Saturday, January 31, 2009

New Home Sales and Foreclosures

The drum beat of economic bad news continued on Thursday. In addition to record levels of continuing claims and further falls in new manufacturing orders, new home sales fell 14.7 percent in December, with large declines in every census region. The drop in sales pushed month’s supply up to a record 12.9. And, the median time for sale since completion rose to 9.3 months: over half of the new homes for sale in December were completed in March or earlier.

The report did not, however, contain only bad news; the number of homes for sale dropped a record ten percent. Inventories are continuing to adjust in the housing sector and apparently the rate of adjustment is accelerating (see my post on the topic here). As I noted previously, but for the record number of foreclosures, I would have expected the housing market to begin its recovery in early summer.

I have been wondering about how to measure the impact of foreclosures on the housing market. Very well done academic studies have failed to find a substantial effect of foreclosures on starts, new home sales, or house prices. (See for instance the recent study by Calomiris et al.) Although these studies control for many variables, by necessity they study foreclosures during relatively good times, times when the economic outlook is fairly benign and when the number of foreclosures is relatively low.

My intuition has always been that foreclosures are an independent negative factor for housing markets. In my view, foreclosures act as inventory in ways that are very similar to new housing: the houses are empty and need to sell. Proving this empirically is difficult as foreclosures do not happen in a vacuum; think of the housing market in a mill town when the mill shuts down, falling prices and high foreclosures.

With this release of new home sales this month, it occurred to me that the differences in behavior between new home sales and existing home sales might give us an indication of the magnitude of the effect of foreclosures. Foreclosure sales appear in the data as an existing home sale. Since both new homes and existing homes are affected by the same macro factors (employment, interest rates, financing availability) a change in the relative sales rate should be informative. An increase in the sales rate of new homes would indicate a relative oversupply of new housing and vice versa.

Take a look at the following picture. In the graph, I plot the ratio of existing home sales to new home sales from 1967 through December 2008. Amazingly, the ratio is relatively constant from the early 1970s through January 2006. This period is not one of stability. There are at least four recessions and as many housing market swings over this interval. Yet, the ratio remained solidly between 4 and 6 for more than 35 years.

It was not until 2006, when the first large wave of subprime foreclosures hit the market, that the ratio began to move upward, that the number of existing home sales began to outpace the number of new home sales. As foreclosures became a more acute problem, the ratio swung rapidly upward, reaching almost 13 in December.

If this increase owes to foreclosures rather than some other factor, I would expect that regions hardest hit by the foreclosure crisis would experience the greatest change in the ratio. The graph below compares the ratio for the West census region to the total shown above. While the ratio for the country has less than tripled, the ratio for the West, which includes the hard-hit states of California and Nevada, has more than quadrupled.
The sudden movement in the ratio is strong evidence that foreclosures themselves are having a large impact on the housing market over and above what would be expected from the downturn alone. However, I cannot use this data to give a numerical estimate of the impact. With essentially only one observation, I cannot map this swing into changes in house prices. I know that foreclosures are an important contributing factor in California and I know that house prices in California are falling. I cannot separately identify the shift in demand from the shift in supply. I can only say that the supply effect (foreclosures) is larger than at any time since 1967.

Wednesday, January 28, 2009

The WSJ on The Recovery and Reinvestment Plan

In this post, I said

I have listened and I have read. I have analyzed and quibbled. I have come to a conclusion: The American Recovery and Reinvestment plan is not a stimulus plan. The plan is a spending plan. Each item in the plan has merit; each item in the plan as costs.

Today, the Wall Street Journal editorial page agreed with me. Take a look: A 40-Year Wish List.

Tuesday, January 27, 2009

The Stimulus Debate: A comment

I love it when economists with different political leanings and opposed economic ideologies begin to debate. In my view, nothing gets quicker to the underlying, and often unstated, tenets of their beliefs. With over a trillion dollars of spending on the table and potentially the largest downturn in the post-war era already begun, economists of every stripe are falling out of the woodwork. And, of course, the name calling has begun in earnest (see Krugman)

To oversimplify, on one side we have the Chicago school. In this camp, monetary policy, in the spirit of Milton Friedman, is the one and only tool that can stimulate output. On the other side we have what I will label the East Coast Paradigm (Krugman is the banner wielding leader of this camp). In this camp, monetary policy is next to useless, at least when nominal interest rates are low, and fiscal policy is a panacea ready to fulfill its promise of returning the economy to full employment. I live in neither camp but visit each with a full measure of skepticism.

I use a recent essay by John Cochrane as a representation of the Chicago School. His note aptly titled Fiscal Stimulus, Fiscal Inflation, or Fiscal Fallacies? disputes the premise that “by borrowing money and spending it, the government can raise the overall state of the economy, raising output and lowering employment.” Clearly he takes umbrage with the basic premise of fiscal stimulus. Yet, I think he is closer to the East Coast Paradigm than he would ever admit.

Take a look at his second paragraph:

One form of “fiscal stimulus” clearly can increase aggregate demand. If the government prints up money and drops it from helicopters, this action counts as fiscal stimulus, since the money counts as a transfer payment … A trillion dollars more money in private hands … People naturally don’t want to sit on a trillion dollars of extra cash. They spend it, first creating demand for goods and services, and ultimately inflation.

This is perhaps the only prediction that it utterly uncontroversial among economists.
Cochrane clearly believes monetary policy can stimulate output. A helicopter drop of cash creates demand for goods and services. He does not give us any more information on how this drop is going to work. We must take it on faith.

Or rather, Cochrane takes it on faith.

This is not the way I learned about helicopter drops (I am of course a student of the Chicago school) nor is it the way I teach them. A helicopter drop is the instantaneous delivery of money to every agent in the economy, say $1000 in every pocket.

How might this stimulate demand for goods and services? The start of the story is easy. I wake up in the morning and finding an extra thousand dollars in my pocket consider myself to be rich. Being a rational permanent income consumer, I decide to run out to the store and spend a portion of my new-found wealth. Every other agent in the economy responds in a similar fashion. We have an instantaneous increase in demand for goods and services.

The end of the story is a bit more complicated. Why didn’t the shop keeper raise his prices? In almost any incarnation of an economic model, prices rise with demand. If he failed to raise his prices (either because he wouldn’t or couldn’t), why didn’t he run out of goods? Surely he does not keep so much inventory on hand to accommodate this type of unexpected demand surge.

A helicopter drop is simply a change in units. Paraphrasing Hume, would we expect the United States to be richer if we listed GDP in trillions of Yen rather than billions of dollars.

It seems to me that for Cochrane’s helicopter drop to boost real demand for goods and services real resources in the economy must have been unused before the drop and that through some unmodeled mechanism the helicopter drop allows these resources to be used. We could, perhaps, write a model in which the drop boosted output but it would not be one that was “utterly uncontroversial among economists”.

Viewed through this lens, the loosely labeled East Coast Paradigm is very similar in fundamental beliefs to Cochrane. They believe that there exist unused resources in the economy. They believe that fiscal policy can exploit these resources to boost output.

Again, the start of the story is the same. Workers or capital lie around idle. The government sweeps in and hires these resources, thereby boosting output. If the spending does nothing more than this, the multiplier is 1. If in addition, these workers spend their paychecks and increase demand for goods and services the multiplier can be greater than one.

I’ve already said my piece on crowding out here. So I won’t rehash it now. The basic point is that if you believe monetary policy (Chicago school) or fiscal stimulus (the East Coast Paradigm) can boost output then you believe real resources are idle. I will caution against this view. Workers become unemployed during recessions. We have to understand why they are unemployed before we can employ them and boost output. For example, the workers may be unemployed because they need new skills to fit the new jobs firms want to create. Hiring them to work for the government may prevent or delay this skill acquisition. They may simply be unemployed because it takes time to find a job; government hiring may slow their search.

For the fiscal stimulus to work, the spending must, in effect, ameliorate some private-sector friction. If we assume the government is good at removing the friction, use fiscal stimulus. If we believe otherwise, do not use fiscal stimulus.

Again, we can build models in which fiscal spending at the magic moment can boost output and increase welfare but they would not be models that were “utterly uncontroversial among economists”.

Friday, January 23, 2009

Asian Trade has Collapsed: The Global Economy may be Next

Earlier this month, I reported on November data for Japan (here). I cited this (Japan: Sharpest drop in industrial output ever) report from Danske Bank written by Mr. Nielsen. He did an excellent job of describing the risks to the Japanese economy and predicted something on the order of a 5+ percent fall in Japanese fourth quarter GDP. I cited a couple of risks to this forecast but generally agreed with his assessment. We were so naïve.

This week we received December trade data from Japan. Real exports fell 9.8 percent adding to last month’s 14 percent decline. Real exports declined more than 40 percent at an annual rate in the fourth quarter. As I expected, real imports also fell in December, but only 2.4 percent. Over the quarter, real imports rose. This is bad news for Japan’s economy. Japan will be extremely lucky to achieve fourth quarter GDP growth greater than -10 percent.

And as I noted in my previous post, a fall in Japanese exports of this size, while bad for Japan, portends horrific things for the global economy. Declines were widespread, with large nominal falls to China (35.5 percent over 12 months), Europe (40 percent), Central and South America (19 percent), and North America (36 percent). But Japan was not the only Asian economy to experience a decline in fourth quarter trade volumes.

Take a look at the graph below. For this picture, I sum imports and exports in billions of U.S. dollars for all of the Asian economies. The data are nominal, which is of some concern, but the fourth quarter fall is not a price story (as shown by the real data for Japan, Singapore, and Taiwan). In the fourth quarter, the volume of Asian trade fell 13 percent (again, not at an annual rate). This fall is larger than during the Asian Financial Crisis.

As we began to learn this week, these trade numbers are already being reflected in GDP numbers. South Korean GDP fell by more than 20 percent (annual rate) and Singapore’s fell by 16 percent. I would be tempted to say that this is just an Asian problem (except it is not). The flash estimate of U.K. GDP came in at a shocking -5.93 percent.

We are going to see falls in GDP in the fourth and first quarters greater than at any other time in the post war era. I still don’t think we are headed for Depression, but I am beginning to think we will be able to see one from where we end up.

January Jobs: How bad will it be?

Okay, we didn’t lose a million jobs in December. I don’t think we are going to lose a million jobs in January either. Nonetheless, initial claims have (almost without fanfare) crept back up to the high 500 thousands and continuing claims are within 2 percent of their all time high, a record set in the early 1980s. This was also the last time the labor market deteriorated as rapidly as it has over the last several months. Take a look at the long time series. Unemployment looks bad. Then take a look at the next graph, a blowup of the more recent data. Both continuing and initial claims have virtually doubled relative to their 2006 levels.

My model is once again predicting a loss of over 800,000 jobs. I am not inclined to step back from this estimate. I see nothing in the macro data to make me believe the estimate is too high. If anything with the collapse in trade and the abysmal growth numbers from the United Kingdom, I am more confident in this estimate than I was in my December forecast.

Trade Finance or Lack of Demand?

The sharp and sudden decline in trade since September, particularly amongst the Asian economies, has led some (site IMF) to speculate that an absence of trade finance is responsible. The story is plausible. The credit crunch has impaired the balance sheets of banks, which have then been unwilling or unable to provide letters of credit. In the absence of these letters, shipping companies have been unable to load their ships and trade has fallen.

Alternatively, the decline in trade could be attributed to a global fall in demand. A country’s exports are a good indicator of the domestic demand of its trading partners; while a country’s imports are a good indicator of its own domestic demand. A global decline in trade volumes then implies a global decline in demand. A likely story; however, the fall in trade seems larger than observed decline in demand.

These two stories are difficult a priori to differentiate. Neither contemporaneous demand nor trade finance or its importance are directly observable. For the former, GDP is released with a considerable lag relative to trade data and is subject to substantial revisions. For the latter, we have no systematic data whatsoever. We are forced to rely on anecdote and intuition alone.

Nonetheless, the two stories have very different global pricing implications. We can use imperfect data on regional prices to infer which story is more likely to be correct.

A fall in trade that is attributable to a fall in demand should be accompanied by a global fall in the price of traded goods. While there may be some regional variation, this fall in prices should be similar whether a country is a producer or an importer of the good in question.

In the absence of trade finance, some shipments that are economically desirable are not made. The absence of finance acts like an increase in trade frictions. In this case, the usual arbitrage that tends to keep global prices near one another should fail. Prices in countries with too much of the good (the producers) should experience a drop in prices, and prices in countries with shortages (the importers) should experience an increase in prices.

Timely micro data on domestic prices of goods is needed for this exercise. I do not have this data. Instead, I try to infer the evolution of micro prices by examining global trade prices. These prices are falling. Export prices across trade categories and across countries are declining and they are declining rapidly. Import prices show the same story. I see no systematic differences between exporters and importers.

Of course, if we stipulate that demand has fallen, it is difficult to determine whether trade prices have fallen more or less than we would have expected given the decline in demand. That is, we cannot tell if trade finance may be playing some role in the decline.

As an alternative approach, one can look for shortages of goods in importing countries. If trade finance is playing a role, then producers may desire more goods than our available and shortages may emerge. I turn to survey data. In the ISM survey, manufacturers are asked each month which if any commodities are in short supply. Over the last two months, no commodities have been listed. Producers do not perceive difficulties in obtaining the number of inputs they desire. Not an outcome I would have expected with increased trade frictions.

The jury remains out on the extent to which a decline in trade finance has reduced global trade volumes. However, I think the evidence is clear that falling demand is the main culprit. And I believe at this point the burden of proof lies with those who believe trade finance is the problem.

I would love to hear your anecdotes on relative prices, shortages, or trade finance reductions. Leave a comment or send me an email at secreteconomist at gmail.

Multi-Family Housing Starts

We all know that the housing market has been bad. We have had nothing but bad news in housing for a long time and the bad news keeps getting worse. Over the last three months, housing starts fell at a near record rate. With a 36 percent fall (not at an annual rate) over the last three months, total starts were within 0.6 percentage points of the all time record three-month fall. If we look at house prices, we see the same trend, a definite deceleration in the fourth quarter.

But one element of the market had been holding up relatively well: multifamily. Take a look at the graph. Over the last 9 months or so the series has punched through its volatility to show a distinct downward trend. Over the last 12 months, multi-family starts have fallen almost as much as total starts: 62 versus 66 percent. Since January 2006, they have fallen much less than single-family starts—66 versus 76 percent—but they are now trying to catch up.

This move is especially important. With only one exception in the early 1970s, multi-family starts have been a more stable series than single family. The series has fluctuated and is cyclical but the moves are mild relative to single family. That this series is making a move now points to the severity of the current recession and the likely true size of the capital overhang in housing.

I had long thought that multi-family starts would put a floor of around 500,000 starts on total housing starts (we are currently two months past the old record low of 992,000 total starts). While this is a low number, it is sufficiently high to keep the core of the residential construction market intact (as long as they don’t stay there too long). With the recent decline in multi-family, my faith in this lower bound has been shaken. Even if the housing market recovers mid-year (an outcome that is increasingly unlikely), the odds of crossing the 500,000 floor are high. These low levels of starts are not enough to maintain the number of construction companies currently in existence. If we start losing more big builders and if the recession tries to stretch into the spring, who knows where we will be.

Thursday, January 22, 2009

It’s Time for some Banks to Fail

In his inaugural address, President Obama said
Our journey has never been one of shortcuts or settling for less. It has not been the path for the faint-hearted — for those who prefer leisure over work, or seek only the pleasures of riches and fame. Rather, it has been the risk-takers, the doers, the takers of things — some celebrated but more often men and women obscure in their labor, who have carried us up the long, rugged path towards prosperity and freedom.

It is time to live up to those words. This is a time to take the hard path: let some firms fail that others may thrive. Give the risk-takers, the doers, and the makers of things a chance to do what they do best unencumbered by a failed financial sector.

The Federal Reserve has approached the entire crisis as one of liquidity. The Fed’s response has been large. The Fed has expanded its balance sheet by more than ten percent of GDP. This is the largest injection of liquidity in history. Yet, the liquidity injections have not helped (despite vociferous claims that “these policy actions helped to support employment and incomes” (Bernanke 2009). The economy has steadily deteriorated under this support. Banks have continued to fail.

Forced (or at least highly encouraged) mergers of banks have created even greater problems. Indeed, the “complex credit products and other illiquid assets of uncertain value” on the balance sheets of these half-failed banks—the assets that were allegedly suffering from fire sale prices—were overpriced in retrospect. The government has not been a good judge of the underlying value of assets.

The illiquidity (in my view) appears to stem more from banks wishing their assets were worth more and hoping they will be worth more in the future than any inability to accurately price the assets now. Economies are always fraught with uncertainty; asset pricing is hard. The only way to find the price is to put the assets out there and find a buyer. If there is no buyer at that price, the asset is not worth that much. When the price is sufficiently low, the assets will sell and markets will clear.

The liquidity injections have not helped because the financial crisis is not caused by a liquidity crisis. The crisis is clearly and absolutely one of solvency. The financial intermediation sector grew too big and must shrink. I suppose it is possible that all of the existing firms (at least those that are left) could simply shrink in size. That is not, however, the typical adjustment path. Usually in an industrial upheaval, the weakest firms fail and the strongest survive. There is a certain amount of dislocation inherent in this process.

Some banks must be allowed to fail.

The lessons of Japan in the 1990s have not been learned. If banks are allowed to hide their bad assets and if the government continues to transfer just enough capital to the banks to keep them solvent, the financial crisis is drawn out. Indeed, the Japanese economy showed few signs of life between 1990 and 2002. Zombie firms and zombie banks worked as an anchor on growth. Japan’s economy did not recover until the banks were forced to cleanse their balance sheets.

Chairman Bernanke has chosen Japan’s path for the United States. He believes he can shelter the U.S. economy from the worst effects of the crisis through ordinary monetary policy. To date, he has refused to even consider taking the hard steps that are necessary. He refuses to even consider the hard steps that may be necessary.

Wednesday, January 21, 2009

Obama’s Stimulus Plan: American Recovery and Reinvestment – My Final Word

I have listened and I have read. I have analyzed and quibbled. I have come to a conclusion: The American Recovery and Reinvestment plan is not a stimulus plan. The plan is a spending plan. Each item in the plan has merit; each item in the plan has costs.

I don’t believe the plan will create jobs. I do believe that the plan will redirect job creation. Clearly this plan will create jobs in the energy sector. At the moment we have very little invested in the Smart Grid; these jobs will be new jobs. These jobs will come at the expense of some existing jobs – see this post () for my views on crowding out.

If you have any doubt as to the nature of the bill pending in congress, take a look at the $650 million for DTV conversion coupons. The $245 million for the farm service agency. The $15.6 billion for Pell grants. The $1 billion for child support enforcement. The $1.15 billion for the 2010 census. This spending may be necessary; it may satisfy the requirements of efficient government spending. The spending is not stimulus. And, it certainly is not the best use of funds if this bill is intended to provide stimulus to a deteriorating economy.

I listened carefully to President Obama’s inauguration speech. The speech was a good one. The President clearly has a vision for the United States. Elements of the American Recovery and Reinvestment plan clearly fit into his vision. His vision may very well be the correct vision for the United States.

Since the plan is clearly not stimulus, I have no further views on the subject. The optimal size of government is a public policy question not one of cut and dried economics. In general, our models punt on the optimal size of government. Government spending is at its heart a transfer program, a reallocation of wealth. Clearly reallocation can be optimal; it depends on the welfare function. Without understanding the clear intention of the spending (a better future is not a specific goal), I cannot make an unbiased judgment on the subject.

This is my final word on this plan. (At least until I write on it again.)

Sunday, January 11, 2009

Krugman: Bad Anti-Stimulus Arguments

Krugman has been a vocal proponent of government spending to end the recession. He is among the comfortable class of economists who never left the Keynesian school of thought: the government has the ability and responsibility to fine tune economic output and fiscal spending is a key tool. And, he is solidly in the camp of economists who believe that the current downturn is likely to be quite bad. As such, it comes as little surprise that he believes the Obama plan is too timid. There is intellectual merit to his arguments.

One of his blog entries, however, is very misleading. In this entry (Bad Anti-Stimulus Arguments), he accuses conservative economists of a basic misreading of economics. In turn, I accuse Krugman of intentionally twisting the truth himself.

Here is a quote from the entry:

Yes, the standard theory of consumer choice says that a consumer gains more utility if he or she gets to freely allocate a dollar of spending than if someone else makes the choices: I’d rather buy myself a $10 meal than have you feed me $10 worth of food that you select.

But that’s not what we’re talking about when we talk about stimulus spending: we’re not talking about the government buying consumption goods for the public at large. Instead, we’re talking about spending more on public goods: goods that the private market won’t supply, or at any rate won’t supply in sufficient quantities. things like
roads, communication networks, sewage systems, and so on. And every Econ 101
textbook explains that the provision of public goods is a necessary function of government.
It’s the last sentence where he is most misleading. The provision of public goods is a necessary role of government: true. It is however a jump in logic from this statement to a statement on stimulus. The fact that the government is the only efficient provider of transportation infrastructure does not imply that government spending on infrastructure can stimulate output, at least in the sense of avoiding downturns in output or fine tuning.

There are two basic problems with the leap: the government should already provide public goods independent of the point in the cycle and even efficient government spending can crowd out private investment and consumption.

Public Provision of Public Goods: To understand the first point, think of the rate of return on government investment. If the marginal rate of return on government investment is higher than the marginal private rate of return, government spending is efficient. That is, if the rate of return on a new highway is greater than the best private rate of return, the highway should be built.

There is lots of government spending that may meet this criterion: police, fire, roads, education, ameliorating liquidity crises. But this does not mean that any of the projects are appropriate for stimulus. From Krugman, “we’re talking about spending more on public goods.” We don’t need the average return on government spending to be high; we need the return on the marginal dollar to be high. These new stimulus projects must have a high rate of return. If they exist, why did the government not make this investment prior to the downturn?

In the stimulus plan, Obama’s team is planning to fund projects that states have on their drawing boards but have decided to postpone for budget reasons, the shovel ready projects. Which projects are states most likely to drop? Those with the highest return? There may be some scope for relaxing state-level liquidity constraints, but it is foolhardy to think these projects are going to have a high social rate of return. The states will continue to fund their best projects. There are no free lunches.

Crowding Out: Even when government spending is efficient, the spending still uses real resources. If the government builds a road, it must hire workers, build capital, and disrupt commutes during the construction. Wages are higher, capital is more expensive, and commuting costs more. As a result, some marginal private investment projects do not occur. The extra money spent by both the private and public sector as a result of the project reduces resources available for consumption.

Private investment and private consumption must fall. This is economics 101.

Saturday, January 10, 2009

My Miss on Jobs

I don't know how many of you noticed, but I missed by a mile on jobs. Payroll employment fell by 524,000 in December, a bad number to be sure, but far below the 900,000 I had expected earlier in the month. It was a large miss plain and simple--I offer no excuses. I do, however, have some thoughts on the number.

First, unemployment claims settled back somewhat from their early month highs. By the end of the month, I had downgraded my estimates but I still expected losses of almost 800,000, still a miss of over thirty percent.

Second, I think there is information from the household survey (my estimates were all for payrolls so this doesn't change my miss). The household survey is currently running about 500,000 jobs ahead of the payroll survey in terms of annual job losses. In my experience (going back only to about 1998), whenever large differences develop between the household survey and the payroll survey, the annual revisions to payrolls pull them toward the household survey. I believe that when we get the annual revisions for 2007 it will subtract between 100 and 200 thousand jobs per month. Remember we did not know of the payroll losses in the 2001 recession until we were already out of the recession and we did not know of the payroll gains in 2003 and 2004 until we were well past.

Now to the monthly numbers (and I only mention these because they are so close to my own estimates). The households survey showed a loss of 806,000 jobs in December, and more importantly, showed an acceleration of job losses between November and December. The monthly sampling variation is too large in the household survey to take these numbers seriously. I just happen to like them this month because they match my priors.

The Recovery and Reinvestment Plan

As regular readers know, I have been both for and against Obama’s stimulus plan. This morning the transition team released details of their economic analysis: the Job Impact of the American Recovery and Reinvestment Plan. We are being sold a bill of goods and I don’t like it.

Let me start my analysis with this quote from Obama’s speech last Thursday.

I don’t believe it’s too late to change course, but it will be if we don’t take dramatic action as soon as possible. If nothing is done, this recession could linger for years. The unemployment rate could reach double digits. Our economy could fall $1 trillion short of its full capacity, which translates into more than $12,000 in lost income for a family of four. We could lose a generation of potential and promise, as more young Americans are forced to forgo dreams of college or the chance to train for the jobs of the future. And our nation could lose the competitive edge that has served as a foundation for our strength and standing in the world. [emphasis is my own]
And from a little farther along in the speech

There is no doubt that the cost of this plan will be considerable. It will certainly add to the budget deficit in the short-term. But equally certain are the consequences of doing too little or nothing at all, for that will lead to an even greater deficit of jobs, incomes, and confidence in our economy. It is true that we cannot depend on government alone to create jobs or long-term growth, but at this particular moment, only government can provide the short-term boost necessary to lift us from a recession this deep and severe. Only government can break the vicious cycles that are crippling our economy – where a lack of spending leads to lost jobs which leads to even less spending; where an inability to lend and borrow stops growth and leads to even less credit.
These are scary words. I am one of those who believe that this recession is going to be bad. I assumed when I read this speech that Obama’s economic agreed with my assessment; in fact, I assumed they had a much gloomier outlook than my own. The release today contains details of the team’s economic analysis.

Take a look at Table 1 on page 5. For the moment, just focus on the first line of the table, labeled without stimulus. According to the analysis, real GDP at the end of 2010 will be $11,770 (annual rate, chained 2000 dollars). From the rhetoric in the paragraph above, I expected their estimate of the decline in GDP to be greater than 10 percent. After all, losing the potential and promise of a generation is a Great-Depression-like event. Instead, Obama’s team is actually expecting GDP to rise 0.5 percent over the next two years (real GDP in 2008:Q3 was $11,712. An annual growth rate of 0.25 percent is very weak: it is not catastrophic.

So first, they want to spend almost $1 trillion dollars to save the economy from slow growth. But there is more. Take a look at the next line; it gives the level of GDP at the end of 2010 with the stimulus. They assume that GDP will reach $12,203 billion. That is, the stimulus will increase GDP by 3.7 percent relative to the non-stimulus baseline.

If they spend $775 billion on the stimulus, they will be spending 5.3 percent of GDP today to boost GDP by 3.7 percent over two years, all to save us from an assumed period of slow growth.

We can do the same analysis with their jobs numbers. According to their analysis the stimulus will save or create 3,674,000 jobs. That is a lot of jobs. I am not quite sure why we are going to lose so many jobs if GDP is going to remain more or less constant, but let’s assume these numbers are correct. At a sticker price of $775 billion, these jobs cost $210,941 dollars each. Median household income in 2007 was $50,233. I am not sure this is a good deal. Which would the median household rather have a job today or $210,941 today followed by a four-year unemployment spell.

We can skip the next several sections—do they really expect us to believe they are so good they can predict who is going to get the jobs—and move to the appendix. The appendix is (allegedly) using estimates of fiscal spending multipliers from FRB/US the Federal Reserve’s economic forecasting model. In the first paragraph, the report says “We considered multipliers for the case where the federal funds rate remains constant.” This assumption seems innocuous. The Fed’s interest rate is at essentially zero and is expected to remain there for a long period of time. But this assumption means that the large increase in government spending has zero effect on the interest rates of any maturity or type. Since no prices move, private consumption and private investment (within the model) cannot react to the government spending. They hardwire into their estimates that the private sector is not crowded out: the only effect of government spending comes through increased income. You don’t have to be a hard-line Ricardian to think that spending a trillion dollars might have some impact on private decisions.

Misusing the multipliers is a serious mistake. The economic team is clearly trying to use the stature of the Federal Reserve to boost the credibility of their estimates. They are either intentionally deceiving us as to the likely effectiveness of their plan or (and much worse) they do not realize the severity of their mistake.

Monday, January 5, 2009

Robert Lucas and Monetary Policy

Required reading in the current financial crisis is Robert Lucas’ recent editorial in the Wall Street Journal: Bernanke is the Best Stimulus Right Now. As can be expected from such a great intellect, the editorial is well-written and cogent. I agree without reservation on his key points: the zero bound is meaningless for the conduct of monetary policy and the Fed can solve liquidity crises at will. His seeming certainty, however, over the effectiveness of monetary policy is at odds with his earlier writings in which he is unsure if monetary policy can stimulate output.

The first two paragraphs combined with the last contain the main elements of Lucas’ intellectual argument for monetary policy as stimulus. The remainder of the article deals mainly with the implementation of the spending. Lucas has apparently also noticed the burgeoning balance sheet of the Federal Reserve (see this note).

I have abbreviated the key paragraphs here, omitting only details for the sake of brevity (I link to the editorial in its entirety above).

The Federal Reserve's lowering of interest rates … was also received with skepticism. Once the federal-funds rate is reduced to zero … doesn't this mean that monetary policy has gone as far as it can go? This widely held view was appealed to in the 1930s to rationalize the Fed's passive role as the U.S. economy slid into deep depression.

It was used again by the Bank of Japan to rationalize its unwillingness to counteract the deflation and recession of the 1990s. In both cases, constructive monetary policies were in fact available but remained unused. Fed Chairman Ben Bernanke's statement last Tuesday made it clear that he does not share this view and intends to continue to take actions to stimulate spending.

There are many ways to stimulate spending, and many of these methods are now under serious consideration. … But monetary policy … has been the most helpful counter-recession action taken to date … It is fast and flexible. There is no other way that so much cash could have been put into the system as fast as this $600 billion was, and if necessary it can be taken out just as quickly. …

These paragraphs give the impression of an intellect that is quite confident in the ability of monetary policy to simulate activity. There can be no question of the meaning or of the intent in these words: monetary policy has stimulated spending and reduced the severity of the recession.

In his 1995 Nobel acceptance speech (also required reading of any who would understand the intellectual issues of monetary policy), he quotes extensively from the various writings of David Hume, pointing out the potential inconsistencies in Hume’s treatment of money.

In the same spirit, I quote here from Lucas’ Nobel lecture.

The work for which I have received this prize was part of an effort to understand how changes in the conduct of monetary policy can influence inflation, employment, and production. So much thought has been devoted to this question and so much evidence is available that one might reasonably assume that it had been solved long ago. But this is not the case: It had not been solved in the 1970s when I began my work on it, and even now this question has not been given anything like a fully satisfactory answer. (opening paragraph)

In summary, the prediction that prices respond proportionally to changes in money in the long run, deduced by Hume in 1752 (and by many other theorists, by many different routes, since), has received ample - I would say, decisive - confirmation, in data from many times and places. The observation that money changes induce output changes in the same direction receives confirmation in some data sets, but is hard to see in others. Large scale reductions in money growth can be associated with large scale depressions or, if carried out in the form of a credible reform, with no depression at all. (the middle of page 252)

These two paragraphs give a distinctly different impression from those in the editorial. These are the careful and thoughtful words of an agnostic with respect to the efficacy of monetary policy. He is not stating that money does not boost output but he is also not convinced that it does. I admit that some years have passed since these words were written. Many things have changed over the 13 years that have elapsed and great progress has been made in monetary theory. Nonetheless, even if the data over this time period aligned perfectly with the idea that money can stimulate output (and it does not), 13 years is not sufficient time to completely change the empirical picture Lucas developed in his lecture. (This article from the St Louis Fed discusses the Nobel lecture further.)

Consistency surely requires at least an attempt to reconcile these disparate views. I don’t believe Lucas is unaware of his earlier work. Nor, do I believe that Lucas has somehow recently become convinced that monetary policy is automatically effective in stimulating the economy.

The following two paragraphs pulled from the middle of the editorial may shed light on this puzzle.

Why do I describe this as an action to stimulate spending? Financial markets are in the grip of a "flight to quality" that is very much analogous to the "flight to currency" that crippled the economy in the 1930s. Everyone wants to get into government-issued and government-insured assets, for reasons of both liquidity and safety. Individuals have tried to do this by selling other securities, but without an increase in the supply of "quality" securities these attempts do nothing but drive down the prices of other assets. The only other action people can take as individuals is to build up their stock of cash and government-issued claims to cash by reducing spending. This reduction is a main factor in inducing or worsening the recession. Adding directly to reserves -- the ultimate liquid, safe asset -- adds to supply of "quality" and relieves the perceived need to reduce spending.

Could the $600 billion in new reserves be called a bailout? In a sense, yes: The Fed is lending on terms that private banks are no willing to offer. They are not searching for underpriced "bargains" on behalf of the public, nor is it their mission to do so. Their mission is to provide liquidity to the system by acting as lender-of-last-resort. We don't care about the quality of the assets the Fed acquires in doing this. We care about the quantity of its liabilities.

I believe the certainty of Lucas’ belief stems from his certainty that the downturn is caused solely by a liquidity crisis—a flight to quality—that is preventing banks from lending and households and businesses from spending. If that were true, then the Fed would be stimulating output, not by boosting production or creating jobs, but by preventing a collapse that would send the global economy into a tailspin. All good economists believe that the Fed can easily resolve liquidity problems.

But these are simply my beliefs. In the editorial itself, there is no hint of a conflicted mind. Lucas clearly intends to leave the reader with the belief that monetary policy is an effective tool for combating the downturn. I would like to know if he has genuinely changed his mind on monetary policy, if he meant effective only in resolving liquidity crisis, or if he had some third agenda I failed to notice.

The editorial surprised me.

Note: If this crisis is merely a flight to quality, why have the Fed’s actions not resolved the crisis? The Fed has expanded its balance sheet by more than 10 percent of GDP. This action should have been more than sufficient to resolve any liquidity crisis. Remember, that when the Federal government prevents a run on the bank by becoming the lender of last resort, it never actually has to spend any money. The mere fact that it stands behind the bank should end the crisis.

I believe, as does Lucas, that the Fed is doing the best it can to end the crisis and that the zero bound itself is meaningless with respect to the conduct of monetary policy. I also believe that the Fed is the institution best situated to deal with financial crises. It can move quickly and its movements create a minimum of market distortions. I do not, however, share his belief that mere loans from the central bank can resolve the crisis.

Excess or Mispriced Capacity?

In a response to this post, NorthGG asks: How does one differentiate between excess capacity and mispriced capacity? What are the policy responses to them?

Excess capacity is always, in some sense, mispriced capacity. When I say excess capacity, I mean that at current prices the capacity of the global system is too high. In order for markets to clear, prices must fall. Lower prices, however, imply lower investment and lower production: firms shift inward along the supply curve.

In an ordinary downturn, the shift in demand is temporary and the long-term implications for the economy are relatively small. In this case, fiscal transfers, either in the form of investment tax credits or outright cash transfers, can provide a temporary boost and ameliorate any negative effects.

I don’t think this is not an ordinary downturn. In this post, I argued that U.S. households are consuming too much relative to their income. Further, I argued that the most likely resolution to this problem was for consumption to fall. A substantial portion of global capacity is dedicated to satisfying the desires of the American consumers. This capital stock must be transformed to other uses.

In the short run, NorthGG is exactly correct. The relative price of these goods will have to fall, leading to something that looks like a deflation. In the long run, the capital stock will shrink and redirect toward some new use.

If I am correct and this is not an ordinary downturn, then policy responses aimed at supporting the current industrial structure are misguided and will only distort and delay the needed restructuring. I will be forever suspicious of government plans to “improve” the manufacturing base. If the government is concerned over welfare, it may do so in the form of transfers to households (see this post).

New (Good) Details: Obama’s Economic Stimulus

President-Elect Obama must read this blog (or he has good economists advising him). Yesterday, the Wall Street Journal (article) reported that Obama is planning to spend about $300 billion dollars on tax cuts in his stimulus plan. According to the WSJ,

“The largest piece of tax relief in the new plan would involve cuts for people
who pay income taxes or who claim the earned-income credit, a refund designed to
lessen the impact of payroll taxes on low- and moderate-income workers.”

This plan is probably as close as we can get politically to my proposal (see this post) to lift the FICA tax. Because the plan changes the withholding tax, it increases incentives to work at the same time the plan is moving cash into a large number of pockets. And, since the plan is aimed at low- to-moderate income groups, the money will appear in the pockets of those who are most likely to be liquidity constrained at the moment.

How much will the plan boost output? I expect the proposal to boost consumption directly by about $85 billion, or almost 1 percent of consumption. This increase is exceptionally large, but so is the stimulus.

But, there is also a sizable indirect effect to the plan. At the moment, banks in the United States seem to need a capital injection. The $215 billion not spent will be saved and the savings will be held in ordinary bank accounts.

As a result, the tax cut will act simultaneously to stimulate consumption and to recapitalize the banks. And, this recapitalization plan is controlled by U.S. households. Banks will have to compete for the money (they have to compensate households for the injection) and any bank that households deem unworthy will not get the injection.

This plan will not end the recession. We are only talking about a 1 to 1.5 percentage point boost to GDP growth at most. Nevertheless, it is the best stimulus idea Obama (or Bush) has put forward. I think this plan already has support on the Hill, but let me add my two cents: pass this part of the stimulus now!

Friday, January 2, 2009

Japan: The Canary in the Coal Mine

"When the canary dies, there is nothing to do but run for the exit" Anonymous

Japan’s economy appears to have fallen off a cliff in the fourth quarter of 2008. The decline in production, exports, shipments, the labor market, … all point to a recession of titanic proportions. Every data series I checked looks at least as bad as it did during Japan’s 1997 recession which took place amidst the Asian Financial Crisis. Most of the series are considerably worse. Flemming Nielsen of Danske Bank does an admirable job of summarizing the recent economic data and its implications for Japan in this note: Japan: Sharpest drop in industrial output ever.

Based on the data received over the past week, Mr. Nielsen expects a fall in fourth quarter output in excess of 5 percent (annual rate). He is most likely right, although I would point out two sources of upside risk to his forecast. First, given the sharp drop in production, imports are likely to fall sharply in December, making an arithmetic positive contribution to GDP. Second, inventory accumulation is large. He points out the large accumulation but seems to miss the potential impact on GDP. This impact could be even further exaggerated if prices fall, boosting real NIPA inventories. Neither of these risks is good for Japan, but they may support GDP.

In any event, Japan’s economy is in big trouble. I am much more concerned, however, with what Japan’s data has to say about the health of the global economy. All of the data releases discussed in Mr. Nielsen’s report are for November: Japan leads the world in the early release of economic data (it’s noisy and subject to revision but early). We have yet to see meaningful macro data in the other industrial countries for November.

The fall in Japanese production was driven by capital goods, intermediate (producer) goods, and motor vehicles. The fall in motor vehicle production, while bad, is not a surprise. We already knew car production was curtailed in the United States and Europe and there is no reason to expect Japanese car makers to escape the decline in auto demand.

The fall in capital and intermediate goods, however, is ominous. The decline in demand, long evident in the consumer sector, has reached the level of production. Capital goods are investment goods and intermediate goods, as the name implies, are necessary for production. Output is falling, is likely to fall much further, and the decline is not isolated in Japan.

Real Japanese exports fell 14.5 percent in November. The drop in exports was spread among Japan’s trading partners, with large falls to the United States, the European Union, and China. While trade data never lines up month for month perfectly, the large drop in Japanese exports implies a large drop in demand across the rest of the world.

The decline in Japanese trade is not anomalous. Since July, the Baltic Dry Index, the best timely indicator of shipping costs, has fallen like a rock. The index, which had soared to astronomical heights over the last several years, is now sitting at about ½ of its long-term average. The most likely candidate for the fall in the price of shipping is a sharp reduction in the volume of global trade.

In addition to the trade data, recent survey data in the United States seem to corroborate the Japanese story. The manufacturing reports for November recently released by the various Federal Reserve banks indicate a sharp fall in activity. Most of these reports have now fallen to record or near-record lows. Taken individually I would be inclined to discount them; but as a group and combined with the Japanese data, they indicate devastation.

Brace yourself. The data flow over the next month or two are likely to reveal a global economy that is significantly weaker than was previously known.