ANOTHER week, another release of inital jobless claim data:
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Initial claims increased by 31,000 last week, to 473,000. The darker line above is the four-week moving average. For most of the last decade, claims hovered between 300,000 and 350,000, so weekly claims are still over 100,000 above “normal”. The tricky thing is, they’ve basically been moving sideways for the last three months.
ON THE subject of loan demand versus loan supply, this is an interesting data point:
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The EIU post from which this is taken reads in part:
A recent Bloomberg article notes that American commercial banks are hoarding record amounts of cash in relation to corporate loans. A steady decline in the ratio of cash to business loans—from around 60% in the 1970s to a low of 20% in late 2008—has reversed sharply over the past year. According to Federal Reserve data, banks hoarded an all-time high of 98 cents in cash for every dollar of existing corporate loans during the week of January 13th. The latest reading, for the week of February 3rd, stands at 95 cents.
Obviously, the ratio of cash to loans would drop dramatically if loans fell, which could be a sign of very low loan demand. But another argument for the hoarding is that banks are preparing for changes in banking rules, to higher reserve requirements and lower leverage ratios. Clearly, we’d like to see more of a cushion against financial disaster at big banks. But this looks bad; more of that cash should be circulating through the economy, finding productive opportunities.
TRACKING, the practice of testing students and directing them along different instructional paths based on performance, has long been a dirty word in America. This, despite generally good results from tracking-based educational systems in Europe and positive research results from breaking up students by ability in American experiments. But this seems to be changing, as a rather significant experiment with the structure of secondary education indicates:
In an experiment that could reshape American secondary education, high schools in eight states will introduce new courses next year, along with a battery of tests for sophomores, that will allow students who pass to get a diploma two years early and immediately enroll in community college.
Students who pass but aspire to attend a selective college may continue with college preparatory courses in their junior and senior years, organizers of the new effort said. Students who fail the 10th grade tests, known as board exams, can try again at the end of their 11th and 12th grades. The tests would cover not only English and math but other subjects like science and history.
There seem to be a few aims with this programme. One goal appears to be to put marginal college students through more preparatory work to increase college completion rates. Another seems to be to direct students who are unlikely to go to a four-year college into technical training. I’m guessing that students who fail the tests and remain at secondary school will receive different instruction from the students who don’t take advantage of the programme because they “aspire to attend a selective college”. In effect, then, this would create four focused secondary school tracks: basic remediation, technical training, college-preparatory remediation, and advanced pre-college instruction. This could potentially increase completion of high school and college programmes, and it generally strikes me as a worthwhile experiment.
I’m just as interested, however, in another suggestion from the panel that produced the above policy recommendation—that school begin at age 3. Nobelist James Heckman has shown that remediation is most effective at very young ages, and that many gaps in preparedness between students are evident by the time public school begins. Better schooling at a young age will also go a long way toward solving problems among secondary school students.
FOOD for thought, from Buttonwood:
The ever-assiduous David Rosenberg of Gluskin Sheff has some interesting data in his latest note. US bank lending fell by $30 billion in the past week, and has declined $100 billion this year so far, or 16% at an annualised rate. Total bank lending has fallen $740 billion from the peak. If you break the data down, credit card balances are off 28%, real estate loans have declined 13.5% and commercial and industrial loans 19.3% (all annualised figures).
This shows up in the broad money data. Growth in M2 is 1.9% year-on-year, the lowest since 1996. Capital Economics calculates a figure for M3, which the Fed has stopped publishing; it has shrunk 3% year-on-year and 5.6% if you annualise the latest quarterly data.
An important question is to what the decline is due to tightened lending standards rather than falling demand. As Buttonwood suggests, a demand-side drop points more toward a Japanese lost decade than a Depression-type episode. Demand shortfalls seem the more likely culprit at this point; while the National Federal of Independent Business continues to warn of tight credit conditions, its latest discussion of small business conditions indicated that the biggest problem facing small employers is a “shortage of customers”. Still, this is something to keep an eye on.
And speaking of the Great Depression, here‘s more interesting stuff from Scott Sumner’s book-in-progress, including a blow-by-blow account of central bank and market moves in 1928 and 1929.
VIA Paul Krugman, this passage from trade economist Doug Irwin demonstrates that economics has managed to improve the universe of accepted policy options somewhat over the last 130 years.
After the Civil War, Congress justified high import tariffs (relative to their prewar levels)” as necessary in order to raise sufficient revenue to pay off the public debt. By the early 1880s the federal government was running large and seemingly intractable fiscal surpluses: revenues exceeded expenditures (including debt service and repurchases) by over 40 percent during that decade. The political parties proposed alternative plans to deal with the surplus: the Democrats proposed a tariff reduction to reduce customs revenue, the Republicans offered higher tariffs to reduce imports and customs revenue. This paper examines this debate and attempts to determine the revenue effects of the proposed tariff changes. The results indicate that the tariff and the price elasticity of U.S. import demand during the 1880s below the maximum revenue rate, and therefore a tariff reduction would have reduced customs” revenue.
Republicans proposed an increase in tariff rates to reduce revenues and ease “seemingly intractable fiscal surpluses”. Remarkable.
HERE’S some great news on the American housing market, as written up by Bloomberg:
Housing starts in the U.S. rose in January to a higher level than anticipated, a sign that government support is helping to stabilize the real estate market.
Work began on 591,000 houses at an annual rate last month, up 2.8 percent from December, figures from the Commerce Department showed today in Washington. Starts were projected to increase to a 580,000 pace, according to the median estimate of 77 economists surveyed by Bloomberg News. Permits, a sign of future construction, fell less than anticipated after rising in December to the highest level since October 2008.
And here‘s what that great news looks like:
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Now, I mentioned yesterday that household growth fell sharply during the recession. A low level of new construction is therefore necessary to facilitate a reduction in inventory overhangs. In a sense, then, this is good news. But a low level of new construction also means a small contribution of residential investment to employment and output. American housing markets remain a long way from normal.
THE Obama administration has been pushing the following image out across the internet:
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It’s a brilliant image for them for a couple of reasons. It reminds voters of who was in charge when things fell apart. It shows a clear trend break around the time Mr Obama took office, implying that the new administration got things turned around immediately. And it uses the upward trend to mask the fact that these are still monthly job losses, November excepted. It’s hard to argue with the strategy. Among the criticisms the administration has been hearing from strategists on the left is that Ronald Reagan survived a deep recession in his first term because he had a compelling narrative detailing who was to blame for the downturn and why. Mr Obama, they complain, has allowed himself to be saddled with the responsibility of much of the downturn’s persistence. This is somewhat overstated; polls still show that most voters hold the Bush adminstration primarily responsible for the recession.
But this is all positioning around the fringes of the broader political gyre that is the jobless recovery. One month of job creation in twelve is not good enough. Another year with employment above 9% will severely test the popularity of the president, which has so far proven surprisingly resilient. In the end, it’s not about charts but about jobs, and the administration is finding it much tougher to create the latter than the former.
DAVID ALTIG weighs in on Olivier Blanchard’s suggestion that macroeconomists consider whether a 4% or so inflation target might not have advantages over the common 2% target. He turns up a couple of interesting findings from IMF studies, like:
Our more detailed results may be summarized briefly. First, there are two important nonlinearities in the inflation-growth relationship. At very low inflation rates (around 2–3 percent a year, or lower), inflation and growth are positively correlated. Otherwise, inflation and growth are negatively correlated…”
One might then ask whether there wouldn’t be some advantage to a slight increase in the target rate, to perhaps 3%. That’s the target a number of prominent economists, including Brad DeLong, have urged Ben Bernanke to adopt as a recession fighting tool.
But Mr Altig is sceptical of the need to give the Fed more room to avoid the zero bound:
The Federal Open Market Committee moved the federal funds rate target to its effective lower bound (0 to ¼ percent) on Dec. 16, 2008. After a very rough start to 2009, gross domestic product (GDP) growth improved substantially in the second quarter. By the third quarter, growth was positive and, as far as we currently know, clocked in near 6 percent in the fourth. Is this the stuff of zero bound disaster?
In fact, Blanchard and company acknowledge that…
“It appears today that the world will likely avoid major deflation and thus avoid the deadly interaction of larger and larger deflation, higher and higher real interest rates, and a larger and larger output gap.”
… but follow up with this:
“But it is clear that the zero nominal interest rate bound has proven costly.”
Clear? Proven? I don’t see it…
This, I think, indicates the scope of the task for macroeconomics that lies ahead. If you ask Scott Sumner, you’ll hear that the Fed certainly improved the situation by cutting rates to zero, but it clearly didn’t do enough. Nominal GDP contracted in 2009 and is forecast to grow at around 3% in both 2010 and 2011, which corresponds to growth below target for both real GDP and inflation. And obviously, labour markets have yet to experience anything like recovery. If we attribute the whole of the stabilisation of the economy to Fed actions, then about the best we can say is that the zero bound didn’t prevent the Fed from halting the steady decline of the American economy. But I’m not sure that’s saying very much.
Complicating this is that we can’t be sure what policy shift did what. Mr Sumner has argued that the policy that actually put the floor under the global economy and protected it from a collapse into deflation was massive stimulus in China. And of course, fiscal stimulus did add a point or two (or three) to measured output in 2009. So then we might find ourselves concluding that despite the zero bound the Fed was able to halt the steady decline of the American economy, with a great deal of assistance from fiscal measures at home and abroad. The implication then might be that the Fed wouldn’t have had enough ammo on its own to stop the economy’s freefall (although Mr Sumner would say that the Fed seemed to have had a particular, though odd, output target in mind, such that it basically offset the effect of other stimulus with tighter monetary policy).
Personally, I would have preferred a more aggressive approach from the Fed. Whether that more aggressive approach was impossible to pursue because of the zero bound is a question worth exploring, and whether increasing the inflation target to avoid the zero bound is worth the potential costs is still another question worth exploring. But I think these are valuable questions, and I appreciate the fact that Mr Blanchard has been bold enough to raise them.
BUTTONWOOD recently commented on the American housing market, saying:
Between 2002 and 2006 American builders constructed 12m new homes while only 7m new households were formed. American homeowners are also much more likely to walk away from their debts because many mortgages are “non-recourse”, meaning that lenders cannot come after borrowers’ other assets. As a result, repossessions are much higher in America than in Britain: Capital Economics says that some 5m foreclosed homes will come onto the market over the next two years.
In sum, there’s a lot of inventory out there relative to demand. One way to get housing markets on more stable ground, then, would be to increase demand relative to supply—to build fewer homes than America adds households. But as Ed Glaeser points out, this is increasingly difficult to do.
The only way to get through the excess is if households form at a faster rate than houses are built. We completed 800,000 units last year, and if the rate of household formation had continued at its past rate of 1.34 million new households a year, then we would have absorbed 700,000 excess homes (assuming a depreciation rate of 200,000 units a year). But the rate of household formation was not anywhere near 1.34 million.
According to the Current Population Survey, only 400,000 new households formed from March 2008 and March 2009.
Amid recession, fewer households are formed, in no small part because more family members live together to cut down on expenses. In particular, the kids aren’t so anxious to be out on their own these days:
The number of 18- to 24-year-olds living at home increased by 300,000. This recession has been particularly hard on younger workers. The number of jobs held by 20- to 24-year-olds declined 4.5 percent in 2009, while the number of jobs held by people over the age of 25 dropped 1.8 percent.
As Mr Glaeser notes, slow household growth puts off housing market recovery, which prolongs the period during which residential investment and construction aren’t contributing very much to output. And that’s true. But I think it’s also probably worth recognising this as a source of shadow demand. Shadow housing supply, recall, refers to housing units held by banks and homeowners who’d like to sell their properties but who are waiting for better market conditions. It is supposed that any brief uptick in housing could quickly lead to renewed decline as shadow supply hits the market.
But it’s also likely that there is shadow demand in the system. I suspect that as economic conditions improve, twentysomethings living at home will quickly look to move out and start their own households. This, in turn, will support housing demand, housing prices, and housing construction, buoying the initial uptick.
To put this another way, everything comes back to unemployment. If you get steady job growth, many housing concerns (though not all) will begin to take care of themselves. Unfortunately, America has still had only one month of payroll growth since the onset of recession.
THE New Republic‘s Jon Chait has a very good blog. I enjoy reading it. When I am at a computer connected to the internet, his words are delivered instantly and at no cost to my RSS reader of choice. Just a few moments ago, a new entry came through the magical tubes into my reader:
I must admit I have only a fuzzy notion of what a Kindle is. But the business people tell me that I’m on it now. This is good news for those of you with Kindles, since you can now read the blog—wherever you happen to be, and in real time—for $1.99 a month.
So if I’m out and about and in the vicinity of a wifi connection, I can read Mr Chait on my computer for free. And if I’m out and about and not in the vicinity of a wifi connection, I can read Mr Chait for free on my 3G phone, on which I can surf the internet. Or I can read Mr Chait on my Kindle (full disclosure: I don’t have a Kindle), for $1.99 a month. Now $1.99, even in recession stricken America, isn’t all that much. But it’s more than nothing. I guess I don’t understand how this is supposed to work.
Is it price discrimination? Is there an advantage to Kindle reading that I haven’t perceived, not having yet purchased a Kindle? Please, explain this to me.
And by the way, if you like reading Free Exchange and you like using your Kindle, you’re in luck: you can now read the blog—wherever you happen to be, and in real time—for $1.99 a month. It’s a steal!
TO JUST update you briefly on where things stand with the situation in Greece, a group of European finance ministers headed by Jean-Claude Juncker has said that it is prepared to offer some support to Greece, but the Greek government must show more significant and credible fiscal cuts than have been put together to date. Greece won preliminary approval of a plan to trim its deficit this year from nearly 13% down to 8.7%, European leaders appear concerned that proposed savings may not materialise. They have therefore given Greece until March 16 to take steps to demonstrate that deficit-cutting is on track. If the Greek government fails to convince Brussels, additional cuts will be ordered.
Greek officials aren’t happy:
George Papandreou, Greece’s premier, warned his EU partners at a summit last week that his government would risk political destruction if it were to ask people to accept more belt-tightening after they had been led to believe that the EU authorities had endorsed its plan…
“I ask those who want new [austerity] measures, ‘If we announced today new measures, would that stop markets attacking Greece?’ My guess is that what will stop markets attacking Greece is a further, more explicit step that makes operational what was decided last Thursday at the European Council,” said George Papaconstantinou, Greece’s finance minister.
“The biggest deficit we’re facing as a country is not the deficit in the public accounts, it’s the credibility deficit,” he told a meeting of the European Policy Centre think-tank.
I sympathise with taxpayers in responsible northern European countries who are uncomfortable with the idea of aid to Greece, but Mssrs Papandreou and Papaconstantinou kind of have a point. There is a limit to the austerity the Greek government can force on its citizenry without sparking political rebellion. If that limit is reached and European officials are still dissatisfied, then they either need to bite the bullet and bail Greece out or let Greece default and accept the (potentially significant) consequences.
And while European finance ministers are concerned, fairly, that providing aid without demanding deep cuts may force open the bail-out floodgates, it also seems true that at some point, they’ll catch more flies with honey. That is, the Greek government may be able to sacrifice more and stay alive once real money is on the table.
Anyway, I suppose we’ll see where things stand in a month.
TO GO along with Matthew Valencia’s Special Report on financial risk, The Economist has put together a videographic explaining the concept of fat tails in risk distributions. Check it out:
I NOTED last week that over half of America’s currenct account deficit can now be attributed to net petroleum imports. And meanwhile, America’s trade balance has continued to improve. Today, Menzie Chinn helpfully provides a chart:
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In December, American exports to China were up just over 60% from the previous December, while imports were just 6% higher. And yet, were you to google “American imbalances”, the results would overwhelmingly focus on China and its currency policy, rather than on America’s reluctance to tax petrol or carbon.
MY EARLIER post on the potential benefit from increasing inflation targets from around 2% to something like 4% touched off some interesting discussion at the Washington office. A few points stood out to me.
One is that news sources have seized on Olivier Blanchard’s suggestion that the question of a higher target get some consideration as having implications for current policy, but this is probably a little off base. A number of writers, myself included, have made the case for a more aggressive monetary approach to the current crisis, but that’s a different question (though the monetary experience through this crisis should inform the discussion over the appropriate target). At any rate, it seems premature to talk about the costs and benefits of 4% inflation in the current environment, given that the core inflation is projected to be safely under 2% through 2012.
Ben Bernanke has been very clear about his reluctance to fiddle with long-run inflation expectations. Underlying this reluctance is a concern that Fed credibility is more tenuous than many believe—that a move by the Fed to address the crisis more agressively may be interpreted as a sign of politicisation of the Fed or of the central bank’s intention to monetise the debt. The Fed would be highly resistant to a move to increase the inflation target in this environment. While an increase in the target might be helpful or benign, there is some risk that it would be interpreted as signaling a compromised Fed. That’s a risk no central banker will run.
As such, it mainly makes sense to discuss Mr Blanchard’s proposal with an eye toward the long run; realistically, that’s where a policy shift could take place. The question then is whether the increased costs posed by a higher inflation rate are outweighed by the benefit of a more flexible monetary regime. These aren’t exact calculations; it’s very hard to know what effect a 3% target will have compared to a 2% target. But a few things seem clear. One is that a higher inflation target should mean fewer cases where monetary policy is trapped against the zero bound:
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With a target of 1%, the funds rate will be at zero around 9% of the time, according to modeling (PDF) by Kansas City Fed economists Roberto Billi and George Kahn. This is significantly reduced with a 3% inflation target.
On the other hand, a higher inflation rate brings with it its own difficulties. Chief among these, according to Mssrs Billi and Kahn, are relative-price distortions. Not all prices inflate at the same rate, and so inflation generates some relative-price distortions which lead to resource misallocation. The higher the inflation rate, the greater these distortions (you can see a helpful discussion of these issues by James Hamilton here). After reviewing the costs and benefits, Mssrs Billi and Kahn conclude that a target just below 2% is optimal.
But the value of avoiding the zero bound depends on the seriousness of the macroeconomic situation. From the vantage point of 2010, a higher target rate seems like a great idea, but economic crises this severe are rare events. Even if there are only small costs to a 3% target relative to a 2% target, they may not be worth the trouble if the goal is to avoid serious trouble once every 80 years.
There is a concern that with a higher level of inflation, inflation will become more volatile and expectations less anchored. At the same time, the higher target might not be enough to handle a recession as deep as the most recent downturn; to achieve the equivalent of a Taylor rule indicated -5% federal funds target without being constrained by the zero lower bound, the Fed would need to target inflation at at least 7%. Separately, these criticisms seem compelling, but taken together they cancel each other out. Recall Mr Blanchard’s point:
The danger of a low inflation rate was thought, however, to be small. The formal argument was that, to the extent that central banks could commit to higher nominal money growth and thus higher inflation in the future, they could increase future inflation expectations and thus decrease future anticipated real rates and stimulate activity today.
If at higher target levels expectations are less anchored then it should be easier for the central bank to take advantage of its ability to raise long-term inflation expectations in a severe crisis, in order to reduce expected real interest rates. In other words, at a 4% target, the central bank still might face the zero bound in a severe recession, but at a higher target, hitting the zero bound is less of a concern, because long-term expectations are more easily massaged by the central bank.
It’s not as easy as it might initially seem to conclude one way or another on this question. It appears to me that the potential benefits of an increased inflation target are large enough that Mr Blanchard was right to ask for a re-evaluation of current policies. But a 4% target isn’t a silver bullet, and it probably shouldn’t be reformers’ sole focus to the exclusion of other fiscal and regulatory changes.
LAST week, IMF chief economist Olivier Blanchard released a staff position paper (PDF) with Giovanni Dell’Ariccia and Paulo Mauro examining the tenets of macroeconomic faith from before the crisis and suggesting ways that they might be in need of tweaking, given what we’ve learned from crisis and recession. Among the sacred cows being sized up for butchering is the importance of an inflation rate that is both stable and low—generally taken to mean 2% or below. Perhaps, Mr Blanchard says, this isn’t such a good idea after all. Here’s his reasoning:
When the crisis started in earnest in 2008, and aggregate demand collapsed, most central banks quickly decreased their policy rate to close to zero. Had they been able to, they would have decreased the rate further: estimates, based on a simple Taylor rule, suggest another 3 to 5 percent for the United States. But the zero nominal interest rate bound prevented them from doing so. One main implication was the need for more reliance on fiscal policy and for larger deficits than would have been the case absent the binding zero interest rate constraint.
It appears today that the world will likely avoid major deflation and thus avoid the deadly interaction of larger and larger deflation, higher and higher real interest rates, and a larger and larger output gap. But it is clear that the zero nominal interest rate bound has proven costly. Higher average inflation, and thus higher nominal interest rates to start with, would have made it possible to cut interest rates more, thereby probably reducing the drop in output and the deterioration of fiscal positions.
Monetary policy is one of the few countercyclical tools that nearly every economist can get behind, and when inflation rates are kept persistently close to zero the effectiveness of monetary policy is limited. Paul Krugman notes that the above statement is interesting not just because Mr Blanchard is thinking along these lines, but because the IMF is releasing these thoughts as a staff policy note. But it’s particularly interesting as Mr Blanchard is adding his voice to a growing chorus, including economists of highly divergent ideological stripes, supporting a move to higher inflation levels. Kenneth Rogoff, Greg Mankiw, Scott Sumner, Paul Krugman, Brad DeLong—all have indicated that higher inflation would be a boon to the struggling economy.
They have approached the subject from different directions, however. Mr Rogoff first made the case for a couple of years of inflation at 6% back in 2008, writing that a burst of inflation would make the burden of deleveraging and market clearing far less painful. American debt loads would constitute a persistent drag on growth, he noted, but could be reduced through an increase in the price level. Housing markets would clear more quickly if nominal prices were supported by a bout of inflation.
And while America’s creditors could become nervous if the American government seemed determined to eliminate most of its sovereign debt burden via inflation, a commitment to a slightly higher rate of inflation could help take some of the pressure of debt reduction off a dysfunctional political system. It wouldn’t be the first time America used inflation to ease an historically high debt level:
[B]etween 1946 and 1955, the debt/GDP ratio was cut almost in half. The average maturity of the debt in 1946 was 9 years, and the average inflation rate over this period was 4.2%. Hence, inflation reduced the 1946 debt/GDP ratio by almost 40% within a decade.
Debt maturities are shorter now than they were immediately after the war, which would constrain the use of inflation to reduce the value of the debt. But so long as we’re talking about a shift in the target rate from 2% to around 3% or 4%, the debt effect should be a salutary one.
Another case for inflation has been made with increasing vigour by Mr Krugman. He has noted that nominal wages adjust downward only with great difficulty, and so if inflation rates are consistently low, any needed downward adjustment in market wages will be slow and painful. If inflation is humming along at 4%, however, then real wages can adjust downward more easily, simply by not keeping up with the price level. A higher inflation rate is therefore consistent with greater labour market flexibility and lower unemployment.
A final push for greater inflation has come from those, like Scott Sumner and Greg Mankiw, who advocate the policy as a means to boost countercyclical monetary policy. Mr Sumner has pointed out that with nominal GDP growth running well below rates generally consistent with a healthy economy (5% per year, more or less) there is plenty of room for monetary authorities to more aggressively boost the economy. Additional inflation would also be stimulative thanks to its effect on the nation’s current account, via the exchange rate. Mr Sumner cites Barry Eichengreen’s research indicating that the massive currency depreciation associated with abandoning of the Gold Standard was the key to escaping the Great Depression—the earlier a country left gold, the faster it recovered. Monetary authorities could engineer a similar recovery today by committing to a 5% rate of nominal GDP growth, which implies inflation of 2% or more.
And Greg Mankiw has pointed out that a commitment to higher inflation would encourage households and businesses to spend money now, which would be stimulative, rather than hoard it. Several pundits have used this line of thinking to point out the strangeness of current Fed policy, which is to convince markets that it will soak up all of the excess liquidity in the banking system as soon as it appears that banks may be ready to use some of it. The Fed is obviously worried about runaway inflation, but given economic weakness, it seems odd to want to immediately neutralise any potential use of the funds it has provided to banks.
The thing is, Ben Bernanke is not unaware of the potential good that could come from inflation. In December he noted:
The public’s understanding of the Federal Reserve’s commitment to price stability helps to anchor inflation expectations and enhances the effectiveness of monetary policy, thereby contributing to stability in both prices and economic activity. Indeed, the longer-run inflation expectations of households and businesses have remained very stable over recent years. The Federal Reserve has not followed the suggestion of some that it pursue a monetary policy strategy aimed at pushing up longer-run inflation expectations. In theory, such an approach could reduce real interest rates and so stimulate spending and output. However, that theoretical argument ignores the risk that such a policy could cause the public to lose confidence in the central bank’s willingness to resist further upward shifts in inflation, and so undermine the effectiveness of monetary policy going forward. The anchoring of inflation expectations is a hard-won success that has been achieved over the course of three decades, and this stability cannot be taken for granted. Therefore, the Federal Reserve’s policy actions as well as its communications have been aimed at keeping inflation expectations firmly anchored.
The funny thing about this is that Mr Bernanke is concerned about the use of increased inflation expectations as a countercyclical tool, because he thinks it will reduce the effectiveness of monetary policy going forward. But what Mr Blanchard is arguing is that the opposite is true—monetary policy could potentially be more effective in a world where prices increase at 4% per year rather than 2%.
Things get really mind-blowing when one reads Mr Blanchard’s explanation of why economists used to think that a higher inflation target wasn’t necessary:
The danger of a low inflation rate was thought, however, to be small. The formal argument was that, to the extent that central banks could commit to higher nominal money growth and thus higher inflation in the future, they could increase future inflation expectations and thus decrease future anticipated real rates and stimulate activity today.
In other words, it was fine to have low inflation, because if monetary policy ever got wedged up against the zero bound, then the central bank could simply work to raise long-run inflation expectations. But that’s just what Mr Bernanke is now refusing to do. This would seem to make the case for a higher target, in good times and bad, much stronger. If it seems likely that skittish central bankers will be reluctant to do what’s necessary to raise inflation expectations when they’re caught against the zero bound, then it makes sense to do what you can to keep them out of that situation.
I don’t think anyone denies that there are potential costs to higher inflation. Stable inflation has been a hard-won success, and one that has paid significant dividends in emerging markets. Inflation is a distortionary tax, which poses certain costs on the economy. And obviously, runaway inflation can be extraordinarily devastating to economies and societies.
But central banks know how to fight inflation; they’ve done it plenty of times in the past. And the refusal to take better advantage of inflation as a countercyclical tool has led to a deeper recession than needed to have been, and the use of other countercyclical policies which may well have generated larger economic costs.
Perhaps the important thing to take away from this discussion is that to central bankers, inflation is a bogeyman. But to good economists, inflation is merely a variable, an economic indicator over which governments have some control and which they can manipulate to good or ill effect. The right approach to inflation is to carefully weigh the costs and benefits of a higher target and determine if, as seems likely, it would be a good idea. It strikes me as a very good thing that prominent economists are raising these questions, and it would be a better thing still if central bankers would stop running in fear from the idea of higher inflation and start engaging the arguments on the table.
OVER the whole of the 20th century, equities were a pretty nice bet. But lately, they haven’t done so well relative to alternate investments. The Daily data point reports:
Since 1900, the equity risk premium—the return achieved above treasury bills—has averaged 4.4% per year, the report claims. There are reasons to believe that this long-term average overstates the prospects for equities in the years to come, the academics argue, with a premium on the order of 3.25% a more realistic expectation in the future. Although whether returns in the next 110 years will revert to their previous 110-year average makes for interesting debate, it also brings to mind the famous forecast of John Maynard Keynes: “In the long run, we are all dead.”
Note that returns from 1985 to 2009 were above the historical norm despite the fact that the premium on equities was negative during the last ten years. That suggests the return above Treasuries from 1985 to 1999 was extraordinarily high. Indeed, stocks rose some 800% over the period, in nominal terms. During the 15 years from 1970 to 1985, stocks rose about 80%. Very peculiar.
THE New York Times has a story today on the growing unease in cities around America concerning the end of government supports for housing markets. Fed purchases of mortgage-backed securities end next month, and the extended housing tax credit will wind down in April. According to the Times piece, the end of Fed purchases could boost mortgage rates by a percentage point, and for first-time buyers looking at cheaper homes, the $7,500 tax credit can represent a large share of the total purchase price.
The problem is that unemployment remains high around the country, and especially in the places where home prices have fallen the most. The combination of high unemployment and negative equity ensures a constant stream of stressed homeowners, delinquent mortgages, and foreclosures. As Buttonwood points out here, American home prices have fallen back to fair value territory, and yet stability in home prices in many markets is elusive:
Between 2002 and 2006 American builders constructed 12m new homes while only 7m new households were formed. American homeowners are also much more likely to walk away from their debts because many mortgages are “non-recourse”, meaning that lenders cannot come after borrowers’ other assets. As a result, repossessions are much higher in America than in Britain: Capital Economics says that some 5m foreclosed homes will come onto the market over the next two years.
There are some metropolitan markets in America where unemployment has stayed relatively low and where population is growing, helping to work off excess inventory more quickly. But it’s worth remembering how big a housing mess there is, still, in America. A lot of government punch went into the effort to stabilise home prices last summer. As that wears off, Americans may begin to remember just how little has been done to seriously address the crises of negative equity and unemployment. Many markets are still years away from recovery.
TODAY’S recommended economics writing:
• Here are your Greek readings for the weekend: Wall Street helped Greece skirt its debt limits, George Papandreou pushes back, some interesting general thoughts, and rescuing Greece need not mean economic union. (New York Times, Financial Times, Mark Thoma, Charlemagne, respectively)
• The case for higher inflation is a good one; I’d like to associate myself with these thoughts. (Paul Krugman)
• Mark Thoma gives a great little lecture on bank reserves, the federal funds rate, and interest paid to banks. (Mark Thoma)
• Check out Matthew Valencia’s Special Report on financial risk. (The Economist)
• Economics of Contempt sets John Cochrane straight. (Economics of Contempt)
NOT long ago I noted that early in 2009, Christina Romer estimated, based on data overestimating American employment by 1 million workers, that a federal stimulus of $1.2 trillion was called for. Ultimately, Congress passed a stimulus bill worth about $800 billion. But that is not where the impact of government policy on growth ends; one has to think about state and local governments, too.
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State budgets have been a persistent drag on output, offsetting much of the discretionary boost from stimulus. As Paul Krugman notes, that federal boost is about to end:
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The House of Representatives has passed a jobs bill seeking to direct another $150 billion or so in spending and tax cuts into the economy, and now the Senate is considering what legislation it will adopt. Brad DeLong links to a story on the deliberations:
States are looking to the federal government for more help balancing their budgets, but the Senate is not heeding their call. Federal aid to the states was among the top priorities in an early Senate job creation bill, as well as in a $154 billion measure passed by the House in December. But it has fallen off the list as Senate Democrats look to craft legislation that will attract bipartisan support. Senate Majority Leader Harry Reid, D-Nev., on Thursday unveiled a jobs bill that does not contain state aid. A Senate Democratic aide said Reid hopes to back a state aid measure in the future. Republican support, however, remains questionable.
Experts and state officials say they need to know now whether they’ll get more funds. Governors are currently crafting their budgets and, for many, it will be their third year of contending with massive deficits due to declining tax revenues. States are looking at a total budget gap of $180 billion for fiscal 2011, which for most of them begins July 1. These cuts could lead to a loss of 900,000 jobs, according to Mark Zandi, chief economist of Moody’s Economy.com…
State legislatures are looking a combined budget gaps worth more than the size of the House jobs legislation, and senators busy themselves stripping aid to states from their bill. Mr Krugman has written that what the euro zone needs is tighter fiscal integration to offset the burdens imposed by a uniform monetary policy. But if America is any indication, tighter fiscal integration doesn’t mean a thing if the people running the show at the federal level are short-sighted, provincial, and apt to choose grandstanding over good policy.
MATT YGLESIAS finds another fun excerpt from the Economic Report of the President, in which the administration defends trade:
For example, the ability to sell books across borders certainly enhanced the income J.K. Rowling was able to collect from writing the famous Harry Potter books. Had she been able to sell her books only in the United Kingdom, her audience and income would have been much smaller. In addition, millions of American readers benefited from the increased consumer choice and the ability to purchase her books. Similarly, more Americans can work as well-paid aircraft engineers or manufacturing employees for Boeing or as technology specialists for Apple because those firms are able to sell on a world market. At the same time, it is distinctly possible that some American authors who would have captured a larger share of the “magic-oriented book” market had there been no trade in literature were crowded out by Rowling’s success, or that some handheld music device engineer in the United Kingdom has had to find another career because of Apple’s success.
The enhanced market size generated by openness also influences decisions to invest and innovate (though it’s not clear how this applies to the specific case of Ms Rowling’s books). Innovation entails the absorption of certain fixed costs, which a business would prefer to spread over as many sales as possible. Thus the ability to sell a product to 3 billion people rather than just, say, 300 million, is a huge advantage. It’s a bigger advantage still for small economies, where costs might otherwise be spread over sales to just a few million people.