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Here's Ryan Avent:

ECONOMISTS are realising that they have got some things about trade wrong in the past. Just because trade can make everyone better off, doesn't mean it will, for instance (at least without some help from politicians). That new research, and this year's political ructions, are generating some reflection on these issues among economists is a good thing. But it is important to maintain one's perspective. Tim Duy has not done that, I think, in this stemwinder of a post on the effects of American trade policy. He quotes Noah Smith, who says:
[I]n the 1990s and 2000s, the U.S opened its markets to Chinese goods, first with Most Favored Nation trading status, and then by supporting China's accession to the WTO. The resulting competition from cheap Chinese goods contributed to vast inequality in the United States, reversing many of the employment gains of the 1990s and holding down U.S. wages. But this sacrifice on the part of 90% of the American populace enabled China to lift its enormous population out of abject poverty and become a middle-income country.
And then writes:
Was this "fair" trade? I think not. Let me suggest this narrative: Sometime during the Clinton Administration, it was decided that an economically strong China was good for both the globe and the U.S. Fair enough. To enable that outcome, U.S. policy deliberately sacrificed manufacturing workers on the theory that a.) the marginal global benefit from the job gain to a Chinese worker exceeded the marginal global cost from a lost US manufacturing job, b.) the U.S. was shifting toward a service sector economy anyway and needed to reposition its workforce accordingly and c.) the transition costs of shifting workers across sectors in the U.S. were minimal.
Before closing:
I don't know how to fix this either. But I don't absolve the policy community from their role in this disaster. I think you can easily tell a story that this was one big policy experiment gone terribly wrong.
I think Mr Duy is getting the story wrong in a few important ways.
I'm not too happy with the way Ryan frames the issue. The first sentence seems to imply that economists didn't understand the second sentence of his post. But virtually every EC101 textbook published in the past 50 years tells students that trade benefits the US overall, but that specific groups in import-competing industries are hurt by trade. That's not a new insight. Otherwise I think Avent's post is excellent, and well worth reading. My only other quibble is that I think the Smith/Duy posts are much weaker than even Ryan suggests, for reasons I'll discuss below:

1. Much of the recent discussion, including posts by Noah Smith, are based on a misinterpretation of research by Autor, Card and Hanson, which I discussed in multiple posts. Autor, et al, provide cross-sectional evidence that areas of the US that were most affected by competition from China did relatively poorly. Many people (including, at times, the authors) misinterpreted that finding as suggesting that the overall impact on the US was negative. But you cannot draw macroeconomic conclusions from a cross-sectional study. They showed that areas most impacted by China trade did relatively poorly (a finding I accept) but their study told us nothing about the macroeconomic impact. It would be like trying to draw macro conclusions about fiscal multipliers by looking at state level multiplier effects. Monetary offset anyone?

2. At times, Autor seems to suggest that China trade might have hurt the US by boosting our trade deficit. First, it's not clear that China trade does boost our trade deficit (which is based on saving and investment flows), but let's suppose it did. What then? Here it might be worth comparing the US to the Eurozone, which has a massive current account surplus, far larger than China's surplus. I did so in this post, and found that Europe has experienced almost exactly the same sort of decline in manufacturing jobs as the US. So trade deficits don't seem to be the culprit.

3. But it's even worse. Their study looked at data from 1990-2007, when the US was not at the zero bound. Paul Krugman pointed out that monetary offset would have been expected to apply during this period, and thus that the Fed would, as a first approximation, expand monetary policy enough to offset any job losses from falling AD due to trade deficits.

Just to be clear, I'm not saying China trade might not have produced some net job loss---one can tell stories where workers losing jobs in manufacturing aren't able to find jobs in the service sector because of a lack of skills, and hence the natural rate of unemployment rises. But the natural rate has not risen. A better story is that somehow China has contributed to workers simply exiting the labor force, and not even looking for jobs. Maybe, but as we'll see, China is probably not the right target, even if that theory is true.

4. I wonder why there is so much focus on China. It's true that about 20% of our imports come from China, but about 80% come from other areas. About 20% of our imports come from Europe, and a much higher figure from NAFTA (Canada plus Mexico). Are Chinese exports particularly toxic? The best argument in favor of that proposition is that Chinese exports were unusually fast growing, and thus unusually disruptive. I agree. But there are many other arguments that cut in exactly the opposite direction:

a. The goods we buy from Europe and NAFTA tend to be goods that we would otherwise produce at home, like cars and other sophisticated manufactured goods. In contrast, the goods we buy from China are often goods that would otherwise have been bought from other countries in East Asia, and elsewhere. This is not always true, but it's certainly true on average. When China opened up to the world, lots of production shifted from the so-called Asian "Tiger economies" to Mainland China. There is no way that industries like clothing, shoes and toys were going to stay in America. If we did not buy these goods from China, we could have bought them from other Asian countries. Today that's probably even true of more sophisticated goods like laptop computers and iPhones.

b. Also keep in mind that China is often simply an intermediary. The important components might be made in Korea or Taiwan, and then sent to China for assembly. The data may show massive growth in imports from China, but the actual value added in China may be much less than the official growth figures. But then how to explain the rapid growth in trade?

c. China's entry into the world economy occurred just as technology like container ships was dramatically reducing the cost of trade, and boosting trade as a share of global GDP. Some of the fast growth in Chinese exports over the past few decades would have instead come from other East Asian countries, or even Mexico, if China has stayed a closed economy. In other words, correlation does not prove causation. How much was trade liberalization, and how much was cheaper trade costs?

d. China's exports to America were rising very fast even before the trade reforms such as WTO, which Tim Duy refers to. I'm not disputing that the reforms boosted trade further. But only a portion of the effects found by Autor, et al can be attributed to the WTO, a big part is simply the fact that China had a huge comparative advantage in lots of industries, and the cost of trade was falling fast.

Now lets suppose that all of the preceding arguments made above, and also by Krugman are wrong. And not just a little bit wrong, but 100% wrong. Just how bad might China trade actually be? What's the worst case?

Start with the fact that we imported $466 billion from China in 2015, about 2.5% of GDP. I'm not going to argue that 2.5% of GDP is a small number, it's not. But can that possibly be all cost? Wouldn't you want to at a minimum look at our exports to China (I view that as a cost, BTW, but mercantilists often see it as a benefit)?

More importantly what about all the goods we get from China? Walmart and Target stores are a cornucopia overflowing with Chinese goods, which provide great benefits to Americans living on modest incomes. Surely that counts for something, indeed quite a lot. I'd say it means the US is a net gainer from trade, but let's say I'm wrong. And let's continue to assume that all of my preceding arguments are utterly without any merit. You are still left with 2.5% of GDP, minus any benefits you attribute to exports to China, minus the undeniably vast benefit to consumers from access to Chinese goods. That's is, 2.5% of GDP minus a number that is almost certainly quite large.

Now contrast that with the rhetoric in the Smith and Duy quotes. Smith refers to a sacrifice by 90% of Americans. Where does this number come from? Well over 80% of Americans are in the service sector. Many others are in construction or export industries. When coal miners or policemen or fireman or teachers or construction workers or Boeing employees or nurses or cashiers go shopping at Walmart, and load up on Chinese goods, precisely how are these groups being devastated by China? I don't get it. Smith seems to be assuming that everything that has gone wrong in America since 1990 is due to China. OK, that's hyperbole, but isn't the 90% figure he cites equally exaggerated?

In other posts I've pointed out that in industries like steel and coal the vast majority of job loss is due to technology, not trade. And of the modest part of job loss that is due to trade, only a modest part of that is due to trade with China (particularly if you keep your eye on value added, and China's role in a global supply chain that often starts in other East Asian countries.)

And I'd say the same about Tim Duy's remarks. I believe the China trade is a good thing. The China growth story since 1980 is literally the best thing that has ever happened on the last 4.6 billion years on planet Earth, and China's opening up to foreign trade is an important part of that story, albeit far from the whole story. (It might be helpful here to think of the worst thing that has ever happened, and then imagine its exact opposite.) The cost to America would have to be mind-bogglingly large in order for this not to have been a wise policy, even if our role in China's growth were modest (which it was.). I share the view of most economists that the US has actually benefited from China trade. But even if there had been a small net loss, how could it possible be set against the obviously vast benefits to extremely poor Chinese from global trade?

Ryan Avent's post is well worth reading, but if anything I believe he understates how far off base Smith and Duy are in this case. To summarize:

1. The problem isn't trade, it's automation.
2. If trade is a small part of the problem, it's not China: it's the other 80% of exporters.
3. If China imports are a tiny part of the problem it mostly reflects deeper changes in East Asian supply chains, and nothing specific about China.
4. And only a small part of that tiny part of the problem is the WTO, a lot of it is cheaper shipping costs and China's powerful comparative advantage in many industries.
5. Chinese goods are a huge boon to low income Americans.
6. If trade really did boost inequality, the way to fix that is with redistribution and/or weaker IP laws, not protectionism.
7. The argument for protectionism is exactly the same as the argument for Ludditism. It hurts society overall, but helps certain groups hard hit by change. Is that what we want? Do policies that make America poorer also make America great again?

I got into blogging in 2009 because I was upset about how monetary policy errors were devastating working class Americans. I'd be really upset if I thought the China complaints were true. But no one (including Autor, et al) has given me a scintilla of evidence for the sweeping claims being made.

PS. There are many more arguments to be made. Those struggling coal towns in West Virginia would be hurt by protectionism against China. Those struggling lumber areas of Oregon (Duy's home state) would also be hurt, as we export both coal and lumber to China. The more you drill down into the details, the weaker the argument against trade becomes. Construction in the US would be hurt as well, as I>S by exactly the amount of our current account deficit.

PPS. EU exports to the US are slightly below China's, but if you add in exports from Switzerland, and other non-EU countries, then Europe's exports would be about the same as China's.

I just got back from a long vacation in my home state of California.  The bad news about California is that its people and government have unusually severe economic illiteracy.  The good news is that their severe economic illiteracy provides enough illuminating examples to fill a textbook.  This trip, my favorite case in point has been California's law requiring stores to charge at least ten cents per bag

Economically speaking, what is this law?  Most non-economists call it a "tax on bags," but it's totally not.  A seller is legally allowed to absorb a tax if he is so inclined.  If the government imposes a  $1 tax on a $10 product, for example, a seller is legally free to cut the list price to $9 so the price with tax stays at $10.  But California merchants are not allowed to charge customers less than $.10 a bag.

If the law isn't a tax, what is it?  A price control.  What kind of price control?  A minimum price, also known as a price floor.  And since bags used to be free, this is clearly a binding floor.

The primary effect of a binding price floor is to create a surplus.  At a price of $.10 per bag, sellers want to sell a lot more bags than customers want to buy.  This may sound strange to California residents: "It's really hard to get bags now.  What do you means there's a 'surplus'?"  But that only shows they don't understand the textbook concept.  A surplus doesn't mean abundance; it means abundance from the seller's point-of-view, combined with scarcity from the buyer's point-of-view.  In fact, textbook econ implies that the bigger the surplus, the less human beings consume.

But binding price floors also have a secondary effect: they raise quality.  If merchants can't make their bags more attractive to consumers by cutting their price, the next-best strategy is to make their bags better.  This abstruse textbook prediction was uniformly fulfilled in every grocery store I saw in California.  Indeed, I've never had better bags in my life!  Every bag was sturdy, pristine, and decorated.  This bag says it all:

bag.jpgBut aren't high-quality bags a good thing?  The general answer is: not necessarily.  Quality costs more; markets let people decide for themselves whether the extra quality is worth the extra cost.  When price floors spur higher quality, however, the extra quality is normally not worth the extra cost.  How do we know?  Because before the law was passed, sellers were free to offer higher-quality, higher-cost bags, but rarely did, demonstrating that consumers place little value on extra quality.

Defenders of California's law who know a smattering of economics will no doubt appeal to the negative externalities of plastic bags.  But in this case, a little knowledge is a dangerous thing.  If you're doing practical policy analysis, you can't just point to a negative externality.  You've got to do quantitative cost-benefit analysis: How much cleaner will the $.10 bag law make the planet - and much aggravation will it inflict on consumers?  I can't find any decent numbers on Google or Google Scholar, but it's pretty obvious that bags are a tiny fraction of all plastic, and plastic a tiny fraction of all potentially hazardous trash.  And it's even more obvious that bringing your own bags to shop is a pain in the neck.

Even if environmental costs heavily outweigh convenience benefits, however, price floors are almost always inferior to simple taxes.  See any decent intro econ textbook: When firms can't efficiently compete on price, they inefficiently compete on everything else.  Taxes change behavior, too, but only by changing prices - leaving firms and consumers free to flexibly and creatively adapt.  And instead of burning up resources on inconvenience and overly fancy bags, taxes change behavior and raise government revenue at the same time.

Strangely, then, the only people with a halfway-decent reason to prefer California's policy to a simple bag tax are libertarians who take the Starve the Beast strategy to its radical conclusion.  Everyone else in California desperately needs to read an econ textbook before he votes again.

UBI.jpg In a very lively EconTalk episode this week, listener favorite Mike Munger returns to discuss his support for a basic income guarantee, or BIG. It's a pretty heated conversation, especially for BFFs Munger and Roberts...We'd like to know where you stand on the issue.

Munger advocates a BIG primarily on grounds of efficiency and transparency. But he and Roberts disagree as to what the effect on the size of government would be under a BIG regime. Nor do they see eye to eye on where the greatest DISincentive effects of a BIG would fall.

The conversation ends on a philosophical note. Munger makes a characteristically startling claim (to be fair, he makes several throughout), that "Jobs are overrated." It's an important point, and one on which Roberts seems to agree. That is, throughout recent history, we seem to have defined ourselves in reference to our jobs. Isn't that what people mean when they ask, "What do you do?" It's refreshing to imagine a future in which we respond with answers like "spending time with my children," "volunteering at the animal shelter," "building gardens," etc. How would you like to answer? And how might a BIG (or another policy alternative) help to effect such a change?

The conversation in the Comments section is as lively as the episode, and we've an Extra coming soon. You can find both, and join in the conversation, at EconTalk. We'd also be really grateful if you'd take a few minutes to complete our annual listener survey and help us make EconTalk better!

CATEGORIES: EconTalk , Political Economy

"The Affordable Car Insurance Act (ACIA), which President-elect Donald Trump and the Republican-controlled Congress have vowed to repeal, was crafted to overcome two basic problems in the provision of car insurance in the United States. First, the costs are incredibly skewed, with just 10 percent of drivers accounting for almost two thirds of the nation's spending on cars that have been in accidents."

This is from Dean Baker, "The Economics of the Affordable Car Insurance Act," January 17, 2017.

Actually, it's not from Dean's article. I've changed a few words.

But before you go and find his article, think through whether this 10 percent of drivers accounting for 2/3 of spending is a problem with car insurance. Once you've thought through that, go and read Dean's article.

HT2 Mark Thoma.

Famed futurist Eliezer Yudkowsky fears the imminent end of the world at the hands of Unfriendly Artificial Intelligence.  I find this worry fanciful.  Many people in Eliezer's position would just dismiss my head-in-the-sandedness, but he's also genuinely impressed with my perfect public betting record.  To bridge the gap and advance our knowledge, we've agreed to the following bet, written in the first person by Eliezier.  Since I've just Paypaled him the money, the bet is now officially on.

Short bet:

- Bryan Caplan pays Eliezer $100 now, in exchange for $200 CPI-adjusted from Eliezer if the world has not been ended by nonaligned AI before 12:00am GMT on January 1st, 2030.


- $100 USD is due to Eliezer Yudkowsky before February 1st, 2017 for the bet to become effective.

- In the event the CPI is retired or modified or it's gone totally bogus under the Trump administration, we'll use a mutually agreeable inflation index or toss it to a mutually agreeable third party; the general notion is that you should be paid back twice what you bet now without anything making that amount ludicrously small or large.

- If there are still biological humans running around on the surface of the Earth, it will not have been said to be ended.

- Any circumstance under which the vast bulk of humanity's cosmic resource endowment is being diverted to events of little humane value due to AGI not under human control, and in which there are no longer biological humans running around on the surface of the Earth, shall be considered to count as the world being ended by nonaligned AGI.

- If there is any ambiguity over whether the world has been ended by nonaligned AGI, considerations relating to the disposition of the bulk of humanity's potential astronomical resource endowment shall dominate a mutually agreeable third-party judgment, since the cosmic endowment is what I actually care about and its diversion is what I am attempting to avert using your bet-winning skills.  Regardless, if there are still non-uploaded humans running around the Earth's surface, you shall be said to have unambiguously won the bet (I think this is what you predict and care about).

- You win the bet if the world has been ended under AGI under specific human control by some human who specifically wanted to end it in a specific way and successfully did so.  You do not win if somebody who thought it was a great idea just built an AGI and turned it loose (this will not be deemed 'aligned', and would not surprise me).

- If it sure looks like we're all still running around on the surface of the Earth and nothing AGI-ish is definitely known to have happened, the world shall be deemed non-ended for bet settlement purposes, irrespective of simulation arguments or the possibility of an AGI deceiving us in this regard.

- The bet is payable to whomsoever has the most credible claim to being your heirs and assigns in the event that anything unfortunate should happen to you.  Whomsoever has primary claim to being my own heir shall inherit this responsibility from me if they have inherited more than $200 of value from me.

- Your announcement of the bet shall mention that Eliezer strongly prefers that the world not be destroyed and is trying to exploit Bryan's amazing bet-winning abilities to this end.  Aside from that, these details do not need to be publicly recounted in any particular regard, and just form part of the semiformal understanding between us (they may of course be recounted any time either of us wishes).

Notice: The bet is structured so that Eliezer still gets a marginal benefit ($100 now) even if he's right about the end of the world.  I, similarly, get a somewhat larger marginal benefit ($200 inflation-adjusted in 2030) if he's wrong.  In my mind, this is primarily a bet that annualized real interest rates stay below 5.5%.  After all, at 5.5%, I could turn $100 today in $200 inflation-adjusted without betting.  I think it's highly unlikely real rates will get that high, though I still think that's vastly more likely than Eliezer's doomsday scenario.

I would have been happy to bet Eliezer at the same odds for all-cause end-of-the-world.  After all, if the world ends, I won't be able to collect my winnings no matter what caused it.  But a bet's a bet!


St. Louis Federal Reserve Bank Vice-President and economist Stephen D. Williamson has written a critical review of Kenneth Rogoff's The Curse of Cash. I use the word "critical" in the sense we academics use it: a balanced critique that looks at pluses and minuses.

I haven't read Rogoff's book yet, although I did edit an Econlib article, "In Defense of Cash," by Pierre Lemieux, who did read Rogoff's book thoroughly.

While Williamson's piece is balanced, I want to focus on one area in which he too easily accepts Rogoff's thinking about crime and another area in which, if I understand him correctly, Williamson seems to make a basic error in economic reasoning.


Williamson writes:

Why is cash a "curse?" As Rogoff explains, one of currency's advantages for the user is privacy. But people who want privacy include those who distribute illegal drugs, evade taxation, bribe government officials, and promote terrorism, among other nefarious activities. Currency - and particularly currency in large denominations - is thus an aid to criminals. Indeed, as Rogoff points out, the quantity of U.S. currency in existence is currently about $4,200 per U.S. resident. But Greene et al. (2016) find in surveys that the typical law-abiding consumer holds $207 in cash, on average. This, and the fact that about 80% of the value of U.S. currency outstanding is in $100 notes, suggest that the majority of cash in the U.S. is not used for anything we would characterize as legitimate. Rogoff makes a convincing case that eliminating large-denomination currency would significantly reduce crime, and increase tax revenues. One of the nice features of Rogoff's book is his marshalling of the available evidence to provide ballpark estimates of the effects of the policies he is recommending. The gains from reforming currency issue for the United States appear to be significant - certainly not small potatoes.

Let's look at those four activities cited. Using large denomination bills to promote, or, even worse, carry out, terrorism is clearcut bad. So score one for Rogoff and Williamson.

How about the other three? What you think of them will depend on how you think about these issues. Consider them in turn.

Distributing Illegal Drugs

One of the major costs of the drug war, which gets far too little attention, is that it raises the cost of illegal drugs to those who want them. We, including me, often write about the costs to innocent parties whose property is stolen by drug users. But we typically leave out the costs to drug users, including those who don't steal. The drug war has destroyed a huge amount of consumer surplus for drug users. In any legitimate cost/benefit analysis, those losses should count too. I supervised a thesis on this in 2002: Marvin H. McGuire and Steven M. Carroll, "The economics of the drug war : effective federal policy or missed opportunity?"

How does this matter for the issue at hand? High-face-value currency, as both Rogoff and Williamson recognize, facilitates illegal drug transactions. Getting rid of that currency makes those transactions more difficult, making the cost to consumers higher. That's their point. So in their view, the consumer surplus loss doesn't count. It should.

Bribing Government Officials

Making it more difficult to bribe government officials could be good or could be bad. It's probably bad, as Francois Melese argues in "Corruption," in The Concise Encyclopedia of Economics. In this paragraph, Melese points out both sides of the issue:

Some economists argue that paying bribes to the right officials can mitigate the harmful effects of excessive government regulation. If firms had a choice to wade through red tape or pay to circumvent it, paying bribes might actually improve efficiency and spur investment. Although this view is plausible, a pioneering study by Mauro found that corruption "is strongly negatively associated with the investment rate, regardless of the amount of red tape" (Mauro 1995, p. 695). In fact, allowing firms to pay bribes to circumvent regulations encourages public officials to create new opportunities for bribery.

My point here is that one should not just assume that bribing government officials is bad.

Evading Taxation

Lemieux says it best:

Furthermore, some activities that the law currently defines as crimes (in certain countries) may actually provide useful built-in constraints against abuse of power. Tax dodging, for example, limits the voracity of Leviathan and its tax exploitation. It increases the cost to the state of raising taxes and, thus, tends to maintain them at a level more likely to gain the consent of most citizens.

Moreover, there's one other area where cash does facilitate crime, but that's good, not bad. Lemieux writes:

The same argument applies to the underground economy more generally. It provides a built-in constraint against overregulation. As regulation increases, more people--consumers, entrepreneurs, unfashionable minorities--move to the underground economy. Thus, government cannot regulate past a certain point, and this constraint kicks in more rapidly in a free society.

That cash plays a role in making these built-in constraints more effective against abuses of power is a benefit, not a cost. In a free society, one could provide a cogent argument for increasing the face value of the largest-denomination notes. The largest Swiss note, for example, is 1,000 Swiss francs (roughly the same as $1,000 at the September 22, 2016 exchange rate).

Because of all these constraints, the cost of fighting crime is certainly higher in a free society. But for the vast majority of individuals, the benefits of freedom are even higher. Liberty is not a bug--it's a feature.

Economics of Interest Rates

Williamson writes:

A typical central banking misconception is that a reduction in the nominal interest rate will increase inflation. But every macroeconomist knows about the Fisher effect, whereby a reduction in the nominal interest rate reduces inflation - in the long run.

Here Williamson broke a cardinal rule, one that my co-blogger Scott Sumner loves to cite: "Never reason from a price change." An interest rate is a price of current availability of resources. If you start by reasoning from a price change, you forget to ask why the price changed.

And that stricture about the direction of reasoning matters in this case. The correct statement of the Fisher effect is NOT that "a reduction in the nominal interest rate reduces inflation." The correct statement is that a reduction in expected inflation, all other things equal, reduces the interest rate.

CATEGORIES: Money , Regulation , Taxation

When I was in grad school in the late 1970s, there was increased interest in the "monetary ineffectiveness proposition", which posited that money was neutral and monetary policy did not impact real variables. There was virtually no interest (at Chicago) in the claim that monetary policy could not impact nominal variables, like inflation and NGDP. By the early 1990s, there was no interest in the nominal ineffectiveness view in any university that I'm aware of.

And yet today I see lots of people denying that monetary policy can control nominal variables. They often make arguments that are completely irrelevant, such as that the monetary base is only a tiny percentage of financial assets. That would be like saying the supply of kiwi fruit can't have much impact on the price of kiwi fruit, because kiwi fruit are only a tiny percentage of all fruits.

Beyond the powerful theoretical arguments against monetary policy denialism, there's also a very inconvenient fact for denialists; both market and private forecasters seem to believe that monetary policy is effective. Let's take a look at the consensus forecast of PCE inflation over the next 10 years (from 42 forecasters surveyed by the Philadelphia Fed):

Screen Shot 2017-01-16 at 9.19.41 AM.png
Notice that most of those numbers are pretty close to 2%. The Fed's official long run target is headline PCE inflation, however in the short run they are believed to target core PCE inflation, which factors out wild swings in oil prices. Core PCE inflation is expected to come in at 1.8% this year. That may reflect the strong dollar, which holds down inflation. They forecast 2.0% inflation for the 2016-2025 period.

Now think about how miraculous that 2.0% figure would be if monetary policy were not determining inflation. Suppose you believed that fiscal policy determined inflation. That would mean that professional forecasters expected Trump and Congress to come together with a package to produce exactly 2% inflation. But I've never even seen a model explaining how this result could be achieved. People who like the fiscal theory of the price level, such as John Cochrane, usually talk about the history of inflation in the broadest of terms. Thus inconvenient facts such as the fall in inflation just as Reagan was dramatically boosting deficits are waved away with talk of things like the 1983 Social Security reforms, which reduced future expected deficits. But unless I'm mistaken, there's no precision in those models, no attempt to explain how fiscal policy produced exactly the actual path of inflation. (This is from memory, please correct me if I'm wrong.)

Another counterargument might be that 2% inflation is "normal", and thus might have been caused by some sort of structural factors in the economy, not monetary policy. But of course it's not at all normal. Prior to 1990, the Fed almost never achieved 2% inflation; it was usually much lower (gold standard) or much higher (Great Inflation and even the Volcker years.) Since 1990, we've been pretty close to 2% inflation, and this precisely corresponds to the period when the Fed has been trying to achieve 2% inflation. Even the catastrophic banking crash of 2008-09 caused inflation to only fall about 2% below target, as compared to double digit deflation during the 1931 crisis.

So private sector forecasts seem to trust the Fed to keep inflation at 2%, on average. But how can the Fed do that unless monetary policy is effective?

How about market forecasts? Unfortunately we don't have a completely unbiased market forecast, but we do have the TIPS spreads:

Screen Shot 2017-01-16 at 9.33.20 AM.png
Notice the 5-year and 10-year spreads are both 2.01%. That's actually closer to 2% than usual, but a couple caveats are in order. First, the CPI is used to index TIPS, and the CPI tends to show higher inflation that the PCE, which is the variable actually targeted by the Fed. So the markets may be forecasting slightly less than 2% inflation. Notice the Philly Fed forecast calls for 2.0% PCE inflation and 2.22% CPI inflation over the next decade. So perhaps the TIPS markets expect about 1.8% PCE inflation.

On the other hand, TIPS spreads are widely believed to slightly understate expected CPI inflation. That's because conventional bonds are somewhat more liquid than TIPS, which means they are presumably able to offer a slightly lower expected return. If so, then expected CPI inflation is slightly higher than the TIPS spreads. To summarize, the TIPS markets are probably predicting slightly above 2.01% CPI inflation, and the expected PCE inflation rate is about 0.22% below that. In other words, TIPS markets predict that PCE inflation will run about 0.22% below a figure that is slightly above 2.01%. That sounds like a figure not very far from 2.0%!

Thus both private forecasters and market participants seem to be expecting roughly 2% PCE inflation going forward. There are lots of other figures they could have predicted, including the 4% inflation of 1982-90, or the zero percent average of the gold standard, or the 8% figure of the 1972-81 period, etc., etc. Why 2.0%? Is it some miraculous coincidence? Or is it because the Fed determines the inflation rate, and people expect the Fed will deliver roughly on target inflation, on average, for the foreseeable future?

Just to be clear, I'm not saying the forecasts will always be this close. I would not be shocked if the next Philly (quarterly) forecast bumped up to 2.1%, perhaps reflecting the impact of Trump's election. My point is that it's difficult to explain any figure that is close to 2% with a "fiscal theory of the price level". Or "demographics". You need to focus on monetary policy, which drives the inflation rate. And that means, ipso facto, that monetary policy also determines NGDP growth. If trend RGDP were to slow, the central bank could simply raise the inflation target to maintain stable NGDP growth. Thus NGDP growth is not driven by structural factors such as productivity, regulation, demographics, fiscal policy, etc., it's determined by the Fed.

There is no question in my mind that the Fed could generate a 4% average rate of NGDP growth, or any other figure. The only question is whether or not they wish to.

PS. Of course there's lots of other evidence against denialism. For instance, exchange rates often respond strongly to unanticipated monetary policy decisions, and almost always in the direction predicted by monetarists, and denied by denialists.

PPS. I'm not a Holocaust denialist, a global warming denialist, or a monetary policy denialist. But I am a fiscal policy denialist and a conspiracy theory denialist, so I'm not opposed to denialism, per se.

PPPS. Regarding the kiwi example, an even better analogy would be the claim that a stock split of Disney can't affect the nominal price of individual Disney shares, because Disney is only a small share of the entire stock market. Of course that's wrong, and so is monetary policy denialism.

Many people are puzzled by the fact that Japan continues to fall short of its 2% inflation target. Some attribute this the Japan being in a "liquidity trap". But surely that can't be the complete explanation. If Zimbabwe can find a way to inflate, it's hard to believe that Japan would be unable to debase its fiat money. If they don't know how, I'd be glad to show them. No charge.

In macroeconomics, causation occurs on many levels. In my book on the Great Depression I pointed to real wage shocks, and then deeper causes like deflation and New Deal polices, and then deeper problems like gold hoarding, and then deeper problems like fear of bank failure, fear of currency devaluation and lack of international cooperation on monetary policy. And then deeper causes of that lack of cooperation (bitterness over WWI, Smoot Hawley, etc., etc.)

So what is the deeper cause of Japan's "lowflation". Back in 2010, John Taylor wrote a post describing how the US used to pressure Japan to avoid depreciating the yen. Taylor does not suggest that this policy caused Japan's 1997-2012 deflation, but it certainly might have.

Is this still true today? This article caught my eye:

If United States president-elect Donald Trump's appointment of Peter Navarro to head a new Council of Trade is the prelude to strained relations between Beijing and Washington, the United States will not wish to alienate Japan at the same time.

Japanese economic policies that might ordinarily raise US eyebrows could instead pass unchallenged. The yen could fall further in value.

I don't believe that the US would actually stop Japan form depreciating the yen. In my view we are a "paper tiger". But Japan may see things differently, and be reluctant to risk a trade war.

You might wonder why Japan doesn't adopt another type of expansionary monetary policy---one that does not involve depreciating the yen. The problem here is that any effective monetary stimulus will depreciate the yen, regardless of whether it is accomplished by the BOJ buying domestic assets or foreign exchange.

That's one reason why I call this a "stupidity trap". US pressure on Japan is based on an EC101-type error. Indeed it's based on four such mistakes:

1. The idea that monetary stimulus can create inflation without depreciating a currency.

2. The idea that Japan's currency account surplus shows that its currency is "undervalued". In fact, it merely shows that Japan saves more than it invests, not surprisingly for a thrifty country with a falling population.

3. And it's based on the misconception that it's possible to prevent Japan from depreciating its real exchange rate (which is what matters for trade), by preventing it from depreciating its nominal exchange rate. Instead, if the equilibrium real exchange rate falls, and the nominal rate is held fixed, Japan's real exchange rate will fall via deflation.

4. It's based on the misconception that a current account surplus in Japan somehow steals jobs from America.

In freshman economics we try to teach students that these ideas are myths. But these views are widely held by people in places like the Treasury Department, even under previous administrations that tended to favor free trade.

Imagine what we'll get with the Trump administration.

David R. Henderson  

Why Are Drug Prices So High?

David Henderson

DiMasi Drug Development Costs.jpeg

Economists have shown that the cost to get one drug to market successfully is now more than $2.8 billion. This cost has been growing at 7.5 percent per year, more than doubling every ten years. Most of this cost is due to FDA regulation. Some potentially helpful drugs don't ever make it to market because the cost the company must bear is too high. Drug companies regularly "kill" drugs that could be effective because the potential profits, multiplied by the probability of collecting them, are less than the anticipated costs. One of us has helped kill drugs for brain cancer, ovarian cancer, melanoma, hemophilia and other debilitating conditions. Imagine a drug for melanoma that never got on the market due to FDA regulation. In a sense, its price is infinite because it can't be purchased. Reduce FDA regulation so that it gets on the market, and the price falls from "infinite" to merely "high." If you had melanoma, which would you rather have: no drug or a high-priced drug that treats it?

If we simply went back to pre-1962 law, the FDA could still require proof of safety, but would not be able to require evidence on efficacy. This one change would allow drugs to be developed faster--often as much as 10 years faster. Market success would establish efficacy. Could there be ineffective drugs? Sure. But as doctors and patients learn, such drugs would disappear over time. This is nothing new; doctors and patients regularly evaluate drugs for efficacy. Clinical trials often show that perhaps only 20 percent, 40 percent, or 60 percent of patients benefit. Even when the FDA finally approves the drug as "safe and efficacious," doctors must still evaluate the drug to find out how efficacious it is for each particular patient. In practice, an FDA certification of efficacy is just a starting point.

Who would want to take a drug that has not been shown, to the FDA's satisfaction, to be effective? Almost everyone. Many drugs have off-label uses. These are uses that doctors have found effective for a particular use but that the FDA has not approved for that use. According to WebMD, "More than one in five outpatient prescriptions written in the U.S. are for off-label uses." Tabarrok cites studies showing that 80 to 90 percent of pediatric patients are prescribed drugs for off-label uses.

As is well-known in the medical establishment, off-label prescribing is legal and widely practiced. Indeed, Congress, the National Institute for Health, Medicare, the Veterans Administration, and the National Cancer Institute all encourage it. Consider gastroparesis, a poorly understood upper gastrointestinal disorder in which the contents of the stomach do not move efficiently into the small intestine. Diabetics are particularly susceptible to this condition. The FDA has approved only one drug to treat it: metoclopramide. But doctors have found that, for some patients, an antibiotic called erythromycin reduces nausea, vomiting, and abdominal pain. Erythromycin is not FDA-approved to treat gastroparesis. But it works. Moreover, off-label uses in oncology account for as much as 90 percent of all cancer treatments. For some diseases, like AL amyloidosis, there are no approved medicines. Not a single one. So what do doctors do? They use medicines developed to treat related diseases, such as multiple myeloma, even though they and their patients would prefer medicines that treat AL amyloidosis directly.

This is from David R. Henderson and Charles L. Hooper, "Why Are Drug Prices so High?" Goodman Institute Brief Analysis No. 117, January 10, 2017.

I was mildly opposed to Obamacare, but mostly because I thought it was a missed opportunity to reform health care. I was bemused to see very strident opposition to the program on the right, with some pretty hyperbolic language about socialized medicine and the end of freedom. (Language I don't recall with Bush's massive increase in government involvement in healthcare.)

In recent weeks I've seen a number of conservatives argue that the GOP would be making a mistake to simply repeal Obamacare. But why? If it's such a horrible program, won't Americans be much better off without it? So just repeal the program, and then later try to work on sensible reforms. That's not my view, but it's the view I'd expect from the people who told us that Obamacare was horrible.

One counterargument is that some people have grown to rely on Obamacare. But if that's an argument against repeal, then it's also an argument against any policy changes in any area of governance. All policy changes create winners and losers. Lots of people who made investment decisions based on the current tax code, will be hurt if the GOP lowers rates and closes loopholes. Should we not do tax reform? (See David Henderson's excellent post discussing this issue.) At most, I would think you'd want to add a three-year grace period for those who were currently insured under Obamacare, to give them time to find suitable alternatives. But if the program is horrible, then get rid of it.

But those are not the arguments I'm seeing. A typical example was recently published in the National Review, a very conservative intellectual publication. The article suggests that Obamacare should be replaced with a new program . . . which sounds almost exactly like Obamacare! Now just to be clear, it's not identical, but the similarities are so strong that it makes me wonder what all the fuss was about. Why did conservatives view Obamacare as a disaster, if they wish to replace it with such a similar program?

As I said, before the election I was to the left of the conservative movement, opposed to Obamacare but viewing some of the opposition as rather hysterical. Now I've shifted to a position to the right of the conservative movement, I favor radical changes in health care:

1. Elimination of all tax subsidies, such as the deductibility of health insurance costs.
2. Radical deregulation, including no barriers to market entry, no quality regulations, open borders for doctors, abolishing the FDA, no barriers on the type of insurance that can be offered.
3. Government healthcare would be provided at the lowest cost possible, even if it meant flying Medicaid patients to Thailand. (It probably would not after open borders for doctors, and no barriers to entry.)

I do favor some role for the government. One idea for overcoming the free rider problem is mandatory health saving accounts and catastrophic insurance. (The alternative is letting people who choose not to be insured simply die when they are sick. Even if that's the right policy, society is not willing to adopt it---so health savings accounts seem like a good second best policy.)

In addition to health savings accounts and catastrophic insurance, there could be some sort of government subsidy for the needy. That might be government run clinics and hospitals, that offer bare bones service, as in Singapore, or subsidies for the purchase of HSAs and catastrophic insurance, for low income people. Singapore's government spends only a tiny fraction of what our government spends on health care, but it has universal coverage and the world's second longest life expectancy.

If people don't like catastrophic insurance, they would be free to buy ordinary insurance, instead of HSAs. But there would be no government subsidy.

The GOP could do these radical changes, which but they would be highly controversial. As a result, they'll probably end up with something similar to Obamacare, but called Trumpcare.

PS. I'm still looking for answers to my questions on the proposed border adjustment tax.

On November 8, Indian prime minster Narendra Modi announced that the two largest denominations of banknotes could not be used for payments any more with almost immediate effect. Owners could only recoup their value by putting them into a bank account before the short grace period expired at year end, which many people and businesses did not manage to do, due to long lines in front of banks. The amount of cash that banks were allowed to pay out to individual customers was severely restricted. Almost half of Indians have no bank account and many do not even have a bank nearby. The economy is largely cash based. Thus, a severe shortage of cash ensued. Those who suffered the most were the poorest and most vulnerable. They had additional difficulty earning their meager living in the informal sector or paying for essential goods and services like food, medicine or hospitals. Chaos and fraud reigned well into December.
This is from Norbert Haring, "A well-kept open secret: Washington is behind India's brutal experiment of abolishing most cash," January 1, 2017.

I posted about the Indian government's action in "India's Assault on Money," November 11, 2016. It hadn't even occurred to me that other international groups might have been instigators.

Another excerpt:

Not even four weeks before this assault on Indians, USAID had announced the establishment of ‚ÄěCatalyst: Inclusive Cashless Payment Partnership", with the goal of effecting a quantum leap in cashless payment in India. The press statement of October 14 says that Catalyst "marks the next phase of partnership between USAID and Ministry of Finance to facilitate universal financial inclusion". The statement does not show up in the list of press statements on the website of USAID (anymore?). Not even filtering statements with the word "India" would bring it up. To find it, you seem to have to know it exists, or stumble upon it in a web search. Indeed, this and other statements, which seemed rather boring before, have become a lot more interesting and revealing after November 8.

In his post, Haring does not make a slam-dunk argument that USAID was an instigator of this extreme measure. He does point to a number of coincidences. But there's no smoking gun.

In my earlier post, I wrote:

Here's what I wonder. If Kenneth Rogoff, the U.S. economist who would like to get rid of cash and, indeed, thinks it's a curse, could push a button affirming this particular Indian government move, would he push it?

The good news is that it looks as if he wouldn't.

On November 17, Rogoff wrote:

Is India following the playbook in The Curse of Cash? On motivation, yes, absolutely. A central theme of the book is that whereas advanced country citizens still use cash extensively (amounting to about 10% of the value of all transactions in the United States), the vast bulk of physical currency is held in the underground economy, fueling tax evasion and crime of all sorts.

But he continued:
On implementation, however, India's approach is radically different, in two fundamental ways. First, I argue for a very gradual phase-out, in which citizens would have up to seven years to exchange their currency, but with the exchange made less convenient over time. This is the standard approach in currency exchanges.

CATEGORIES: Monetary Policy , Money

Scott Sumner  

Border tax bleg

Scott Sumner

Martin Feldstein had a recent piece in the WSJ that defended the idea of a border tax adjustment, which would be a part of the proposed corporate tax reform. He points out that if imports were no longer deductible, and exports received a subsidy, then the border adjustment would not distort trade. Rather the effect would be exactly offset by a 25% appreciation of the dollar. I certainly understand that this would be true of a perfect across-the-board border tax system. But is that what we will have?

1. Will the subsidy apply to service exports? (Recall that services are a huge strength of the US trade sector.) Let's take Disney World, which makes lots of money exporting services to European, Canadian, Asian and Latin American tourists visiting Orlando. Exactly how will Disney determine the amount of export subsidy it gets? Do they ask each tourist what country they are from, every time they buy a Coke? That seems far fetched---what am I missing? If Disney doesn't get the export subsidy, then the 25% dollar appreciation would hammer them, and indeed the entire US service export sector.

2. What about all those corporate earnings that are supposed to be repatriated? (And future earnings as well.) If the dollar appreciates by 25%, then doesn't this hurt multinationals? Or am I missing something?

Update: It just occurred to me that corporate cash stuffed overseas is probably held in dollars. But future overseas earnings may still be in local currency.

Keep in mind that the prediction of 25% dollar appreciation is from the supporters of the plan, like Martin Feldstein. If you did this sort of adjustment without any dollar appreciation, the impact would be devastating on companies like Walmart. Given the Fed's 2% inflation target, how could they pass along a (effective) 25% tariff on almost everything they sell?

It's clear to me that I am missing something here. Can someone who knows more about the nuts and bolts of border adjustment taxes please explain exactly how this is supposed to work? I'm not saying the border tax is a bad idea--I'm agnostic so far. But unless I get good answers here, I'd recommend they not do it, or perhaps phase it in extremely gradually (like 1%/year for 25 years), and see what sort of side effects occur before going all the way to a 25% dollar appreciation.

Not to mention this violates WTO rules, which the US has previously argued must be adhered to. (Insert Trump sarcasm here.)

PS. Feldstein makes the following claim:

Since a border tax adjustment wouldn't change U.S. national saving or investment, it cannot change the size of the trade deficit. To preserve that original trade balance, the exchange rate of the dollar must adjust to bring the prices of U.S. imports and exports back to the values that would prevail without the border tax adjustment. With a 20% corporate tax rate, that means that the value of the dollar must rise by 25%.

With a 25% rise in the value of the dollar relative to foreign currencies, the $80 net price of U.S. exports would rise in the foreign currency to the equivalent of 1.25 times $80, or $100, and therefore back to the initial price. Similarly, the 25% rise in the value of the dollar would reduce the real import price to the U.S. retail customer back to $125/1.25, or $100, as it is without the border tax adjustment.

Although the combination of the border tax adjustment and the stronger dollar leaves exports and imports unchanged, it has the important advantage of raising substantial tax revenue. Because U.S. imports are about 15% of GDP and exports only about 12%, the border tax adjustment gains revenue equal to 20% of the 3% trade imbalance or 0.6% of GDP, currently about $120 billion a year. At that rate, the border tax adjustment would reduce the national debt by more than $1 trillion over 10 years.

That makes no sense to me. If the tax raises lots of revenue, then why doesn't national saving go up? Isn't government tax revenue a part of national saving? Feldstein is far better at public finance than I am, so I must be missing something here.

Can anyone help me?

Update#2: I forgot about foreign dollar denominated debts. How are they handled if the dollar appreciates by 25%? Tough luck?

recession.jpg What made the "Great Recession" great? How did its effects, and the policy responses prompted by it, differ from those seen with earlier recessions? This week's EconTalk episode, with Stanford economist and Chairman of the NBER's Business Cycle Dating division Robert Hall, explores why we haven't seen a significant recovery in the wake of this most recent recession.

There's been much discussion about the role of the Federal Reserve in the Great Recession, and Roberts and Hall begin there, exploring the question of whether the Fed acted too aggressively- or not aggressively enough- in response. Hall argues that the Obama administration's stimulus package wasn't effective, but for very different reasons than you might expect. Very little of the money went to the sort of "shovel-ready" projects touted, but instead went toward the debt obligations of state and local governments. For Hall, this suggests the federal government doesn't have sufficient tools to induce local governments to spend, which is needed for any stimulus package to work.

Roberts and Hall have an extended discussion on the nature of interest rates and the influence of the Fed on them. (I'm reminded of this 2013 Feature Article by Jeffrey Rogers Hummel.) The conversation naturally turns to the influence of interest rates on reserves and real interest rates in the larger economy. What is the purpose of the excess reserves being held? Hall predicts the Fed will be phasing out these "old-fashioned" reserves in favor of the newer RRP reserves.

There's a lot of macro to digest in this week's episode, some rather technical. For those interested in more general topics, the conversation includes interesting take-aways as well. Roberts and Hall discuss the changing character of macroeconomics. (Hall coined the Saltwater/Freshwater distinction.) Hall argues that the idea of differing "schools" of macroeconomic thought has disappeared. Hall also shares (as much as he's able!) how he and the rest of the NBER Business Cycle Dating committee work to determine the start and end of each recession. While today it's more complicated than that, it turns out that looking for two consecutive quarters of declining GDP is still a good generalization, just like we all learned in class.


David R. Henderson  

Trump's Trade Trifecta

David Henderson
Well, it's now obvious that Canada has not dodged a bullet. One of President-elect Trump's most sincerely held views is that free trade is suspect. He buys into virtually every mercantilist myth, even claiming in a recent tweet, "China has been taking out massive amounts of money & wealth from the U.S. in totally one-sided trade."

This goes way beyond mercantilism into incoherence. No trade can be a little one-sided, let alone "totally one-sided." The reason is that when you trade, you give something up and get something in return. Trade is necessarily two-sided. Even more flabbergastingly, Trump is not complaining that Americans don't get enough from China in return. He's complaining that it gets too much! This massive amount of wealth that he thinks China is taking from America is, mysteriously, in the form of goods that we Americans buy from China at low prices. What nerve those Chinese people and firms have, selling us things at low prices when, Trump seems to be saying, we should prefer to buy them at high prices.

This is from my most-recent blog post at the Fraser Institute blog. The post is titled "Trump's trade trifecta will likely target China, Canada and beyond."

In it, I highlight the threat from the trifecta of Navarro, Ross, and Lighthizer.

James Alexander directed me to a very good Bloomberg article on "monetary offset":

Federal Reserve Chair Janet Yellen may well be thinking it. Jeffrey Lacker, president of the Richmond Fed, came close to saying it. "A more stimulative fiscal outlook usually warrants higher policy rates," Lacker said a week after Donald Trump won the presidency. Translation: Trump's plans to stimulate economic growth could inspire the Fed to move in the opposite direction. Such a move, which would put the U.S. president and its central bank at odds, is called a monetary offset.
In my view, monetary offset is less discretionary than most people assume. Of course in a literal sense the title of this post is wrong, the Fed can choose to engage in monetary offset, or not choose to. But in a deeper sense I don't really think they have much choice.

Right now the Fed has a very impressive economic research apparatus, which models the economy under alternative monetary policy options. FOMC members then produce forecasts of inflation under "appropriate monetary policy". When you look two years out, the Fed's inflation forecast is generally about 2%. That's because the Fed's inflation target is 2%, and they wish to set policy at a level where they achieve this target. An exception might occur during a deep slump like 2009, where the Fed might believe that it will take a bit more than 2 years to get back to 2% inflation. But of course that's not where we are today.

As long as the Fed decides policy using this deliberative procedure, monetary policy is somewhat automatic, or at least less discretionary than most people assume from looking at the FOMC ponder over rate changes. And this means that as long as they continually set the fed funds target at a level expected to produce 2% inflation a couple years in the future, they will be automatically adjusting interest rates to completely offset the demand-side effects of fiscal stimulus (of course supply-side effects are another story.)

How would we know if the Fed had decided not to sterilize the impact of fiscal stimulus from the Trump administration? The answer is simple, you'd see the Fed's 2018 inflation forecast rise to 2.5%, or 3%. But that's not what we see, and I think it's very unlikely that we will see this sort of inflation forecast in the near future. If they didn't raise the inflation target during the recession (when it would have been helpful for growth) why would they raise it now?

Perhaps people are confused about this because they think in terms of stimulus being aimed at boosting growth, not inflation. Since the Fed has no mandate to restrict growth, why would it offset fiscal stimulus? But the direct effect of fiscal stimulus is to boost NGDP, and any further impact on RGDP depends on the slope of the short run AS curve. (Or the Phillips curve, if you prefer.) Even some economists appear confused on this point. Here's Simon Wren-Lewis, discussing empirical studies of monetary offset:

As far as I know, no one had expressed a concern about fiscal austerity because of the impact this will have on nominal GDP. The issue is always the impact on real activity, for reasons that are obvious enough.
Here Wren-Lewis confuses the ultimate goal with the direct effect. Real GDP can rise for many reasons, including demand and supply-side shocks. Keynesian stimulus is generally assumed to work through demand-side effects, which means that both growth and inflation should rise if stimulus is boosting demand. If you see growth rise but no change in NGDP, then the cause of the growth is obviously not "more spending" it's an increase in the incentive to work, invest and innovate. That sort of growth would not validate the theories of John Maynard Keynes; it would validate the theories of Arthur Laffer.

Here's how Nick Rowe responded to Wren-Lewis:

I disagree on the NGDP vs RGDP thing. Sure, RGDP is what we care about, but we don't know whether a rightward shift in the AD curve will cause increased RGDP, increased price level, or (more likely) some mixture of the two. Using NGDP instead of RGDP is a crude way of acknowledging our ignorance about the slope of the Short Run Phillips Curve.

Now, if fiscal loosening (in countries with flexible exchange rates) causes RGDP to increase but does not cause NGDP to increase, which is what your results and Mark's [Sadowski] results seem to imply, when taken together, we have a very uncomfortable conclusion for all of us. It tells us that the Short Run Phillips Curve slopes the wrong way. It tells us that an expansionary fiscal policy causes inflation to *fall*. Which is a very strange result indeed, unless you want to talk about the supply-side benefits of bigger deficit spending.

Now the supply-side argument is not stupid. If you suddenly lay off thousands of government workers, that causes some real supply side issues, because those workers won't be able to reallocate instantly even if aggregate demand does not fall. The search theorists do have some sort of a point. Any sort of change in the composition of demand between private and government sectors, in either direction, will cause some temporary increase in frictional unemployment, shifting the SRPC in the bad direction.

I don't find my above "explanation" fully convincing. But it's better than assuming the SRPC slopes the wrong way, so that an expansionary fiscal (or monetary) policy *reduces* inflation in the short run.

I agree. But an even simpler explanation is that tax increases reduce output in exactly the way predicted by Art Laffer.

I'm not an enthusiastic supply-sider like Laffer or Larry Kudlow, but even a moderate supply-sider like me would predict some negative growth effects from tax increases.

To summarize, Wren-Lewis thought he was testing the Keynesian model, whereas it was actually a test of whether Keynesian or supply-side models are correct. His results suggest that the basic demand-based Keynesian model is wrong and the supply-side model is right.

PS. New Keynesian models actually do allow for some supply-side effects. Thus if you spend a lot on military goods, then workers will feel poorer, and therefore they will wish to work harder to maintain their living standards. Obviously this is not the sort of transmission mechanism that people like Paul Krugman and Wren-Lewis have in mind when advocating fiscal stimulus.

HT: Ramesh Ponnuru, Stephen Kirchner

Scott Sumner  

Deficits always matter

Scott Sumner

Paul Krugman has a new post entitled "Deficits Matter Again":

Not long ago prominent Republicans like Paul Ryan, the speaker of the House, liked to warn in apocalyptic terms about the dangers of budget deficits, declaring that a Greek-style crisis was just around the corner. But now, suddenly, those very same politicians are perfectly happy with the prospect of deficits swollen by tax cuts; the budget resolution they're considering would, according to their own estimates, add $9 trillion in debt over the next decade. Hey, no problem.
He's right about the GOP hypocrisy, but I can't help noticing that the GOP is not the only group that changed their tune after the election.

Unlike Krugman, I've consistently argued that deficits are not a good way of stimulating the economy, and that monetary policy should be used to assure the appropriate level of aggregate spending.

Those apocalyptic warnings are still foolish: America, which borrows in its own currency and therefore can't run out of cash, isn't at all like Greece. But running big deficits is no longer harmless, let alone desirable.

The way it was: Eight years ago, with the economy in free fall, I wrote that we had entered an era of "depression economics," in which the usual rules of economic policy no longer applied, in which virtue was vice and prudence was folly. In particular, deficit spending was essential to support the economy, and attempts to balance the budget would be destructive.

This diagnosis -- shared by most professional economists -- didn't come out of thin air; it was based on well-established macroeconomic principles. Furthermore, the predictions that came out of those principles held up very well. In the depressed economy that prevailed for years after the financial crisis, government borrowing didn't drive up interest rates, money creation by the Fed didn't cause inflation, and nations that tried to slash budget deficits experienced severe recessions.

That last sentence is incorrect. If you look at the group of nations with independent monetary policy, there is no correlation between (cyclically-adjusted) deficit reduction and growth. At the beginning of 2013, a letter signed by 350 Keynesians warned that fiscal austerity risked pushing the US into recession. Instead the deficit fell by nearly half, and economic growth actually sped up in calendar year 2013 (Q4 to Q4). The reason is simple---monetary offset.

But these predictions were always conditional, applying only to an economy far from full employment. That was the kind of economy President Obama inherited; but the Trump-Putin administration will, instead, come into power at a time when full employment has been more or less restored.

How do we know that we're close to full employment? The low official unemployment rate is just one indicator. What I find more compelling are two facts: Wages are finally rising reasonably fast, showing that workers have bargaining power again, and the rate at which workers are quitting their jobs, an indication of how confident they are of finding new jobs, is back to pre-crisis levels.

What changes once we're close to full employment? Basically, government borrowing once again competes with the private sector for a limited amount of money. This means that deficit spending no longer provides much if any economic boost, because it drives up interest rates and "crowds out" private investment.

This isn't really the issue. To the extent that the Keynesian model allows fiscal stimulus to work, it is based on the zero bound issue, not the economy being deeply depressed. Thus in 1982 the economy was deeply depressed, but nowhere near the zero bound. Fiscal stimulus would have been almost completely ineffective at boosting demand (even in the New Keynesian model) because Paul Volcker would have tightened monetary policy enough to keep the economy on track for his low inflation goals. (Of course, there may have been supply-side effects.)

One area where I do agree with Krugman is that economic slack is almost gone. In this recent MoneyIllusion post I also cited the acceleration in hourly wage growth. James Alexander contested this argument, pointing to more ambiguous data for weekly wage growth. But I like hourly wages best, because they are a particularly sticky variable. When the growth rate of hourly wages changes, it usually signals a disequilibrium in the labor market. (In fairness, James points to one case (2008) where they briefly gave a false signal. They probably are not the best forward looking indicator, but I do think they are one of the best indicators of the current condition of the labor market--perhaps with a slight lag.

Krugman links to an earlier post that provided one argument for stimulus, even without much economic slack:

Does this mean that the case for easy monetary and fiscal policies is over? No, but it's subtler now: it hinges mainly on the precautionary motive. Right now the economy looks OK, but things may change. Of course they could get better, but they could also get worse -- and the costs of weakness are much greater than those of unexpected strength, because we won't have a good policy response if it happens.

What I mean is that because interest rates are still near zero, a bout of economic weakness can't be met with strong monetary expansion; and discretionary fiscal stimulus is politically hard, especially given who'll be running things. This strongly suggests that you want to build up some momentum, get further away from a lee shore, pick your metaphor; that means letting the economy build strength, inflation rise modestly.

In this post I criticized this view. The Fed may want to raise its inflation target (although I prefer other reforms) but it should not overshoot an unchanged inflation target to build up ammunition against a potential zero bound problem. Doing so would make inflation even more procyclical, and make another recession more likely. Indeed excessive monetary stimulus in 2006 was one of the causes of the 2008 recession. It pushed inflation above target, and a couple year slater the Fed tightened to reduce inflation at the worst possible time.

A better solution would be to switch to 4% NGDP level targeting. This would generate countercyclical inflation.

In yesterday's Wall Street Journal, talk radio host Hugh Hewitt has an op/ed titled "Policy Purity is Bad Politics." In it, he argues against capping the mortgage interest deduction.

I'll comment on three things:
1. His economic analysis,
2. His political analysis,
3. My own puzzle about realtors' views on this.

1. His economic analysis.

Hewitt's economic analysis is approximately correct. He quotes the statement of economist Richard McKenzie, who has often written the Econlib Feature Article, to the effect that "the value of every home in America would decline by 10% to 15% the day after the deduction is capped." I don't know if he has quoted Richard correctly. My guess is that Richard was analyzing not a cap on the interest deduction but a complete elimination of the interest deduction. If the cap were a very low number, say, on the order of $5,000 per year (which would be the interest, at 4%, on a $125,000 loan), then Hewitt is roughly correct. If the cap is a high number, on the order of, say, $20,000 per year (the interest, at 4%, on a loan of $500,000), he's incorrect. The cap would hurt owners of higher-price homes but because the majority of homes are valued at under $600,000 (this allows for a loan of $500K and equity of $100K) they would not be much affected. And it probably wouldn't be the next day. House prices, unlike prices of widely paid stocks, are sticky. But it probably would happen within a year.

One major problem, though, is that Hewitt's argument could be used to argue against almost any major tax reform in which reduction of deductions is traded for lower tax rates. In fact, Hewitt, in this very article, proceeds to do that, arguing against limiting deductions for state and local taxes.

2. His political analysis.

Hewitt writes that Americans live:

in homes they bought at a value based on the existing deduction, in states whose taxes were partly offset through the federal code. Change those rules and what's left of the GOP in high-tax states will be gone.

But two of the highest tax states are California and New York, and there's little of the GOP there anyway. (Hewitt and I live in what is effectively a one-party state, California.) So a cap, say, of $20,000 on mortgage interest and a cap on the deductibility of state and local taxes (the latter include property taxes) would disproportionately hurt the owners of high-price homes. Where are those pricy homes disproportionately located? In coastal California and urban New York, which, as noted, is where the GOP is already very weak. So a cap would be seem to be potentially a smart political move, not a dumb one.

3. Why do realtors oppose the cap on mortgage interest deductibility?

Hewitt points out that after President-elect Trump announced Steven Mnuchin's nomination, Mnuchin said that the administration planned to "cap mortgage interest, but allow some deductibility." Hewitt writes, "That instantly energized the 1.2 million-strong National Association of Realtors against the tax reform."

I don't doubt Hewitt's statement. The NAR has always been one of the strongest defenders of the mortgage interest deduction.

What I wonder is: Why? You might say that it's because the 6% they get on sales of homes gives them a lower amount when the homes sell for a lower amount. Maybe that's it and end of discussion. But offsetting this factor is that the equilibrium of home ownership changes. People who find that the cap makes owning a home too expensive would try to sell. Other people who might buy are people wanting to pay a large down payment and take out a small loan. So there would be more buying and selling transactions. This means more commissions for realtors. It's not obvious to me that on net realtors would be hurt.

Of course, it's also true that many realtors buy houses and condos on their own accounts. I can think of a number of realtors in the Monterey area of whom that's true. So maybe much of the NAR opposition is due to the fact that many of them would take a capital loss. That might be one's first reaction. But probably almost all of these properties they buy on their now account are ones they rent. And when you rent, you get to deduct the mortgage interest and the property taxes from the rent. I doubt that Mnuchin's proposal would change that.

So I'm still left with a bit of a puzzle.

HT2 Mark Barbieri.


David R. Henderson  

Gruber on Romney and Obama

David Henderson

I found this 33-minute PBS interview of Jonathan Gruber, one of the architects of both Romneycare in Massachusetts and Obamacare for the United States, interesting.

I've posted about Gruber earlier in these 14 posts.

The interviewer is lobbing softballs throughout, which isn't necessarily a bad way of extracting information. It works in bringing out Jonathan's views about the issues and about Romney and Obama. Sometimes I like those interviews because too much "gotcha" can fail to bring out interesting things. It was extreme, though, in that the interviewer didn't at all mention some of the amazing things Gruber was caught saying on tape. The interviewer also didn't ask any tough questions about Obamacare.

Parenthetically, I know I shouldn't say this, because you're supposed to hate people you disagree with, but I found the Jonathan in this interview a sincere passionate man: for all his talk about tricking the voters, here's someone who thought things through (within a very limited framework--see my reference to his graphic novel below) and followed up by actually acting on what he thought. This was the man I sat beside and testified with in 1994 when we were on opposite sides of Hillarycare.

Some highlights:
26:30: In discussing the tax exclusion for employers' expenditures on employees' health insurance--health insurance paid for by the employer is not taxed as employee income whereas wages and salaries are taxed--Jonathan says, "It's regressive: the richer you are, the bigger tax break you get." That doesn't make is regressive. For a tax to be regressive, it has to be the case that the higher-income you are (what Jonathan meant by "richer"), the bigger the break you get as a percent of income. But since the employer's contribution to the employee's health insurance is a much higher percent of income for the low-income person than for the high-income person, the exclusion is progressive, not regressive. Here's what a Commonwealth Fund study found in 2009:

Claims that the current tax treatment of health insurance benefits is regressive are typically based on changes in absolute tax dollars rather than changes in tax rates. In economics, tax increases are defined as "progressive" if they represent a greater share of income for higher-income households. Defined as a share of income, the value of the current tax exemp- tion is larger for low- and middle-income households with employer-provided coverage than for high- income households. Elimination of the exemption would thus introduce a much greater increase in fed- eral tax liability for households with incomes below $50,000 than for those with incomes above $200,000, and increase the tax rate of lower-income households with employer coverage more than those higher- income households. Therefore, a cap on the tax exemption of health benefits would represent a regres- sive--not progressive--change in tax policy.

27:20: "There is not one single health expert in America, who, if setting up a system from scratch, would have this employer subsidy in place." It's mainly an employee subsidy--if you can call the untaxing of something a subsidy, and, in some respects you can--but his point remains.

Gruber talks throughout about how he was highly impressed both with Romney while working on Romneycare and with Obama while working on Obamacare.

28:35: "If you really want to see publicly how Obama works, the key thing to do is watch that Blair House meeting." Gruber concludes that he's "a smart guy." I think that's true. I haven't watched the whole 6 hours, but I watched a couple of them at the time. Gruber is referring to to the February 26, 2010 6-hour Blair House meeting with Congressional representatives from both major parties.

But I never think of that meeting without thinking about one Obama statement that had me gasping about Obama's lack of understanding of one basic aspect of insurance. It was this segment at 1:40:02 of the morning session:

When I was young, just got out of college, I had to buy auto insurance. I had a beat-up old car. And I won't name the name of the insurance company, but there was a company -- let's call it Acme Insurance in Illinois. And I was paying my premiums every month. After about six months I got rear-ended and I called up Acme and said, I'd like to see if I can get my car repaired, and they laughed at me over the phone because really this was set up not to actually provide insurance; what it was set up was to meet the legal requirements. But it really wasn't serious insurance.

It was serious insurance, but it didn't insure everything. If he wanted collision insurance, he needed to buy it. I'd bet dollars to doughnuts that what he bought was the minimal liability coverage to handle the externality from the accidents he might cause.

I remember thinking, "Of course Obama could make that mistake as a young person, but he doesn't seem to have figured out yet that it was a mistake in his own thinking about insurance rather than simply a feature of his insurance policy."

So maybe at other points in the day Obama was impressive, but this one really made me wonder if he gets insurance. Some of the actual features of Obamacare don't cause me to wonder less. Specifically, Obamacare requires the insurance company to cover, with zero copayments, certain procedures. This would have been like making him, as a young man, buy collision insurance for a "beat-up old car."

32:20 "It is so unfortunate, the misunderstanding of this law. I've actually written a comic book, a graphic novel, to try to explain the health care law."
Yes, and it was awful. To see why, read my co-blogger Bryan Caplan's analysis, which I would rank in his top 20 of the thousands of posts he has written.

Brian Moore asked me the following question:

I have read your site for years, but this is the first time I felt compelled to ask a question: some friends and I were discussing the various benefits to society that would accrue from say, my purchasing a product, vs investing the same amount of money in the stock market. While I know, at a high level, that investment is necessary to grow the economy, I had a more difficult time explaining the specific mechanism by which the action of "I buy 100 bucks of index funds on Vanguard" translates to "investment" in the economy. We were easily able to understand that if I buy a 100 dollar widget from Widget Corp, that benefits that company (and the economy), which now has $100 more to spend on wages or machines, but I am having difficulty coming up with a similar concrete sequence of steps for the 100 dollar stock investment.

On a larger point, I think this reflects part of the skepticism and suspicion that people have towards the stock market, particularly from the crowd that throws around terms like "gambling" and "speculation."

This is a surprisingly confusing subject. Consider the sentence that begins "We were easily able to understand . . . ". In fact, I don't think they do understand, as money spent on wages and machines is not a benefit to the economy, it's a cost. The benefit comes from consuming the widget. In the examples that follow, I'll assume the $100 widget is a meal at a restaurant for the Moore family.

Before considering Brian's stock market question, suppose he were trying to decide between spending the $100 on a meal, or spending it on materials for a new front sidewalk. The meal is considered consumption, and the new sidewalk is investment, because it's durable and yields a flow of services for many years, or even decades. The money spent on the sidewalk is called "saving". In either case, output gets produced and the effect on GDP is roughly the same, in the short run. In the long run, GDP will be a bit higher with the sidewalk investment, as it will continue to produce a flow of services for many years.

Now suppose Brian is trying to decide between the $100 meal and loaning $100 to a neighbor who will install the sidewalk. So far things are the same, at least in the aggregate. But now suppose the neighbor waits 2 weeks to do the sidewalk project. In that case, the restaurant meal may lead to more GDP in the very short run (less than 2 weeks), as compared to loaning the money to the neighbor. Over a three week period, output is the same either way.

Now suppose Brian is trying to decide between spending $100 on a meal, or investing $100 in the stock of a company that will use the money to install sidewalks. This is still pretty much the same as the previous example of the loan to the neighbor, it's just that the financial arrangements are getting steadily more complicated---more reliance on financial intermediaries. It's still true that money saved leads to investment, but the connection gets progressively more difficult to see.

So far we've been assuming full employment, and in the end I'd argue that this is the correct assumption for answering Brians's question. But first I'd like to play the devil's advocate (aka Keynes's advocate). Let's assume that Brian's purchase of stock does not lead to more investment. The company does not respond by building more sidewalks. What then?

My response is that S=I is an identity, and that more saving implies more investment.

The devil would respond that that's true in aggregate, ex post, but also that Brian's extra saving would not cause aggregate saving to rise, for "paradox of thrift" reasons. His decision not to go out to eat would lower AD, pushing the economy into a tiny recession. Consumption would be $100 lower than if he had bought the meal, but investment would not rise, nor would saving, in the aggregate. Instead, the extra $100 in Brian's saving would be offset by $100 less in saving by someone else, perhaps the owner of the restaurant that saw a lower income when Brian did not eat out.

This devil's advocate position explains why people tend to think it's "good for the economy" if consumers spend a lot of money. But is it? That depends on monetary policy. If the Fed targets interest rates, then the devil is correct. An attempt by Brian to save a bit more will put downward pressure on interest rates. To keep them from falling the Fed will reduce the money supply a bit, and NGDP will fall. Instead of Brian's saving leading to more investment, it will lead to lower NGDP.

My response is that over any meaningful time frame the Fed does not target interest rates, they adjust them as needed to keep inflation or NGDP on target. This means the Fed provides enough "aggregate demand" so that when Brian tries to save more, NGDP does not fall. Instead, that $100 boosts investment somewhere in the economy.

I don't mean to suggest that this works perfectly, rather that it works on average. Sometimes the Fed injects a bit too much money, and sometimes not enough. That's because they are not watching Brian as he ponders whether to spend $100 at the restaurant. So his decision not to eat out will cause a drop in NGDP at that very moment, relative to the alternative decision to buy the meal. The Fed tries to guess how people are behaving in the aggregate, and tries to supply enough money so that the classical model is true, that is, enough money to keep aggregate demand growing at the Fed's target rate.

Since monetary policy works on average, it's the default assumption that Brian and his friends should make when thinking about consumption and saving.

As the economics job market is underway and the AEA meetings in Chicago wrap up today, it is perhaps apropos to recount how one of the leading figures of economics in the 20th century was hired. Milton Friedman is one of the few names synonymous with Chicago Economics. For many it would be easy to assume that he was a straightforward appointment when hired at University of Chicago in 1946. As it turns out, he was not. Friedman was the compromise candidate.

Before a job offer was made to Milton Friedman, Chicago made offers to John Hicks, Albert Hart, and George Stigler. Offers were also approved for Lionel Robbins and Paul Samuelson. F.A. Hayek was proposed for a position in the department that same year. Had any combination of these appointments gone through, Chicago Economics would look distinctively different from what it became.

In 1946, the economics department at University of Chicago was in transition. Jacob Viner left for Princeton and T. W. Schultz took over as head of department. Two loose factions of the department emerged along theoretical, methodological, and ideological divides. On the one hand, you had Frank Knight, Henry Simons, Lloyd Mints, and H. Gregg Lewis - Marshallian in theoretical leaning, appreciative of free markets, and emphasizing policy applications. On the other hand, you had Jacob Marschak and Tjalling Koopmans of the Cowles Commission - favoring economic planning, active government intervention, aggregate econometric modelling, and a Walrasian general equilibrium framework.

Within this context, a new paper in the Journal of Political Economy by David Mitch gives a behind the scenes account of the hiring of Friedman drawing on detailed archival evidence. Using the Borda count method, on February 11, 1946, 12 members of the department cast votes.

John Hicks was clearly the first choice, despite the Knight group favoring Stigler as a theorist and to teach the core graduate price theory course. Hicks declined and instead took an appointment at Oxford. Albert Hart was the second choice, but he had already committed to spend a year at Columbia and ended up staying. The remaining offer in the first round was made to George Stigler. The University's central administration famously vetoed Stigler's initial job offer and it wasn't until 1958 that he was attracted back to Chicago.

With the department's first three picks off the table, Paul Samuelson and Milton Friedman were left. As the paper documents, the department wasn't just searching for the best economists. They were looking to make appointments that would define the field and what it meant to do economics at Chicago.

In 1945, Henry Simons writes:

Friedman is young, flexible, and available potentially for a wide variety of assignments. He is a first-rate economic theorist, economic statistician, and mathematical economist, and is intensely interested over the whole range of economic policy. ... Perhaps the best thing about Milton, apart from his technical abilities, is his capacity for working as part of a team. He is the gregarious kind of intellectual, anxious to try out all his ideas on his colleagues and to have them reciprocate. He would doubtless be worth his whole salary, if he neither taught nor published, simply for his contribution to other people's work and to the Department group as a whole. But he is also intensely interested in teaching, and far too industrious not to publish extensively. Our problem would be not that of finding ways to use him but that of keeping him from trying too many tasks and, especially, of leaving him enough time for his own research.

Samuelson was particularly controversial. As Mitch details in the paper, "All four members of the Knight group ranked Samuelson as 5 out of 5, as did Kyrk and Harbison. On the other side, the Cowles group and affiliates (Marschak, Koopmans, Lange, and Douglas) along with Schultz all ranked Samuelson as second after Hicks..... The opposition to Samuelson seems to have been grounded as much in perceptions of his activist and Keynesian approach to government economic policy and his arrogant personality as on his formal, mathematical approach to economic theory or his technical approach to applying theory to policy issues."

Marschak knew Friedman was ideologically free-market but argued that appointing him along with Samuelson "will just preserve the present dis-equilibrium. Since both are sincere thinkers and not shallow politicians, a hearty controversy between them will not do the harm it usually does between men who have more respect for faith than truth, and who refuse to face an argument if it threatens to lead to unpleasant conclusions."

A memo likely by Simons written in early 1946 states,

"Friedman is, I think, the most talented and promising of younger economists. His technical equipment (mathematical economics and statistics) is superlative. But Friedman has also an inordinately catholic interest in the whole range of economic policy and mature judgment on policy problems. Unlike other persons with comparable technical skills, he remains primarily interested in real policy problems and in political economic philosophy." It was arguably this mix of technical skills and serious policy interests that made Friedman viable as a compromise candidate.

Clearly Samuelson and Friedman revolutionized economics in dramatically different ways. Their comparable Google scholar citation counts are stunning: Samuelson (99,856 citations / h-index: 106) and Friedman (123,649 citations / h-index: 96). There are also less measurable, arguably equally important ways of making an impact. One wrote the nation's economics textbooks for 30 years, the other had a much more immediate influence on policy and public discourse. A Google Ngram picks up some of this difference:

Ngram small.PNG

For 2017 job candidates, two things are clear from this case study of inside baseball. For the candidate, there is a recipe to have in hand: (PhD + publications + teaching) + or - your personality = academic potential. Bring your A game. But there are always internal dynamics and differences in vision for future departmental development. You can't control what is going on behind closed doors and it really is often about finding the right "fit". May the odds be ever in your favor.

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