Tuesday, January 31, 2012

My New Book -- "The Instant Economist: Everything You Need to Know About How the Economy Works."

Here's the start of my new book called The Instant Economist: Everything You Need to Know about How the Economy Works. It's available as of today on Amazon here, or at Barnes and Noble here.
"Talking about the wisdom of economists in polite company is like talking about the honesty of politicians or the lips of chickens. Yet in the face of this prejudice, I maintain that economics has useful lessons for understanding the world. My wife says I hold this belief because I am an evangelist, with economics as my religion. Perhaps so, but I have also been asked many times, by many people—at venues as diverse as conferences and cocktail parties—to recommend “just one book” that explains economics. These people aren’t looking for a treatise on the beauty of the free market, or for a lecture on the need for government regulation. They have their own views on politics and policy, but they are self-aware enough to recognize that at least some of their views are built on a shaky or nonexistent understanding of economics. I can sympathize. There are dozens of books out there on economics—freaky and otherwise—but I’m hard-pressed to point to a readable non-textbook that would give a soup-to-nuts understanding of the key principles of economics. I hope that the book you’re reading will impart a working understanding of both micro- and macroeconomics, not enough to prepare you for setting up your own economic forecasting business, but enough that you can read and speak about economics topics with greater confidence and conviction."

"I know what you’re thinking. You’re wondering if I’m out to push a certain set of economic policies, and if so, whose side of the political fence I’m on. Such skepticism is understandable, but here’s the honest truth: If you’re wondering whether this book’s contents are slanted toward liberal or conservative economic policy—or toward the Democratic or Republican Party—the short answer is no. Professional economists of all political leanings use the tools and concepts I will discuss here. Economics is not a set of answers, but a structured framework for pursuing those answers." 

For an idea of what the book tries to accomplish, maybe it's useful to tell the back story of how this material has percolated a long time, through five episodes of thinking about how to teach intro economics.

Episode #1 started in the late 1980s was when I worked with Joseph Stiglitz in putting together his introductory economics textbook. This led to episode #2, which was when I started teaching large-lecture introductory economics courses at Stanford University in the late 1980s. This in turn led to episode #3 a few years later, when Stanford got a Pew Foundation grant to bring over groups of young diplomats from countries of eastern Europe. Many of them had been educated and trained with the expectation that they would become part of the larger Soviet diplomatic apparatus, but with the break-up of the Soviet Union, those expectations has become obsolete. Groups would come over and spend a few months based at Stanford, with side trips to see other parts of the U.S. They sat in on various courses, but also had an international affairs course and an economic course just for their group. For a few years while the grant money lasted, I gave the economics lectures, which were were an intuitive and nontechnical 15-hour version of the intro economics course.

This led to episode #4, which was a call from the Teaching Company, a firm based near D.C. I'd won a student-voted award as the outstanding teacher of a large lecture class at Stanford, and they wanted to know if I would record a version of that course for their adult education lectures. I'd never heard of the company, but I had the lecture notes pretty much ready to go from my talks to the eastern European diplomats, so I said "sure." That course was first recorded in 1994; the most recent edition (the third) was recorded in 2005. This led to episode #5, when Penguin/Plume started having talks with the Teaching Company about turning some of their more popular courses into books. They asked if I would take a stab at doing this with the economics book. This involved a huge cut in the word count from the 18 hours of lectures, because they didn't want a tome, and then updating the material as needed so that it would cover the economic events of the Great Recession and its aftermath.
I'm pleased with the book. For those looking for an actual introduction to economic thinking, and a bunch of examples and applications, this book should help to organize  the concepts and clarify the tradeoffs. I suspect that the book may also be used as background reading for those who want to teach an intro economics course with almost no graphs or equations. Buy a bunch and give 'em out as party favors! Send a copy to political figures! Use them as paperweights!

Here's the review from Library Journal, which I thought captured the flavor of the book:

"Taylor’s (managing editor, Journal of Economic Perspectives) volume can help conversationalists looking to raise the bar for their watercooler chats and casual readers who want to understand better the current economic condition of the United States. Taylor uses simple language with field-specific vocabulary to explain economic concepts, and each concept is successfully reinforced with a real-life—and usually entertaining—example. He hits all the subjects that might interest a layperson, such as division of labor, supply and demand, wages, competition and monopoly, inflation, banking, and trade, for a total of 36 petite chapters—just enough information to give the reader a basic but well-rounded understanding of the subject. VERDICT This highly readable, nonpoliticized look at some of the economic principles that shape our society, presented in an engaging, anecdotal fashion, is highly recommended for armchair economists and anyone with a general interest in the state of our economy. —Poppy Johnson-Renvall, Central New Mexico Community Coll. Lib., Albuquerque

Economic Underpinnings of the U.S. Revolutionary War

The U.S. war for independence from Britain is often described in terms a desire for democratic self-government and protection of the rights of citizens. But among historians, there has been a long tradition arguing that economic factors were more important. Perhaps most famously, Charles Beard argued back in 1913 in his book, An Economic Interpretation of the Constitution of the United States that the Founding Fathers were just out to protect their own personal property. But as the decades passed, a consensus developed that Beard's arguments was so simplistic and contentious and stark that it was just wrong.

Staughton Lynd and David Waldstreicher offer a refreshing take on the role of economic forces in the U.S. Revolution in "Free Trade, Sovereignty, and Slavery: Toward and Economic Interpretation of American Independence." It appears in the October 2011 issue of the William and Mary Quarterly, which is not freely available on-line, but will be available to many with academic ties if their institution has a certain kind of JSTOR subscription. Here's their opening (footnotes omitted):

"What kind of revolution was the American Revolution? Four basic answers, all first suggested before 1800, continue to shape the scholarship. They can be denoted Answers A, B, C, and D.

Answer A was advanced by the Revolution's leaders and echoed by their friends in Great Britain, such as Edmund Burke: The American Revolution was a struggle for constitutional rights.

Answer B was that of the Revolution's opponents, again both in the American colonies and in Great Britain: The American Revolution was a struggle for economic independence from the British Navigation Acts and other economic restrictions. 

Answers C an D were put forward in a second round of controversy during the 1790s, as Americans tried to determine their proper relationship to the French Revolution. Answer C was that of the Jeffersonians: The American Revolution was a democratic movement essentially similar to the French Revolution. Their Federalist opponents responded with Answer D: The American Revolution was a colonialist independence movement essentially different from the French Revolution. ...

We offer for further exploration what might be described as a B-D interpretation. That is, the American Revolution was basically a colonial independence movement and the reasons for it were fundamentally economic."

I can't hope to summarize their argument point-by-point, but in large part, it comes down to pointing out how economic conflicts were often prior in time other events of the Revolution,  and loomed large in importance. Britain often sought to tax or even to embargo various kinds of trade from the American colonies to the West Indies: for example, the import tax with the Molasses Act of 1733, or the way in which the British Navy tried to cut off trade between the colonies and the French West Indies during the Seven Years' War. The "single most contentious issue" in the First Continental Congress in 1774 was about the extent to which the British Parliament could regulate the U.S. economy, including these and other limits on navigation as well as acts that sought to prohibit manufacturing in the colonies (so that the colonies would need to import from Britain, instead). After reviewing the history in some detail, they write:

"The commercial dispute preceded the constitutional, not just once but again and again in these years. It is important that colonists melded economic and constitutional arguments under the category of sovereignty--but not so important that we should ignore the originating nature of economic forces."

To anyone who has passed through the U.S. public school system, or who has listened to the rhetoric of politicians, thinking of U.S. independence as driven by economic motives has nearly sacrilegious overtones. Lynd and Waldstreicher respond like this:
"If the American Revolution had fundamentally economic causes, it is not thereby demeaned. Post-World War II colonial independence movements should have taught us something about the many-sided meanings of economic sovereignty for developing nations. If not only merchants but also artisans, tenant farmers, cash-strapped yeoman, fishermen, and debt-ridden slave-owning planters can be shown to have had compelling economic reasons to favor independence, it should not seem too narrow or conspiratorial to suggest that they acted on these reasons and sought to combine them with a language that spoke to principles as well as to the bottom line."

To me, it seems quite plausible and believable that the urge of the colonists to move beyond protest and into actual war and rebellion needed the push of economic factors. In addition, if we have learned nothing else from last two centuries, it should be that when anyone starts talking about a revolution is needed for freedom and justice and for people to get their "rights," warning sirens should go off in your brain. Such promises from revolutionaries have certainly been betrayed far more than they have been honored.

But it also seems to me that the cause of an event is often quite different than the lasting legacy of that same event. The causes of the U.S. Revolution probably were largely economic, albeit expressed in a language of constitutionalism. But the lasting legacy of American Independence was the creation of a constitutional structure that is flexible enough to adapt and strong enough to endure.

Monday, January 30, 2012

Robert Kennedy on Shortcomings of GDP in 1968

Every year or two, I run across this lovely quotation from Robert F. Kennedy about the fundamental shortcomings of gross national product as a measure of well-being. It's from a speech he gave at the University of Kansas on March 18, 1968, and a transcript is available here.  Here's RFK:

"Too much and for too long, we seemed to have surrendered personal excellence and community values in the mere accumulation of material things.  Our Gross National Product, now, is over $800 billion dollars a year, but that Gross National Product - if we judge the United States of America by that - that Gross National Product counts air pollution and cigarette advertising, and ambulances to clear our highways of carnage.  It counts special locks for our doors and the jails for the people who break them.  It counts the destruction of the redwood and the loss of our natural wonder in chaotic sprawl.  It counts napalm and counts nuclear warheads and armored cars for the police to fight the riots in our cities.  It counts Whitman's rifle and Speck's knife, and the television programs which glorify violence in order to sell toys to our children.  Yet the gross national product does not allow for the health of our children, the quality of their education or the joy of their play.  It does not include the beauty of our poetry or the strength of our marriages, the intelligence of our public debate or the integrity of our public officials.  It measures neither our wit nor our courage, neither our wisdom nor our learning, neither our compassion nor our devotion to our country, it measures everything in short, except that which makes life worthwhile.  And it can tell us everything about America except why we are proud that we are Americans."

Although economists sometimes stand accused of worshiping GDP, this charge is untrue. Every introductroy economics textbook, including my own (available here through Textbook Media), acknowledges these shortcomings, although I confess we lack the poetic cadences of RFK. But the quotation can be a nice supplement when introducing students to the concept of GDP, or when looking for a topic for a short writing assignment or essay question.

The speech isn't long, and if you are a connoisseur of political rhetoric, it's worth reading. Of the current politicians on the national stage, I don't think any of them has the lovely touch with self-deprecating humor at the start of this kind of talk. Here's RFK warming up the audience--and remember that there are many Kansas students in the audience who don't especially support him:

"I'm very pleased and very touched, as my wife is, at your warm reception here.  I think of my colleagues in the United States Senate, I think of my friends there, and I think of the warmth that exists in the Senate of the United States - I don't know why you're laughing - I was sick last year and I received a message from the Senate of the United States which said: "We hope you recover," and the vote was forty-two to forty. And then they took a poll in one of the financial magazines of five hundred of the largest businessmen in the United States, to ask them, what political leader they most admired, who they wanted to see as President of the United States, and I received one vote, and I understand they're looking for him.  I could take all my supporters to lunch, but I'm - I don't know whether you're going to like what I'm going to say today but I just want you to remember, as you look back upon this day, and when it comes to a question of who you're going to support - that it was a Kennedy who got you out of class."

It's also hard to imagine that the speechwriters for any contemporary politician would let them finish a speech with this kind of classical reference and slightly obscure flourish: " I want the next generation of Americans to look back upon this period and say as they said of Plato: "Joy was in those days, but to live.""

Friday, January 27, 2012

Economic Underpinnings of Arab Spring

Adeel Malik and Bassem Awadallah discuss "The economics of the Arab Spring" in a working paper (WPS/2011-23) for the Center for the Study of African Economies at the University of Oxford. They point out that despite rapid growth in education levels, access to water, and urbanization--all patterns that are often associated with sustained economic development--the region has failed dismally to develop a robust private sector. As a result, well-educated and youth-heavy populations see little chance for economic advancement. Here are some excerpts: 

On large numbers of young and unemployed workers: 

"Over the last few decades, the Middle East has witnessed an unprecedented youth bulge that has dramatically changed its demographic profile. An overwhelming proportion of its population--in many countries about three-quarters--now consists of young people under the age of 30. Together with a greater female participation in the labour force, these demographic trends have greatly enhanced the number of people looking for jobs. During the period 1996=2006, labour force in Middle East and North Africa has grown three times as much annually as in the rest of the developing world, resulting in one of the larges rates of youth unemployment in the world."

On the collision between rising education and thwarted aspirations:

"Of the tip 10 countries that made the most impressive strides in human development during the last 40 years, five were from the Arab world. Starting from one of the lowest levels of educational achievement in the 1960s, adult education rose faster in the Middle East during the 19890-2000 period than any other region in the World. Despite reservations about the quality of education imparted, even this quantitative expansion of education has led to a silent revolution of sorts. It is a revolution of aspirations. Even as aspirations have become more mobile with the new gadgets of globalization, the local systems of governance are ossified and offer limited economic mobility to the region's youth." 

On the centrality of government in the economic sphere:

"The state in most Arab economies is the most important economic actor, eclipsing all independent productive sectors. When it comes to essentials of life, such as food, energy, jobs, shelter, and other public services, the state is often the provider of both first and last resort. The functioning of this system rests on a heavy dose of subsidies, economic controls, and a variety of other uncompetitive practices. ... The state-centred development paradigm rests on an uninterrupted flow of external windfalls. In fact, many of the region's pathologies--whether it is a weak private sector, segmented labor markets, or limited regional trade--are ultimately rooted in an economic structure that relies overwhelmingly on rents derived from fuel exports, foreign aid, or remittances. Reliance on such unearned income streams is the "original sin" for Arab economies."

On the paucity of intra-Arab trade:

"With a population of 350 million people that share a common language, culture, and a rich trading civilization, the Arab world doesn't function as one common market. ... Few Arab countries consider their neighbors as their natural trading partners. Pan-Arab trade is noticeably insignificant. Despite having tripled between 2000 and 2005, the share in intra-Arab trade in total merchandise trade still hovers around 10 percent. ... The share of intra-Arab imports, despite having fluctuated widely, is only marginally higher than that in 1960. ... Even this limited trade is geographically clustered, with countries in the Gulf and North Africa trading predominantly within their own sub-regions."

Location and water access don't seem to be helping: 

"The Arab world is well-positioned to be a global trade and production hub. Geographically, it lies at the cross-roads of major sea and trading routes with easy access to Europe, Africa, and the near East. ... Strictly speaking, there is not even a single landlocked country in the Arab world, even if Iraq and Jordan have narrow coastal strips. ... It is ironical that a region that connects Asian merchants with European markets is itself stuck in primary production. Everywhere in the world proximity to coasts tends to be associated with lower transport costs and better access to global markets. The Arab world defies these forces of gravity, however."

Urbanization doesn't seem to be helping:

"[C]ities offer a range of mutually supportive activities. Bringing together machinery, skills, suppliers and resources together in a single location can be tremendously advantageous for firms. Such agglomeration economies are missing in the Middle East, even if it is more urbanized today than several developing regions: 58 percent of the region's population lives in urban areas, compared to 30-37 percetn in sub-Sarharan Africa and south Asia. ... Yet, Arab firms are failing to reap the cost advantages that growing urbanization confers on them."

The jobs challenge and the private sector:

"The private sector is at once the most despised as well as the most desirable aspect of reform. Business in the Arab world is often comfortably embedded within the state, wtiht eh result that it invokes images of crony capitalism. At the same time, an estimated 100 million jobs need to be created in the MENA [Middle East and North Africa] region in the next decade or so. This employment challenge cannot be addressed without a strong private sector. .. An independent business sector will also serve a vital political function: it can generate a middle class that can serve as a powerful constituency for political reform. ... Viewed in this light, the struggle for a new Middle East will be won or lost in the private sector."

Malik and Awadallah lay particular emphasis, among all the policy steps that might be taken, on policies that would help to create a regional market across the Middle East: that is, policies and investments to make travel, shipping, business, and communication cheaper and easier. Such policies might be more politically acceptable (that is, less upsetting to local elites) than attempts to open more directly to the global economy. Riding the wave of discontented and well-educated young adults, such policies might also help to harness the power of Arab spring in a productive manner.

Thursday, January 26, 2012

Doha Seems Dead: What Next for the WTO?

The Doha round of trade talks kicked off in 2001. They now include 153 countries trying to reach agreement across nine areas at a time when the high-income countries are suffering the aftermath of a deep recession and watching a shift in global economic power toward emerging markets. After eleven years of negotiation, maybe it's time for the World Trade Organization to focus on something else.

Sure, there's a solid case to be made for the merits of the Doha trade round. Will Martin and Aaditya Mattoo edited a Vox e-book published last November called Unfinished Business: The WTO's Doha Agenda. In a column describing the main findings of the book, they point out: "The tariff cuts on the table compare favourably with those achieved in earlier rounds of multilateral negotiations. Even after allowing for flexibilities such as for sensitive and special products, Doha would cut the applied tariffs faced by exporters of agricultural and non-agricultural goods by around 20% ... The global real income gains from this market opening alone are conservatively estimated at around $160 billion per year. The agricultural proposals also include the abolition of export subsidies, and sharp reductions in maximum levels of domestic agricultural support in the EU and the US. ... A hard-to-quantify but nevertheless significant gain from the negotiations would be greater security of market access."

The main action in international trade talks in recent years has been through "preferential trade agreements" negotiated between two or more countries. The U.S. currently has such agreements with  17 countries.  Worldwide, the WTO now has a list of 512 regional trade agreements.

Regional agreements can lead to reduced trade barriers within the group of participating countries, but greater trade barriers between that group and the rest of the world. Thus, their net effect on free trade is not clear. Caroline Evans of the San Francisco Fed points out in a recent newsletter that preferential/regional trade agreements often lead to complex "rules of origin" about what share of value-added was made in which country, and also to different tariff rates across countries. She gives an example of U.S. trousers imports: 
"Rules of origin are put in place to eliminate cheating, whereby one country imports a product from a non-partner country and then re-exports it to the free-trade partner. Satisfying rules-of-origin requirements has become increasingly complex, since production processes now stretch across multiple countries. When an assembling country sources inputs from a number of other countries and then exports the finished product to another final market, it becomes difficult to determine exactly where the product originates. Since each PTA has its own rules of origin for particular parties to the agreement, meeting those requirements may become quite complicated."

"Different trade agreements also lead to separate tariff rates on imports from different countries. For example, U.S. imports of a certain kind of men’s trousers from most countries face a duty of $0.61 per kilogram plus 15.8% of the product’s value. However, if the trousers are imported from Bahrain, Canada, Chile, Israel, Jordan, Mexico, Peru, or Singapore, no duty is imposed. Trousers from Australia incur an 8% tariff; from Morocco $0.62 per kilogram plus 1.6%; and from Oman $0.488 per kilogram plus 12.6%. For non-WTO member countries, a $0.772 per kilogram plus 54.5% tariff is imposed.  ...  Rules of origin and the profusion of tariff rates increase the costs of trade, both for businesses involved in cross-border commerce and governments enforcing trade rules. Furthermore, they may distort production decisions as businesses navigate the web of rules and rates to minimize transaction costs."
So if the Doha round is becalmed and the alternative of regional trade agreements is imperfect at best, what should the WTO and other friends of free trade be focusing on these days? Last November, the Strategy, Policy and Review Department of the IMF put out a paper called "The WTO Doha Trade Round--Unlocking the Negotiations and Beyond" with some suggestions for multilateral steps that could perhaps be debated and even implemented through the WTO mechanism.

Some of the ideas seem potentially useful to me. For example, greater monitoring of protectionist measures, including nontariff barriers and rules that require governments to buy domestically produced goods and services, seems like a step in the right direction. There are concerns that some countries restrict food exports at certain times, which makes other countries unwilling to rely on food imports, and thus leads them to subsidize their own domestic food production. Perhaps this set of issues could be isolated and discussed. And perhaps it might be possible for WTO to negotiate a set of guidelines for the proliferating preferential trade agreements, so that they are more likely to reduce overall trade barriers for the world economy, rather than reducing trade barriers for participants but raising them for everyone else.

On the other side, some of the IMF suggestions seem implausible to me. For example, one suggestion is that WTO should get into climate change issues, which would mean trying to jump-start one set of dead-in-the-water negotiations by getting involved in another set of dead-in-the-water negotiations. Another suggestion is that the WTO might develop an international antitrust policy. I'm not feeling it.

The power of the World Trade Organization is often highly overstated in public discussions. It's not a colossus imposing its own vision of a new world economic order. It's an organization with a staff of about 600 people, where decisions are made by consensus of the 153 member nations. But it is useful to have a world meeting-place for hashing out international trade issues, and there's a lot of knowledge and experience and skill wrapped up in the WTO apparatus. But if the future of the WTO is wrapped up in the endlessly stalled Doha negotiations, the organization seems likely to marginalize itself into irrelevancy.

Wednesday, January 25, 2012

McKinsey on Reducing Debt and the Pathway to Economic Health

 The McKinsey Global Institute has just published "Debt and deleveraging: Uneven progress on the
path to growth." The report uses the cases of Sweden and Finland in the 1990s as a map for how recovery from too much debt, asset bubbles, and financial crisis might proceed.  MGI writes:
"The examples of deleveraging in Sweden and Finland during the 1990s have particular relevance today. Both nations experienced credit bubbles that led to asset bubbles and, ultimately, financial crises. But both also moved decisively to bolster their banking systems and deal with debt overhang. And—after painful recessions—both nations went on to enjoy more than a decade of strong GDP
growth.  The experiences of the two Nordic economies illustrate that deleveraging often proceeds in two stages. In the first, households, the financial sector, and nonfinancial corporations reduce debt, while economic growth remains very weak or negative. During this time, government debt typically rises as a result of higher social costs and depressed tax receipts. In the second phase, economic growth rebounds and then the longer process of gradually reducing government debt begins."

With this pathway to eventual recovery in mind, MGI makes an argument that the U.S. economy is actually further down the road to recovery than most other high-income countries:

"Since the end of 2008, all categories of US private-sector debt have fallen relative to GDP. Financial-sector debt has declined from $8 trillion to $6.1 trillion and stands at 40 percent of GDP, the same as in 2000. Nonfinancial corporations have also reduced their debt relative to GDP, and US household debt has fallen by $584 billion, or a 15 percentage-point reduction relative to disposable income. Two-thirds of household debt reduction is due to defaults on home loans and consumer debt. With $254 billion of mortgages still in the foreclosure pipeline, the United States could see several more percentage points of household deleveraging in the months and years ahead as the foreclosure process

Historical precedent suggests that US households could be as much as halfway through the deleveraging process. If we define household deleveraging to sustainable levels as a return to the pre-bubble trend for the ratio of household debt to disposable income, then at the current pace of debt reduction, US households would complete their deleveraging by mid-2013. ..."

Here's a figure showing the rapid increase in U.S debt by sector, and the recent change. In contrast to this U.S. pattern, MGI notes that in Japan private-sector debt levels didn't start falling until eight years after the bursting of the bubble.

 What steps should we be seeing along the way in the next year or two that would reassure us that the U.S. economy is returning to health? The MGI report offers six "markers." Here, I'll focus on how the U.S. economy measures up on these markers, although the report offers many intriguing comparisons to other countries, especially the United Kingdom and Spain.

"Marker 1. Is the banking system stable?"
The U.S. economy does seem to have stabilized the banking system (at some cost!). "Net new mortgage lending only recently turned positive in the United States."

"Marker 2. Is there a credible plan for long-term fiscal sustainability?"
In terms of what Congress has enacted and President Obama has signed into law, the answer is clearly "no."

"Marker 3. Are structural reforms in place to unleash private-sector growth?"
"The United States should encourage business expansion by speeding up regulatory approvals for business investment, particularly by foreign companies, and by simplifying the corporate tax code and lowering marginal tax rates in a revenue-neutral way. Business leaders also say that the United States can improve infrastructure and the skills of its workforce and do more to encourage innovation."

"Marker 4. Are the conditions set for strong export growth?"
This step was especially important for Sweden and Finland, as small open economies. It's less crucial for the U.S., with its huge internal market and, by world standards, relatively low trade-to-GDP ratio. Still, the U.S. economy should be recognizing that the most rapid growth in the world economy in the next few decades is going to be happening outside our borders, and we need to be thinking about how we can tap into this growth, with everything from building connections for exporters to encouraging tourism.

"Marker 5. Is private investment rising?"
"Today, annual private investment in the United States and the United Kingdom is equal to roughly 12 percent of GDP, approximately 5 percentage points below pre-crisis peaks. Both business investment and residential real estate investment declined sharply during the credit crisis and the ensuing recession. While private business investment has been rising in recent quarters, total investment remains low because of slow housing starts." My own expectation is that real estate investment isn't going to be driving the U.S. economy forward in the next few years--at best, we can hope that it won't be a drag. So the key to U.S. investment is business investment levels.

"Marker 6. Has the housing market stabilized?"
"Both Macroeconomic Advisers and the National Association of Home Builders predict that new housing starts will not approach pre-crisis levels until at least 2013—coincidentally the year in which we estimate that US households may be finished deleveraging."

In my own view, the most important policy steps that flow from this analysis are the importance of building to an agreement on a credible middle-term plan for holding down the ongoing rise in U.S. government debt levels, and finding ways to encourage business investment.

Tuesday, January 24, 2012

U.S. Science Needs to Look Beyond Our Borders

The U.S. has traditionally been the dominant world presence in science, although it of course needed to pay some attention to scientific efforts in western Europe, Japan and Canada as well. America is used to scientists and business people from other countries coming here to learn the latest breakthroughs. But the U.S. scientific edge is diminishing. As Caroline S. Wagner writes in "The Shifting Landscape of Science",
in the Fall 2011 issue of Issues in Science and Technology: "The days of overwhelming U.S. science dominance are over, but the country can actually benefit by learning to tap and build on the expanding wellspring of knowledge being generated in many countries." Here are some excerpts:

Here's Wagner with an overview of the past and what's coming: "Since the middle of the 20th century, the United States has led the world rankings in scientific research in terms of quantity and quality. U.S. output accounted for more than 20% of the world’s papers in 2009. U.S. research institutions have topped most lists of quality research institutions since 1950. The United States vastly outproduces most other countries or regions in patents filed. ... In 1990, six countries were responsible for 90% of R&D spending; by 2008, this number has grown to include 13 countries. According to the United Nations Educational, Scientific, and Cultural Organization (UNESCO), since the beginning of the 21st century, global spending on R&D has nearly doubled to almost a trillion dollars, accounting for 2% of the global domestic product. Developing countries have more than doubled their R&D spending during the same period. ...The UNESCO report documents that the global population of researchers has increased from 5.7 million in 2002 to 7.1 million in 2007. The distribution of talent is spread more widely, and the quality of contributions from new entrants has increased."

One common (if imperfect) measure of scientific output is the number of scientific papers published. By this metric, the European Union has taken the lead from the United States, and countries like China and Korea are rising rapidly.

Wagner's overall message is that in a world economy where science and technology are of increasing importance, and a world where a greater share of that research is happening elsewhere, and where pressures on government budgets mean that U.S. spending on R&D isn't likely to rise in a sustained and dramatic way--in that world, the U.S. scientific establishment needs to focus more on identifying excellent research happening around the world and in in keeping tabs on that research and finding ways to participate in it. Here's Wagner:
"Although the U.S. research system remains the world’s largest and among the best, it is clear that a new era is rapidly emerging. With preparation and strategic policymaking, the United States can use these changes to its advantage. Because the U.S. research output is among the least internationalized in the world, it has enormous potential to expand its effectiveness and productivity through cooperation with scientists in other countries.
"Only about 6% of U.S. federal R&D spending goes to international collaboration. This could be increased by pursuing a number of opportunities: from large planned and targeted research projects to small investigator-initiated efforts and from work in centralized locations such as the Large Hadron Collider in Geneva to virtual collaborations organized through the Internet. Most federal research support is aimed at work done by U.S. scientists at U.S. facilities under the assumption that this is the best way to ensure that the benefits of the research are reaped at home. But expanded participation in international efforts could make it possible for the United States to benefit from research funded and performed elsewhere.
"U.S. policy currently lacks a strategy for encouraging and using global knowledge sourcing. Up until now, the size of the U.S. system has enabled it to thrive in relative isolation. Meanwhile, smaller scientifically advanced nations such as the Netherlands, Denmark, and Switzerland have been forced by budgetary realities to seek collaborative opportunities and to update policies. ... An explicit U.S. strategy of global knowledge sourcing and collaboration would require restructuring of S&T policy to identify those areas where linking globally makes the most sense. The initial steps in that direction would include creating a government program to identify and track centers of research excellence around the globe, paying attention to science funding priorities in other countries so that U.S. spending avoids duplication and takes advantage of synergies, and supporting more research in which U.S. scientists work in collaboration with researchers in other countries."
"One recent example of movement in the direction of global knowledge sourcing is the U.S. government participation with other governments in the Interdisciplinary Program on Application Software toward Exascale Computing for Global Scale Issues. After the 2008 Group of 8 meeting of research directors in Kyoto, an agreement was reached to initiate a pilot collaboration in multilateral research. The participating agencies are the U.S. National Science Foundation, the Canadian National Sciences and Engineering Research Council, the French Agence Nationale de la Recherche, the German Deutsche Forschungsgemeinschaft, the Japan Society for the Promotion of Science, the Russian Foundation for Basic Research, and the United Kingdom Research Councils. These agencies will support competitive grants for collaborative research projects that are composed of researchers from at least three of the partner countries, a model similar to the one used by the European Commission. ..."
"Looking for the opportunity to collaborate with the best place in any field is prudent, since the expansion of research capacity around the globe seems likely to continue and it is extremely unlikely that the United States will dramatically increase its research funding and regain its dominance. Moreover, it may be that the marginal benefit of additional domestic research spending is not as great as the potential of tapping talent around the world. Thus, seeking and integrating knowledge from elsewhere is a very rational and efficient strategy, requiring global engagement and an accompanying shift in culture."

Monday, January 23, 2012

Thoughts on Ultra-Low Interest Rates

Philip Turner asks "Is the long-term interest rate a policy victim, a policy variable or a policy lodestar? in a December 2011 working paper for the Bank of International Settlements.

Not all long ago, a number of papers tried to estimate the "normal" long-term real interest rate on safe assets. Estimates were typically in the range of 2-3%, which is a substantially higher than the barely-above zero percent rates of interest on safe borrowing, like 10-year U.S. bonds that pay an interest rate above the rate of  inflation.  Here's Turner: "There has been much debate among economists about the “normal” long-term interest rate. Hicks (1958) found that the yield on consols over 200 years had, in normal peacetime, been in the 3 to 3½% range. After examining the yield on consols from 1750 to 2006, Mills and Wood (2009) noted the remarkable stability of the real long-term interest rate in the UK – at about 2.9%. (The only exception was between 1915 and 1964, when it was about one percent lower). Amato’s (2005) estimate was that the long-run natural interest rate in the US was around 3% over the period 1965 to 2001 and that it varied between about 2½% and 3½%." [For the record, a "consol" is a kind of perpetual bond issued by the British government: that is, it paid interest but had no date of maturity.]

Here's a figure showing the U.S. federal funds rate, as well as yields on 10-year inflation-linked Treasuries in the U.S. and the UK:

Turner sorts through the possibilities: Are these ultra-low interest rates a result of U.S. monetary policy? Are they a result of a "savings glut"--historically high rates of saving in the global economy, driven primary by the growing and high-saving economies of Asia, which drives down interest rate? Or are they the result of the ability of private financial markets to produce a huge supply of "safe" financial assets--although many of those assets then turned out not to be so safe.

My own sense is that although other explanations may have been more relevant a few years ago, longer-term interest rates now are low largely as a result of policy decisions, and that the "quantitative easing" policies in which central banks buy and hold government debt are a sign that such debt would not be sold at the same low interest rate without a policy intervention. However, as Turner rightly points out after a discussion of the relevant theory:  "This paper argues great caution is needed in drawing policy implications based on the real long-term interest rate currently prevailing in markets. This interest rate has moved in a wide range over the past 20 years. At present, it is clearly well below longstanding historical norms. Several explanations come to mind. But not enough is known about how far the long-term rate has been contaminated by government and other policies. Nor is the persistence of such effects clear. And the various policies will have impacted different parts of the yield curve in ways that are hard to quantify."

But whatever the reason behind the ultra-low long-term interest rates, what possible risks do they raise? The obvious possibility is that low interest rates encourage borrowing and discourage saving. At present, the ultra-low interest rates are keeping debt payments low, despite the historically high underlying levels of debt. Turner touches on this point in several places:

"From the mid-1950s to the early 1980s, this aggregate [debt of domestic US non-financial borrowers – governments, corporations and households] was remarkably stable – at about 130% of GDP. It was even described as the great constant of the US financial system. The subcomponents moved about quite a bit – for instance, with lower public sector debt being compensated by higher private debt. But the aggregate itself seemed very stable. During the 1980s, however, this stability ended. Aggregate debt rose to a new plateau of about 180% of GDP in the United States. At the time, this led to some consternation in policy circles about the burden of too much debt. It is now about 240% of GDP. Leverage thus measured – that is, as a ratio of debt to income – has increased. Very many observers worry about this. Whatever the worries, lower rates do make leveraged positions easier to finance. Once account has been taken of lower real interest rates, debt servicing costs currently are actually rather modest: Graph 3 illustrates this point."

Graph 3 shows nonfinancial debt in the U.S. economy as a share of GDP with the solid line, rising to aboug 240% of GDP as measured on the right-hand axis. It shows the falling real long-term Treasury yields as a measure of interest rates on the left-hand scale, with the thin dashed line. And it shows interest expenses as a share of GDP with the thick dashed line, measured on the left-hand axis. Notice that even thought debt is historically very high, interest payments are historically low."

In this setting, an ever-larger share of private assets are locked into very low real returns. Institutions that have liabilities far into the future, like insurance companies and pension funds, suffer greatly when interest rates are so low. It becomes much easier for the federal government to finance its huge budget deficits with such low interest rates. The pressure on households and firms to reduce their borrowing and to save more is greatly reduced, too.

This combination of high debt and low interest rates creates a potentially unstable situation. If or when interest rates rise again, the oversized debt burdens will be tougher to finance. All of those who are locked into long-term low interest rates--including large financial institutions and the Federal Reserve--would see the value of those investments fall if higher interest rates become available. Turner concludes:

"The concluding note of caution is this: beware of the consequences of sudden movements in yields when long-term rates are very low. Accounting and regulatory changes may have made bond markets more cyclical. There is no evidence that bond yields have become less volatile in recent years. Indeed, data over the last decade or so mirror Mark Watson’s well-known finding that the variability of the long-term rate in the 1990s was actually greater than it had been in the 1965–78 period. A change of 48 basis points in one month ...  would have a larger impact when yields are 2% than when they are 6%. With government debt/GDP ratios set to be very high for years, there is a significant risk of instability in bond markets. Greater volatility in long-term rates may create awkward dilemmas in the setting of short-term rates and decisions on central bank holdings of government bonds. Because interest rate positions of financial firms are leveraged, sharp movements could also threaten financial stability."
One sometimes hears the argument that as long as inflation isn't noticeably rearing its head, ultra-low interest rates should continue onward, for years if necessary. I quite agree that inflation isn't a threat just now, or in the near future. But historically ultra-low interest rates raise other dangers, too.