Paradoxical Responses to Fedspeak

Throughout November, the US Treasury bond market seems to have been responding to Fedspeak by going in the opposite direction from what Fed statements would suggest about interest rates. Early in the month, when Fed officials were sounding (to my ears, anyhow) hawkish, interest rates fell. Over the past few days, with Fed officials sounding more dovish, interest rates have risen.

With respect to long-term bonds, this behavior is consistent with a view in which statements by Fed officials give clues about the Fed’s degree of commitment to keeping inflation low. Hawkish statements mean less inflation, which means lower long-term interest rates. Dovish statements mean more inflation, which means higher long-term interest rates.

It’s a bit harder to rationalize the response of short-term bonds (by which I mean 2-year Treasury notes, Treasury bills, and seasoned securities nearing maturity). The Fed’s commitment to keeping inflation low shouldn’t be much of an issue here, because there isn’t enough time for the inflation to develop before the bond matures.

Another explanation is flight to quality: when the Fed is more hawkish, bondholders worry more about the creditworthiness of other borrowers and shift their assets into Treasury securities, causing the interest rates on those securities to fall. But even the Eurodollar market, which is considered more risky than the Treasury market, has been responding in the same direction.

A variation on the flight to quality explanation is that the flight is from stocks: hawkish statements by the Fed cause investors to sell stocks and replace them with bonds, thus causing bond yields to fall. But presumably the reason investors sell stocks is that they think higher interest rates are bad for the stock market. Why would this cause them to bid down interest rates to an even lower level? Once interest rates fall, wouldn’t they immediately go back into stocks?

My best guess about what’s going on is that the bond market thinks it understands Fed policy better than the Fed does. The bond market is convinced that interest rates will eventually have to come down to prevent, or to recover from, a recession. The sooner the Fed starts cutting – the sooner it sets into motion the recovery process – the less cutting it will eventually have to do. In particular, if the Fed cuts sufficiently at the next two meetings, it may be able to avoid a recession. If not, a recession is nearly certain, and more dramatic (and longer lasting) cuts will be necessary to recover from the recession. This is how I imagine that the bond market reasons, but I’m not convinced that the bond market is right.

Falling Angels

Tanta at Calculated Risk has an interesting (but very long) post about the nature of “subprime” lending. A central idea is that, before the recent lending boom, subprime borrowers were essentially just prime borrowers whose credit had gone sour – typically people with mortgages who needed to borrow more money to keep making the payments on their existing mortgages. The availability of “traditional” subprime loans often allowed them to avoid default on their original mortgages, which kept those mortgages in the “prime” category. The increased availability of subprime credit in recent years has thus helped keep down default rates on prime loans. But now that subprime credit has dried up, the prime loans are going to start looking worse than ever: potential defaulters that would, in the past, have been caught by the subprime safety net, will now become actual defaulters.

It occurs to me that there is an imperfect but perhaps useful analogy to be drawn with the junk bond market in 1980s. Prior to the 1980s, “junk bonds” were almost all “fallen angels” – bonds that had been considered investment grade at the time they were issued but which had been downgraded. During the 1980s, through the efforts of Michael Milken and others, it became acceptable to issue bonds with low ratings, and the junk bond market as we now know it was born. As I recall, the junk bond market fell into disarray in 1990, but it eventually recovered, Michael Milken got out of jail, and “high-yield bonds” are now a permanent niche within the investment world.

Tanta is not so optimistic about the future of subprime lending for original purchases (analogous to the type of junk bond issuance that became popular in the 1980s). She seems to regard that type of subprime lending as an inherently bad idea. On the other hand, she sees the “fallen angel” type of subprime lending as being critically important, and she argues that (particularly given the type of positive feedback that occurs in the housing market) most prime borrowers are in danger of falling from grace: “We are all subprime now.”

Indirect Effects of Export Demand

Today let us be thankful for multiplier and accelerator effects. And in any case let us at least be aware of multiplier and accelerator effects. In particular, if you want to talk about the potential role of export demand in preventing a US recession, the story you tell should mostly be about multiplier and accelerator effects rather than direct effects. If you tell the story without mentioning multiplier and accelerator effects, the prospect looks pretty dismal, as in the following from an otherwise excellent commentary by Martin Wolf:

But exports are only some 12 per cent of GDP. They must grow by considerably more than 10 per cent a year, in real terms, if the contribution of net trade to the rate of growth is to be as much as 1 percentage point. It is likely to be much less.

“Much less” than 1 percentage point sounds like a pretty feeble force to set against the likely effects of a meltdown in housing and a collapse of credit, given the apparent importance of credit and of the “wealth effect” in maintaining consumer spending. But borrowing and wealth effects have never been the primary elements used to explain consumer spending: rather, they are factors that help explain deviations from the normal relationship between spending and income. That relationship has certainly not disappeared, and income is still the primary factor. The personal savings rate may be unusually low, but this doesn’t mean that consumption has started to follow a path independent of income. And when income rises, as it would from an increase in exports, we can expect consumption to rise also.

A little quick Keynesian arithmetic should make the point. Let’s suppose that the marginal propensity to consume is 0.7. That is, for every dollar in new income that households receive, they increase their consumption by 70 cents. (There may be other things happening simultaneously that reduce their consumption, so I don’t necessarily expect consumption to grow at 0.7 of the growth rate of income, but 0.7 seems plausible to me as an estimate of the direct effect of income. It’s certainly a lot more conservative than what we would get from the rule of thumb that takes the average propensity to consume as an estimate of the marginal propensity.) Then, as the familiar story goes, people in the export industry will spend 70% of their new income; then the people from whom they buy will spend 70% of their new income; and the people from whom those people buy will spend 70% of their new income; and so on. The sum of that infinite series is 1/(1-0.7) or 3.3. The total effect of that hypothesized 1 percentage point contribution from export growth becomes 3.3 percentage points. Suddenly I’m glad the actual export contribution is unlikely to be that high: I wouldn’t want the Fed to have to raise interest rates dramatically to prevent overheating.

I’ve ignored the effect of taxes, because I think 0.7 might be a reasonable guess at the marginal propensity to consume out of gross income, including the effect of taxes. US consumption shows a striking tendency to gravitate toward about 70% of GDP, though the mechanism might be something completely different. Anyhow, I’ll leave it to real economic modelers to sort out the details. The point is just that the multiplier effect is quantitatively important, and if one tries to discuss the effect of exports without it , one will miss more than half the picture.

But let’s not forget the accelerator effect either. After the last 5 or 25 years, the US is probably not geared up to be an export powerhouse. Recent export growth has nonetheless been impressive. But with few economists predicting a significant recovery in the dollar any time soon, the important question for businesses is not how much they can export immediately but how much they can export over, say, the next 10 years. The process of gearing up becomes a worthwhile proposition in itself. Thus it is to be expected that export demand should induce a significant increase in the category of nonresidential investment (although, as with consumption, it may be partly offset by other factors causing a decline in nonresidential investment). Then there is the interaction between the multiplier and accelerator effects: some investment will also be needed to support the new consumption that results from export demand, and so on.

It may have gone out of fashion to talk about multiplier and accelerator effects as such. But we still read statements like, “Gains in employment and income will support growth in consumer spending.” The gains in employment and income don’t come out of nowhere; there has to be some underlying source of demand. A scenario under which exports provide an underlying source of demand, and the indirect effects offset weakness in other areas, seems quite possible to me.


[UPDATE: I forgot to include the hat tip to Mark Thoma for that Martin Wolf commentary.]

Exchange Rate Expectations and Interest Rates

Since I’m (unhappily) short US Treasury bonds at the moment, I should be glad so many people think that uncovered interest parity means US bond yields have to rise when investors lose confidence in the dollar. (See the comments section of this post from Brad DeLong.) But it just ain’t so! Unquestionably, there are reasons to expect interest rates (bond yields) to rise when the dollar weakens, but those reasons are more subtle, and have different economic implications, than a brute force application of uncovered interest parity would suggest.

The theory seems simple enough: if investors expect the value of the dollar to decline, they will require higher yields on their dollar-denominated bonds, to compensate for the lower exchange value of the dollars in which they expect to be paid. The problem is that people take the clause “investors expect the value of the dollar to decline” to refer to a condition independent of how investors respond to that condition. In most models, what actually happens when “investors expect the value of the dollar to decline” is that the value of the dollar immediately declines, and then investors no longer expect the value of the dollar to decline. And most of those models include uncovered interest parity.

Suppose international investors, holding US bonds, suddenly come to believe that the value of the dollar will decline. What do they do? First they sell their bonds, which does cause yields to rise temporarily, but… What do they do with the proceeds? Do they sit on those dollars and wait for yields to rise enough to entice them to buy bonds again? I would think not, if they expect the value of the dollar to decline: instead, investors convert those dollars into (for example) euros and sit on those euros (or invest them in European bonds) until some combination of interest rate and exchange rate movements entices them back to the US bond market. But they don’t have to wait very long, because, in the process of converting those dollars to euros, they have pushed down the value of the dollar sufficiently that it no longer needs to decline. Suddenly, with the dollar no longer expected to decline, US bond yields become very attractive. They become so attractive that investors bid yields back down to their old levels.

In the paragraph above, I’ve snuck in some elasticity assumptions to assure that the value of the dollar doesn’t rise again when investors convert their euros back into dollars to buy back the US bonds. In principle, interest rates and exchange rates should be determined simultaneously. But if we believe in the expectation-based world of uncovered interest parity, then we must also believe in a similar expectational parity between short-term and long-term interest rates. Short-term interest rates are set by monetary policy, and long-term interest rates depend on expectations of future short-term interest rates. So if we hold expected monetary policy constant, all interest rates will be constant. If long-term interest rates rose, investors would try to exchange all their short-term bonds for long-term bonds, but since monetary policy assures a perfectly elastic supply of short-term bonds, this process would not stop until long-term rates came back down. Under these circumstances, the only way the market can adjust to a loss of confidence in the dollar is by bidding down the exchange value of the dollar immediately, until it is no longer expected to fall.

Now, you might point out that expected monetary policy will likely respond to the declining value of the dollar by raising interest rates. That’s true, since the cheaper dollar makes US goods more attractive and thereby produces a stimulus that monetary policy needs to offset. But that is a consequence of the monetary policy reaction function and the goods market equilibrium, not a consequence of uncovered interest parity. And it doesn’t allow one to make the argument, “When investors lose confidence in the dollar, US interest rates will rise, causing the economy to weaken,” because the Fed is only expected to raise interest rates enough to prevent the economy from strengthening, not to weaken it relative to its original condition. There are other, more subtle arguments you could make about why interest rates might rise further (the inflationary impact of the J-curve, behavior of foreign central banks, etc.), and the economy might actually weaken, but we have already wandered far afield from uncovered interest parity. If you want to argue that a loss of confidence in the dollar will weaken the US economy, you’ve got a lot of explaining to do.

Is a Cheap Currency Good?

In the comments section of my first post about the euro, reader Keith asks:

1. Isn't it better to have a cheap currency? You get to export more and bring in more money. A cheap currency hurts if you travel outside the country, but on the other hand, you have more money to spend because you export more.
   
   
2. Why has the US followed a strong dollar policy? It seems Japan has had the right idea by keeping their currency cheap.

The simple answer to the first question is that a cheap currency is good for the tradables sector (exports, potential exports, and industries that actually or potentially compete with imports) but bad for the notradables sector (everything else). It’s bad for the nontradables sector because the economy has limited resources, and the additional resources that get used in the tradables sector are no longer available for use in the nontradables sector. For example, China has a cheap currency, and it has thriving export industries, but it has really bad health care, presumably in part because people who could be training to be nurses find it more convenient to take factory jobs in the export sector.

There are any number of problems with the last paragraph. For one thing, Gabriel is probably going to complain about my cavalier use of the words “good” and “bad.” I’m pretty sure that, in a model with nominal rigidities, fixed capital, and search costs, a cheap currency can be shown to have good and bad welfare consequences (respectively) in the short run for people associated with those respective sectors. But I’m also quite sure that the proof would be a pain in the ass, and I expect that somebody (I have no idea who) has already done it, so I’m not going to attempt it. As for the long run, exchange rates are irrelevant because prices and wages adjust completely. (Well, not really irrelevant, because there is path-dependence: what happens in the particular short runs helps determine the long-run equilibrium. But that’s getting too deep for now.)

The second problem is that the phrase “limited resources,” while quite valid, is misleading. Resource limitations are not a simple, tight constraint. There is always some unemployment, and always some idle capacity, so there is always the opportunity to push on resource limitations. The problem is, when unemployment gets too low, or capacity utilization gets too high, then inflation starts to accelerate. And it’s never exactly clear how low is too low and how high is too high. If the country has plentiful slack resources, then a cheap currency is good for everybody. If the country is already overutilizing its resources, a cheap currency could be bad for everybody if it causes an inflationary spiral (but if the central bank is on its toes, this presumably won’t happen).

The third problem is that my China example is not a very good one. (Maybe someone else can think of a better example.) China’s health care problems have more to do with bad insurance markets than with potential nurses becoming factory workers. And China’s construction industry – also part of the nontradables sector – seems to be doing fine. China is quite an interesting case, though, because, on the one hand, it appears to have plenty of slack resources (people working inefficiently in agriculture who can easily take factory jobs) and therefore one might think that there is no disadvantage to a cheap currency. But on the other hand, it is beginning to experience an inflation problem, which would suggest that it is getting the worst disadvantage from a cheap currency. Part of the solution to this paradox, I think, is that China is trying to mobilize its slack resources too quickly and running into bottlenecks. And there’s also the issue of natural resources. I could go on and talk about China’s potentially destabilizing absorption of massive dollar reserves and about China’s possible attempt to exploit path dependence and so on, but I want to get to the second question.

So, why has the US followed a strong dollar policy? And should it? In the late 1990s, I think a strong dollar policy made sense (though Dean Baker disagrees). The reason it made sense is that the nontradables sector in the US was doing a lot of useful things – creating new technologies and investment goods to make US production more efficient in the future – and a weaker dollar would have forced a shift of resources out of the nontradables sector.

Today, though, I don’t think a strong dollar makes any sense, and I think most economists would agree. The economy is weak, and we may be going into a recession, so there are a lot of potential slack resources, and the nontradables sector in recent years has not been doing anything terribly useful with its marginal capacity (mostly building a lot more houses than we really need). That doesn’t necessarily mean, though, that a “strong dollar policy” is a bad idea, if a “strong dollar policy” just means a lot of cheerleading by the Treasury Secretary. I think most economists would agree, what we want is for the dollar to fall slowly, so as not to destabilize markets or cause a bout of inflation. But if investors expect the dollar to fall slowly, they will all sell their dollar assets, and the dollar will fall quickly. The solution, I suppose, is for Hank Paulson to keep saying we like a strong dollar and to convince a gradually decreasing number of suckers that he really means it, so they will wait before selling their dollar assets and prevent a free fall.


[Afterthought: I’m beginning to wonder, though, whether the dollar still is very much overvalued against the euro. It’s getting easy to imagine that, at a dollar/euro exchange rate not too far from the present level, once temporary effects wash out, the Euro Zone and the US could both end up with moderate trade deficits, rather than (as it has been recently) the US having a very large deficit and the Euro Zone having roughly balanced trade. Increasingly, the problem is not an overvalued dollar but undervalued currencies that happen to be pegged to the dollar but that perhaps at this point might almost as well be pegged to the euro.]

Social Security

According to Greg Mankiw,

Concern about social security's future comes not from decades of scare-mongering by conservative ideologues but from decades of dispassionate analysis by some of the best policy economists.

He cites a 1998 statement by Bill Clinton and another by President Clinton’s Advisory Council on Social Security. Greg certainly has a point that Paul Krugman is stretching by using the word “decades,” since 1998 was less than a decade ago, and there were, at the time, clearly many relatively liberal policy analysts who were concerned about the future of Social Security (though I think the most vocal expressions of concern came from conservatives). But I think Greg is also being a bit disingenuous here.

Though I know little about the details of Social Security projections, I know something about the assumptions that go into them, and those assumptions, I’m pretty sure, have changed dramatically between 1997 (when the Advisory Council published its report) and 2007. The title of the report is “Report of the 1994-1996 Advisory Council on Social Security,” which suggests that the analysis was done before 1997, at a time when the US productivity slowdown that began in the 1970s still appeared to be an ongoing process. When productivity grows slowly, the outlook for Social Security looks bad.

Starting in the mid-1990s, but not fully apparent in available statistics until the decade was drawing to a close, US productivity accelerated to growth rates not seen since the 1960s. Productivity in the early 2000s appeared to accelerate even further. Over the past couple of years, productivity has appeared to decelerate again, but this deceleration is at least partly a cyclical phenomenon that is not expected to last (and, for the last two quarters, I might add, productivity has accelerated again, although that acceleration is also suspect). Certainly the average expectation of economists today would call for much faster productivity growth in the future than did the average expectation in 1996. When productivity grows quickly, the outlook for Social Security looks fine.

One could, however, make the point that, if we want to be honest with ourselves, we really don’t have much of a clue whether the Social Security system is in trouble or not. Any expectation – high, low, or in between – about the future rate of productivity growth is scarcely more than a slightly educated guess. To be truly conservative, we should make the worst reasonable assumption (based still on only a slightly educated guess as to what range of assumptions is reasonable), and use that assumption in the analysis, which will then tell us that Social Security is in trouble. So on this issue at least, the conservatives (and Barrack Obama) really are being conservative.

But I still have a problem with Senator Obama’s conservative position. As I understand it, the Medicare system fails even under fairly optimistic assumptions about productivity. If you make the assumptions bad enough to make Social Security require significant changes, you’ve made them so bad that the Medicare system requires a complete overhaul and damn near goes broke anyway. Given our limited analytic and political resources in coming up with and implementing solutions to these problems, doesn’t it make sense to spend those resources in such a way that we at least have a chance of coming out OK – that is, spend them on a Medicare overhaul that is almost surely necessary, rather than on a Social Security overhaul that may or may not be necessary?

Boobs

Perhaps tomorrow I’ll go back to writing about international trade imbalances, but what the heck, it’s Saturday. I should preface this whole entry by noting that you probably shouldn’t pay attention to what an economist has to say about evolutionary biology (unless that economist happens to be a biologist as well, which is certainly not the case with me). Nonetheless, it has been observed that, when the subject is boobs, people tend to pay attention no matter who’s talking.

Daniel Davies had an entry on Crooked Timber today entitled “Busty barmaids and other developments in science,” which reports the finding of a study (apparently a genuinely scholarly one, despite its subject matter) by the Cornell School of Hotel Administration: there is a linear relationship between the size of a barmaid’s breasts and the size of her tip. A linear relationship means that, no matter how big a barmaid’s breasts are, one with even bigger breasts will tend to get bigger tips. (I haven’t read the study, so I don’t know if they included a dummy variable for Shelley Long.) One might imagine that one of those BBW porn models with an alliterative pseudonym like “Henrietta Hugeones” would have an absolute advantage as a barmaid, even if her comparative advantage is in her field of choice. (Well, an absolute advantage as far as tipping goes; depending on the arrangement of the bar, she might be at a disadvantage in performing her service efficiently.)

Mr. Davies uses the study as an occasion to speculate on the topic of why men like big breasts (by which he apparently means, why they find women with big breasts sexually attractive). His theory seems to be that men have an unconscious facility that attempts to find good mothers for their children and that mistakenly “figures out” that big breasts are better for feeding infants. Then I suppose it unconsciously tells the men to pursue women with big breasts, even if the men aren’t consciously interested in having children. In order for this to work, the facility has to repeat its mistaken logic for each individual, because big breasts aren’t in fact better for feeding infants, so there is no selection pressure to prefer large breasts independently of that mistaken conclusion. It’s not a theory that I find compelling.

There is a related fact that one might also want to explain: the fact that women have distended breasts in the first place. It’s trivial to explain why lactating women have breasts, but in most species, the females don’t develop distended breasts until their first pregnancy. Among human beings, even virgins have boobs, which is a bit of an anomaly. You might say that women have breasts because men like them, but then you need an explanation for men’s preference that doesn’t get circular by depending on the fact that women have breasts. For example, one commenter suggests that men like big breasts because they are a sign of sexual maturity, which might be a fine explanation, except that it begs the question of why sexually mature virgins have breasts.

I would also note that the specific study discussed does not demonstrate that men find big breasts sexually attractive, only that men like to give gifts (in the form of larger than average tips) to women who have big breasts. That in itself is fairly easy to explain. Presumably in some proto-human species, big breasts (or any substantial breasts, for that matter) in a young woman were a reliable sign that she was pregnant or lactating. Giving gifts (which presumably would have taken the form of food) to pregnant and lactating women makes a lot of sense on the face of it (and also, as I will argue, had an evolutionary advantage). They are, after all, “eating for two,” and they presumably have a harder time foraging for their own food than most people do.

The following theory of breast evolution pulls it all together:

1. Among men who have surplus food (or surplus money to spend at bars), evolution favors the gene that predisposes them to give that food to women who look pregnant, because (in the evolutionary environment) such a woman had a disproportionate chance of carrying the man’s own offspring or that of a close relative, and because she needed food more (and would have a harder time getting food for herself) than a non-pregnant woman.
   
   
2. Among species that walk upright, so that their eyes don’t naturally look toward the belly, distended breasts are a particularly useful signal of pregnancy.
   
   
3. The genetic mutation causing virgins (and childless women in general) to have breasts was favored because it made them look pregnant, so that they would get goodies normally reserved for pregnant women. (Not consciously reserved, of course; it’s just that men like to give gifts to women who have this characteristic originally associated with pregnancy.)
   
   
4. A gene for sexual attraction to virgins with breasts (stronger the larger, and therefore more obvious, those breasts were) was favored because men who chose mates with a gene for virginal breasts would have daughters with virginal breasts, who would then get goodies normally reserved for pregnant women and be more likely to survive.
   
   
5. Then the whole sexual selection / positive feedback thing kicks in. There is an evolutionary advantage to a gene for attraction to a characteristic that others find attractive, since that gene makes your offspring more attractive, so that you’re more likely to have grandchildren. Then there is an evolutionary advantage to a gene that exaggerates such a characteristic in yourself because it makes you more attractive and therefore more likely to have children. Etc.

Why doesn’t Europe have a large trade deficit? (Part 2)

The first rule of this game is that you’re not allowed to answer, “Because Europe has a high savings rate.” The whole point of Paul Krugman’s post to which I linked in Part 1 (as well as this 1995 Krugman piece to which he links therein) is that there has to be some mechanism by which a higher savings rate leads to a smaller trade deficit (or a surplus). The usual mechanism is the exchange rate, but in this case, the dollar has not appreciated against the euro. (It has depreciated in nominal terms and probably mildly depreciated in real terms also.) You can’t just say that when people save more, they buy fewer imports: if this were the only mechanism, then an increased savings rate would necessarily lead to a huge recession, because people would also buy fewer domestic products. Once the central bank and the financial markets make the necessary adjustments to avoid that recession, they increase the demand for imports again, and we’re back where we started. Unless something else – such as the value of the currency – changes.

I’m somewhat disappointed that I haven’t yet seen an answer that is both convincing and conventional. Apparently, there is no easy story that explains the divergence in trade balances between the US and Europe. (When I say Europe, BTW, I mean the Euro Zone – since I’m speaking with reference to exchange rates. Steve Waldman points out that there is diversity within the Euro Zone, with Germany running a surplus and most of the others running deficits. At a pinch, I’ll make this whole discussion about Germany and say, “Why does Germany still have a trade surplus?”)

There were a couple of interesting unconventional answers that involve complementarity. Karl Smith (in a comment that he develops more fully on his own blog) suggests a complementarity between Asian production and US distribution. In this story, the major cause of the US trade deficit is what might be called the “Wal-Mart effect.” Imports have become cheap to buy in the US, not so much because they have become cheap to produce in Asia, but because US retailers have learned to operate on thinner margins. European retailers, on the other hand, have not.

A couple of people hinted at another possible complementarity: between European (i.e., German) exports and the Asian production process. If the Asian (Chinese) investment boom has created a specific demand for European (German) capital goods, then the resulting export demand could outweigh the effect of euro’s appreciation. It’s not entirely clear to me why it wouldn’t also create a demand for (presumably cheaper) US capital goods, but then I know very little about the details, so perhaps US capital goods just aren’t the kind that China needs.

Some people suggested various things, such as European protectionism and the VAT, that might help explain why Europe has in general had a stronger trade balance than the US, but as far as I can tell, they don’t explain why the US has developed a trade deficit over the past decade and Europe hasn’t. The VAT was there a decade ago, when the euro was weaker and Asia was less productive, so why didn’t Europe have a large trade surplus at that time?

Gabriel M. asks why it all matters. He wants the answer to boil down to welfare. Steve Waldman gives an answer which may help satisfy Gabriel. As for me, I don’t have an answer that boils down to welfare, because in this case I’m one of the agents trying to form my own expectations about exchange rates. The observation that the US is importing a lot more than it is exporting, and the presumed unwillingness of people outside the US to keep sending goods to the US without eventually receiving something in exchange, suggests to me that the dollar is overvalued. The fact that a similar argument cannot be made for Europe suggests that the euro is undervalued against the dollar. But I’m troubled because there is a piece of the puzzle that doesn’t seem to fit.

A Crude Form of Inflation Targeting

In his latest sermon against core inflation, Barry Ritholtz makes an important point – sort of. At least, he brings up an important issue, but I think his message that the core is evil distracts him from thinking more subtly about the implications. The title of his post, “Rising Crude Oil Pushes Consumer Prices Higher,” says most of it, and when he says, “consumer prices,” he means, “even core prices.” It’s a fact that we can’t escape: energy is a critical input to many goods (and services) that are part of the core. And even if it is only targeting a core price index, the Fed still has to worry about oil prices.

This is, as I said, an important point, but I don’t think it implies that everyone who emphasizes the core is either a liar or an idiot. It just means that anyone who claims to make an optimal forecast of the core without taking oil prices into account is not being careful. It also means that, even if we are confident that the Fed is targeting a core index, we should expect the Fed to take into account the inflationary impact of large oil price increases. At the same time, the Fed may take into account the potential recessionary impact of rising oil prices, if it judges that the price increases are a supply-side effect and not a demand-side effect.

So the monetary policy implications of rising oil prices are ambiguous, but they clearly don’t follow the simple formula that the bond market sometimes seems to expect: tighter oil => weaker economy => easier money. If the change in oil prices is a demand-side effect, then it’s actually a symptom of a stronger economy rather than a cause of a weaker economy, and the formula goes something like this: stronger economy => tighter oil => tighter money. If the change in oil prices is a supply-side effect, it will unambiguously tend to weaken then economy, but the Fed may perhaps prefer an even weaker economy to an unchecked inflationary impulse, and the result may still be tighter money.

If it were up to me, the Fed’s target would not be core consumer prices but something (such as unit labor costs) that excludes the effects of energy shocks altogether. Such a target would allow the US to take an adverse energy shock entirely in the form of a higher price level (rather than going through the painful process of squeezing profit margins, which tends to have unemployment as a side effect) without raising long-term inflation expectations. (An abrupt energy shock could still weaken the economy by James Hamilton’s mechanism of forcing difficult transitions – squeezing profit margins in some areas while raising them in others – but I don’t think there’s much we can do about that.) Since unit labor costs seem to be a politically unacceptable target (and the data are unreliable in the short run), one could perhaps imagine a core price index that is corrected for the indirect effects of food and energy prices. (I guess that would piss Barry Ritholtz off even more.) I’d also like to exclude import prices, so the GDP deflator might be a reasonable first-round candidate, though it brings in another set of problems.

Why doesn’t Europe have a large trade deficit?

Paul Krugman (hat tip: Greg Mankiw) points out that, for national savings (and investment) to affect the trade balance, it first has to affect the exchange rate. (In particular, if the US had a higher savings rate, the trade deficit wouldn’t fall unless the dollar depreciated further, so it is absurd to blame the weak dollar on the low savings rate.) One of the implications of this realization is that one can talk about the immediate causes of trade imbalances without mentioning national savings or investment: the cause has to be either in the (real) exchange rate or in the business cycle.

In terms of exchange rates, it’s pretty easy to see why the US has a large trade deficit today. (For now I’ll leave out the oil issue, though that’s part of the explanation.) The Asian countries (and China in particular) have become dramatically more productive over the past decade. Therefore their prices for traded goods have fallen dramatically, but they have not allowed their currencies to appreciate commensurately. Consequently, the dollar is overvalued (in real terms) relative to those currencies today. Ergo, the US has a trade deficit.

OK, so far it makes sense, but wait a minute: productivity growth in Europe has not been much faster than productivity growth in the US over the past decade. Prices of traded goods produced in Europe have not fallen. The euro has not, on balance, depreciated against the dollar. And Europe didn’t have a huge surplus with the US a decade ago (despite the booming US economy at the time). So if Asian goods are cheap today relative to US goods, then Asian goods must also be cheap relative to European goods. So why doesn’t Europe have a large trade deficit like the US?

If I get a chance, I’m going to download actual data on trade balances and exchange rates and see if I can figure this out. For now, though, it’s a puzzle. And it makes me wonder if we should start to get really worried about Europe’s trade balance now that the euro has appreciated dramatically against the dollar.

Carbon Taxes

Apparently, the public in most countries supports Pigovian carbon taxes, but economics students (at least those at Gettysburg College) don't.

Stay Away from the Fan

If we lived in my fantasy world where the Fed targets unit labor costs and everybody knows it, we’d be fine – and due for some more substantial rate cuts. Not that I would have the Fed react dramatically to the latest dip in unit labor costs – which is only one quarter out of many and, after all, could be revised away. My fantasy Fed might take the latest labor cost report as a minor reason to congratulate itself on past policy actions, what with earlier seeming evidence of an acceleration in labor costs turning out to have been falsely alarming. But as for cutting rates, the Fed has plenty of other reasons: a deepening financial crisis that threatens to affect the real economy; a deepening housing recession (depression?) that threatens to spill over to the rest of the economy; a substantial decline in labor demand that has finally begun to show up in the unemployment rate. If labor costs were the target, the Fed could respond to all these concerns and shrug off the other news: the fastest increase in commodity prices since the 1970s. If everyone knew the Fed were targeting labor costs, then workers wouldn’t expect pay increases to compensate for rising energy costs and the like, and the Fed could ease without risking losing credibility or creating an inflationary spiral.

If we lived in my other fantasy world where the Fed follows a backward-looking Taylor rule, we’d be doing OK too – and still (in my opinion) due for some more rate cuts. Although there is inflation on the horizon, the Fed could use (and could already have used) the low reported trailing inflation rates as an excuse to cut rates. By the time the commodity price increases found their way into core inflation, hopefully the financial crisis would be over, and, with any luck, the Fed would re-tighten at just in time to prevent a boom.

But in the real world, Fed policy is judged not by unit labor costs or by its adherence to a backward-looking rule but by outcomes in the core inflation rate. (I’m thankful at least that I live in the USA, where we know that smoking cigarettes causes cancer and targeting headline inflation causes unnecessary recessions and booms.) If the Fed lets the core inflation rate rise for any reason, that will lead people to question the resolve of its still relatively new chairman. And workers, facing a reasonably healthy economy, will feel entitled to wage increases to offset their rising cost of living. And businesses, facing that same reasonably healthy economy and a seemingly friendly Fed chairman, will see no reason not to raise prices enough to preserve their record profits and compensate both for increased energy and materials costs and for increased wages. Unfortunately, the only way for the real Fed to maintain its credibility today is by keeping the economy weak and risking recession, so as to damp any economic optimism, which, in combination with rising non-labor costs, would result in a higher core inflation rate.

So here we are, people. Just over a month ago, I insisted that the s___ was not yet hitting the fan, but it looks like I spoke too soon. The fan is running. The s___ is flying. Just get out of the way.

Health Care Problems Exaggerated?

I’m a bit confused by Greg Mankiw’s latest blog post on the subject of health care. He seems to be arguing that, aside from redistribution issues and the perception of rising prices, the problem is relatively minor. (“...the magnitude of the problems we face are often exaggerated by those seeking more sweeping reforms...”) I suppose Greg regards the actuarial insolvency of the Medicare system as a problem of smaller magnitude than those alleged by reformers, or perhaps as a purely demographic problem that is only nominally related to the health care issue. But it seems to me, if the government has made a commitment to pay for certain things, the fact that the prices of those things are rising rapidly – regardless of whether quality is rising faster than prices – is a big problem.

I agree with Greg’s contention (in his New York Times piece) that it can be perfectly rational to spend a larger and larger fraction of our income on health care, but that doesn’t change the fact that, under current institutional arrangements, figuring out how to pay for it is a big, big problem. To put my point a little differently, those “pundits of the left” who pretend to be concerned about the health care system but really have a redistribution agenda, they would seem to be holding some pretty good cards right now, given that the government has already promised more free health care than it will be able to deliver under current fiscal arrangements.

When Greg asks the question, “What health reform would you favor if the reform were required to be distribution-neutral?” it is impossible to answer without making an assumption about how the distributions will be worked out under the current system. One possible assumption is that the Medicare problem will be solved by means testing. If so, one objection I have to the current system is that it will distort saving incentives by means-testing away the wealth that people have saved. That is an efficiency problem, not a distribution problem, but it’s hard to think how one might address that problem in a way that is both distribution-neutral and politically feasible. I believe (though Greg may disagree) that taxing rich workers is more efficient than taxing middle-class capitalists, but clearly that change is not distribution-neutral. I also believe (and Greg will probably agree) that taxing middle-class workers is more efficient than taxing middle-class capitalists, but…like that’s gonna happen.

I suspect that Greg is wrong about the motivation of radical health reform advocates. Redistribution, I would argue, is not the reason for health reform but the way to sell it. Somebody’s going to have to pay for Americans’ future health care, and if you say you’ll make the rich pay for it, the non-rich majority will be more willing to listen to the rest of your ideas.

I also suspect that Greg is wrong about why Americans are unhappy with the current system. I personally don’t mind rising prices, but I am unhappy with the current system. What makes me most unhappy (and has ever since I graduated college during a recession and had to apply for individual health insurance because I didn’t have a job yet) is the insecurity of it. Group health insurance (which most Americans get through their own or their spouse’s employer) is expensive but not prohibitively so. Individual health insurance is on average somewhat more expensive, but the problem is not the mean; the problem is the variance. If you don’t have access to group health insurance, there is no guarantee that you can be insured for any price.

There’s a distributional issue that’s important to me, too, but it’s not the rich vs. everyone else distribution that Greg talks about. And it isn’t the poor (in general) vs. everyone else either: the poor already have Medicaid. The category of people that I worry about are those who are poor, or who become poor, specifically because they (or people in their families) are sick. In some cases, it is probably their own fault for passing up health insurance when it was available. In other cases, I imagine, they never had a chance to become insured, or their insurance was cancelled.

No doubt the breadth of both of these problems – the problem of insecurity and the problem of people who are poor because of large health expenses – is exaggerated in my mind, but they make me very uncomfortable with the current system. And I don’t sense that the virtues of the current system (compared to those in other industrialized countries) are sufficient to justify the existence of these problems.

Incentive Effects of Progressive Taxation at the High End

Does progressive (labor) taxation at the high end reduce the incentive to engage in high-value activities? It seems to me that (to the extent that highly lucrative activities really are high value) it actually increases the incentive. Most of the people with the highest compensation -- movie stars, star athletes, CEOs of large corporations, successful hedge fund managers, successful entrepreneurs, etc. -- have that high compensation not just because of decisions to engage in (ostensibly) high-value activities but because of a combination of an intentional occupational choice decision and unpredictable outcome of success in that occupation. The ones who made the same occupational choices but weren't so successful -- ordinary actors, minor league athletes, middle managers of large corporations, hedge fund managers without a lot of assets under management, entrepreneurs with limited or no success, etc. -- don't get that ultra-high compensation.

How could the tax code encourage people to undertake these activities? If people were risk-neutral, the progressivity wouldn't make much difference, since any increase in taxation of the high rewards for being successful would be offset by a decrease in taxation of the lower rewards of being not-so-successful. But economists usually assume that people are risk-averse. If so, progressive taxation encourages people to enter high-risk, high-value occupations, because it provides a form of insurance for people who choose to do so. If you're successful, you make gobs of money, and you have to pay a lot in taxes, but you still end up with gobs of money; if you're not so successful, you don't make so much money, but you get an insurance payment in the form of a reduced tax bill. If the government were explicitly providing an at-cost insurance policy for actors, athletes, business people, hedge fund managers, and so on, I don't think there would be much question that the policy would encourage, rather than discourage, entry into these occupations.