Author: R.A. | WASHINGTON

EARLIER this week, I discussed the problem of the long-term unemployed, of which there are now over 6m in America. Part of the problem with the labour market, I noted, was that the economy’s underlying innovative capacity seems to have been eroding for years, and educational levels have ceased growing. President Obama has done me a big favour by including some helpful charts in his Economic Report of the President. Like this one:

For most of the last century, educational attainment grew rapidly. Schooling noticeably leveled off in the late 1960s, however, and it actually hit a peakin the late 1990s before pulling back. Now, one obvious thing to note is that 14 years of school generally means an entire primary and secondary education and perhaps one year of post-secondary education. That’s quite a bit, and to boost the mean above that level would not necessarily be easy. At the same time, given dynamics in the current economy, a world in which the average student does not get multiple years of post-secondary education—in occupational or technical training or in professional or typical undergraduate studies—is one in which a large share of the population is languishing in fields that pay poorly or that are subject to competition from lower wage labour abroad or automation.

And so it’s distressing enough that educational attainment has ceased growing. If the declining trend were to continue—as with the share of students dropping out of high school rising, this is not at all impossible—then economic growth is likely to slow and to become more uneven.

Then we have this:

One thing worth pointing out is that there is a considerable lag between R&D spending and contribution of innovations to growth. It’s good that R&D spending has grown in recent years, but the economy may well be feeling the big decline that took place in the 1970s.

Growth is complex phenomenon, but it’s not a total mystery. It’s important to do the basic stuff, and America has not done the things it did last century to produce strong, stable, and broad-based economic growth.

THIS week’s paper features a Briefing and a Leader on the challenge facing governments around the world—to time their exit strategies correctly. Withdraw support too soon, and the world economy collapses into a double-dip recession. Too late, and budget crises will spread, likewise damaging recovery:

The course of action is clear when the recovery is robust, as it is in big emerging markets and rich countries far from the centre of the financial crisis. Their economies have little spare capacity and no reason to keep monetary or fiscal policy at emergency settings. It is no surprise that they have been the first to tighten.

Australia, Israel and Norway increased interest rates late in 2009. A month ago China raised banks’ reserve requirements and began to clamp down on lending. India’s central bank followed suit, raising reserve requirements on January 29th. Fiscal policy is also being tightened. Brazil (see article), India and Mexico all plan to cut their underlying deficits this year.

Today we learn that China is raising reserve requirements again, as it seeks to prevent its economy from overheating. For developed nations, the policy path is complicated by the fact that recovery is slow to unfold and weak. Barack Obama’s new Economic Report of the President (PDF) suggests that the American economy will add an average of 95,000 jobs a month in 2010—not enough to keep up with population growth. Even so, the Federal Reserve is going ahead with plans to end MBS purchases on schedule, and markets believe that a rate hike isn’t out of the question before the end of the year.

Meanwhile, recovery in Europe appears to have stalled out. According to the latest data from Eurostat, both the euro area and the European Union expanded by 0.1% from the third to the fourth quarter, down from expansion of 0.4% and 0.3%, respectively, the previous quarter. A number of large economies, including Italy and Spain, continue to contract. Greece’s economy shrank by more in the fourth quarter, 0.8%, than in the third quarter.

It’s understandable that economies with large fiscal burdens would be increasingly anxious about the prospect that markets will turn on them, but they must be careful. If the developed world sinks back into general contraction, that will make repair of government and household balances sheets all but impossible. It will place renewed pressure on financial markets (not for nothing have global markets been extremely skittish in recent weeks). Once momentum is lost, it may be difficult to regain. The biggest threat to the global economy at the moment is clearly economic weakness. While planning to address budget deficits, leaders shouldn’t take their eyes off the ball.

STEPHEN GORDON posts a fascinating chart:

Mr Gordon quotes from a September post of his, in which he said:

The more I look at the US, the more I see unpleasant parallels to Canada’s experience of the 1990’s – what Pierre Fortin called The Great Canadian Slump. Even after we emerged from the worst of the 1990-91 recession, we still had to deal with a large current account deficit, out-of-control government deficits and significant NAFTA-induced sectoral shifts. The outlook for the US is depressingly similar, although their sectoral shifts are associated with re-allocating resources away from construction and finance.

Others might credit the stability of Canadian banks for the difference, in what has ultimately been a finance-driven boom and bust. And still others might note that Canada looks a lot like an amalgam of parts of America that have done relatively well during this recession: the Great Plains south to Texas and the Northeast corridor. I’d be interested in seeing a comparison of household debt levels in Canada and America. But the contrast here seems likely to me to be instructive.

KEVIN DRUM links to Tom Ricks discussing the question of success metrics in Afghanistan. He lists good indicators as prepared by counter-insurgency expert David Kilcullen. A sample:

“Prices of exotic vegetables” and “Transportation prices.” Now we are getting into the nitty gritty. Anything that embarrasses your S-3 as he discusses it in the briefing probably is a good metric. Until now most of DK’s recommendations have been more or less rooted in common sense. But to understand this weird one, you need to understand local conditions. What people are paying for vegetables grown outside their district is a quick indicator of road security. Trucking companies factor in the risks they face, as well as the cost of bribes and other forms of corruption. So variations over time may be a helpful indicator of trends in public perception of security conditions and the corruption level of government security forces.

In addition to being more valuable as indicators, these metrics strike me as more likely than bad ones to encourage the right strategic thinking. Asking yourself the question, “How do we reduce transportation prices,” is more likely to produce strategy leading to a better Afghan outcome than asking, “How do we minimise coalition deaths?”. And it may well actually minimise coalition deaths.

STEVEN PEARLSTEIN has earned himself a lot of links with this quote:

I realize there are lots of problems that cannot be solved just by throwing money at them, but snow removal is not one of them. We have the know-how, we have the technology and we have the money and economic self-interest to do it right. What we don’t seem to have is the leadership or political will.

He has some bold suggestions for how the problem might be tackled:

Local governments could provide neighborhood groups with snow blowers that trained residents could use to clear sidewalks, alleys and parked cars, or small plows that volunteers could attach to their trucks to remove snow from side streets and school parking lots. More sophisticated computer systems could allow public works managers to make better use of GPS, satellite images, the Internet and social networks to get help to where it is most needed and squeeze greater productivity from existing equipment. And instead of waiting a week for government employees or contractors to dig out school buses, counties could get it done in a day by putting out a call for volunteers to homebound parents and students.

He adds:

Our snow blindness is a metaphor for the tyranny of diminished expectations that has taken hold in American politics and government.

Mr Pearlstein goes on to go through the sort of tortured calculations that frequently appear in the wake of snowstorms, attempting to determine how much was lost, economically, from days schools and businesses were forced to close. I think this will inevitably get what has actually taken place wrong. Much of the “lost” business will simply be done after the snow melts (and a lot of business was ramped up before the closings in expectation of the impending storms). Many, many of the people who have been unable to get to work have nonetheless been able to do their jobs from home. As Mr Pearlstein points out, many hourly workers can’t make up the earning opportunities they lost. On the other hand, the snow has created earning opportunities where there weren’t any before; in Washington the snow economy is in full force, as able-bodied citizens offer to shovel walks and clear driveways for a modest sum. Individuals with plows are pouring in from the relatively snow-deprived north to make a few bucks moving snow. Meanwhile, other typical, variable urban costs are significantly reduced during the down period. Crime figures across the Washington metro area have tumbled. Building owners across downtown Washington are saving a bundle on energy costs this week.

And I think Mr Pearlstein is wrong to think that state and local governments could get enough of a return on additional snow-clearing dollars to justify the effort. The low-cost solutions are the first to be put in place: activation of all local snow-clearing equipment. Bringing in additional workers will cost more and will likely duplicate, to some extent, removal that private citizens might otherwise have undertaken themselves. And with this much snow on the ground, as Jon Chait points out, there are diminishing returns to snow-clearing efforts; more plowing creates rather than reduces hazards by blocking cars and driveways.

And while one obviously wants the government to ensure that emergency service vehicles can get where they need to be, it’s worth pointing out that this is a freak occurence. This is the most snow Washington has ever received, at least while records have been kept. In an average year, the federal government loses zero days to snow closings, and this year—this worst of all years—it will most likely lose seven or fewer. I suspect that if local governments rushed to throw $50 more million at the problem, at a time when local and state governments are already making painful cuts to services, residents would be very angry, and rightfully so. We’ll be back on Monday anyway, they’d say, so why not let the kids enjoy the days off?

There are more problems that we probably appreciate that can be fixed by throwing government money at them. But that doesn’t mean that the government should therefore throw money at them. Given limited resources, choices must be made concerning benefits relative to costs. I see this lost week not as an indicator of the “tyranny of diminished expectations” but as a time when local governments made pretty good decisions about what resources to allocate to the problem.

DEREK THOMPSON calls this “the scariest employment graph I’ve seen this year”:

That is a pretty distressing picture. Just over 6 million American workers have been out of a job at least half a year. Mr Thompson then links to this likewise distressing Atlantic piece about how joblessness will shape America’s future.

There seem to be a number of issues at work shaping the current crisis of unemployment. One is obviously the deep recession, which produced millions of cyclical unemployed. Another is a sectoral crisis; rising debt levels fueled growth in economic sectors which can no longer be sustained. Employment growth in sectors like construction and retail will lag for years to come while households work off thei debt loads. There are other issues, as well. Don Peck writes in the story linked above:

But according to the economist Edmund Phelps, the innovative potential of the U.S. economy looks limited today. In a recent Harvard Business Review article, he and his co-author, Leo Tilman, argue that dynamism in the U.S. has actually been in decline for a decade; with the housing bubble fueling easy (but unsustainable) growth for much of that time, we just didn’t notice. Phelps and Tilman finger several culprits: a patent system that’s become stifling; an increasingly myopic focus among public companies on quarterly results, rather than long-term value creation; and, not least, a financial industry that for a generation has focused its talent and resources not on funding business innovation, but on proprietary trading, regulatory arbitrage, and arcane financial engineering. None of these problems is likely to disappear quickly. Phelps, who won a Nobel Prize for his work on the “natural” rate of unemployment, believes that until they do disappear, the new floor for unemployment is likely to be between 6.5 percent and 7.5 percent, even once “recovery” is complete.

Lagging innovation isn’t the only trouble. Another Nobelist, James Heckman, has warned of deterioration in the educational levels of successive generations and pointed out (PDF) that the high school graduation rate in America actually peaked in the late 1960s and has since declined. One doesn’t have to look very hard to find other potential limiting factors: rapid growth in congestion on transportation systems, poor broadband coverage relative to other developed nations, and so on.

What seems clear is that at no time in the living memory of working Americans has the economy gone through a recession like this—deep, and with a jobless recovery. It will influence society and culture for a generation. It may also produce a serious bout of reflection in America, concerning just how the economy lost its way over the past decade (and perhaps longer).

AS SOMEONE who thinks that variables like teacher quality and class size are ascribed too much importance relative to student background and peer effects, I found this interesting:

We show that a large fraction of ”bad” peers at school – as identified by students in the bottom 5% of the ability distribution – negatively and significantly affects the cognitive performance of other schoolmates. Importantly, as we show in our work, it is only the very bottom 5% students that (negatively) matter, and not ‘bad’ peers in other parts of the ability distribution (e.g. the 5-to-10% worst students).

Using the variation in the data, we can also assess how sizeable these effects are. To do so, we consider the peer effect for a pupil who experiences a change in the fraction of bad peers from 20% (the maximum in our data) to 0% (the minimum). She would experience an improvement in her age-14 test score of about 2 percentiles, which amounts to 0.17 of the within-pupil standard deviation in the age-14 test distribution. A more modest 10 percentage point decline would imply an improvement of around 0.08 of the standard deviation. Relative to other studies that focus on school inputs and interventions, our estimates of the effect of academically weak peers capture a small-sized, but non-negligible effect.

On the other hand, we uncover little evidence that the average peer quality and the share of very ‘good’ peers – as identified by students in the top 5% of the ability distribution affect the educational outcomes of other pupils. But these findings mask a significant degree of heterogeneity along the gender dimension.

By separating our sample into boys and girls, our results also show that girls significantly benefit from interactions with very bright peers, whereas boys are negatively affected by a larger proportion of academically outstanding peers at school. We also find that the positive effect stemming from interactions with ”good” peers is more pronounced for female in the bottom part of the ability distribution. On the other hand, while not strongly significant, our results suggest that more able boys suffer from interacting with a larger fraction of outstanding schoolmates.

As the authors note, one should be careful about extrapolating these findings to policy recommendations. But they do suggest that a potential policy experiment in which the most able and least able students are removed from a classroom would unambiguously improve performance among males but would have diverging effects on girls of different abilities. Fascinating stuff.

ACCORDING to the latest data from the National Federation of Independent Business, small businesses were more optimistic in January than they were in December, but the NFIB’s index of business optimism remains at historic lows. Sentiment improved across a range of categories—employment, sales expectations, and credit conditions, for example—but things remain pretty grim. Once more, firms cutting employment outnumbered those adding jobs, which is particularly distressing given the job-creating role small business plays in the economy.

What’s the biggest problem?

“Small business owners entered 2010 the same way they left 2009, depressed,” said William Dunkelberg, NFIB chief economist. “The biggest problem continues to be a shortage of customers.”

That will tend to make life hard on a businessman. Of course, that biggest of problems won’t be going away until the economy begins adding more jobs than it’s destroying, and obviously small businesses aren’t there yet. The Obama administration is betting that by creating an incentive to hire, it will change the math—firms will move from cutting jobs on net to adding jobs on net, which will increase the number of customers out there, which will, in turn, feed more hiring. Hopefully, that will be enough, but the proposed $33 billion looks awfully small given the 15 million unemployed.

PAUL KRUGMAN puts worries about European debt into perspective, posting a chart of European GDP shares:

As you can see, Greece is but a small part of the European economy. Portugal, too. Why, then, the concern? It’s worth looking at a generally helpful piece on the debt crisis in southern Europe by Charles Wyplosz:

There is no reason for the Greek government to default. It is not in its interest and it can service its debt, whose size is half that of the Japanese government and the same order of magnitude as that of many other governments, including soon the UK and the US…Yet, markets can force the government to default if they refuse to refinance the parts of the debt that reach maturity. This is a pure case of self-fulfilling crisis…

A debt default by the Greek government, on its own, would be a non-event. Greece is a relatively small country (with 7 million people, its GDP amounts to less than 3% of Eurozone’s GDP). Contagion to Portugal, which is even smaller, would also be a non-event. Moving on to Spain and Italy is another matter…

The real worry is the banking system. Some European banks hold part of the Greek debt and, if still saddled with unrecognized losses from the subprime crisis, some might become bankrupt. Many governments have simply not pushed their banks to straighten up their accounts and they are now discovering some of the unforeseen consequences of supervisory forbearance…

Contagious debt defaults, along with bank failures, could lead to a double-dip recession in Europe, possibly affecting the US as well. If that were to happen, with the interest rate at the zero lower bound and fiscal policy not available any more, we could face a terribly bad situation.

Lehman Brothers was not a remarkably massive firm, nor did it make up a huge share of the American financial sector. Losses from the Lehman collapse ultimately were far smaller than was originally feared. The real damage was the message the failure sent—that the government might not do everything it could to prevent struggling firms from failing chaotically. This led firms to reevaluate the trustworthiness of other banks (and their obligations) and to rush for safety, and this in turn led to crisis.

My sense of the potential for real trouble in Europe is that a failure to adequately address crisis in Greece may tip a financial system that is still very wobbly back into panic. And as Mr Wyplosz says, that could be a very damaging turn of events.

HERE’S Ezra Klein with the quote of the day:

I’ve been racking my brain all morning, but I really can’t come up with another example of a president gambling major legislation on a televised, hyped showdown with the leadership of the minority party. Congressional Democrats have been begging Obama to involve himself more directly, but this is the most aggressive presidential intervention into an ongoing legislative debate that I can remember. Can anyone think of anything even slightly comparable, or is this the opening of an entirely new playbook?

Here‘s the context. Intrade is not impressed.

ONE more thought on the situation in Europe, and then I’ll move on to something else. Felix Salmon has a post up disputing that declines in equity markets have anything to do with the issues in the euro zone, but confusingly, he quotes this, from Reuters:

Data held by State Street contains no obvious evidence of an institutional exit from euro zone assets; the flows which are occurring appear to be no more defensive than those being seen elsewhere during a period of risk aversion for financial markets around the world…

Recent falls by the euro may be unrelated to worries that worsening fiscal problems in the euro zone’s weaker members could eventually drive them out of the zone.

The euro has fallen about 4.5 percent against the dollar this year. Euro zone stocks have been battered, with the MSCI Europe exUK index down 6.9 percent for the year.

But many of the moves made by big investors have fit in with other trends. MSCI’s all-country world index is down 6.7 percent.

Here are other quotes from the same story:

The latest Reuters asset allocation polls, taken in late January, showed both international and euro zone investors cutting back on exposure to euro zone stocks quite substantially. They held an average of 19.3 percent of their stock money in euro zone equities in late January, down from 25.0 percent a month earlier…

[T]he poor economic performance of southern Europe could shave several tenths of a percentage point off the zone’s growth this year, and conceivably delay the European Central Bank’s decision to withdraw its ultra-loose monetary policy.

Spreads between benchmark German bonds and peripheral-country debt have blown out to as much as a record 405 basis points in the case of Greek 10-year government bonds.

The costs of insuring Greek, Portuguese and Spanish government debt against default all rose to record highs on Friday. Greece’s five-year credit default swap price is much closer to Iraq’s than it is to Germany’s…

Also, moves out of the euro zone have been underway for a while. The latest data from the European Central Bank, for November, show net portfolio outflows from the region of 10 billion euros in stocks and 5 billion euros in debt.

This was attributed to foreigners selling euro zone debt and euro zone investors buying overseas stocks.

Sounds much worse, no? I think Mr Salmon has a point when he writes:

The fact is that the fiscal status of the Eurozone countries has not changed, and that if people are more worried about such things than they were a few weeks ago, that’s because of the action in the markets, as opposed to the action in the markets being caused by some kind of spontaneous uptick in generalized concern.

But I think he’s mistaken when he says:

[A]s for the eurozone, it has big problems today, and it had big problems last year, and it will have big problems next year. Sometimes there’s a lot of chatter about those problems. And sometimes markets move. But let’s not pretend that there’s some strong correlation between the two.

Mr Salmon knows that market moves can become self-fulfilling prophecies. And to emphasize a point I made earlier today, let me quote this other bit from the Reuters piece linked above:

In fact, many analysts believe the weak members remain some distance from the pain thresholds at which membership of the euro would be intolerable for them — and that if the thresholds were reached, rich states would intervene with some kind of aid to keep the zone intact.

The Reuters story is essentially saying that speculators are making short-term plays based on euro zone fears, but institutional investors and analysts still believe that this will all work out well in the end—that someone in Brussels or Frankfurt or Washington will come to his or her senses and intervene to prevent crisis. But this confidence may not last forever; at some point, bigger players may believe the dominant narrative and sell on the reluctance of European policymakers to intervene. And then we’ll all be in trouble.

The situation is somewhat analogous to the state of the financial system in early to mid-2008. There was a growing sense that government officials were failing to provide the needed, systematic policy solution to the brewing crisis. Most people ultimately believed, it seems, that governments wouldn’t allow a large bank to fail. During that time, many people were arguing that declines in individual financial stocks weren’t justified by the fundamentals—that irrational fear was hurting everyone. And ultimately the crisis came to a painful head, as everyone ran for the exits.

In short, if we were at the point where institutional investors were fleeing the euro zone, then we’d already be in September of 2008, and we’d really like to avoid being there once more. And it’s bizarre that policymakers would play with this fire so soon after they nearly torched the global economy.

MY COLLEAGUE closes the post below by saying:

So why then, as Mr Krugman asks, are investors still willing to purchase American debt at such low interest rates? Does this mean markets are not worried about America’s long-run fiscal outlook? Maybe, but I doubt it. Some investors always crave “risk-free” assets. American debt still, to a large degree, is the best “risk-free” option. What else is there? Eurobonds don’t look so good at the moment. But the current lack of better alternatives can not be the justification to not get your financial house in order.

Here’s a look at the recent relationship between the euro and the dollar:

What you see there is a long run of euro appreciation, then a sudden reversal amid the flight to safety associated with the 2008 financial crisis, then a return to appreciation, and finally another bout of dollar strengthening. The reversal there at the end of 2009 and the beginning of 2010 is just what you’d expect to happen amid growing fears of sovereign debt problems in the euro zone. Such issues would increase the desire for safe havens and dampen the demand for euros, both of which trends would boost the dollar.

This just goes to show how tricky it is to be the issuer of the world’s reserve currency. On the one hand, it’s nice that America can borrow cheaply amid crisis. On the other hand, any new round of uncertainty disadvantages American exporters, undermining recovery and slowing the process of rebalancing. And it means that America is somewhat insulated from market pressures to address deficits. Which, again, is nice when you need to provide stimulus, but it makes it very difficult to get American legislators to make hard decisions about long-run budget problems.

THE situation in Greece, at present, is rather uncomfortable. Markets are unhappy with the country’s debt load, which has forced the Greek government to pursue a broad austerity package designed to rein in deficits and cut public debt. There are serious questions as to whether such measures will be sufficient, however. The Greek public may sour on painful cuts to government spending and increased taxes, and austerity may prove counterproductive if it plunges the Greek economy into deep recession, reducing revenues. So the question on everyone’s mind is who will step in if Greece can’t manage to address its troubles on its own, as seems likely.

The obvious answer is the European Union, in an effort led by the deep-pocketed Germany, but Simon Johnson warns that this outcome currently looks unlikely:

The right approach would be to promise credible budget tightening down the road and to obtain sufficient resources – from within the eurozone (the IMF is irrelevant in the case of such a currency union) – to tide the country over in the interim.

But the Germans have decided to play hardball with their weaker and – it must be said – somewhat annoying neighbors.  As we entered the weekend, markets rallied on the expectation that there might be a bailout for Greece (and all the others under pressure).  But, honestly, this seems unlikely.  The Germans hate bailouts – unless it’s their own banks and auto companies on the line.  And the Europeans policy elite loves rules; in this kind of situation, their political process will grind on at a late 20th century pace. 

In contrast, markets now move at a 21st century global network pace.  This is a full-scale speculative attack on sovereign credits in the eurozone.  Brought on by weak fundamentals – it’s the budget deficit, stupid – such attacks take on a life of their own.  Remember the spread of pressure from Thailand to Malaysia and Indonesia, and then the big jump to Korea all in the space of two months during fall 1997.

The fall-out from a Greek default would negatively impact Germany, probably significantly. As Mr Johnson well knows, the role of emergency international lender would, but for the EU, fall to the IMF, but he lays out a number of reasons why the Fund is unlikely to step in here. I’m not so sure that the IMF will be a non-factor. Most of Mr Johnson’s bullet points boil down to “IMF intervention would look bad for the EU”, which is a good reason to think that the EU will ultimately intervene when it’s clear that only the IMF is left as a support option, but not a good reason to think a deal couldn’t be made if the EU were dead set against assistance for the Greek economy. In the meantime, the dynamic is not dissimilar to a game of chicken, which is a poor way to make crucial policy decisions.

The situation has become dire enough that eyes are now turning toward the European Central Bank as a potential source of aid. This is disconcerting, as the ECB has a limited set of tools at its disposal, and as the ECB has been fairly conservative throughout the crisis. So far, ECB head Jean-Claude Trichet has been very clear about his view that the crisis is one of a lack of integration of fiscal rules and policies. He’s absolutely correct, but that’s entirely irrelevant to the immediate mess. The question now is who is willing and able to act.

Departure from the euro zone is simply not a realistic option for Greece, or for the other troubled PIIGS economies. Failure to intervene would severely test the global financial system; Mr Johnson is only being somewhat hyperbolic in warning that Europe may be heading toward Depression. It seems unbelievable to me that the international community might fail to arrive at deal to help Greece through this mess (with contingencies for other troubled countries), but the longer we go without seeing real action on this front, the more markets may begin to wonder if the unbelievable is imminent.

Would Europe really risk another Lehman moment? I’m still betting no, but I’m not as confident about this as I used to be.

YORUM BAUMAN (the stand-up economist) has released his “Cartoon Introduction to Economics“. It can be yours, for just over $12. I enjoy the fact that according to Amazon, cutomers who bought Mr Bauman’s book also bought “The Cartoon Guide to Statistics”, “The Cartoon History of the Modern World” (parts 1 and 2), and “The Cartoon Guide to Sex”. Some people apparently prefer to get all their knowledge in cartoon form.

Anyway, via Tyler Cowen, here‘s a video of Mr Bauman on PBS, talking about comedy and economics. And because I feel bad for not being able to embed the video, here’s Austan Goolsbee on the Daily Show:

A FEW weeks ago, my colleague argued that while the threat of deflation should still be on central bankers’ radar, inflation is the more likely to become a problem. He wrote:

Core inflation hasn’t dropped as much as I’d expected to date, and the drop that has occurred seems entirely due to owners’ equivalent rent. Goods prices inflation has been surprisingly sturdy.

Yesterday’s report by the Congressional Budget Office also prompted me to reexamine my assumptions. The CBO has raised its CPI inflation rate forecast for 2010 to 2.4% from 1.7%, while leaving the 2011 forecast at a still very low 1.3%. It marked down even more its forecast of inflation as measured by the GDP price index…

Some of the inflation revision is because of the lower dollar, which is putting upward pressure on prices of tradable goods. The CBO also seems to think higher unemployment is exerting less disinflationary influence than traditional estimates of this relationship, called the Phillips Curve, assume. Inflation hawks at the Fed and elsewhere have made this argument for some time; I find it interesting the CBO is giving it some credence since, like me, the CBO puts a lot of stock in the Phillips curve.

I haven’t switched my deflation alarms off altogether. Goldman Sachs has argued that most of the sturdiness in inflation to date reflects just four categories: gasoline, cars, tobacco, and medical care, and “only the last of these seems likely to repeat its contribution from 2009.” Moreover, the most direct evidence of the output gap’s impact is wage growth, which continues to slow.

But the odds of outright deflation, as opposed to very low inflation, seem to have diminished a lot.

At least one Fed banker agrees. A month ago, I probably would have said that while inflation basically posed no threat in the short- to medium-term, the risk of deflation had been more or less eliminated thanks to Chinese growth and the effect of ample central bank liquidity on asset prices. Now, I’m not so sure. Markets have lost nearly 7% of their value in the past two weeks. Commodity prices have tumbled, as well. China’s government is tightening. The American economy has yet to return to steady job growth, and the momentum in American housing markets appears to have hit a winter plateau (while rents continue to decline). Loan demand among businesses and households continues to weaken. James Hamilton reviews the evidence and concludes:

My bottom line: the scales tipped last week in the direction of near-term deflationary pressures, despite the strong 2009:Q4 U.S. GDP report and falling unemployment rate.

I’d have to agree. This is a dangerous time for the global economy. Policymakers seem to be overestimating the return to stability. I’d say the argument for forgetting about inflation entirely until we see two quarters of core inflation at or above a 3% annual rate is quite strong.

ON FRIDAY, I disputed a point Paul Krugman made here—that the trouble in southern Europe isn’t about deficit profligacy, but is instead the result of monetary union without broader coordination of fiscal policy and labour markets. I agree that insufficient integration is a problem, but I disagreed with Mr Krugman that the PIIGS, as they’re known, were responsible in the years before the crisis.

As Brad DeLong points out, I illustrated the argument with a chart showing changes in current account deficits—trade deficits—when a chart of government budget deficits would have been more appropriate. Here is what total government deficits as a share of GDP looked like over the relevant time period:

And here is government debt as a share of GDP:

Mr Krugman was specifically referring to the crisis in Spain, and as you can see, he has a point. Prior to the crisis, both Spain and Ireland were running budget surpluses and enjoying a shrinking debt burden. Now one might argue that those surpluses were supported by unsustainable housing bubbles, and so were not indicative of responsible government behaviour, but the numbers are clear.

Greece, Italy, and Portugal are a different story. All are habitual deficit runners, and all suffered from large (and in Portugal’s case, increasing) debt loads. What’s more, monetary union has almost certainly helped these countries by reducing their debt costs. Were they not a part of the euro area, debt crises would likely have come earlier. To use Mr Krugman’s example, were Florida a sovereign state, it could devalue to improve its ability to export to the American market. On the other hand, it would lose the implicit backing of the federal government, and its debt costs would soar. If its debt were valued in dollars, devaluation would make it very difficult to repay. Were it instead valued in something like floridians, then interest rates would rapidly climb, choking off much of the benefit of devaluation.

As Mr Krugman says, the way around this is tighter integration, such that the federal government provides support during down times, and has some means of reducing the incentive to run deficits during good times. But the broader point of my earlier post, that worries over debt loads are spooking markets, contributing to the public furore over deficits, still stands.

YESTERDAY, Paul Krugman’s column addressed “fiscal scare tactics”, or the seemingly bizarre obsession wth fiscal deficits at a time when the economy is extremely weak. He writes:

These days it’s hard to pick up a newspaper or turn on a news program without encountering stern warnings about the federal budget deficit. The deficit threatens economic recovery, we’re told; it puts American economic stability at risk; it will undermine our influence in the world. These claims generally aren’t stated as opinions, as views held by some analysts but disputed by others. Instead, they’re reported as if they were facts, plain and simple.

Yet they aren’t facts. Many economists take a much calmer view of budget deficits than anything you’ll see on TV. Nor do investors seem unduly concerned: U.S. government bonds continue to find ready buyers, even at historically low interest rates. The long-run budget outlook is problematic, but short-term deficits aren’t — and even the long-term outlook is much less frightening than the public is being led to believe.

So why the sudden ubiquity of deficit scare stories? It isn’t being driven by any actual news. It has been obvious for at least a year that the U.S. government would face an extended period of large deficits, and projections of those deficits haven’t changed much since last summer. Yet the drumbeat of dire fiscal warnings has grown vastly louder.

Look, I think that the immediate priority should be economic weakness rather than deficits (although these needn’t be mutually exclusive—you can always pass budget fixes now that take effect several years down the road). But it’s just not true to say there is no news driving the interest. There is actually quite a bit of news on the risk of sovereign debt crises, driven by developing conditions in Europe. Here is just one of the stories describing the deficit worries sweeping Europe. Mr Krugman has been arguing that Europe’s debt troubles don’t have anything to do with fiscal irresponsibility, but that’s also wrong. As you can clearly see at right, Europe’s deficit troubles began well before the global economic collapse.

Now, there was an interesting discussion in the Washington office this week over whether it was possible for there to be a simultaneous crisis for all sovereign debt. While perhaps technically possible, it does seem unlikely, and so one might argue that countries with a relatively sound fiscal position, like America, have a lot of room to borrow for now, because debt worries elsewhere are causing investors to look for relatively safe havens. Perhaps so. But it’s just not right to say that there is no news driving these headlines, and no reason, other than politics, for people to be discussing these issues.

I HAVE a News analysis column up on the main page discussing this morning’s unemployment figures out of America. The drop in the unemployment rate, from 10% to 9.7%, is grabbing a lot of attention, but I’d suggest that’s not providing the most accurate picture of the labour market. Looking instead at the establishment data, we see that the employment picture was more or less flat in January (payrolls officially fell by 20,000), but that labour markets are struggling to climb out of a much deeper hole than was initially realised:

The Labour Department published the results of its annual benchmark revision of previous employment data. Through the 12 months to March 2009, the American economy lost 930,000 more jobs than had been previously estimated. It now appears that over 700,000 jobs were lost in each of the first three months of last year, a significantly worse performance than originally thought. Meanwhile, data for the last two months of 2009 were revised to show a larger increase in employment in November, but a larger decline in employment in December, for a net drop in employment of 5,000 jobs relative to previous reports.

Let me repeat one particular figure: the American economy lost over 2.1 million jobs during the first three months of 2009. Between November of 2008 and March of 2009, employment fell by 3.4 million. And as of March of 2009, the economy had lost nearly a million more jobs than the official statistics were showing. Think about that, then think about this, from a New Yorker piece on Larry Summers, dating to last October:

The most important question facing Obama that day was how large the stimulus should be. Since the election, as the economy continued to worsen, the consensus among economists kept rising. A hundred-billion-dollar stimulus had seemed prudent earlier in the year. Congress now appeared receptive to something on the order of five hundred billion. Joseph Stiglitz, the Nobel laureate, was calling for a trillion. Romer had run simulations of the effects of stimulus packages of varying sizes: six hundred billion dollars, eight hundred billion dollars, and $1.2 trillion. The best estimate for the output gap was some two trillion dollars over 2009 and 2010. Because of the multiplier effect, filling that gap didn’t require two trillion dollars of government spending, but Romer’s analysis, deeply informed by her work on the Depression, suggested that the package should probably be more than $1.2 trillion…

When the meeting broke up, after four hours of discussion, interrupted only briefly when the President brought out a cake and led the group in singing “Happy Birthday” to Orszag, there was still indecision about how big a stimulus Obama would recommend to Congress. Summers, Romer, Geithner, Orszag, Emanuel, and Jason Furman huddled in the corner to lock down the number. Emanuel made the final call: six hundred and seventy-five to seven hundred and seventy-five billion dollars, with the understanding that, as the bill made its way through Congress, it was more likely to grow than to shrink. The final legislation was for seven hundred and eighty-seven billion dollars.

With the too-optimistic data she had in hand, Christina Romer estimated that a $1.2 trillion package would be justified, and a package worth roughly $800 billion was ultimately approved.

There are a couple of important things to mention here. One is that the Federal Reserve had the same mistaken data in its hands, and might have acted much more aggressively had it known the actual damage taking place. Another is that the political calculus over the headline figure would likely have been significantly different had the real employment pain been more clear. And a third is that no one should be surprised that stimulus failed to generate the predicted outcome given its now apparent inadequacy in the face of a collapsing labour market.

The bottom line is that too little was done, and so the economy is struggling mightily to generate jobs. Immediately after the New Yorker section quoted above, we read:

“A lot of my research has been figuring out what policymakers did, why they did it,” Romer told me. “I have a whole new level of sympathy. Until you’ve experienced it, you don’t realize how hard it is. It’s humbling.”

It makes one wonder: if there was uncertainty about what needed to be done and what was politically possible, why not push for a large but contingent stimulus, that is, one which would end up being worth $1.5 trillion given one set of circumstances, $1.2 trillion in another, and $800 billion in another? Why not try to come up with some way to insure against the possibility that you’re seriously underestimating the severity of the situation? Given the political risks of doing too little, you’d have thought this would be foremost on the mind of the administration and of legislators. But mistakes were made, and now the consequences are clear.

Anyway, have a look at this chart, courtesy of the Dallas Fed:

That about says it all, I think.

ARVIND SUMBRAMANIAN has a Financial Times piece up which argues that the world should be concerned about China’s undervalued currency, not because it limits exports from America, but because it negatively impacts other emerging markets:

In the short run, with capital pouring into emerging market countries, their ability to respond to the threat of asset bubbles and overheating is undermined. Emerging market countries such as Brazil, India and South Korea are loath to allow their currencies to appreciate – to damp overheating – when that of a major trade rival is pegged to the dollar.

But the more serious and long-term cost is the loss in trade and growth in poorer parts of the world. Dani Rodrik of Harvard University estimates that China’s undervaluation has boosted its long-run growth rate by more than 2 per cent by allowing greater output of tradable goods, a sector that was the engine of growth and an escape route from underdevelopment for postwar successes such as Japan, South Korea and Taiwan.

Higher tradable goods production in China results in lower traded goods production elsewhere in the developing world, entailing a growth cost for these countries. Of course, some of these costs may have been alleviated by China’s rapid growth and the attendant demand for other countries’ goods. But China’s large current account surpluses suggest that the alleviation is only partial.

I would say that Mr Subramanian’s “of course” caveat there at the very end is very important. The growing Chinese market has borne up many of its neighbours with it, and while other industrialisers have likely suffered some from Chinese competition, exporters of primary resources, who may in general be poorer than industrialising emerging markets, have done well. And while we can’t know the but-for outcome, it hardly seems that the Indian and Brazilian economies are stalling under competitive pressure from China.

But I agree that this is something worth taking seriously. And I also agree with this:

By default, it has fallen to the US to carry the burden of seeking to change renminbi policy. But it cannot succeed because China will not be seen as giving in to pressure from its only rival for superpower status. Only a wider coalition, comprising all countries affected by China’s undervalued exchange rate, stands any chance of impressing upon China the consequences of its policy and reminding it of its international responsibilities as a large, systemically important trader.

It is a very bad idea for America to take the lead on this. American pressure is risky and likely to prove counterproductive. We have seen no indication that intensified American pressure will change Beijing’s mind, and I don’t understand why writers like Paul Krugman continue to argue that if America were to “get tough”, some headway could be made.

YES:

That chart is provided by Econbrowser’s Menzie Chinn, who writes:

Notice that nominal exports certainly doubled in the mid-1970s and early 1980’s. Nominal exports also almost doubled by 1990 and 2008, approximately 5 to 6 years after peaks in the trade-weighted exchange rate.

He adds:

Hence, continued dollar depreciation would have a substantial direct impact on export quantity. But rapid rest-of-world growth could be even more important, given the high income elasticity.

Renminbi appreciation certainly wouldn’t hurt American exports, and it would unambiguously improve America’s trade balance with China. But China’s dollar peg needn’t stand in the way of a general increase in American exports.