Tuesday, July 31, 2012

Truckonomics: An Update

Like a lot of teachers of economics, I have a riff about the deregulation of various industries in the late 1970s and early 1980s. For example, the Motor Carrier Act of 1935 allowed the Interstate Commerce Commission to set prices and limit entry for the trucking industry. However, in the 1970s Presidents Ford and Carter started appointing commissioners to the ICC who favored more deregulation, and the Motor Carrier Act of 1980 gave them the power to decontrol trucking.

Deregulation of industries at around this time (not just trucking, but also airlines, rail, banking, natural gas, and others) turned out to be a boon to consumers and innovation. For those who want the overall story, Clifford Winston had a nice overview of "U.S. Industry Adjustment to Economics Deregulation" in the Summer 1998 issue of my own Journal of Economic Perspectives. The Concise
Encyclopedia of Economics has a short article by Thomas Gale Moore on the history and benefits of "Trucking Deregulation" here.

The short story is that after decades of regulation that had set prices and blocked entry and exit, trucking was ready to evolve. Winston notes that the trucking industry traditionally has two parts:
"‘less-than-truckload' (LTL), which uses a network of terminals to consolidate shipments of more than one shipper’s goods on a truck, and `truckload' trucking, which provides point-to-point
service for one shipper’s goods that fill an entire truck." In addition, some firms provide their own trucking services, while other firms contract for that service. Winston cites evidence that after deregulation, trucks carried fuller loads and service times improved. Costs and prices in the LTL segment dropped 35%; costs and prices in the truckload segment dropped 75%.

However, my riff on the effects of deregulation s largely draws on evidence from the 1980s and 1990s. I have no clear idea what's up with the trucking industry these days. As a starting point to getting me back up to speed, I was delighted to see the article by Nancy Condon called "Truckonomics: An Industry on the Move" that appeared in the Second Quarter 2012 issue of Econsouth, published by the Federal Reserve Bank of Atlanta. It has lots of intriguing tidbits:

The tonnage of goods carried by trucks is sometimes used as an indicator for the overall health of the economy. Thus, it's interesting that as of early 2011, truck tonnage had regained its pre-recession level.

In thinking about main concerns for the trucking industry looking forward, fuel prices do not seem a major concern, because truckers can typically pass along fuel costs to consumers. However, short-term price spikes can be a concern: "There is typically a 45- to 60-day lag between when the carrier makes a shipment and when the shipper pays the carrier for that shipment. If the shipper is paying a fuel surcharge based on the cost of fuel two months ago, and the prices are experiencing a double-digit rise, the carrier can be seriously harmed." (Of course, the economist in me notes that it is quite possible for even small companies to hedge against short-term price spikes, if they are really concerned about this risk.)

The two issues of greater concern are constraints on the capacity of the industry and a potential shortage of drivers in the future.

The issue of capacity for the industry grows out of decisions made back in 2006, when the industry was expecting "mandated decrease by the U.S. Environmental Protection Agency (EPA) in diesel
emissions for heavy-duty trucks, to take effect in 2007. So in 2006, many trucking companies conducted what is called a “pre-buy.” To avoid having to buy the upgraded, costlier trucks, they purchased inventory ahead of their normal schedule. So when the recession began in late 2007 and demand plummeted, these companies were left holding all their new equipment ... With so much excess capacity, truck values also plummeted and the companies ended up upside down (that
is, they had negative equity) on their equipment. When times are good, most companies run their trucks through the warranty period—about 48 months—and then buy new ones to replace the old. More recently, many companies have held onto their trucks longer than normal for several
reasons: they lost the equity in their trucks, did not have enough cash reserves, or could not get credit even if they did have equity. All these factors combined to increase the age of the fleet in
the postrecession industry. ... In 2011, the trucking industry was operating with 12 percent
fewer trucks than at the height of their business in 2006 ..." For now, capacity constraints are allowing trucking companies to raise their rates. But the demand for new trucks started rising again in 2011.

During the recession, and with fewer trucks on the road than several years ago, both the number of drivers and the number of recruiters has diminished. "What’s more, many of the largest truckload carriers in the industry—including Swift, headquartered in Phoenix, Arizona, and Schneider National Inc. in Green Bay, Wisconsin—had eliminated their driver training programs altogether." Employment in trucking hasn't yet recovered to its pre-recession levels, and the industry is apparently thinking about ways to find new drivers: looking to demographic groups not well-represented among truckers in the past like women, redesigning routes so that long-haul truckers don't have to be away from home so long, and building heavy-duty trucks with automatic transmissions, which are physically easier to operate than the old 13-speed transmissions. It looks likely that the trucking industry will be looking to hire those who have the necessary licenses in the next few years.

Condon's six-page article whetted my appetite for more on the trucking industry. If anyone out there knows of a nice recent overview paper or report about structure, costs, industry practices, employment and wages in the trucking industry over the last decade or two, I'd love to see it.

Monday, July 30, 2012

Comparing Cities and Countries by Size of Economy

When we refer to an "economy," we are often talking about a national economy, or in some cases the global economy. But of course, local economies operate as well. In fact, $13.1 trillion of the total U.S GDP of $14.5 trillion in 2010--roughly 90%-- happened in urban economies.

In the table below, the first column lists the 20 largest U.S. metropolitan areas (which are broader than official city boundaries) ranked by size of the metro-area economy, while the second column shows the gross metropolitan product of those cities in 2010, using data from the U.S. Bureau of Economic Analysis. Just because comparisons like this always scramble my brain a bit, the last column shows some cities and countries of comparable economic size around the world. The city data is for 2008 data from a PriceWaterhouseCooper report. The estimates of country GDP are for 2010 from the World Bank.

At least for me, these kinds of intuition don't always fit my pre-existing intuitions. Now and again, it's useful to align one's thought with the data! For example:
  • The New York City metro area has an economy more than twice the size of Chicago. The Los Angeles metro area has an economy about twice the size of Dallas or Philadelphia.
  •  Shanghai, which is the largest city in China by the size of its metro-area economy, is roughly equal to the city of Seattle (or the country of Portugal). 
  • My own metro area of Minneapolis is roughly equal in economic size to the country of Ireland or the city of Mumbai. 
  • Saudi Arabia has an economy the size of the Dallas metro area. Nigeria has an economy about the size of Phoenix. Pakistan has an economy about the size of San Diego. Kuwait has an economy about the size of Baltimore.

Friday, July 27, 2012

Sustainability and the Inclusive Wealth of Nations

First there was gross domestic product, and it was useful, but limited. After all, it measured only economic output, and left out considerations like the health or education of the population, or the quality of the environment, or whether a country was investing enough to sustain continued growth in the future. In the Spring  2008 issue of my own Journal of Economic Perspectives, J. Steven Landefeld, Eugene P. Seskin, and Barbara M. Fraumeni offer a tour through the history and the estimation of this statistic in "Taking the Pulse of the Economy: Measuring GDP." The U.S. Bureau of Economic Analysis page for GDP is here.

In response to these shortcomings, the United Nations Human Development Program created the Human Development Index. Instead of ranking countries by GDP alone, it added life expectancy as a measure of health and years of schooling as a measure of education.  The Human Development Reports going back to 1990 are available here. This was a useful step, but there was controversy over how to combine and to weight these different characteristics. Moreover, while the Human Development Index offered a snapshot of comparisons across a single year, it didn't address in an direct way whether the country was on a sustainable trajectory. It also had nothing to say about the environment.

Now the United Nations has taken another stab at developing a broader measure of economic performance, this one focused on sustainability. It appears as the Inclusive Wealth Report 2012, and is apparently intended to be an ongoing report in the future. The effort was led by Partha Dasgupta, who long ago in graduate school taught me pretty much everything I know about the details of welfare economics. The report seeks to construct an inclusive measure of total wealth. For this first report, the emphasis is on three categories: the total value of human capital, produced capital, and natural capital. (There are also supplementary calculations to expand these measures to consider technological productivity, carbon damages, and capital gains on oil reserves.) The notion is that a sustainable economy will be increasing its total wealth over time--which allows for the possibility that gains in human capital or produced capital would offset declines in natural capital.

For detail on how these numbers are constructed, you can look at the report and the supporting working papers. Here, I'll just say that human capital wealth is based on a mixture of statistics on mortality, employment, education, pay, divided by age and gender. Produced capital is based on levels of investment, depreciation, the lifetime of assets, output growth, and productivity. Natural capital looks at statistics and prices related to on fossil fuels, minerals, forests, agricultural land, and fisheries. These measures of wealth are compiled for 20 countries from 1990-2008.

Here's a figure showing the calculations for the United States. The rising top line shows the growth in physical capital wealth over time. The bottom declining line shows the drop in natural capital wealth. The blue-gray line in the middle shows the rise in human capital over time. The green line combines these into an overall Inclusive Wealth Index. The rising level of the inclusive wealth index implies that U.S. economic growth is sustainable, in the sense that the country's stock of wealth is rising.

Compared to other advanced economies, the U.S. economy has a relatively high dependence on natural wealth and on human capital. Here's a graph for 2009. Compared to Norway, with its oil reserves, the U.S. economy relies less on natural capital. But relies more on natural capital than Japan, France, or the United Kingdom. The U.S. relies less on human capital than does the UK, but more than the other comparison countries here, which tend to rely more on physical capital.

Here is a figure showing the comparison for 1980-2009 for each of the 20 countries. For each country, the first bar combines annual growth rates for natural capital, human capital, and produced capital, as shown in the bar chart. The second bar for each country then shows the Inclusive Wealth Index. Among the top five countries on inclusive wealth, the growth of China, India, and Chile were  primarily driven by a rise in produced capital, while the growth of Germany and France were primarily driven by a arise in human capital.  The countries at the other end are largely resource exporters, and the decline in the value of their natural capital over time is not being offset by rises in human or produced capital.

The authors of this first Inclusive Wealth Index would be the first to say that the measures will need to develop and evolve over time. Rather than pick nits with the index, I'll just say that when it comes to economic statistics, I'm a believer that "more is better." Reality is multidimensional, and additional statistics are often useful for highlighting particular dimensions that I had not considered sufficiently.

Thursday, July 26, 2012

Russian Economic Inefficiency

Back in the old days of the Soviet Union, it was often useful to complement the theoretical discussion of dysfunctional incentives in the planned economy with a mixture of jokes and anecdotes. Perhaps the best-known one-line was muttered by Soviet workers everywhere: "We pretend to work, and they pretend to pay us." The old line came to mind when reading some of the anecdotes in an article in the Economist magazine of June 14, about "Industry in Russia: Lurching into the Fast Lane." 

For example, a Russian car company called GAZ hired a former GM executive named Bo Andersson to turn the company around. Here's the anecdote:

"A conscientious Swede, Mr Andersson insisted on zero tolerance for corruption. For a Russian factory this was a tall order. But he has got rid of various “managers” who ran businesses on the side, helping themselves to GAZ’s supplies. He has introduced bonuses for workers who turn up sober and refrain from stealing, and the sack for those who do not. Thousands of surplus workers have been laid off; more will follow. This has not made Mr Andersson popular in Nizhny; hence the bodyguard who accompanies him everywhere, even inside the plant. GAZ is now in profit and producing double its 2009 output, despite cutting its workforce by half to 23,000, says Mr Andersson. In 2010 only 16% of vans rolling off the line were fit to be sent out without remedial work; that is now up to 64%."

 There's also a tell-tale graphic about the costs of building a road, in millions of dollars per mile. Low wages would help to explain why it's less expensive to build a road in China. But wages in Russia are lower than in the U.S. or the 27 countries of the European Union.

Sometimes people forget how badly Soviet central planning worked. A variety of economic studies found that vast swaths of Soviet industry were producing with negative value added: that is, the world-market price of the raw materials and energy that they were using as inputs was greater than the world-market price of the outputs being produced.

There were stories that factories producing televisions sometimes shipped only the external case, with and no electronics inside, because they were desperate to meet the official quota for production of television sets. When Soviet companies did produce actual televisions, the quality control issues were legendary. In one company, 70% of the televisions produced failed quality control checks. Those televisions that escaped the factory tended to explode. One study blamed most of the apartment fires in Moscow on exploding televisions.

Jokes were a way of letting off steam. Here are a few from my old lecture notes:

At the annual May Day parade in Moscow, there was a long parade of marching soldiers, followed by tanks, missiles, and other weapons. Then right at very back of the parade there are a few open trucks, carrying a group of middle-aged men wearing badly-fitting grey suits. Up on the podium, reviewing the parade as it goes by, one of the senior Communists looks at the person next to him and says: "So who are those men and why are they in the parade?" And the other responds: "Ah, they are economists from the central-planning bureau. You've no idea how much destructive capacity they possess."

“How is the economy doing is today?"
"Yes -- worse than yesterday, better than tomorrow, so -- average."

Did you know that Adam was the first Communist? Who else would walk around stark naked, holding a single apple, and believe he was in Paradise?

My old notes also have a quotation from Condoleeza Rice, a Soviet expert later to become Secretary of State, back in 1991: "Think about the Great Depression in this country and multiply that by a hundred. Add to that the crisis of legitimacy and authority that the United States had between 1968 and Watergate. Add to that questions that we had about whether the Union ought to stay together just before the Civil War. Multiply that by one hundred, and then you've got a fix on what the Soviet Union's problem is."

Truly, modern Russia under Vladimir Putin has all sorts of troubles: economic, political, and social. But it is still a considerable improvement over what came before.

Tuesday, July 24, 2012

Reverse Mortgages

 The number of new reverse mortgages in the U.S. was below 10,000 per year in the 1990s. But now the baby boomers are reaching retirement age. The number of reverse mortgages topped 110,000 in both 2008 and 2009, before dropped back to a range of 70,000-80,000 in 2010 and 2011. As the economy regains its footing, the total may start rising again. Thus, one small part of the Dodd-Frank legislation was to instruct the newly-created Consumer Financial Protection Bureau (CFPB) to publish a study on "Reverse Mortgages," which was published in late June.

 What exactly is a reverse mortgage? Here's an explanation:

"A reverse mortgage is a special type of home loan for older homeowners that requires no monthly mortgage payments. Borrowers are still responsible for property taxes and homeowner’s insurance. Reverse mortgages allow seniors to access the equity they have built up in their homes now, and defer payment of the loan until they die, sell, or move out of the home. Because there are no required mortgage payments on a reverse mortgage, the interest is added to the loan balance each month. The rising loan balance can eventually grow to exceed the value of the home, particularly in times of declining home values or if the borrower continues to live in the home for many years. However, the borrower (or the borrower’s estate) is generally not required to repay any additional loan balance in excess of the value of the home."

Reverse mortgages have been around for several decades. They have a fairly small share of the market: "Today, the market for reverse mortgages is very small. Only about 2 to 3 percent of
eligible homeowners choose to take out a reverse mortgage.  Only about 582,000 HECM [Home Equity Conversion Mortgage] loans are outstanding as of November 2011, as compared to more than 50 million traditional mortgages and more than 17 million home equity loans and lines of
credit." But the number of such loans was rising fast before the recession hit, and remains far above levels from just 10 years ago.

For many borrowers, a reverse mortgage can offer a useful tool so that they can receive income while continuing to live in their house. As the CFPB report explains: "The original purpose envisioned for reverse mortgages was to enable older borrowers to convert home equity into cash they could use to help meet expenses in retirement. Borrowers could choose between an income stream for everyday expenses, a line of credit for major expenses (such as home repairs and medical expenses), or a
combination of the two. It was anticipated that most, though not all, borrowers would use their loans to age in place, living in their current homes for the rest of their lives or at least until they needed skilled care. Upon the borrower’s death, or upon leaving the home, the borrower or the estate would sell the home to repay the loan and would receive any remaining home equity."

But when a loan has the property that you may never need to repay it, that loan has some potential to be used in a way that the borrower will later come to regret. Here are a few signs that at least make made me raise my eyebrows:

  • "Reverse mortgage borrowers are taking out loans at younger ages than in the past. In FY2011, nearly half of borrowers were under age 70. ... By tapping their home equity early, these borrowers may find themselves without the financial resources to finance a future move – whether due to health or other reasons."
  • "Reverse mortgage borrowers are withdrawing more of their money upfront than in the past. In FY2011, 73 percent of borrowers took all or almost all of their available funds upfront at closing. This proportion has increased by 30 percentage points since 2008."
  • "A surprisingly large proportion of reverse mortgage borrowers (9.4 percent as of February 2012) are at risk of foreclosure due to nonpayment of taxes and insurance. This proportion is continuing to increase."
For many people, the equity in their home is their ultimate buffer to help them out later in life. If you take that buffer and spend it during your 60s, you (or your spouse or children) may well end up regretting it in later years. It turns out that many of those who take out a reverse mortgage are using it to pay off their existing mortgage. But a situation can easily arise where the interest rate being paid on the reverse mortgage is greater than the interest rate that is earned by re-investing the lump sum that is received, or even would have been paid on just keeping the existing conventional mortgage.

My first instinct is to have rules about providing information accurately, and then to let people make their own financial choices. But I've also seen my own grandparents, as well as aging relatives of my friends, reach an age where they would have been quite vulnerable to someone telling them "the smart thing to do" and offering the siren call of a large check that wouldn't ever have to be repaid.  The reverse mortgage market is likely to grow rapidly as the boomers age. It's going to offer a useful product for many, and some ugly scandals and frauds for others.

Monday, July 23, 2012

How Did Time Use Change in the Recession?

When U.S. unemployment rate started rising, going from 5.0% in January 2008 to 7.3% by December 2008, and thus on up to a peak of 10.0% in October 2009, many people had many fewer work hours. What did they do with those hours? Mark Aguiar, Erik Hurst, and Loukas Karabarbounis have the answer in "Time Use During Recessions," which is NBER Working Paper #17259. (NBER working papers are not freely available to the public, but many academic readers will have access through library subscriptions.)

The authors make use of the American Time Use Survey, which is conducted by the Census Bureau. It first started collecting data regularly on how people spend their time in 2003.  Here's a summary figure showing patterns of hours worked, leisure hours, and hours of non-market work. The blue dashed line in each panel is a best-fit line for the data from 2003-2008, extrapolated forward for 2009-2010. The solid line is actual data. Thus, hours of market work was on an upward trend in 2003-2008, but dropped sharply when the recession hit. Leisure hours were on an upward trend, but then rose faster. Hours of non-market work were on a downward trend, but then reversed direction.

Figuring out how the reduction in hours worked is related to the rise in leisure and in non-market work is a bit tricky. Earlier trends need to be taken into account, for example. The Aguiar, Hurst, and Karabarbounis approach is to look at data across states. In general, states were showing much the same overall pattern in time use from 2003-2008. But the unemployment rates varied across states, and so one can then use statistical methods to see how time use changes in states that had bigger changes in unemployment vs. states with medium or lesser changes. Given that approach, here's what they find (citations omitted):

"[W]e find that roughly 30% of the foregone market work hours are reallocated to non-market production (excluding child care). ... In particular, about 13% of foregone work hours are allocated to what we refer as core home production activities (cooking, cleaning, laundry, etc.), about 8% to increased shopping intensity, another 4% to the care of other older adults, and about 7% to home maintenance and repair. In addition, around 6% of the foregone market work hours are reallocated to child care.

"[L]ess than 1% of the foregone market work hours are allocated to job search. However, this represents a fairly large percentage increase given how little time unemployed workers allocate to job search. We show that individuals increase their time investments in their own health care, their own education, and civic activities. Specifically, around 12% of foregone market hours are allocated to these investments."

We show that the bulk of the foregone market work time during the recent recession is allocated to leisure. ...  These categories include, for example, socializing with one’s friends, watching television, reading, and going to the movies. We include sleep, eating, and personal care into our leisure measure given that the marginal investments in these activities may be more akin to leisure than personal maintenance. ... [L]eisure activities absorb only about 50% of a given decrease of market work. Additionally, a large fraction of this reallocation is directed towards sleep (more than 20% of foregone work hours)."

Friday, July 20, 2012

Shifts in Financing College Costs

Sallie Mae started off its existence back in the early 1970s as a government-sponsored enterprise aimed at organizing financial support for student loans. It was officially privatized, with all official links to the government cut, in 2004. The company website reports that the "company and its subsidiaries manage or service $234 billion in education loans and administer $38 billion in 529 college savings plans." For the last five years, Sallie Mae has published an annual study based on survey data called "How America Pays for College." This year's report highlights the stresses that are arising between high costs of higher education and households under financial stress on the other hand. Here are some points that caught my eye. 

What do families actually pay for college? On average, the answer was $20,902 in 2011-2012, which is down from $24,097 in 2009-2010. The total also varies by income level. 

How are the sources of this funding changing in the last few years? Here's a figure showing the sources of funding and how they have changed in the last five years: below the figure, I'll list three major changes as described in the the report. The short story is that parents are paying less and grants and scholarships are covering less, but student loans and work are on the rise.

"In 2012, families shifted how they paid for college in three major ways. First, parents cut their contributions from income and savings. In 2012, parents spent an average of $5,955 from their income and savings, down from $6,664 in 2011. This is 32 percent lower than in 2010, when parent spending peaked at $8,752. Parents’ income and savings paid for 28 percent of college costs, slightly below last year’s share (30%) but significantly below prior years’ (37% in 2010 and 36% in 2009). ...."

"Second, in 2012, fewer families utilized scholarships: 35 percent of all families in 2012, down from 45 percent in 2011. This decline may be because colleges are unable to maintain previous award levels. ... As a percentage of total college costs, grants and scholarships covered 29 percent of college expenditures in 2012, a higher share than in 2009 or 2010, but lower than last year. ..."

"Third, students paid more out of pocket, partially offsetting decreases in parent and scholarship contributions. This year, students picked up an increased share of their college costs through their own savings and income, contributing on average $2,555 in 2012 (12% of the total cost of college). In addition to contributing more from their savings and current income, students borrowed more in 2012 than in previous years. In 2012, students contributed 18 percent of the total cost of college through borrowing ... The continuing upward trend in the percent of students using federal student loans has driven most of the increase in student borrowing, which has grown from 25 percent in 2009, to 28 percent in 2010, to 30 percent in 2011, and to 34 percent in 2012. This year, high-income students in particular increased their use of federal loans substantially — 27 percent used federal loans in 2012, up from 19 percent in 2011. In addition, the average amount students borrow from federal loans has risen substantially (55%) over the last five years, to $7,874 in 2012 from $5,075 in 2008."
Another theme from the report that bears highlighting is some of the steps that families are taking to hold down their college costs--remember, the average family is paying less in 2011-2012 than the average was paying a couple of years ago. "The most common cost-saving measures include living at home (51% in 2012 compared with 44% in 2011 and 43% in 2010) or adding a roommate (55% in 2012), reducing spending by parents (50% in 2012), reducing spending by students (66% in 2012), students working more hours (50% in 2012) ..."

In addition, families are shifting from four-year public schools to less expensive two-year public schools: "In 2012, families maintained the shift toward lower-cost two-year public schools that emerged in the 2011 responses. Twenty-nine percent attend two-year public schools and 45 percent attend four-year public schools (compared with 2010’s 23% and 52% respectively)."

For some earlier posts about financing higher education, see:

Thursday, July 19, 2012

When is the Financial Industry Too Big?

It's a standard lesson in development economics that "financial deepening," which refers to growth and sophistication of the financial sector, helps economic growth. But in looking at the events leading up the Great Recession, it certainly looks at first glance (and second and third glance, too) that the financial sector ran amok. Is there a point where the financial sector gets too big? Stephen Cecchetti asks this question in a provocative short paper that kicked off the the 11th Annual BIS Conference  on the theme "The Future of Financial Globalization."

Here's Cecchetti laying out the basic theme that finance is useful in building growth--until it isn't.

"We teach that, because it allocates scarce resources to their most efficient uses, one of the best ways to promote long-run growth is to promote financial development. And, a sufficiently well-developed financial system provides the opportunity for everyone – households, corporations and governments – to reduce the volatility of their consumption and investment.

"It sure sounds like finance is great. But experience shows that a growing financial system is great for a while – until it isn’t. Look at how, by encouraging borrowing, the financial system encourages an excessive amount of residential construction in some locations. The results, empty three-car garages in the desert, do not suggest a more efficient use of capital!

"Financial development can create fragility. When credit extension goes into reverse, or even just stops, it can induce economic instability and crises. Bankruptcies, credit crunches, bank failures and depressed spending are now the all-too familiar landmarks of the bust that follows a credit-induced boom.

"What is more, financial development is not costless. The expansion of finance consumes scarce resources that could be used elsewhere. And finance’s large rewards attract the best and the brightest. When I was a student, my classmates dreamed of curing cancer, unifying field theory or flying to Mars. Those in today’s cohort want to become hedge fund managers. Given finance’s booms and busts, is this the most efficient allocation for such scarce resources? I doubt it. So, when does financial deepening turn from good to bad and become a drag on the economy?"
To tackle this question, Cecchetti provides some key figures from a January 2012 working paper co-authored with Enisse Kharroubi. Their approach starts by collect data on the size of finance in an economy, which they measure by the share of employment and the share of value-added happening in the financial sector. They collect this data for 16 OECD countries from 1980 to 2009. They also collect data on labor productivity growth. They then estimate regressions with productivity growth as the dependent variable, one of the measures of the size of the financial sector as an explanatory variable, and controlling for level of investment, employment growth, openness to trade, initial labour productivity, and country-specific dummy variables.

 They find an upside-down U-shape: that is, a larger financial sector helps an economy up to a point, but not after that point. Here are two figures, the first one showing the relationship from finance's share of employment to productivity, and the second showing the relationship from finance's share of value added to productivity,  holding the other factors constant.

As Cecchett summarizes: "[T]he conclusion emerges that there is a point where both financial development and the financial system’s size turn from good to bad. That point lies at 3.2% for the fraction of employment and at 6.5% for the fraction of value added in finance. Based on 2008 data, the United States, Canada, the United Kingdom and Ireland were all beyond the threshold for employment (4.1%, 5.7%, 3.5% and 4.5%). And the United States and Ireland were also beyond the threshold for value added (7.7% and 10.4%)."

In another calculation, Cecchetti finds that when the financial sector is growing faster, growth is slower: "Faster-growing financial employment hurts average productivity growth, as does “too much” value added. In particular, a 1 percentage point increase in the growth rate in finance’s share of employment cuts average productivity growth by nearly one-third of one percentage points per year."

Cecchetti summarizes the overall findings this way: "Combined, these facts lead to the inescapable conclusion that, beyond a certain point, financial development is bad for an economy. Instead of supplying the oxygen that the real economy needs for healthy growth, it sucks the air out of the system and starts to slowly suffocate it. Households and firms end up with too much debt. And valuable resources are wasted. We need to do something about this."

I have less confidence in this evidence than Cecchetti seems to have (although in fairness, he is giving opening remarks at a conference and hoping to spur discussion). It is notoriously difficult to draw strong inferences about cause-and-effect from a panel of cross-country data.  The economies of these 16 countries, and the development of their financial sectors, are surely influenced by a number of other events and variables. Perhaps it's not the sheer size of the financial sector, but some other characteristic of the financial sector. But with a certain degree of explanatory froth, the bottom line that growth of financial markets will not always benefit an economy certainly seems plausible.

Wednesday, July 18, 2012

Trade Imbalances: A Parable for Teachers

Last week I posted about "Current Account Deficits," and the reasons for which they may be cause for concern. In explaining these issues to students, it's often hard to get across that there's nothing intrinsically wrong with trade surpluses or trade deficits. It's also delicate to explain that a U.S. trade deficit is the mirror image of an inflow of foreign investment capital, and that a country with a trade surplus is by definition experiencing an outflow of capital. I've had good luck teaching these topics with a parable about trade between Robinson Crusoe and Friday. Here's the parable as it appear in my Principles of Economics textbook, published by Textbook Media (pp. 466-467).

(Of course, if you are teaching a college-level intro econ class, I'd encourage you to give the book a look. It's mainstream in its content and approach; it has worked well in a lot of classrooms; students can get both e-versions and paper versions; it's available in micro and macro splits; and it's very competitively priced at $40 for the entire book and electronic access combined. For information on the book, click here.) 

"To understand how economists view trade deficits and surpluses, consider a parable based on the story of Robinson Crusoe. Robinson, as you may remember from the classic novel by Daniel Defoe first published in 1719, was shipwrecked on a desert island. After living alone for some time, Robinson is joined by a second person, whom he names Friday. Think about the balance of trade in a two-person economy like that of Robinson and Friday.

Robinson and Friday trade goods and services with each other. Perhaps Robinson catches fish and trades them to Friday for coconuts. Or Friday weaves a hat out of tree fronds and trades it to Robinson for help in carrying water. For a period of time, each individual trade is self-contained and complete. Because each trade is voluntary, both Robinson and Friday must feel that they are receiving fair value for what they are giving. As a result, each person’s exports are always equal to his imports, and trade is always in balance between the two men. Neither person experiences either a trade deficit or a trade surplus.

However, one day Robinson approaches Friday with a proposition. Robinson wants to dig ditches for an irrigation system for his garden, but he knows that if he starts this project, he won’t have much time left to fish and gather coconuts to feed himself each day. He proposes that Friday supply him with a certain number of fish and coconuts for several months, and then after that time, he promises to repay Friday out of the extra produce that he will be able to grow in his irrigated garden. If Friday accepts this offer, then a trade imbalance comes into being. For several months, Friday will have a trade surplus: that is, he is exporting to Robinson more than he is importing. More precisely, he is giving Robinson fish and coconuts, and at least for the moment, he is receiving nothing in return. Conversely, Robinson will have a trade deficit, because he is importing more from Friday than he is exporting.

This parable raises several useful issues in thinking about what a trade deficit and
a trade surplus really mean in economic terms.

The first issue raised by this story of Robinson and Friday is: Is it better to have a trade surplus or a trade deficit? The answer, as in any voluntary market interaction, is that if both parties agree to the transaction, then they may both be better off. Over time, if Robinson’s irrigated garden is a success, it is certainly possible that both Robinson and Friday can benefit from this agreement.

A second issue raised by the parable is: What can go wrong? Robinson’s proposal to Friday introduces an element of uncertainty. Friday is in effect making a loan of fish and coconuts to Robinson, and Friday’s happiness with this arrangement will depend on whether that loan is repaid as planned, in full and on time. Perhaps Robinson spends several months loafing, and never builds the irrigation system. Or perhaps Robinson has been too optimistic about how much he will be able to grow with the new irrigation system, which instead turns out not to be very productive. Perhaps after building the irrigation system, Robinson decides that he doesn’t want to repay Friday as much as
previously agreed. Any of these developments will prompt a new round of negotiations between Friday and Robinson. Friday’s attitude toward these renegotiations is likely to be shaped by why the repayment failed. If Robinson worked very hard and the irrigation system just didn’t increase production as intended, Friday may have some sympathy. But if Robinson loafed, or if he just refuses to pay, Friday may become peeved. Whenever money is borrowed for an investment project and the project goes bad, a negotiation takes place between the borrower and the lender as to how much of the original loan will be repaid. Such negotiations are often full of accusations and anger.

A third issue raised by the parable of Robinson and Friday is that an intimate relationship exists between a trade deficit and international borrowing, and between a trade surplus and international lending. The size of Friday’s trade surplus is exactly how much he is lending to Robinson. The size of Robinson’s trade deficit is exactly how much he is borrowing from Friday. Indeed, to economists, a trade surplus literally means the same thing as an outflow of financial capital, and a trade deficit literally means the same thing as an inflow of financial capital."

Tuesday, July 17, 2012

The Improving U.S. Labor Market

The headline measure of U.S. labor markets, the unemployment rate, remains dismally high. It rose above 8% in February 2009, and so as of June 2012, it has now been above 8% for 41 months. The unemployment rate had been tiptoeing downward from its peak of 10.0% in October 2009 to 8.3% in January 2012. However, even that modest rate of decline seems to have levelled off, with an unemployment rate of 8.2% in June 2012.

However, under the headline unemployment rate, more detailed labor market data from the Bureau of Labor Statistics shows signs of improvement. Here are three examples from the July 2012 data on the Job Openings and Labor Turnover Survey).

One measure of the tightness of the labor market is how many unemployed people there are for each job opening. Back in the mid-2000s, the number of unemployed people per job opening hovered around 2. At the worst of the recession, it spiked above 6 unemployed people for every job opening. By May 2012, the ratio had fallen to about 3.5--certainly not a healthy labor market yet, but improving.

Another way to look at the labor market is to look at those getting jobs, which is the blue line showing"hires," and those losing jobs, which is the red line showing "total separations." Notice that in the mid-2000s, the blue line for hires is mostly above the separations line, and so the green line showing total employment is rising. During the recession, hires drop very quickly, and even those separations are declining as well, the red line is higher than the blue line, and total employment falls.  More recently, the blue line showing hires has been mostly above the red line showing separations, and so total employment has been growing again.

One last slice of these more detailed labor market numbers is to break down those who lose jobs into two categories: quits and layoffs/discharges. In a fairly healthy labor market, like the mid-2000s, quits in which people leave jobs voluntarily (often for an alternative job) are higher than layoff/discharges, where people lose their job involuntarily. In the recession, quits drop dramatically, because people were more motivated to stick with the job they had, while layoff/discharges rose as firms in trouble let workers go. More recently, the level of layoffs/discharges has dropped back to pre-recession levels. Quits have risen, which is a sign that alternative jobs are becoming more available. Although quits aren't back to pre-recession levels, they are again exceeding layoffs/discharges.

Monday, July 16, 2012

Cost of Living Adjustments for Retirees

When discussions about whether a pension should include a cost-of-living adjustment come up, the arguments often focus on what is "fair." That argument has force: the high inflation rates of the 1970s taught U.S. workers a tough lesson: if you retire on a fixed nominal income, inflation will nibble or gobble away at its purchasing power. Thus, Social Security benefits began to receive an automatic cost-of-living adjustment in 1975.  Today, almost all state and local government pensions have some form of built-in cost-of-living adjustments, too.

But making a promise about future payments is, ultimately, all about what you are able and willing to pay when the bills come due. In an otherwise completely forgettable song about 20 years ago, a group called Stetsasonic sang: "[J]ust like my mother used to say in the past/ Don't let your mouth write a check that your ass can't cash." A lot of state and local pension funds let their mouths write checks that they are no longer willing to cash. At some point, Social Security may make a similar decision.

The National Association of State Retirement Administrators last month put out a "NASRA Issue Brief: Cost of Living Adjustments," which tallies how many states have been backing away from their COLA promises for retirees.  The report states: "It has been estimated that an automatic COLA of one‐half of an assumed CPI of three percent, compounded, will add 11 percent to the cost of the retirement benefit. An automatic COLA of three percent, compounded, will add 26 percent to the cost of the benefit." Here's a map showing states that made changes in their COLA arrangements for retirees from 2009-2011 (although some of these changes are being challenged in court): states in white haven't made changes; in orange, changes affecting current retirees; in green, changes affecting new hires only; and in blue, changes affecting both new hires and current retirees.

Here are some examples of how the COLA adjustments are happening: A number of states have COLAs that are not linked to inflation, but instead are just an automatic percentage amount each year. Some states (Colorado, Hawaii) have reduced the promised annual percentage increase.  Other states have gone further and sought to eliminate any automatic COLA increases at all, while of course still leaving open the possibility that legislatures could increase pensions on an ad hoc basis in the future (Kansas, Washington, and Florida). Still other states have set up rules that the full COLA, or any COLA, would only be paid if the pension fund achieves either a certain annual return (Massachusetts) or achieves a certain level of funding (Minnesota, New Jersey, Oklahoma). Still other states have set a cap on either how much income the COLA will apply to (Maine) or a cap on how much the COLA can increase salary over the lifetime of a retiree (Nevada, Missouri). A number of states have tried several of these ideas.

How likely are we to see similar changes as a way of addressing the problem of Social Security?
The Social Security actuaries estimate that if the COLA for Social Security was adjusted to be the rate of inflation minus 1 percentage point each year--instead of the full rate of inflation--that change alone would solve nearly three-quarters of the projected gap over the next 75 years between expected revenues and promised benefits.

I don't expect that politicians will do anything that transparent to Social Security. But as part of a package of changes to assure that Social Security is funded in a way that it can cover its promises over the next 75 years, I wouldn't be at all surprised to see less-transparent changes in benefit formulas that have the effect of reducing COLA adjustments.

As I noted at the start, there is a fairness argument that adjusting COLAs is unfair. But what is also unfair is for past legislatures and for Congress to set up pension and retirement programs, make promises about benefit and then fail to finance those programs sufficiently, and hand off the whole mess to future taxpayers and future retirees. The real blame in the pension and Social Security messes shouldn't go to those who are trying to address the problem, but to those who created it.

Friday, July 13, 2012

BIS on Dangers of Continually Expansionary Monetary Policy

The 82nd Annual Report of the Bank of International Settlements, released in late June, has an interesting chapter about "The Limits of Monetary Policy." For those not familiar with the organization, the BIS has been around since 1930. It's based in Switzerland. It serves as a sort of bank for central banks through actions like (as its website reports) "acting as a prime counterparty for central banks in their financial transactions" and "serving as an agent or trustee in connection with international financial operations." It also produces a steady stream of research and analysis which often strikes me as interesting because of its international perspective. The opening two paragraphs of the chapter summarize the BIS perspective and concerns nicely: 

"In the major advanced economies, policy rates remain very low and central bank balance sheets continue to expand in the wake of new rounds of balance sheet policy measures. These extraordinarily accommodative monetary conditions are being transmitted to emerging market economies in the form of undesirable exchange rate and capital flow volatility. As a consequence, the stance of monetary policy is accommodative globally.

Central banks’ decisive actions to contain the crisis have played a crucial role in preventing a financial meltdown and in supporting faltering economies. But there are limits to what monetary policy can do. It can provide liquidity, but it cannot solve underlying solvency problems. Failing to appreciate the limits of monetary policy can lead to central banks being overburdened, with potentially serious adverse consequences. Prolonged and aggressive monetary accommodation has side effects that may delay the return to a self-sustaining recovery and may create risks for financial and price stability globally. The growing gap between what central banks are expected to deliver and what they  can actually deliver could in the longer term undermine their credibility and operational autonomy."
I supported the extraordinary monetary policy actions of the U.S. Federal Reserve during the financial crises from late 2007 through 2009 and into 2010: taking the key federal funds interest rate down to zero, making short-term loans to many financial players, not just banks; and the "quantitative easing" of printing money for the Fed to buy Treasury bonds and housing-backed securities. But the actual recession ended about three years ago, in mid-2009. Actions that made sense as a response to the emergency conditions of 2007-2009 don't necessarily continue to make sense when extended for years into the future. Thus, as of August 17 of last year, I was posting on the question "Can Bernanke Unwind the Fed's Policies?"    

In this spirit, the BIS writes: Decisive action by central banks during the global financial crisis was probably crucial in preventing a repeat of the experiences of the Great Depression. ... However, while there is widespread agreement that aggressive monetary easing in the core advanced economies was important to prevent a financial meltdown, the benefits of prolonged easy monetary conditions are more controversial. In particular, their implications for effective balance sheet repair as a precondition for sustained growth, the risks for global financial and price stability, as well as the longer-term consequences for central banks’ credibility and operational autonomy, are subject to debate." Here is some additional detail from BIS on each of these three points. 

"Implications of effective balance sheet repair as a precondition for sustained growth"

"Ultimately, there is even the risk that prolonged monetary easing delays balance sheet repair
and the return to a self-sustaining recovery through a number of channels. First, prolonged unusually accommodative monetary conditions mask underlying balance sheet problems and reduce incentives to address them head-on. ... [L]arge-scale asset purchases and unconditional liquidity support
together with very low interest rates can undermine the perceived need to deal with banks’ impaired assets. ... And low interest rates reduce the opportunity cost of carrying non-performing loans and may lead banks to overestimate repayment capacity. All this could perpetuate weak balance sheets and lead to a misallocation of credit. ...

"Second, monetary easing may over time undermine banks’ profitability. ... Low returns on fixed income assets also create difficulties for life insurance companies and pension funds. Serious negative profit margin problems associated with the low interest rate environment contributed to a
number of life insurance company failures in Japan in the late 1990s and early 2000s. ...

"Third, low short- and long-term interest rates may create risks of renewed excessive risk-taking. ...  However, low interest rates can over time foster the build-up of financial vulnerabilities by triggering a search for yield in unwelcome segments. There is ample empirical evidence that this channel played an important role in the run-up to the financial crisis. Recent large trading losses by some financial institutions may indicate pockets of excessive risk-taking and require scrutiny.

"Fourth, aggressive and protracted monetary accommodation may distort financial markets. Low interest rates and central bank balance sheet policy measures have changed the dynamics of overnight money markets, which may complicate the exit from monetary accommodation ..."

  "The risks for global financial and price stability"

"While prolonged monetary easing probably has only limited potency to rekindle sustained growth in the advanced economies, its global spillover effects may be substantial. Persistently large interest rate differentials support capital and credit flows to fast-growing emerging market economies and have
put upward pressure on their exchange rates. This makes it more difficult for emerging market central banks to pursue their domestic stabilisation objectives. ...

"The prevailing loose global monetary conditions have been fuelling credit and asset price booms in some emerging market economies for quite some time now. This creates risks of rising financial imbalances similar to those seen in advanced economies in the years immediately preceding the crisis. Their unwinding would have significant negative repercussions, also globally as a result of the increased weight of emerging market economies in the world economy and in investment portfolios.
Loose global monetary policy has probably also contributed to the strength of commodity prices since 2009 ..."

"Consequences for central banks’ credibility and operational autonomy"

"In the core advanced economies, if the economy remains weak and underlying solvency and structural problems remain unresolved, central banks may come under growing pressure to do more. A vicious circle can develop, with a widening gap between what central banks are expected to deliver and what they can actually deliver. This would make the eventual exit from monetary accommodation harder and may ultimately threaten central banks’ credibility. ... This concern is reinforced by growing political economy risks. Central banks’ balance sheet policies have blurred the line between monetary and fiscal policy ... "

 Looking at all this, I'm reminded of the comment by William McChesney Martin, who served as chairman of the Federal Reserve through five presidents in the 1950s and 1960s, and who famously said that it was the job of the Federal Reserve was to take away the punch bowl just as the party gets going--by which he meant that a central bank should to raise interest rates early in an economic upswing, not late. The Federal Reserve policies of 2007-2009 were less like a punch bowl and more like a defibrillator designed to jolt the economy through the financial crisis. But good medical practice suggest that while a defibrillator is sensible during a crisis, you don't try to keep shocking the patient all the way back to good health. I am particularly struck by the BIS statement about the risks of "a widening gap between what central banks are expected to deliver and what they can actually deliver"--and the tacit admission that what ails the U.S. economy isn't likely to be fixed just by applying ever-greater jolts of monetary expansion.

Thursday, July 12, 2012

Economics of the Dust Bowl

The Dust Bowl refers to a pattern in which severe droughts of the 1930s in the American Plains states led to a loss of ground cover, which then led to devastating erosion of more than 75% of the topsoil in many areas.  Richard Hornbeck discusses "The Enduring Impact of the American Dust Bowl:
Short- and Long-Run Adjustments to Environmental Catastrophe," in the June 2012 issue of the American Economic Review. (The AER isn't freely available on-line, but many readers will have access through library or personal subscriptions.)  Hornbeck offers a reminder of the severity of the Dust Bowl (footnotes and citations omitted):

"Dust storms in the 1930s blew enwormous quantities of topsoil off Plains farmland; on “Black Sunday” in 1935, one such storm blanketed East Coast cities in a haze. The dust storms were unexpected and some feared that the region would become the once-imagined “American Desert”. The Dust Bowl period continued through 1938 and ended with the return of wetter weather and increased ground cover. In the aftermath of the Dust Bowl, much farmland was left severely eroded. ..."

"The Dust Bowl is estimated to have imposed substantial relative long-run agricultural costs in more-eroded counties. From 1930 to 1940, more-eroded counties experienced large and permanent relative declines in agricultural land values: the per acre value of farmland declined by 30 percent in high-erosion counties and declined by 17 percent in medium-erosion counties, relative to changes in low-erosion counties. Agricultural revenues declined substantially and immediately in more-eroded counties relative to less-eroded counties, and these revenue declines mostly persisted over time."
There are three possible adjustments for an area faced with this kind of negative shock: people can change their production methods--in this case, their farming practices--in response to the shock; people can leave the area; or people can keep doing pretty much what they were doing before, but be less productive and receive less income.  While Hornbeck is focused on the Dust Bowl, his analysis of the choice between changing, leaving, and plowing ahead as one did before is broadly applicable to many situations of a severe negative shock, like what would potentially happen if the predictions of climate change come to pass.

Hornbeck writes: "The main margin of economic adjustment was large relative population declines in more-eroded counties. From 1930 to 1940, populations declined by 12 percent in high-erosion counties and declined by 9 percent in medium-erosion counties, relative to changes in low-erosion counties. ... The Great Depression may have limited outside employment opportunities and, by 1940, population adjustment remained incomplete: unemployment was higher, a proxy for wages was lower, and the labor-capital ratio in agriculture was higher. These indicators recovered as large relative population declines continued through the 1950s. "

A number of potential methods of adjusting farm production were encouraged by farm bureaus at the time, including a shift toward hay (rather than wheat) and livestock (compared to crops). But such changes were not especially common. "Relative adjustments in agricultural land use were slow and limited, despite the availability of productive land-use adjustments recommended by contemporary
state agricultural experiment stations and extension services." The main reason that Hornbeck can provide evidence for is that shifts required credit, which wasn't easily available to struggling farmers in the 1930s. Other possible explanations are that the adjustments required larger-sized farms, and that tenant-farmers had little motivation to make such changes. Hornbeck summarizes: "Estimated relative changes in land values and revenues imply that agricultural adjustments recovered less than 25 percent of the initial relative cost in more-eroded counties."

Behind Hornbeck's estimates seems to me a deeper pattern of human behavior. When confronted with difficulties, leaving to try somewhere else is hard, but do-able. Staying and continuing with the same behavior is unpleasant, but do-able. But staying and dramatically altering one's behavior seems somehow hardest of all.

Aficionados of this blog may recognize that I have an interest in applications of economics to history, especially U.S. history. Here are some examples from the last 8-9 months:




Wednesday, July 11, 2012

Distribution of Taxes in 2009: CBO

The Congressional Budget Office has put out another of its useful reports on the distribution of the tax burden across income levels: "The Distribution of Household Income and Federal Taxes, 2008 and 2009."  I suspect that many readers will see in these numbers an affirmation of their own beliefs about whether taxes on the rich should be either higher or lower. Back in 1938, Henry Simons of the University of Chicago wrote a book called Personal Income Taxation, where he commented: "The case for drastic progression in taxation must be rested on the case against inequality -- on the ethical or aesthetic judgement that the prevailing distribution of wealth and income reveals a degree (and/or kind) of inequality which is distinctly evil or unlovely."

I don't expect to persuade people about the extent to which they find inequalities of income to be "evil or unlovely." But at least it would be useful if everyone was arguing from the same fact base. I'll focus my comments mostly on describing the situation of the top 1%, and let readers consider the rest of the data on their own.

For starters, here's  a table showing average tax rates for different kinds of federal taxes, across income levels.  Thus, the second column shows that the top 1% paid on average 21% of their income in federal income taxes. Conversely, the lowest quintile and the second quintile had negative income tax rates: that is, after taking into account refundable tax credits, their after-tax income was higher than their before-tax income. The top 1% paid 2.5% of income in social insurance taxes, a much lower rate, because Social Security taxes are only collected up to a certain income limit, which was $106,800 in 2009. The CBO estimates what income groups actually end up paying corporate taxes, and since those with high incomes own more stock, they pay a higher share of corporate taxes. The top 1% has income that is 5.2% lower because of corporate taxes. Federal excise taxes on gasoline, cigarettes, and alcohol weigh more heavily on those with lower income levels, and the top 1% pays 0.2% of its income in such taxes, compared with 1.5% for the lowest quintile.

Next, here's a table showing how the total level of federal taxes shifts the before-tax and after-tax distribution of income. The top 1%, for example, had average before-tax income of $1,219,700 in 2009. They paid 28.9% of that amount in federal taxes, so that this group had after-tax income of $866,700. The taxes paid by the top 1% were 22.3% of all taxes received by the federal government in 2009. The top 1% had 13.4% of total income on a before-tax basis, but 11.5% of total income on an after-tax basis.

Finally, here's a graph showing how the average federal tax rate has changed over time for those at different places  in the income distribution. Again, it's worth noting that those with higher income levels do, on average, pay more than those with lower income levels. The top 1% saw the share of income that they pay in federal taxes fall sharply in the early 1980s, at the time when the Reagan tax cuts reduced top marginal tax rates. After taxes on this group were raised under the first couple of years of the Clinton administration and the stock market was taking off, their average rates increased again in the mid-1990s. After the Bush tax cuts in the early 2000s, average tax rates fell for all groups. In 2009, with large numbers of unemployed not earning income, the average tax rate for the lowest quintile dropped off dramatically.

Tuesday, July 10, 2012

Current Account Imbalances

The U.S. economy has been running very large trade deficits for the last . China and Germany, among others, have been running very large trade surpluses. Should this be a matter for concern? If so, why?
As a starting point, here are figures showing the current account balances in the U.S., China, and Germany, from the ever-useful FRED website at the Federal Reserve Bank of St. Louis.

Of course, no economist would want to endorse the claim that nations should always have balanced trade. There are valid reasons for a nation to run trade deficits for a time (which means importing capital from abroad) or to run trade surpluses for  a time (which means investing capital abroad). Long ago, the standard textbook example was that high income countries, where capital was relatively plentiful, should run trade surpluses and invest the funds in low-income countries, where capital was relatively scarce. With the U.S. economy running huge trade deficits and China's economy running huge surpluses, that scenario is now standing on its head.

In the June 2012 issue of Finance and Development, Mohamed A. El-Erian offers a nice essay expressing the conventional wisdom about large and persistent trade imbalances.

"There will eventually come a point when deficit nations will find it difficult to continue to spend massively more than they take in. Meanwhile, surplus countries will find that their persistent surpluses undermine future growth. For both sides, the imbalances will become unsustainable, with potentially serious disruption to the global economy. ... The global imbalances are best characterized as being in a “stable disequilibrium.” They can persist for a while. But if they do, the global economy will continue to travel farther afield from the equilibrium associated with high global growth, sustainable job creation, and financial soundness ...

Indeed, where most academics do not differ is in their concern that persistent imbalances expose the global economy to sudden stops in investment flows, as happened in the fourth quarter of 2008. At that time funds ceased flowing to emerging markets and sought safe havens like U.S. government securities, which is what happened more recently in Europe. The extreme worries relate to currency fragmentation in Europe and worsening funding conditions for the United States. Both of these low-probability “tail events” entail catastrophic disruptions, with virtually no country in the world immune to negative spillover effects. Economists also point to mounting risks of currency wars
and protectionism ..." 
But as one digs down into the conventional wisdom on trade imbalances, the exact reason to worry about them is not as clear as one might like. Are the patterns of very large surpluses and deficits bad for their countries in and of themselves? Or is the danger that the trade imbalances may make global financial crises more likely? Or is the problem just that globalization has created larger and tighter linkages across countries, and the trade imbalances are not a central part of the story? Maurice Obstfeld takes on these kinds of questions in his Richard Ely lecture that was recently published in the May 2012 issue of the American Economic Review. (The AER is not freely available on-line, although many readers will have access through library subscriptions.)

Obstfeld makes clear that current account imbalances are not always a cause for concern. He writes:
"Before proceeding, I have to emphasize that just as the “consenting adults” framework claims, some current-account imbalances, even very large ones, can be justified in terms of economic fundamentals and do not pose threats to either the national or international economy. Such imbalances need not be a symptom of economic distortions elsewhere in the economy, but instead reflect reasonably forward-looking decisions of households and firms, based on realistic expectations of the future. Not all fall into this category, however, and the facts of the case are typically amenable to different interpretations--witness the debate over the global imbalances of the mid-2000s, notably the US deficit ..." (The Summer 2008 issue of my own Journal of Economic Perspectives had a pro and con on the U.S. trade imbalance, with Richard Cooper arguing that the U.S. trade deficits were a reasonable outcome of underlying economic forces, and Martin Feldstein arguing that they were an unsustainable situation and cause for concern.)

That said, Obstfeld offers three reasons for concern over current account deficits. First, current account imbalances may in some cases be a sign of an underlying economic problem; in particular, it may represent a surge of borrowing and credit that is fueling an unsustainable asset-market bubble. However, current account imbalances don't always signal an unsustainable credit boom, and credit booms can happen without a current account deficit. Obstfeld write:

"Numerous crises have been preceded by large current-account deficits—Chile in 1981, Finland in 1991, Mexico in 1994, Thailand in 1997, the United States in 2007, Iceland in 2008, and Greece in 2010, to name just a few. But temporal priority does not establish causality, and the empirical literature of the last two decades has not established a robust predictive ability of the current account for subsequent financial crises (especially where the richer economies are concerned). There are cases in which even large current-account deficits have not led to crises, as noted above, and furthermore, several notable financial crises were not preceded by big deficits, including some of the banking crises in industrial countries during 2007–2009 (for example, Germany and Switzerland)."

 Obstfeld's second concern is that large trade deficits, when an economy is receiving an inflow of foreign capital, make an economy vulnerable to a "sudden stop" of that capital. I've make this point before in a post about ways of illustrating the financial crisis of 2008. The graph shows the inflow of foreign capital to the U.S. economy. Notice first how this inflow of foreign capital rises dramatically through the 2000s, as the U.S. trade deficit plummets. But then focus on what happened during the financial crisis in late 2008 and early 2009: those inflows of financial capital not only went away, but actually turned into an outflow for a time. The inflows of foreign financial capital have since returned--but the vulnerability of the U.S. economy to a "sudden stop" of capital inflows is clear.

Obstfeld's third point is that current account imbalances may be a signal of larger financial imbalances.  He writes: 

 "Global imbalances are financed by complex multilateral patterns of gross financial flows, flows that are typically much larger than the current-account gaps themselves. These financing patterns raise the question of whether the generally much smaller net current-account balance matters much any more, and, if so, when and how. ... In the mid-1970s, gross financial flows were much smaller than trade flows, but the former have grown over time and on average now are of comparable magnitude to trade flows. ...

I will also argue that while policymakers must continue to monitor global current accounts, such attention is far from sufficient to ensure global financial stability. ... [L]arge gross financial flows
entail potential stability risks that may be only distantly related, if related at all, to the global
configuration of saving-investment discrepancies. Adequate surveillance requires not only
enhanced information on the nature, size, and direction of gross global financial trades, but better understanding of how those flows fit together with economic developments (including
current-account balances) in the world’s economies, both rich and poor."

In the conclusion, Obstfeld writes: "To my mind, a lesson of recent crises is that globalized financial markets present potential stability risks that we ignore at our peril. Contrary to a complete markets or “consenting adults” view of the world, current-account imbalances, while very possibly warranted by fundamentals and welcome, can also signal elevated macroeconomic and financial stresses, as was
arguably the case in the mid-2000s. Historically large and persistent global imbalances deserve
careful attention from policymakers, with no presumption of innocence."

Thursday, July 5, 2012

The Taylor Rule and Unconventional Monetary Policy

Aaron Steelman has an "Interview with John B. Taylor" in the First Quarter 2012 issue of Region Focus, published by the Richmond Federal Reserve. The interview touches on a number of topics, but here, I'll focus on the "Taylor rule" and monetary policy. The questions that follow are my own phrasing: the answers are from the interview. (For the record, I've known John Taylor on a professional level for many years and have considerable respect for his work, but the fact that we share a last name is pure coincidence!)

What is the "Taylor rule" for monetary policy?

"The rule is quite simple. It says that the federal funds rate should be 1.5 times the inflation rate plus .5 times the GDP gap plus one. The reason that the response of the fed funds rate to inflation is greater than one is that you want to get the real interest rate to go up to take some of the inflation pressure out of the system. To some extent, it just has to be greater than one — we really don’t know the number precisely. One and a half is what I originally chose because I thought it was a reasonably good benchmark."

How closely has the Fed followed the "Taylor rule"?

"The biggest period where the deviations are apparent is the 1970s. ...  I also think there were significant deviations from the rule from 2003 to 2005, when basically there were rate cuts greater than I think any reasonable interpretation of the rule would suggest. So I think the period when the rule was followed fairly closely was roughly from the 1980s through 2003. The way I think about it is that the Fed’s actions have been largely consistent with the rule without using it explicitly.  ... In the late 1990s Chairman Greenspan told me that it explained about 80 percent of what they were doing during his tenure, but that doesn’t mean that he was looking at it explicitly."

What are the dangers of the nonconventional monetary policies that the Fed has used since 2008?

"During the worst of the 2008 panic, the Fed also provided funds that increased the balance sheet and if it had stuck to the exit policies that it pursued following 9/11 [when the Fed first increased and then reduced reserves], those reserves would have been reduced pretty quickly. But instead the Fed moved after the panic into interventions in the mortgage market and the medium-term Treasury market. ... [I]n the early part of 2009, Don Kohn [then vice-chairman of the Federal Reserve] was on a panel with me at a conference; I argued that while the Fed can talk about these temporary interventions during the panic, I would worry that if the recovery is slow, it will continue to do these sorts of things — not because there is a liquidity problem, but just because the economy is still sluggish. Kohn said, no we won’t do that. But that, in fact, was what the Fed did.

"So now we have a situation where there are massive interventions that are not conventional monetary policy and we need to get away from that. However, I’m not sure the Fed will get away from such policies, because now people are writing papers, including academic papers, which say the Fed can and should do these things: It can have its role in terms of setting the interest rate and it also can use its balance sheet to supposedly stimulate growth. The reason it can do that, people argue, is that the Fed now pays interest on reserves and thus it can ignore the supply and demand for money or reserves when setting the interest rate. I think that is not a good approach. It is very unpredictable and it will inherently raise questions about the independence of the Fed. So I would like the Fed to go back to a world where the interest rate is determined by the supply and demand of reserves. That would prevent this extra instrument from playing such a big role."

"The other thing that happened during this episode was that the interest rate got to the zero lower bound. That generated this idea that something else had to be done, that the balance sheet had to increase a lot. That is not the implication. The implication is that when the interest rate is at the zero lower bound, you should make sure money growth doesn’t fall. Whatever aggregate you look at, you need to make sure it doesn’t decline. That is much different than massive quantitative easing."