planned to cut back on their gifts and allowances. Still, only 12% of the multimillionaire cheaters said they plan to give up on their lovers altogether for financial reasons.

Competing Alliteration

Instead of fiscal stimulus that is temporary, targeted, and timely, John Taylor suggests that it be permanent, pervasive, and predictable.

What the Obama administration is aiming for, it seems, is helpful, hopeful, and humongous.

Critics fear it might end up pointless, political, and pork-filled.

-----

Update: A reader emails me that Larry Summers now calls for stimulus that is speedy, substantial, and sustained.

Other readers think it will be:

• big, bloated, and borrowed.
• immodest, immoral, and imbecilic.
• clumsy, corrupt, and counterproductive.
• expansive, extensive, and expensive.
• weighty, worrisome, and wayward.
• politicized, pandered, and pathetic.
• socialized, silly, and sorry.
• random, record-setting, and ridiculed.
• ultimate utilitarian utopianism.
• absolutely abjectly apocalyptic.

Ben and the Crisis

A New Yorker profile of Ben Bernanke.

The Financial Crisis

1. As seen by Martin Baily, Bob Litan, and Matthew Johnson.
2. As seen by Bob Hall and Susan Woodward.

Christy Romer to the CEA

President-elect Obama plans to name Christina Romer... to chair his Council of Economic Advisers.

An excellent choice.

$280,000 per job

The Washington Post reports:

Facing an increasingly ominous economic outlook, President-elect Barack Obama and other Democrats are rapidly ratcheting up plans for a massive fiscal stimulus program that could total as much as $700 billion over the next two years....Obama has set a goal of creating or preserving 2.5 million jobs by 2011.

Dividing one number by the other, that works out to $280,000 per job.

What is going on here? Logically, it must be one of three possibilities:

1. The fiscal stimulus is going to be much smaller than is being reported.
2. The new administration is setting a low bar for itself when it comes to job creation.
3. The Obama team believes in very small fiscal policy multipliers.

Let me amplify the last point with a rough back-of-the-envelope calculation. The average weekly earnings of production and nonsupervisory workers is about $600, or about $60,000 over a two-year period. Granted, labor income is only about two-thirds of national income, and we have to add a few supervisors into the mix. So let's say each job created means $100,000 of extra national income. If we are generating $100,000 of income with $280,000 of government spending, the multiplier is only 100/280, or 0.36. By contrast, traditional Keynesian models suggest a multiplier closer to 2.0.

----

Update: Readers have sent me several suggestions for how to reconcile the multiplier numbers. First, annual GDP per worker is larger than the $50,000 figure implicit in the above calculation. Second, because of labor hoarding in downturns, the percentage change in GDP could be larger than the percentage change in employment. Third, part of Obama stimulus may take the form of tax cuts rather than spending hikes; the traditional Keynesian multiplier for a tax cut is about 1.2 rather than 2.0. Finally, as I noted in my original post, the Obama plan could well be less than $700 billion. All good points.

The Outlook

This figure, from Menzie Chinn, shows log real GDP, from 26 Sep 08 final release (red), from 30 Oct 08 advance release (blue), potential GDP (black), the mean forecast from the Wall Street Journal's October survey of forecasters (pink circle), and from the November survey of forecasters (teal triangle).

Real GDP a year from now is forecast to be about 5 percent below potential.

Summers to the NEC

Larry Summers is going to be director of the National Economic Council.

I wonder: What role will the Council of Economic Advisers have in the new Obama administration? And how will the CEA and NEC get along?

When I worked for President Bush as CEA chair, the NEC and CEA had distinct and complementary roles. The CEA was staffed by professional economists, many from academia, whose expertise was economic analysis. By contrast, the NEC was staffed by those with experience on Wall Street and Capitol Hill. The NEC's main role was to coordinate the policy process, to act as an honest broker, to make sure that all points of view were heard, and to facilitate discussion among the relevant departments so all felt they had a fair shot to make their case. Steve Friedman, formerly of Goldman Sachs, ran with NEC with impressive intelligence, humility, and diplomacy.

But the situation will likely be very different with Larry as head of the NEC, and perhaps Jason Furman as his deputy. Their skill set will overlap substantially with the three members of the CEA. In other words, the NEC and CEA will be more like substitutes than complements.

Only time will tell how well this alternative organizational structure will work.

News Flash

Wall Street Journal: Bankruptcy Is Option to GM Board

Associated Press: GM says board doesn't see bankruptcy as option

Treasuries as Negative Beta Assets?

As the above graph illustrates, the relationship between Treasury securities and inflation-indexed bonds has been very odd of late. The blue line is the yield on 5-year nominal Treasuries. The red line is the yield on 5-year inflation-indexed Treasuries.

My colleague Robert Barro suggests a hypothesis:

Greg:

Had an interesting discussion with [xxxxx] about the odd recent behavior of indexed-bond rates. The basic idea is that, in the present environment, nominal Treasuries have a negative beta. If we go into Depression, the expectation is that this will be accompanied by substantial deflation, so that Treasuries will do well in real terms. In contrast, the typical pattern is different--perhaps bad times are usually accompanied by high inflation or at least average inflation. Therefore, especially at the shorter end, the relation between indexed and conventional Treasuries has shifted--the real rate on indexed bonds now has to be well above the expected real rate on nominal bonds. This observation also means, particularly at the shorter end, that the spread provides little information about expected inflation.

Of course, there are also liquidity stories, concerning the thinness of indexed bond markets. But I don't think this would apply particularly to shorter maturities. And the market has always been relatively thin.

Robert

Thanks, Robert.

Lessons from the New Deal

As seen by GMU economist Tyler Cowen.

A Macroeconomic Puzzle

(Click on the graph to enlarge. The blue line is the value of the dollar in foreign exchange markets. The red line is the yield on five-year inflation-indexed bonds.)

For those of you who teach macroeconomics, here is a question to spark class discussion.

You observe an economy sinking in recession. As this occurs, real interest rates are rising, and the currency is strengthening. What shock, or set of shocks, could have caused these events?

Glaeser on the Auto Industry

Another economist for Chapter 11.

An Underserved Market

Thanks to my friend Mark Showalter for sending this in.

What is the Fed to do?

This picture from Paul Krugman is deeply troubling. It shows the real interest rates on corporate bonds, with the expected rate of inflation from the spread between 20-year TIPS and 20-year Treasury rates.

The Fed is supposed to cut real interest rates as the economy weakens, but the opposite seems to be happening. The problem is that the Fed is close to its zero lower bound on the federal funds rate, perceptions of credit risk are rising, and expected inflation is falling. Indeed, as I pointed out yesterday, people are increasingly concerned about possible deflation.

What is the Fed to do (other than pray)? Expectations management is the key.

Here is one idea. Suppose the Fed cuts the federal funds rate once again to, say, 25 basis points. More important, at the same time, the Fed announces a target path for the price level as measured by the core CPI. The price path might be, say, an increase of 2 or 3 percent per year. The Fed promises not to raise the fed funds rate over the next 12 months and, after that, will keep the funds rate at that low level as long as the price level is significantly below its target path.

The credibility of the promise is paramount. To get long-term real interest rates down, the Fed needs to convince markets that it will vigorously combat deflation, and that if deflation happens in the short run, the Fed will reverse it by subsequently producing extra inflation. A credible promise of subsequent price reversal after any deflation ensures that long-term expected inflation stays close to the inflation rate implied by the Fed's target price path. Monetary economists will recognize that this policy is price-level targeting rather than inflation targeting.

Would such an announcement by the Fed have the credibility it needs to work? Would such a monetary policy be enough to avoid a deep downturn? I am not sure. That's where the prayer part comes in.

A Sustainable Auto Industry

Dartmouth economist Matthew Slaughter:

On Sunday, President-elect Barack Obama asked, "What does a sustainable U.S. auto industry look like?"

Well, it looks a lot like the automotive industry run by "foreign" car companies that insource jobs into the U.S. In 2006 these foreign auto makers (multinational auto or auto-parts companies that are headquartered outside of the U.S.) employed 402,800 Americans. The average annual compensation for these employees was $63,538.

At the head of the line of sustainable auto companies stands Toyota. In its 2008 fiscal year, it earned a remarkable $17.1 billion world-wide and assembled 1.66 million motor vehicles in North America. Toyota has production facilities in seven states and R&D facilities in three others. Honda, another sustainable auto company, operates in five states and earned $6 billion in net income in 2008. In contrast, General Motors lost $38.7 billion last year....

Will fewer companies look to insource into America if the federal government is willing to bail out their domestic competitors?

The answer is an obvious yes. Ironically, proponents of a bailout say saving Detroit is necessary to protect the U.S. manufacturing base. But too many such bailouts could erode the number of manufacturers willing to invest here.

Deflation Worries

From Google Trends, above is a graph of the internet search volume for the word "deflation." Note the sizable spike of late. Presumably, this is not because motorists are suddenly concerned about their tires running out of air.

Update: The CPI drops 1 percent. Even the core CPI is falling.

This is your brain blogging

Here is a website that analyzes blogs and, supposedly, tells you the blogger's psychological profile.

Here is what it says about this blog:

INTJ - The Scientists The long-range thinking and individualistic type. They are especially good at looking at almost anything and figuring out a way of improving it - often with a highly creative and imaginative touch. They are intellectually curious and daring, but might be physically hesitant to try new things. They are intellectually curious and daring, but might be physically hesitant to try new things.

The Scientists enjoy theoretical work that allows them to use their strong minds and bold creativity. Since they tend to be so abstract and theoretical in their communication they often have a problem communicating their visions to other people and need to learn patience and use concrete examples. Since they are extremely good at concentrating they often have no trouble working alone.

How is the middle class doing?

Better than many people think.

HT: MR.

More Members

Allan Sloan joins the Pigou Club:

Having permanently high gas prices would let the market, rather than incomprehensible, loophole-ridden Corporate Average Fuel Economy regulations, make the decisions on what kind of vehicles Americans get to drive. As part of my plan, I'd scrap these CAFÉ standards, abandon the current attempts to force automakers to spend tens of billions of dollars to meet higher fuel-economy standards. Instead, the market, guided by a high gas tax, would rule.

And so do many CEOs:

Members of the Journal’s CEO Council tasked with discussing priorities for the U.S. economy and finance offered several fairly uncontroversial suggestions to the incoming administration: implement a fiscal stimulus plan without worsening the long-term deficit, appoint a panel to address financial regulation, create an economic vision.

Tucked away in the proposal, in the category of long-term tax policy, was this political grenade: “consider raising taxes on gasoline.”

Expected Return

This picture, courtesy of Johns Hopkins econ prof Chris Carroll, shows the correlation of the stock market's price-earnings ratio (where earnings are a 10-year average) and the subsequent real return on equities. The point labelled 1996 is the era dubbed "irrational exuberance."

The bottom line: Right now, the expected inflation-adjusted return is about 6 percent.

Defining Terms

(Click on the strip to enlarge.)

P(Depression) = 0.15

Here, according to betting at Intrade, is the probability of a depression in 2009, defined as a cumulative decline in GDP of more than 10.0% over four consecutive quarters.

>

Larry Summers as Treasury Secretary?

Michael Kinsley is Pro and Stanley Fish is Con.

Auto Industry Bailout?

Jeff Sachs is Pro and Gary Becker is Con.

Another Member

The Washington Post editorial board joins the Pigou Club.

Cost Differences

If you want to figure out why the U.S. auto industry is in deep trouble, while Japanese car companies operating in the United States are doing a bit better, this picture from Mark Perry, an econ prof of University of Michigan, Flint, may be a good place to start.

Update: Here is a discussion of where these differences come from.

Death and Taxes

You can't avoid them. But sometimes more of one means less of the other.

CNN reports:

Higher taxes on alcohol can make a night out more expensive but could save lives, according to a study released Thursday.

Each time the state of Alaska raised its alcoholic beverage tax, fewer deaths were caused by or related to alcohol, according to the study that examined 28 years of data.

When Alaska raised its alcohol tax in 1983, deaths caused by or related to alcohol dropped 29 percent. A 2002 tax increase was followed by an 11 percent reduction, according to the study published in the American Journal of Public Health.

"Increasing alcohol taxes saves lives; that's the bottom line," said the study's lead author, Dr. Alexander Wagenaar, a professor at the University of Florida's Department of Epidemiology and Health Policy Research....

"No other state in recent years has increased alcohol taxes in the way that Alaska did in 2002," Wagenaar said. "Basically, they conducted the experiment, and we studied it."...

Nearly half of the states have had the same alcohol taxes for more than 20 years, and Wyoming hasn't raised its tax on alcohol since the 1930s, thus not keeping up with inflation.

Update: A reader points out that the relationship between death and taxes may not be monotonic, as suggested by a story from 2006:

SCORES of Russians have died and more than 900 have been treated in hospital after drinking home-brewed spirits and illicit substances, following the introduction of a new tax on vodka.

Rising prices of legitimate spirits have created a booming market in illegal vodka and a range of substitutes including lighter fluid, cleaning fluid and industrial alcohol.

The New Edition and the 2008 Downturn

An economics instructor recently asked me how the new edition of my principles textbook, just published, handles the current financial crisis and economic downturn. Here is the answer, which might be useful to a few blog readers.

Because events are still unfolding, any textbook will, necessarily, be somewhat out-of-date even before it is shipped from the printer. (That's one reason for this blog.) But the early stages of the crisis are covered in the new edition. Not surprisingly, the topic shows up in the macroeconomics part of the book.

In particular, let me call attention to this material that I added in the fifth edition:

• The chapter on The Monetary System includes a new feature on The Financial Crisis of 2008 that discusses the Fed's role as lender of last resort in the wake of the nationwide fall in house prices and rise in mortgage defaults.
• The chapter on Aggregate Demand and Aggregate Supply has a new discussion of The 2008 Fiscal Stimulus that aimed to give a boost to consumer spending.
• The chapter on The Influence of Monetary and Fiscal Policy on Aggregate Demand has a new feature called The FOMC Explains Itself which includes the Fed's explanation for its recent, substantial cuts in interest rates.
• The chapter on The Short-run Tradeoff Between Inflation and Unemployment includes a new section called Bernanke's Challenges which discusses the macroeconomic shocks the Fed has recently been dealing with.

Overall, there are more than 40 new applications (as well as some more subtle pedagogical improvements) in the fifth edition, averaging more than one per chapter. The four new features listed above are those that relate most directly to recent downturn in the U.S. economy.

Addendum: If you are a professor eligible for a free examination copy to consider for your classes, or if you have any other questions, the person at the publisher to contact is Brian Joyner. His email is Brian.Joyner@cengage.com.

Inferior Goods

A reader alerts me to a story about income elasticities:

The economy is in tatters and, for millions of people, the future is uncertain. But for some employees at the Hormel Foods Corporation plant here, times have never been better. They are working at a furious pace and piling up all the overtime they want.

The workers make Spam, perhaps the emblematic hard-times food in the American pantry....

Even as consumers are cutting back on all sorts of goods, Spam is among a select group of thrifty grocery items that are selling steadily.

Pancake mixes and instant potatoes are booming. So are vitamins, fruit and vegetable preservatives and beer, according to data from October compiled by Information Resources, a market research firm.

“We’ve seen a double-digit increase in the sale of rice and beans,” said Teena Massingill, spokeswoman for the Safeway grocery chain, in an e-mail message. “They’re real belly fillers.”

Economics students will recognize these as inferior goods: Goods for which demand rises when income falls.

Note: "Inferior" is not a pejorative, just a description of the sign of the income elasticity.

Stock Market Valuation

This chart, courtesy of Jim Hamilton, shows the stock market relative to the average of the past ten years of earnings. The red line is the historical average. (Click on the graph to enlarge.) According to this metric, stocks are now cheap, but not exceptionally so.

P(Larry Summers at Treasury)

The probability according to Intrade betting:

A $600 Billion Fiscal Stimulus?

Paul Krugman makes the case here and here.

President Bush on the Economy

The President gives his take on the challenges we face.

Kristof on Education

Nicholas Kristof channels Claudia Goldin and Larry Katz.

Note: There will be a book party for Goldin and Katz on Tuesday.

Cues from History

Tom Cooley and Lee Ohanian on how to fix the economy.

Update: Another from Tom.

Financial Rescue Update

The WSJ reports:

the Treasury Department, signaling a new phase in its $700 billion financial-rescue plan, is considering requiring that firms seeking future government money raise private capital in order to qualify for public assistance, according to people familiar with the matter....

"We are carefully evaluating programs which would further leverage the impact of a TARP investment by attracting private capital, potentially through matching investments," Treasury Secretary Henry Paulson said in a broad speech on the Troubled Asset Relief Program, known as TARP, the global credit crunch and the government's recent steps to address the financial meltdown.

Good idea.

Time to Buy Stocks?

From University of Chicago economist John Cochrane.

FYI, I asked John about the units for the returns in this figure. He tells me that it plots nominal returns, so "1" means 100% cumulative (not annualized) return for 7 years.

The Meltzer Plan

Carnegie-Mellon economist Allan Meltzer wants to prop up housing demand:

To address the housing problem, Congress and the administration should take actions that increase the current demand for housing. For a limited time, say up to the end of 2009, allow buyers to use the value of their down-payment (or some part of it) as a tax deduction. Or, reduce the tax rate for qualified buyers who purchase a house between now and January 2010. Or do both. Give the benefit to all home buyers, including those buying a second or third house.

Split Opinion

On October 23-26, 2008, Gallup asked:

"People feel differently about how far a government should go. Here is a phrase which some people believe in and some don't. Do you think our government should or should not redistribute wealth by heavy taxes on the rich?"

The poll results:

Should: 46 percent
Should not: 50 percent
Unsure: 4 percent

Almost the exact same answers were given when the question was asked ten years ago.

I suppose one can debate the meaning of the word "heavy." My own view is that a 93 percent marginal tax rate qualifies.

Tax Policy during the Great Depression

Thanks to Alex Tabarrok for the pointer.

The Silver Lining

Columbia economist Bruce Greenwald:

I'll tell you the one really nice reason to be a value investor: When things like this happen, you cannot help but go nuts at the opportunity. What this looks like is the end of 1974, where good stocks are selling at three times sustainable earnings and stocks that normally wouldn't have sold at less than 20 times earnings are selling at 10 times earnings. These are exciting times. The short-term issue is that in the near term there will be a painful macroeconomic environment and we don't know how long it will last.

Memo to the POTUS-elect

Congratulations, Senator Obama. You ran a good campaign, and you racked up an historic victory. As you get ready for your new responsibilities, let me suggest four ways for you to become a reliable steward of the economy:

Listen to your economists. During the campaign you assembled an impressive team of economic advisers from the nation’s top universities, including Austan Goolsbee from University of Chicago and David Cutler and Jeff Liebman from Harvard. Your campaign’s director of economic policy, Jason Furman, is a smart, sensible, and well-trained policy economist. I know: He is a former student of mine.

Pay close attention to what they have to say. They will often give you advice quite different from what you will hear from congressional leaders Nancy Pelosi and Harry Reid. To make sure you hear the views of your economists, put them in offices close to yours. Tell your chief of staff to invite them to all the relevant meetings.

Embrace some Republican ideas. No party has a monopoly on truth. Be ready to take the best Republican policy proposals and make them your own, as Bill Clinton did with welfare reform in 1996.

Health policy is a case in point. Over the past several months, you lambasted McCain’s proposal to reform the tax code to include a refundable health insurance tax credit. Did you know that long before McCain ever proposed this idea, it was advanced by Mr. Furman, your campaign’s policy director? He can explain to you why the Furman-McCain plan makes a lot of sense.

Now you may decide that this plan does not go far enough. You may want a more generously funded social safety net to help the less fortunate get health care. Fair enough, but in pursuing that goal, you run into the next issue.

Pay attention to the government’s budget constraint. The nation faces a long-term imbalance between government spending and tax revenue. The fundamental problem is that the federal government has promised the elderly more benefits than the tax system can support. This fiscal imbalance will become acute as more baby boomers retire and start collecting Social Security and Medicare.

Yet during the campaign, you promised that you would cut taxes for 95 percent of Americans, that you would vastly expand health insurance coverage, and that you would never cut Social Security benefits or raise the retirement age. You will almost surely have to renege on some of these promises. As your economic team will often remind you, even if the laws of arithmetic are ignored during campaigns, they provide a real constraint when making actual policy.

Recognize your past mistakes. As a new senator, you voted along predictable left-wing lines. As president, you will need a more eclectic, nuanced approach.

Take trade policy, for example. In the senate, you voted against the Dominican Republic-Central American Free Trade Agreement. You opposed free trade agreements with Colombia and South Korea. You supported Senators Charles Schumer and Lindsey Graham in their quest to put tariffs on Chinese goods if China failed to revalue its exchange rate. You supported the Byrd Amendment, which encouraged domestic companies to file anti-dumping suits against foreign competitors. You supported subsidies for domestic producers of corn-based ethanol and tariffs on imports of more efficient sugar-based ethanol.

Your economists can explain to you why these positions were wrong-headed. Economic isolationism is not in the national interest. A high point of the Clinton presidency was the enactment of the North American Free Trade Agreement, which passed both the House and Senate with a majority of Republicans and a minority of Democrats.

This past Tuesday, many people voted for you hoping you would achieve the kind of economic success that Bill Clinton enjoyed in the 1990s. Your best chance of delivering what they want requires that you abandon some of your past positions and pursue a more moderate, bipartisan course.

----
Tomorrow's NY Times includes an edited version of this article.

An Epistemological Digression

I have been rereading Robert Pirsig's Zen and the Art of Motorcycle Maintenance. This passage really sticks with me:

After a while he says, "Do you believe in ghosts?"

"No," I say.

"Why not?"

"Because they are un-sci-en-ti-fic."

The way I say this makes John smile. "They contain no matter," I continue, "and have no energy and therefore, according to the laws of science, do not exist except in people’s minds."

The whiskey, the fatigue and the wind in the trees start mixing in my mind. "Of course," I add, "the laws of science contain no matter and have no energy either and therefore do not exist except in people’s minds. It’s best to be completely scientific about the whole thing and refuse to believe in either ghosts or the laws of science. That way you’re safe. That doesn’t leave you very much to believe in, but that’s scientific too."

The New Draft

From the President-elect's website:

The Obama Administration will call on Americans to serve in order to meet the nation’s challenges. President-Elect Obama will expand national service programs like AmeriCorps and Peace Corps and will create a new Classroom Corps to help teachers in underserved schools, as well as a new Health Corps, Clean Energy Corps, and Veterans Corps. Obama will call on citizens of all ages to serve America, by developing a plan to require 50 hours of community service in middle school and high school and 100 hours of community service in college every year. Obama will encourage retiring Americans to serve by improving programs available for individuals over age 55, while at the same time promoting youth programs such as Youth Build and Head Start.

In the past, economists of both the right and left opposed the military draft. Will they similarly come together to oppose conscription for community service? I hope so.

This initiative brought to mind the opening passage of Milton Friedman's Capitalism and Freedom:

In a much quoted passage in his inaugural address, President Kennedy said, "Ask not what your country can do for you -- ask what you can do for your country." It is a striking sign of the temper of our times that the controversy about this passage centered on its origin and not on its content. Neither half of the statement expresses a relation between the citizen and his government that is worthy of the ideals of free men in a free society. The paternalistic "what your country can do for you" implies that government is the patron, the citizen the ward, a view that is at odds with the free man's belief in his own responsibility for his own destiny. The organismic, "what you can do for your country" implies that government is the master or the deity, the citizen, the servant or the votary. To the free man, the country is the collection of individuals who compose it, not something over and above them. He is proud of a common heritage and loyal to common traditions. But he regards government as a means, an instrumentality, neither a grantor of favors and gifts, nor a master or god to be blindly worshipped and served. He recognizes no national goal except as it is the consensus of the goals that the citizens severally serve. He recognizes no national purpose except as it is the consensus of the purposes for which the citizens severally strive.

The free man will ask neither what his country can do for him nor what he can do for his country. He will ask rather "What can I and my compatriots do through government" to help us discharge our individual responsibilities, to achieve our several goals and purposes, and above all, to protect our freedom? And he will accompany this question with another: How can we keep the government we create from becoming a Frankenstein that will destroy the very freedom we establish it to protect?

Update: The presidential transition website to which I linked above no longer uses the word "require." The passage quoted above was copied and pasted from that website (with bolding added by me). But within a few hours after I posted it here, the wording changed to "setting a goal."

I am delighted to see this blog having so much influence on the policies of the new administration. That's change I can believe in!

Addendum: Click here for a shot of the original webpage.

Hire Better Teachers

Says Harvard economist Ed Glaeser.

Trust the Voters

Says Northwestern economist Tim Feddersen (in a piece published Tuesday, before the polls closed).

The Youth Vote and the GOP

This picture from Andrew Gelman is striking. It suggests that the major difference between the past two elections and this one was the youth vote. In this election, the young left the Republican party in droves.

Why? I am not enough of a political scientist to be sure, but recent conversations I have had with some Harvard undergrads have led me to a conjecture: It was largely noneconomic issues. These particular students told me they preferred the lower tax, more limited government, freer trade views of McCain, but they were voting for Obama on the basis of foreign policy and especially social issues like abortion. The choice of a social conservative like Palin as veep really turned them off McCain.

So what does the Republican Party need to do to get the youth vote back? If these Harvard students are typical (and perhaps they are not, as Harvard students are hardly a random sample), the party needs to scale back its social conservatism. Put simply, it needs to become a party for moderate and mainstream libertarians. The actual Libertarian Party is far too extreme in its views to attract these students. And it is too much of a strange fringe group. These students are, after all, part of the establishment. But a reformed Republican Party could, I think, win them back.

Can the Republican Party move in this direction without losing much of its base? I have no idea, but for the GOP, that seems to be the challenge ahead.

Larry, Vindicated

A flashback to 2006:

“President Summers asked me, didn’t I agree that, in general, economists are smarter than political scientists, and political scientists are smarter than sociologists?” [former dean Peter] Ellison told the Globe.

Here (via Mark Perry, posted two days ago) are GRE scores by field. Economists rank number 4. Political scientists are number 17, and sociologists are number 23.

In last place is public administration.

(Click on table to enlarge.)

Tom Cooley's Dream

The NYU economist imagines change he can believe in.

Congratulations, President Obama

The Inequality Debate

As seen by Robert Samuelson.

Prediction from the Fair Model

Ray Fair says:

51.91 for the Democrats and 48.09 for the Republicans, for a spread of 3.82.

Update: The actual spread was 5.4.

Should you vote?

If you are reading this blog, then you are well-informed, so voting is a civic responsibility. But what about those who don't read this blog? The answer is here.

Downsizing

Galbraith on Mainstream Economics

I was struck yesterday by an excerpt from an interview with economist James Galbraith:

But there are at least 15,000 professional economists in this country, and you’re saying only two or three of them foresaw the mortgage crisis?

Ten or 12 would be closer than two or three.

What does that say about the field of economics, which claims to be a science?

It’s an enormous blot on the reputation of the profession. There are thousands of economists. Most of them teach. And most of them teach a theoretical framework that has been shown to be fundamentally useless.

Like his late father, Galbraith the younger is highly critical of mainstream economics. This is noteworthy in part because Galbraith is listed as an Obama economic adviser.

One of the more telling things to look out for in the coming weeks (assuming the seemingly inevitable Obama victory) will be which economists get which jobs in the new adminstration. Will the important positions be filled with people like Austan Goolsbee and Jason Furman, who are essentially mainstream economists with slightly left of center political views, or with heterodox economists like Galbraith who are deeply skeptical of the economics found in most textbooks? If the administration is filled with prominent members of both groups, the internal battles over the heart and soul of the new adminstration's economic policy should prove fascinating to watch.

Tax Hedging?

Over at Intrade, you can bet on future tax rates. Currently, the implied probability of a hike in the top income tax rate in 2009 is about two-thirds.

This surprises me. Even assuming an Obama victory, I would put the probability much lower. As an economic matter, raising anyone's taxes with the economy so weak seems ill-advised. As a political matter, why not just let the Bush tax cuts expire at the end of 2010? Obama could then claim in four years that he never signed a tax hike. It seems neither economically nor politically sensible for the new President to push for an immediate tax increase, even if an eventual tax increase is his goal.

How then to explain the betting at Intrade? I can think of three hypotheses:

1. The Obama people are not as savvy as I think they are and will push for an immediate tax hike.

2. The Intrade market is so thin that the pricing there does not mean much.

3. Some people are using the Intrade market as a hedge. A high-income person bets that tax rates will go up and bids up the implied probability above the true probability. If the bet pays off, his winnings reduce some of the hit his after-tax income takes by the tax change. It is a form of insurance. Those traders on the other side of this bet--who win if taxes do not rise--are buying a high-risk asset, as measured by covariance with their consumption. They need to be compensated for taking this risk. Under this hypothesis, the Intrade price is not a good gauge of the actual probability but includes a substantial risk premium.

Update: Tony Smith, an economics professor at Yale, emails this comment:

Dear Greg:

I read with great interest the post on your blog today about how to interpret the prediction market price for the event of a tax hike in 2009. Tyler Cowen made a similar point about interpreting the market price for the event that Congress would approve a bailout before September 30. And, in fact, last May I wrote a comprehensive exam question for the Ph.D. students at Yale that revolved around this same observation in the context of an election prediction market. But I have seen no formal papers that make this point. I think it is a critical one for evaluating the usefulness of prediction markets in aiding decision-making.

The general point that rational investors will use prediction markets to hedge risks can also help to explain an apparent puzzle throughout the recent election campaign: in particular, statistical models designed to predict election outcomes (see, for example, www.fivethirtyeight.com and David Stromberg's website) generally reported probabilities for an Obama victory that exceeded the corresponding market prices on both intrade and betfair. If we take seriously the predictions of these statistical models--that is, if we view them as giving an accurate estimate of the actual probability that Obama will win--then evidently investors seem to think that Obama will be relatively good for the economy compared to McCain, driving down the equilibrium price for an Obama contract (since this contract pays off when marginal utility is low). To help voters make an informed decision, maybe you should post this "evidence" on your blog!

Regards,

Tony Smith

Thanks, Tony.

Sowell lets loose

Economist Thomas Sowell really, really, really does not like the Democratic ticket.

Shiller on Groupthink

Yale economist Bob Shiller discusses why bubbles are hard to diagnose.

Election Fact of the Day

Obama leads in 18 out of the 19 states with the largest recent declines in home prices, whereas McCain leads in 13 out of the 14 states with the largest recent increases in home prices.

Click here to see the data.

The Health Care Debate

David Cutler and Brad DeLong make the case for the Obama health plan. Arnold Kling dissects their analysis.

David and Brad lost me in their second sentence:

Every other North Atlantic country is healthier than America.

That falls into the category I once described as "true but misleading statements about health care that politicians and pundits love to use to frighten the public."

The Economist endorses...

...Barack Obama.

Vernon Smith on Barack Obama

A letter in the Wall Street Journal from Nobel Prize winning economist Vernon Smith:

I think the answer to Alan Reynolds's excellent question and article ("How's Obama Going to Raise $4.3 Trillion?," op-ed, Oct. 24) is that Barack Obama is not going to raise $4.3 trillion, and he is not going to perform on his rhetoric. He excels as a rhetorician -- common to both the great and the least of past presidents -- but performance cannot run on that fuel. Inevitably, I think his luster will fade even with his most ardent supporters as that reality sets in. We also have seen luster fade time after time with Republican presidents. The rhetoric of a smaller and less invasive government always leads to king-size performance disappointments. This weakness is as central to the reality of our political economy as are its strengths. With all its foibles, its strengths become transparent when you compare it, not with our various idealizations, but with the litter of human experiments in political economy that have delivered far more suffering and murder than human betterment to the citizens of those economies.

Of course it is entirely likely that Mr. Obama will succeed in going for higher business, capital gains and income taxes, but it is an economic illusion to think for a minute that this will benefit the poor. All our wars on poverty have been lost by failing to help the poor help themselves. Higher business taxes, which ultimately can only be paid by individuals anyway, will simply export more economic activity to the world economy. Higher capital gains and income taxes will primarily reduce savings and investment at the expense of greater future productivity, which is at the heart of cross-generational reductions in poverty. A dozen countries, including the third largest economy, already have zero taxes on capital gains, and eight of them score high on the Economic Freedom Index and high in gross domestic product per capita.

I favor making all individual savings and direct investments deductible from income for tax purposes. In that world there would be no need to make any distinction between ordinary income and capital gains. By adding a negative feature to such a net consumption tax, the poor would not only receive redistribution benefit, but have an incentive to save and accumulate capital. Some poor will see this as an opportunity to help themselves.

Vernon L. Smith