Bryan Caplan  

Sumner: An Embarassment of Riches

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Help with the Spinach... Dean Baker on the Uninsured...
I could devote a dozen posts to Scott Sumner's latest essay-length entry.  But I'll limit myself to the highlights:

Stop worrying about inflation.

...Laffer is too good an economist to say anything blatantly false, but the entire tone of his WSJ piece is that high inflation is just around the corner...

One reason that I was so discouraged by this piece is that Laffer was one of the "new monetary economists" of the early 1980s who understood that traditional monetarism had important defects.  Rather than focusing on the money supply, Laffer suggested that we needed to look at forward-looking market indicators such as the price of gold.  Today we have an even better forward-looking indicator--TIPS spreads.  And it is very clear that investors are not worried about high inflation.  Not now, not in 10 years, and not in 20 years.

Krugman doesn't really believe in the liquidity trap.
Many Keynesians assume that monetary stimulus is ineffective during a liquidity trap.  Krugman definitely does not believe that, indeed he specifically argues that only conventional monetary policy tools are ineffective in a liquidity trap.  He acknowledges that unconventional tools (such as an inflation target) might be highly effective, but also that they might be politically unacceptable.
Krugman, ants, and central banks.
As I read Krugman, his attitude seems to be something like the following (which is my interpretation, not his words):

"Ah, what a pity it is that these conservative central banks aren't willing to commit to a modest amount of inflation.  That would be the easiest way to boost AD, and the least costly.  But as they aren't willing to adopt effective policies, we can assume that monetary policy is ineffective.  Now let's move right along and look at fiscal policy."

At this point Krugman directs his moral outrage at the conservative knuckleheads in Congress who won't accept anything bigger than a measly $800,000,000,000 stimulus package, which he thinks is woefully inadequate.

In my view Krugman is mixing science and advocacy in a very misleading and inappropriate way.  When he evaluates central banks, he seems to take a deterministic, scientific, and clinical attitude, as if studying a colony of ants...  Central banks are assumed to be impervious to public pressure.  On the other hand his stance toward fiscal policy is much more normative.  Now he is an advocate, he's part of the game, passionately calling for more stimulus.  But I don't see how this makes any sense.  If we are going to take a deterministic view of things, it seems likely that Congress is also far too conservative to implement the sort of spending that Krugman advocates.  Indeed, hasn't that already been shown?   Couldn't one just as reasonably say: "Since Congress clearly won't do what it takes, we must fall back on the Fed as our only hope for the sort of stimulus that the economy needs."

Krugman's not shrill enough.
Krugman is 100 times more influential than I am.  With his NYT column, and his ideological allies in the White House, he is arguably the most influential economic pundit in the world.  And he is also known (for better or worse) for his moral outrage over perceived injustices.  In many cases I think he goes a bit over the top.  But here it is just the opposite.  I am outraged over Krugman's lack of outrage over current monetary policy.
Laffer is under-rated.
When I was at the University of Chicago during the late 1970s most economists seemed to think Laffer was a bit of a crackpot.  I recall one famous macroeconomist disproving the Laffer curve using a Keynesian model.  I can only imagine the contempt in which he was held at salt water universities.  But guess what happened next...  Every single developed economy adopted Laffer's ideas.  They all cut marginal tax rates for the rich.  Most cut rates very sharply.  Even Sweden cut its top rate from 87% in 1980 to 50% in 1995, before bouncing back up to 56%.  Did Laffer get any credit?  No, and I think this shows how the economics profession as a whole is still in deep denial about what occurred.
Why even economists under-estimate the dangers of high taxes.
[H]igh MTRs have a much more powerful effect on efficiency than most economists imagine, but the supply-siders are up against three problems:

1.  Tax cuts for the rich seem unfair.

2.  The supply-side effects are counter-intuitive (most people with 40 hour/week jobs can't envision changing their hours worked because of tax rates.)  Another counter-intuitive (and long run) effect of high MTRs is to make our health care system much more costly.

3.  Many of the most important incentive effects are very long term (such as the impact on the incentive to acquire more human capital.)

Tax cuts: Reagan and Thatcher were only the messengers.
I don't know if liberals are even aware of the fact that all countries, including Sweden, were doing the same thing at the same time.  This revolution would have occurred even if Reagan and Thatcher had never been elected.  Rather they reflected a change in the intellectual atmosphere surrounding public policy formation.  A change in what you might call the zeitgeist.   Pragmatic policymakers all over the world (on both the left and right) looked at the evidence and reached a consensus that high tax rates for the rich were counterproductive.
Whew.  There's so much thought-provoking content in this post, I really have to wonder if Sumner is on the wrong side of the pedagogical Laffer curve: Sometimes readers learn less when you teach more.  Then again, I've always preferred profs who teach to the top of the class...


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The author at Jim's Blog in a related article titled Inflation looms writes:
    The bond market does not tell us what the smart money people think inflation will be. It tells us what those among the smart money people who do not expect very high levels of inflation think inflation will be. In addition to an on budget deficit of t... [Tracked on June 18, 2009 5:15 PM]
COMMENTS (23 to date)
baconbacon writes:

"Today we have an even better forward-looking indicator--TIPS spreads. And it is very clear that investors are not worried about high inflation. Not now, not in 10 years, and not in 20 years."

TIPS spreads only of limited use in predicting inflation because they are based on the notion that investors can protect themselves from inflation by buying TIPS since the government will pay them the inflation rate on top of their interest rate. Consider what happens to the value of TIPS under Zimbabwe/Weimar type inflation. Would the federal government be able to pay interest of millions of % a year on their TIPS obligations? No, we saw this in Germany where the government literally build multiple printing presses and ran them 24 hours a day and couldn't print enough money- expectations eventually exceed actual money supply growth. We can see quickly that there are certain scenarios where TIPS will be woefully inadequate at protecting against inflation and thus we cannot use tips as a reliable predictor for those events.
In reality the top end of protection coming from TIPS is going to be well below hyperinflation levels. With public debt approaching 100% of GDP 100% annual inflation is unpayable for the US government. I would venture to guess that somewhere between a 20 and 30% inflation rate would make TIPS unviable in protecting against inflation due to the destruction of productive capacity that accompanies these levels and the obligations of the US that are tied to inflation rates (SS for one).
Then there is also the consideration that the US government is in charge of calculating the inflation rate and they have fiddled with the formula multiple times. The prospect of them holding the official figure down is a real concern for many investors.

ThomasL writes:

"Today we have an even better forward-looking indicator--TIPS spreads. And it is very clear that investors are not worried about high inflation. Not now, not in 10 years, and not in 20 years."

TIPS has two other fundamental flaws as a predictor for inflation, beyond what bacon mentions.

1. If everyone in the mainstream is saying, "Don't worry about inflation," isn't there some chance that they will convince their listeners? The idea that TIPS can accurately predict future inflation assumes that those involved have access to the information they need and understand the situation fully enough to gauge the risk.


2. The entity guaranteeing your inflation protection also tells you what the inflation rate is. A lot of people will, I think, not trust the government to report the numbers accurately, which drives down the value of TIPS. The TIPS spread is not a predictor for inflation. It is a predictor for how much of a difference someone expects the government to pay between it and a regular treasury. In normal times, that probably tracks will with inflation, but in uncharted waters, I don't imagine the people who think high rates of inflation are coming trust the government to pay out honestly. Given the choice of TIPS or gold, they'll go gold.

Continuing the first point:

I know there are a lot of smart financial experts around the world, but think back about a year, and ask yourself how awesome these same people were at predicting the coming meltdown.

Even a few months in advance, most missed it, but now they can see 20y ahead with perfect clarity? How many are the same ones that missed it then that are saying not to worry about inflation? How many of the people who did see this coming are saying that you should?

Jesse writes:

I hadn't realized that Arthur Laffer was associated with the idea that taxes can create a deadweight loss. I thought he was associated with the idea that you can increase government revenues by cutting tax rates.

What's weird is that Sumner actually acknowledges this, and is also clearly unwilling to argue that the Laffer curve has any relevance to the real world ("Actually, Laffer said revenue *might* go up, not that it always would rise"). Yet he is confused about why Laffer doesn't get more credit for his intellectual contributions.

Lee Kelly writes:

I do expect inflation, but why would I expect "the market" to expect inflation? I don't.

JS writes:

"And it is very clear that investors are not worried about high inflation. Not now, not in 10 years, and not in 20 years."

Let's hope they're a little better at predicting inflation than they are at predicting housing prices.

unit writes:

"Today we have an even better forward-looking indicator--TIPS spreads. "

Can someone explain this sentence? What are TIPS, what are spreads, why are they indicating anything etc...

baconbacon writes:

"Can someone explain this sentence? What are TIPS, what are spreads, why are they indicating anything etc..."

unit

TIPS are Treasury Inflation Protected Securities (though I often get acronyms wrong)

The basic idea is that the government pays you the interest rate you agreed to + the inflation rate (I think they calculate quarterly, but don't recall). So if you have an interest rate of 2% and inflation of 3% your TIPS pay 5%.

The TIPS spread is the difference between a normal treasury bill and a TIPS bill - usually the 10 year varieties. The spread is used as a proxy for inflation expectations- it works like this (in theory). If the regular bill yield is 4% and I think inflation will average 2% for the next 10 years I am going to buy TIPS at any base Yield > 2% and will buy regular bills at any TIPS yield

Crawdad writes:

Speaking of certain Nobel winning prognasticators and advice givers on matters economic:

"To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to creat a housing bubble to replace the Nasdaq bubble." Paul Krugman, Aug. 2, 2002 NY Times.

Done. So how did that work out for ya?

Dan Weber writes:

Unit:

TIPS are Treasury Inflation-Protected Securities. Instead of paying you a fixed interest rate, you get paid a slightly lower fixed interest rate, plus a premium depending on what (after-the-fact) inflation was.

The spread is the difference between the fixed rate on a normal bond and the fixed rate on a TIPS bond.

If expected inflation is 1%, then a market that demands 2.5% interest on a normal bond would demand 1.5% interest on a TIPS bond. (Roughly.)

Daniil writes:

I am not an economist. But regardless of that I don't understand how market players can reliably predict the rate of inflation which is an aggregate indicator unrelated to most individual economic decisions. Isn't that a misuse of aggregates that Hayek lamented?

Lance writes:

Jesse,

the Laffer Curve is related to the deadweight loss from taxation insofar as deadweight loss is a function of the elasticity of the supply curve. Laffer has stated as much that the shape of the Laffer curve was not meant to be precise, but rather a useful teaching tool for his students to get the concept of the elasticity of the supply curve, with implications for government revenue with resulting changes in taxation policy.

Les writes:

I recoil at the use of the words "the rich" because:

A) It is used by the liberals in their class warfare to raise taxes ever higher;

B) As used by the liberals "the rich" is often misused for those of modest income, rather than high income.

C) As used by the liberals "the rich" is often misused to measure wealth by income alone, whereas it seems that wealth is a stock rather than a flow, and should therefore be measured by assets less liabilities and not by income.

So I suggest that non-liberals should avoid use of "the rich" in order to avoid indirectly using and giving respect to this false term and political canard.

Dan Weber writes:

Done. So how did that work out for ya?

I'm not a fan of Krugman (well, the post-election-of-Bush Krugman), but it's pretty clear from context that he wasn't advocating a housing bubble. Rather, he explaining the Fed's course of action.

Mr. Econotarian writes:

"Don't worry about inflation"

Reminds me of "don't worry about housing prices, they can go up but they can never go down, especially 30%!"

baconbacon writes:

Dan Weber,

What Krugman is doing in that column in not just explaining the Fed's course of action but he is explaining the only possible way of avoiding the double dip recession according to Keynesian economics.

"The basic point is that the recession of 2001 wasn't a typical postwar slump, brought on when an inflation-fighting Fed raises interest rates and easily ended by a snapback in housing and consumer spending when the Fed brings rates back down again. This was a prewar-style recession, a morning after brought on by irrational exuberance. To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble."


with the most important piece being

"This was a prewar-style recession, a morning after brought on by irrational exuberance. To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment"

Billy writes:

Many investors also didn't worry about the housing bubble or credit default swaps.

Greg Ransom writes:

"To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble."

-- that's Paul Krugman in 2002 ...

S Andrews writes:

"To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble" --Krugman (2002)

link here

Winton Bates writes:

Good post!

It seems to me that Scott Sumner's views might need to get more consideration if the U.S. is to avoid following Japan's example of how not to conduct macro-economic policy.

Mattyoung writes:

Congress is very much an imperfect pricer of government goods. So, I always go back to the macro evidence I see; when marginal tax rates rise the budget deficit goes down. Keep the budget deficit around zero.

We will never get transparency from Congress about who pays for what services. So you end up with this indirect solution. When marginal rates are high enough, then wealthy people pay attention to the government goods they receive and the price they pay. The marginal rate system is the only tool we have to enforce rationality in Congress.

D. Watson writes:

Re: baconbacon,

1) "Consider what happens to the value of TIPS under Zimbabwe/Weimar type inflation. Would the federal government be able to pay interest of millions of % a year on their TIPS obligations? No,..."

I think you are saying there is a probability of default. That probability gets factored in as well: people won't buy them unless the interest rate on them is higher because of the risk of default. The fact that we don't see a spread between TIPS and regular bonds is an indication that this isn't the issue.

Also, suppose the market believed HI was imminent. No one would buy either type of bond - vanilla bonds would be worthless and TIPS (as you argue) would be defaulted. We would see the interest rates on both going skyhigh. We don't.

2) "Then there is also the consideration that the US government is in charge of calculating the inflation rate and they have fiddled with the formula multiple times. The prospect of them holding the official figure down is a real concern for many investors."

Isn't that always a risk? The gov always has an incentive to do so, but I have yet to see the research indicating or even suggesting this has been the case. If it were a real concern for many investors, the spread between TIPS and vanilla bonds would be larger. If the concern about gov fiddling were larger now than in the past because the incentive is larger, the spread would grow. It hasn't.

Put it together, and this says that investors aren't (particularly) worried about hyperinflation, default, or number-fiddling.

happyjuggler0 writes:

A tip for those who have issues with Scott Sumner's blog writings:

He regularly answers critiques in the comments sections to his blog posts.

Sumner views TIPS from the point of view of the market's inflation expectations. It is important to note that he doesn't think it is a perfect tool, just that he thinks it is either the best tool out there, or one of the best. Or at least that is my interpretation of his views, rightly or wrongly.

The Laffer Curve is indeed a concept, not a mathematical formula. The concept, from a tax point of view, is twofold:

First, deadweight loss from high tax rates on the wrong side of the curve will result in less tax revenue collected as the tax rate goes up.

Second, deadweight loss from high tax rates on the "smarter" side of the curve will cause tax changes to not be linear. Which is to say, tax increases will raise tax revenues, but not as much as one would expect from a static analysis point of view.

Art Laffer's curve doesn't have numbers on it, it is a pedagogical device, not a precise formula, and hence it is also not a curve in the shape it is usually drawn. However, at some low tax rate, the deadweight loss is relatively minimal, and the curve, if one could actually map it, would start trending in a much more linear way. The reason is that deadweight loss is minimal at low tax rates for most types of taxes.

None of this should be controversial. What is controversial are guesses as to where any given economy's personal income tax or corporate income tax is along the curve.

Finally, the Laffer Curve doesn't only apply to high income individuals (I agree that "the rich" is horrible framing), it applies to anyone with high marginal tax rates on their combo of income, government benefits (e.g. EITC, housing subsidies), and their purchases of goods that use price discrimination (e.g. college tuition, the marriage tax penalty, daycare costs for working women), so people such as low and middle income people can sometimes face Laffer Curve situtations, such as in this link. A pertinent quote from the link:

A woman called me out of the blue last week and told me her self-sufficiency counselor had suggested she get in touch with me. She had moved from a $25,000 a year job to a $35,000 a year job, and suddenly she couldn’t make ends meet any more....

happyjuggler0 writes:

Oops. I did not mean to imply that daycare rates were an example of price discrimination. They simply are a huge quasi-tax on anyone who works and also has children to care for.

I've know several women who face effective "tax" rates of over 100% of their income because of day care costs. Why do they work if that is the case? Usually it is some combo of self respect and signaling, although sometimes they are taking the long view and think they will be earning much higher wages over time, but they need the experience first.

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