Monday, May 29, 2006

X or not X

Which of the following is closer to truth?

(1) The 2003 tax cut stimulated spending and thereby helped strengthen the current recovery.

(2) The 2003 tax cut did not stimulate spending and therefore is not contributing to the low national savings rate.

I tend to go with (1), but I’m willing to look at evidence for (2). What troubles me, though, is that most Democrats – including people like Paul Krugman and Brad DeLong, who should know better – seem to think the answer is “none of the above.” I happen to be a Democrat myself, but I also support the Party of Logic and Arithmetic, which somehow seems to be opposed by both major parties (not to mention most occasional third parties) most of the time. Either people spent the tax cut or they saved it, or perhaps they spent half of it and saved the other half, but you can’t say, “For purposes of calculating the short-run macroeconomic impact, they saved the tax cut, but for purposes of calculating the growth and balance of payments implications, they spent it.”

I’d like to suggest that, if you want to make the case for the Democrats, you’re better off with (1). Yes, you do have to acknowledge that the Bush administration did something that was not 100% stupid or 100% evil. But in return, you get to make a logically coherent case that they did something maybe 50% stupid or 50% evil, depending on how you look at it. After all, most economists consider the low national savings rate to be a big problem.

On the other hand, if you want to make the case for the Republicans, you’re better off with (2). Yes, you have to give up the argument that the tax cut saved the country from ruin. But in return you get – well, a free lunch. If the tax cut didn’t affect the overall savings rate, then young people will inherit the same savings, so there is no intergenerational transfer. Taxpayers overall are a little better off. If you’re a risk-averse taxpayer, you’re right where you started: just buy a Treasury bond and make your future tax payments with the proceeds. If you’re a less risk-averse taxpayer, you get to take advantage of the government’s credit rating and invest the money in something more profitable. So all these macro effects add up to a slight benefit, and the micro effect – less distortionary taxation, leading to a more efficient economy – is just gravy.

Of course, the Democrats could counter that this tax cut went to the rich, while the compensating future tax receipts (or benefit cuts) might come from the middle class (or the poor). But that argument only works if you expect the Republicans to stay in power. And frankly, personally, Democrat though I am, I would not be terribly unhappy to see the revenue made up with, say, a value added tax. I do like progressive taxes, but my feeling is, since people with nothing at all pay no taxes at all, any tax is progressive in the most critical income range.

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Saturday, May 20, 2006

Positive Feedback

Having established in my previous post (not to everyone’s satisfaction, I realize) that Bernanke is actually a hawk, let me now turn my attention to how the Man with the Helicopter should react to the latest inflation report. If you follow the news at all, you will recall that Wall Street reacted with great dismay to Tuesday’s report of a greater than expected increase in the Consumer Price Index. Ostensibly, the reason for the dismay was the expectation that more monetary tightening would be necessary to combat the newly revealed inflation.

Let’s take a closer look. It wasn’t the large increase in the energy component of the CPI that troubled Wall Street: this wasn’t a surprise to anyone who drives. What troubled Wall Street was the unexpected increase in service prices. But in fact, there was no broad increase in service prices. The CPI for services excluding rent of shelter has risen by 0.0% over the past 3 months – hardly the stuff inflationary spirals are made of. The whole problem was with rent (especially “owner’s equivalent rent” for homeowners)..

Housing costs are important, and we certainly shouldn’t ignore them when evaluating the overall inflation situation, but we have to consider today’s rent increases in the context of recent experience. We need to consider the reasons that rents are increasing and the dynamics of any Fed response.

A few years ago, when interest rates were very low, renters began to find it economical to buy houses of their own, demand for rental housing went down, and rents – which might otherwise have risen – were kept in check. That dynamic helped keep the overall inflation rate extremely low. Today, the opposite dynamic is taking place: interest rates are higher, homeownership is uneconomical, rental demand is up, and rents are rising, contributing positively to the overall inflation rate. When you smooth out these cyclical fluctuations, though, the trend rate of increase in rents is neither dramatically high nor dramatically low. We can anticipate that interest rates will eventually reach a peak, housing markets will eventually stabilize, and rents will eventually settle into some equilibrium growth rate not too far from their historical trend.

But what will happen if the Fed responds to rising rents by raising interest rates? The answer is pretty clear: interest rates go up, so rents go up, so interest rates go up, so rents go up, and so on. (Arguably, this is, in reverse, part of what happened on the way down.) Eventually, interest rate increases will deflate the rest of the economy and put an end to the vicious circle, but at the cost of an unnecessary slowdown. If the Fed has a policy of responding to rent increases with interest rate increases, that is a positive feedback mechanism that will tend to amplify the business cycle. Of course, part of the Fed’s job is to dampen, rather than amplify, the business cycle.

So, as a first cut, the answer to how Bernanke should react to the inflation report is that he should ignore it. Unfortunately, he can’t ignore Wall Street’s reaction. The spread between TIPS yields and nominal bond yields indicates increased inflation expectations, and, as a new Fed chairman, Bernanke cannot be seen making excuses not to raise interest rates – even if they later turn out to have been good excuses. On the other hand, with the stock market down, there is more reason to worry about a weakening economy, so perhaps this offsets concerns about credibility. All in all, it’s hard to say what Bernanke should do, but in any case, Wall Street’s reaction seems a bit excessive.

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Friday, May 19, 2006

Hawk Helicopter

Fed Chairman Bernake is famous for once having given a speech in which he trumpeted the Fed’s ability to combat deflation by creating money – if necessary, by dropping it from a helicopter. The image of Old Ben piloting a chopper, raining dollars on a world fertile for price growth, has stuck in the minds of many inflation hawks and left them with the impression that the Chairman is likely to be relatively soft on inflation. But when we look at his famous statement in context and apply the logic of central banking, it becomes clear that this conventional interpretation is not just incorrect but diametrically opposite to the statement’s true implication.

First we have to recognize that there is a consensus that deflation is bad. It is a matter of dispute just how bad deflation is. But it is fair to say that those who regard deflation as a potentially healthy process are a small minority. To many, deflation conjures up images of the early 1930s, probably the most unpleasant period in the history of capitalism. There is also dispute – and this is where Bernanke’s speech weighs in – about how hard it would be to end a deflation if such a thing were to materialize. The example of Japan suggests a rather pessimistic prognosis, but Bernanke’s speech makes clear that he thinks more effective anti-deflation policies would have succeeded much sooner in Japan.

As a central banker, one is faced constantly with the problem of balancing risks. The biggest risks, I think most would agree, are, on the one side, deflation, and, on the other side, excessive inflation. The problems associated with high inflation are well known. From a central banker’s point of view, it isn’t really the end of the world, because it is generally acknowledged to be curable. The cure, however, is painful and politically difficult, so most central bankers make diligent efforts to provide more than an ounce of prevention. Deflation, on the other hand, is not generally acknowledged to be curable, so some central bankers might regard it as the end of the world. Anyone who does regard deflation as the end of the world is likely to tilt the balance of risks toward inflation.

Bernanke, it should be abundantly clear, is not such a central banker. Bernanke thinks deflation is a solvable problem, just like inflation, and the solution to the deflation problem is a lot less painful than the solution to the inflation problem. Accordingly, Bernanke is not likely to be overly concerned with the risks of pursuing a tight money policy. With his helicopter fueled and ready in case it should be needed, Bernanke’s inclination will be to tilt the balance of risks toward deflation rather than inflation.

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Wednesday, May 10, 2006

Weak Yuan in the Long Run?

In a comment on an earlier post, reader mvpy points out that labor’s share of national income has a very robust tendency to revert to its mean over time. How, mvpy suggests, can I therefore argue that the weak yuan policy can have lasting effects on US income distribution?

The answer is, I can’t. Even on theoretical grounds, there is no reason (generally) to think that the weak yuan policy would have long-run effects on anything. (The exception – not accounted for in traditional theory – is path-dependence – the effect of the past on the future. For example, the weak yuan may make it profitable to build factories in China. If the yuan subsequently strengthens, but those factories have already been built, it may still be profitable to run them.)

Let’s be clear on this: exchange rates are a short-run phenomenon. In the long run, if China maintains the weak yuan, the strong demand in China will cause inflation, and the weak demand in the US will cause deflation (relatively speaking). The ultimate result is that it will no longer be cheaper to buy things in China than in the US. This phenomenon is known as “real appreciation,” and, in the long run, it renders exchange rate policy irrelevant.

The concern I have is that the long run may take a lot longer to arrive this time around. Ordinarily, when exchange rates are out of whack, it is because some country is trying to defend its currency at an unrealistically high value. To avoid running out of exchange reserves, that country has to tighten monetary policy, which has a deflationary impact and hastens the real depreciation of its currency.

China is in the opposite situation, and the picture is not symmetric. China does not have to worry about running out of reserves. Therefore, China can sterilize its foreign exchange intervention to blunt the inflationary impact. China need not follow a loose monetary policy, so the real appreciation may be a long time in coming. So (though again I hesitate to blame the low labor share in the US predominantly on China’s exchange rate) don’t be too surprised if labor’s share remains away from its mean for a lot longer than usual.

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Friday, May 05, 2006

Why I support a windfall oil profits tax

Ordinarily windfall profits taxes are one of my least favorite kinds of tax. After all, basic economics says that windfall profits serve an important function: they draw needed capital into industries where supply is currently insufficient to meet demand without driving prices above normal levels. Moreover, the possibility of windfall profits is an important motivator for investment in risky businesses even in more normal times. If potential investors anticipate that there will be windfall profits taxes if things turn out better than expected, then they face a “heads I win, tails you lose” situation going into a venture: if things go badly, they get nothing; if things go well, the government gets everything. In general, our policies should probably be designed to encourage, rather than discourage, entrepreneurial risk taking.

But oil is a special case. I should start by saying that I have long (for at least 26 years, since the last oil crisis – but I won’t say whether I was old enough to vote at the time) been an advocate of much higher energy taxes in the US. I have also long been aware (particularly after observing the fates of John Anderson in 1980 and Ross Perot in 1992) that higher energy taxes are pretty much a lost cause politically. Higher taxes on fossil fuels would encourage conservation, encourage the development of renewable energy sources, discourage pollution of the environment, and slow down exploitation of our limited fossil fuel resources. But, in all probability, they just aren’t going to happen.

In a sense, however, they already are happening. There is a tax on oil, and the tax is being collected not by the government but by the oil companies themselves, with some help from energy speculators. Ordinarily, a dramatic increase in the price of a commodity would induce new investment in the industry, which would increase availability of the commodity and thus ultimately moderate the price. Today, however, that doesn’t seem to be happening: instead of making major new investments, oil companies – somehow bizarrely worried that oil might go back down from $70 to $10/barrel – are sitting on their profits, being good tax collectors but not good capitalists. And as a supporter of higher energy taxes, I think this is a good thing. We are getting exactly what we need: encouragement for conservation, encouragement for development of renewable energy sources, discouragement for pollution, and slowed exploitation of our limited resources.

The only thing we’re not getting is revenue – well, Exxon’s stockholders are getting plenty of revenue, but the federal government is still running a huge deficit. So why not just take some of those oil company revenues and declare them to be revenues of the federal government instead? This will of course further discourage the already ridiculously conservative oil companies from finding and exploiting more oil. Which is all for the better, in my view. Leave the oil in the ground, and it will still be there when we really need it. Some time 20 or 80 or 300 years from now, when oil has become more precious than gold and SUVs have become uneconomical even for the rich, we can repeal the windfall profits tax and say, “Get out there and dig!”

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Wednesday, May 03, 2006

Distributional Effects of the Weak Yuan in the US

In general, having a strong currency (e.g. the dollar against the yuan) tends to benefit consumers and hurt producers. Consumers get more for their money, and producers face weaker demand (lower prices) because of the competition. In our society, most people are both producers and consumers. However, richer people tend to do more consumption than poorer people (in absolute terms, though not as a fraction of income), whereas richer people probably don’t, on average, do more production than poorer people. Consequently, the weak yuan tends to shift distribution from poorer to richer people in the US.

You might argue that only those producers who compete directly with the Chinese are hurt by the weak yuan. The problem is, though, that US workers – even those in different industries – compete with one another. If you get laid off because your job is being outsourced to China, and then you come and apply for my job, it makes my boss that much less likely to give me a raise.

US workers compete with other US workers, nationally, but US capitalists compete in a global capital market. Thus, even though capital is part of the production process, the capital side of production isn’t hurt (at least not in aggregate) by the weak yuan. Sure, if you have all your money in one domestic business, and the Chinese start making your product more cheaply, you’ve lost part of the value of your investment. But if you have a diversified portfolio of capital assets, you’ll take losses on some and gains on others. If the expected return on US capital goes down, you stop investing in the US and start investing abroad. Workers don’t have an analogous option.

Just as most consumers are also producers, most workers are also capitalists, but again it is a matter of degree. Poorer people, and younger people, tend to derive most (or all) of their income from labor, whereas richer people, and older people, derive a comparatively greater share from capital. Thus, again, the weak yuan tends to shift distribution from poorer to richer people in the US (and from younger to older people).

In a comment to one of his blog posts, Greg Mankiw implicitly made the counterargument that (1) consumers benefit in proportion not to the total amount that they consume but to the amount of Chinese goods they consume, and (2) Chinese goods are widely consumed by the poor and middle classes. (“Inexpensive goods from China are sold at Walmart…”) This becomes an empirical issue: I won’t concede that rich people consume a much smaller proportion of Chinese goods until someone shows me the evidence.

Another counterargument (also perhaps implicit in Greg’s comment) is that, even though the distributional shift may be toward the rich, the poor still end up better off. When I see real wages falling, I’m rather skeptical of this argument, too. Of course, we can’t blame falling US real wages primarily on the weak yuan, but I’m guessing it’s a factor.

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