The following Real World Economics column appeared on page 7D of the Sunday, May 25, 2008 issue of the St. Paul Pioneer Press.
By Ed Lotterman
I don't have a Ph.D., so perhaps that is why I occasionally suffer from "money delusion." But if other average Joes would be shocked by expensive fertilizer, as I recently was, some economic theories are on shaky ground.
"Money illusion" occurs when people make decisions based on nominal prices - the dolar figure printed on the invoice - rather than on "real" prices that are adjusted for inflation.
Money illusion is irrational. Many economists believe people are too samrk to be fooled by inflation in this way. Important theories depend on this belief.
I wasn't rational when I bought fertilizer one day about a week ago. I'm trying to keep alive some spruce planted in soil with a high pH. A forester friend said they might survive better if I acidified the soil around the tree.
One way to do that is with sulfur. The fertilizer-grade sulfer I bought when farming 30 years ago was a dusty powder. So I thought my current applications system - a five-gallon bucket and a tomato can - would work better if I mixed the sulfur with other ordinary fertilizer.
My local co-op mixed 50 pounds of sulfur with 300 pounds of potassium chloride. Now 350 pounds of fertilizer makes a very small pile in a pickup bed, so I was taken aback when the bill was $108.50. It was 27 cents-per-poun potash rather than 55-cent sulfur that tripped me up.
That was irrational. I am an economist. Every year I teach many students to adjust for inflation using price indexes. I make such calculations all the time. Yet I fell into the money illusion trap.
If someone had asked me what I used to pay for potash, I would have said about $90 a ton. How much higher might it be now? Perhaps it tripled, to $270 a ton.
It was exactly twice that, $540 a ton. I might have made a different decision if I had realized the bill would be that high.
Do workers make similar bad decisions about wages they accept? Do consumers ignore inflation when they consider alternate purchases or investments? Many economists, especially the monetarists and rational expectationists who are highly critical of government attempts to manage the economy, think not. Their theoretical models depend on nearly everyone being both well-informed and rational.
Would my naive money illusions change these theorists' minds? Probably not. They could argue that I was confused about a small item in our household spending, a minor hobby. A knitter returning to her craft after a hiatus of a few years similarly might be surprised by the price of yarn. But both of us, they would argue, probably know how our salaries are doing compared to inflation and how the prices of milk, bread and chicken breasts have changed.
Perhaps. Macroeconomic theories based on hyper-rationality were all the craze in the 1980s. More recently, microeconomists examining actual human behavior find that money illusion happens. Psychologist Amos Tversky provided strong evidence of this. If not for his untimely death, he would have shared the 2002 Nobel Prize for Economics with Daniel Kahneman.
This may seem neither here nor there for most people. In the meantime I need to scare up a couple bucks and run to the corner store for a gallon of milk.
Showing posts with label Ed Lotterman. Show all posts
Showing posts with label Ed Lotterman. Show all posts
Sunday, May 25, 2008
Friday, May 16, 2008
Default swaps carry uncertain risks
The following Edward Lotterman "Real World Economics" column was published on page 1C of the Thursday May 15, 2008 issue of the St. Paul Pioneer Press.
It is dangerous when anyone plunges into business deals they don't fully understand. Over the past 25 years, the securities industry has developed myriad new financial instruments intended to better manage risk. But it's becoming clear that not everyone dealing in these securities really knows the risks relative to the rewards.
Most people have never heard of a "credit default swap," but they're making news as the risks posed by such once-obscure financial instruments gain visibility.
A credit default swap is insurance against loss from default on another financial instrument. Suppose you own a corporate bond. It is highly likely the corporation will make all promised principal and interest payments. But you want to be sure, so you make periodic payments to a third party who agrees to make good your loss in the unlikely event that the bond goes bad.
This is little different from insurance on houses. I don't expect my house to burn down or blow away, but I am willing to pay several hundred dollars a year for the right to be reimbursed if that does happen.
At this basic level, a credit default swap is straight-forward and useful. One party wants to reduce their risk and is willing to pay a premium to do so. Someone else is willing to assume risk for a fee. Both can be better off in the long run.
But such swaps do differ from insurance in important ways. Insurance companies won't write policies unless the buyer has an "insurable interest." I can buy a policy on my own house, but I cannot go out and buy a policy on Joe Blow's house three blocks down the street. I can insure my own life, but I cannot buy policies that will pay me if Tom Hanks or Tiger Woods dies.
One can, however, either buy or sell protection against a bond defaulting even when neither you nor your counter-party actually owns the bond.
Moreover, default swaps fail a classic test for separating "investors" or "hedgers" from "speculators." Is a given party always on the same side of the transaction or not? Homeowners always are insurance buyers. Insurance companies always are sellers. Grain elevators contract to sell wheat in the future. Flour millers usually contract to buy.
But a financial institution may sell default protection on a bond one week and buy it for the same bond a week later, depending on its assessment of which side is more profitable.
The number of houses in a country limits the volume of mortgage lending. The borrowing needs of governments and corporations limits the number of bonds issued. The number and size of corporations limits the total value of shares of stock. A country's total stock of buildings puts an upper limit on how much property insurance can be sold.
But there is no limit to the volume of credit default swaps that can exist at any time. And their growth has been enormous.
In 1994, there were some $45 billion in such swaps. By 1998, that had quadrupled to $180 billion. Over the next six years the volume increased 44 times to $8 trillion. It is now estimated at $45 trillion, three times the U.S. Gross Domestic Product.
So what, you may ask. Why should the fact that large financial institutions have made large bets on unlikely events affect the average family?
There need not be any effect if all of the players in the credit default swaps market have correctly estimated the underlying risks, and if the prices paid for swaps fully reflect that risk. As long as everyone involved holds up their end of the bargain, come what may, these swaps need not affect the real economy.
However, the ongoing collateralized mortgage debacle demonstrates that financial institutions can be way off base in pricing new, poorly understood securities. Moreover, it is clear that many of the institutions that have jumped on the credit swap bandwagon, including obscure banks in Africa and Asia, don't have the financial wherewithal to pay up if some insured default actually occurs.
When financial institutions lose trust that other parties in deals are willing and able to carry through on commitments, fear comes to dominate markets and they seize up.
That is what happened to commercial paper last August and September. Fear that Bear Sterns no longer was a reliable counterparty is what brought that firm from apparent strength to near bankruptcy in days in March.
As with many other financial sector innovations, the horse is long out the door. There isn't much government can do right now to reduce the threat default swaps pose for the broader economy. We can hope that participants can unwind their positions smoothly in coming months, allowing firms' exposure to drop, without anyone going broke in the process. But don't count on it.
It is dangerous when anyone plunges into business deals they don't fully understand. Over the past 25 years, the securities industry has developed myriad new financial instruments intended to better manage risk. But it's becoming clear that not everyone dealing in these securities really knows the risks relative to the rewards.
Most people have never heard of a "credit default swap," but they're making news as the risks posed by such once-obscure financial instruments gain visibility.
A credit default swap is insurance against loss from default on another financial instrument. Suppose you own a corporate bond. It is highly likely the corporation will make all promised principal and interest payments. But you want to be sure, so you make periodic payments to a third party who agrees to make good your loss in the unlikely event that the bond goes bad.
This is little different from insurance on houses. I don't expect my house to burn down or blow away, but I am willing to pay several hundred dollars a year for the right to be reimbursed if that does happen.
At this basic level, a credit default swap is straight-forward and useful. One party wants to reduce their risk and is willing to pay a premium to do so. Someone else is willing to assume risk for a fee. Both can be better off in the long run.
But such swaps do differ from insurance in important ways. Insurance companies won't write policies unless the buyer has an "insurable interest." I can buy a policy on my own house, but I cannot go out and buy a policy on Joe Blow's house three blocks down the street. I can insure my own life, but I cannot buy policies that will pay me if Tom Hanks or Tiger Woods dies.
One can, however, either buy or sell protection against a bond defaulting even when neither you nor your counter-party actually owns the bond.
Moreover, default swaps fail a classic test for separating "investors" or "hedgers" from "speculators." Is a given party always on the same side of the transaction or not? Homeowners always are insurance buyers. Insurance companies always are sellers. Grain elevators contract to sell wheat in the future. Flour millers usually contract to buy.
But a financial institution may sell default protection on a bond one week and buy it for the same bond a week later, depending on its assessment of which side is more profitable.
The number of houses in a country limits the volume of mortgage lending. The borrowing needs of governments and corporations limits the number of bonds issued. The number and size of corporations limits the total value of shares of stock. A country's total stock of buildings puts an upper limit on how much property insurance can be sold.
But there is no limit to the volume of credit default swaps that can exist at any time. And their growth has been enormous.
In 1994, there were some $45 billion in such swaps. By 1998, that had quadrupled to $180 billion. Over the next six years the volume increased 44 times to $8 trillion. It is now estimated at $45 trillion, three times the U.S. Gross Domestic Product.
So what, you may ask. Why should the fact that large financial institutions have made large bets on unlikely events affect the average family?
There need not be any effect if all of the players in the credit default swaps market have correctly estimated the underlying risks, and if the prices paid for swaps fully reflect that risk. As long as everyone involved holds up their end of the bargain, come what may, these swaps need not affect the real economy.
However, the ongoing collateralized mortgage debacle demonstrates that financial institutions can be way off base in pricing new, poorly understood securities. Moreover, it is clear that many of the institutions that have jumped on the credit swap bandwagon, including obscure banks in Africa and Asia, don't have the financial wherewithal to pay up if some insured default actually occurs.
When financial institutions lose trust that other parties in deals are willing and able to carry through on commitments, fear comes to dominate markets and they seize up.
That is what happened to commercial paper last August and September. Fear that Bear Sterns no longer was a reliable counterparty is what brought that firm from apparent strength to near bankruptcy in days in March.
As with many other financial sector innovations, the horse is long out the door. There isn't much government can do right now to reduce the threat default swaps pose for the broader economy. We can hope that participants can unwind their positions smoothly in coming months, allowing firms' exposure to drop, without anyone going broke in the process. But don't count on it.
Sunday, April 27, 2008
Surging food, fuel prices cloud inflation picture
The following Ed Lotterman article appeared in the Sunday April 27, 2008 issue of the St. Paul Pioneer Press on page 3D.
Even economists experience sticker shock. I just bought one gallon of skim milk and one of 2 percent at the corner store. I do this regularly, but $9.14 for two gallons of milk still seems like a lot.
I'm not alone. Millions of people perceive that rising fuel and food prices are crimping their families' standard of living. No wonder they get upset when monthly inflation numbers are released and some expert notes that "core inflation" is up only slightly. It contradicts their daily personal experience.
The problem stems from the misapplication of a statistical measure - core inflation - that is useful in some situations but misleading right now.
For 80 years, the U.S. government has tabulated price indices to measure changes in general price levels. The consumer price index is the best known, as it measures goods and services that households buy. Every month, the government checks prices on thousands of items. On the whole, the CPI is an accurate indicator.
But prices of some items jump around more than others. Both food and fuel are important for most households, so they have a lot of influence on the overall index. But their prices tend to fluctuate more in the short term than those of clothing, household goods, shelter or recreation.
The fluctuations, incorporated in something tabulated on a month-to-month basis, can mislead.
Suppose overall prices are increasing at an average annual rate of 3 percent. Items other than food and fuel may increase at a rate of 2.5 percent one month and 3.5 percent the next, but follow this 3 percent trend. Then suppose food and fuel increase at a rate of 6 percent one month and again unchanged the next. Again, the long-run trend is 3 percent.
If you just consider the month that food and fuel rose at a 6 percent rate, it will appear that inflation is hot. The next month it will look like inflation is non-existent. But in the longer run, the trend in food and fuel is about the same as for other goods.
One can avoid this confusion by measuring consumer prices generally, but then making a separate tabulation that excludes volitile items. Weighing the two tabulations together gives us a better picture.
That is why the "core inflation" tabulation was introduced, to allow analysts to factor out short-run volatility that might be misleading.
A problem arises, however, when the longer-term trend for food and fuel is not the same as for other items. Suppose other items increase at rates between 2 percent and 4 percent with a trend of 3 percent. Month after month, food and fuel fluctuate between 6 percent and 10 percent annual rates with an average trend of 8 percent. Just looking at core inflation blinds one to a larger problem.
Taking comfort in a measure designed to dampen short-run fluctuations can mislead one about true prices trends. Over most of the past 25 years, food and fuel pries ahve increased more slowly than everything else. In the last two years, however, they have increased faster, and the discrepancy is widening. Citing restrained core CPI numbers as evidence of constrained inflation assumes that food and fuel will soon be dropping. REalistically, that is not in the cards.
St. Paul economist and writer Edward Lotterman can be reached at elotterman@pioneerpress.com
Even economists experience sticker shock. I just bought one gallon of skim milk and one of 2 percent at the corner store. I do this regularly, but $9.14 for two gallons of milk still seems like a lot.
I'm not alone. Millions of people perceive that rising fuel and food prices are crimping their families' standard of living. No wonder they get upset when monthly inflation numbers are released and some expert notes that "core inflation" is up only slightly. It contradicts their daily personal experience.
The problem stems from the misapplication of a statistical measure - core inflation - that is useful in some situations but misleading right now.
For 80 years, the U.S. government has tabulated price indices to measure changes in general price levels. The consumer price index is the best known, as it measures goods and services that households buy. Every month, the government checks prices on thousands of items. On the whole, the CPI is an accurate indicator.
But prices of some items jump around more than others. Both food and fuel are important for most households, so they have a lot of influence on the overall index. But their prices tend to fluctuate more in the short term than those of clothing, household goods, shelter or recreation.
The fluctuations, incorporated in something tabulated on a month-to-month basis, can mislead.
Suppose overall prices are increasing at an average annual rate of 3 percent. Items other than food and fuel may increase at a rate of 2.5 percent one month and 3.5 percent the next, but follow this 3 percent trend. Then suppose food and fuel increase at a rate of 6 percent one month and again unchanged the next. Again, the long-run trend is 3 percent.
If you just consider the month that food and fuel rose at a 6 percent rate, it will appear that inflation is hot. The next month it will look like inflation is non-existent. But in the longer run, the trend in food and fuel is about the same as for other goods.
One can avoid this confusion by measuring consumer prices generally, but then making a separate tabulation that excludes volitile items. Weighing the two tabulations together gives us a better picture.
That is why the "core inflation" tabulation was introduced, to allow analysts to factor out short-run volatility that might be misleading.
A problem arises, however, when the longer-term trend for food and fuel is not the same as for other items. Suppose other items increase at rates between 2 percent and 4 percent with a trend of 3 percent. Month after month, food and fuel fluctuate between 6 percent and 10 percent annual rates with an average trend of 8 percent. Just looking at core inflation blinds one to a larger problem.
Taking comfort in a measure designed to dampen short-run fluctuations can mislead one about true prices trends. Over most of the past 25 years, food and fuel pries ahve increased more slowly than everything else. In the last two years, however, they have increased faster, and the discrepancy is widening. Citing restrained core CPI numbers as evidence of constrained inflation assumes that food and fuel will soon be dropping. REalistically, that is not in the cards.
St. Paul economist and writer Edward Lotterman can be reached at elotterman@pioneerpress.com
Sunday, February 24, 2008
Cure the Disease, Not Just the Symptoms
by Ed Lotterman
St. Paul Pioneer Press
Thursday January 24, 2008 1C
Politicians and journalists are missing a key question when talking about ongoing U.S. economic problems: Is the current slowdown in economic activity and decline in asset prices cyclical or structural? Without answering that question, much public discussion is pointless.
Cyclical economic events result from the business cycle, the historical pattern of fluctuation in output, employment and inflation. Structural ones stem from longer-term shifts in the underlying framework of an economy.
This distinction is often applied to types of unemployment. Autoworkers laid off for a few months because auto sales drop during a recession are cyclically unemployed. The thousands of boilermakers let go in the 1950s as railroads shifted from steam locomotives to diesels represented structural unemployment.
The cyclical-structural distinction also applies to budget deficits. If tax receipts fall below outlays solely because a sluggish economy redues income - and sales-tax revenue, the deficit is cyclical. However, if a deficit persists at full employment and high output, the problem is structural.
The key question right now is wehther our economic problems are primarily cyclical - resulting from a long-established (even if not perfectly regular) pattern ofincreases and decreases in output, employment and prices. Or are our problems more fundamental and long-term?
Policies commonly deemed appropriate responses to business-cycle problems - manipulating the money supply, interest rates, taxes and government spending - are ineffective in addressing structural challenges. Indeed, they may make the situation worse rather than better.
We are in the same quandary as Japan was in 1989. That country faced an asset price bubble much greater than ours. Japanese stock prices rose by a factor of five in the 1980s. Real estate price increases were even more extreme.
At prevailing exchange rates, the grounds of the Imperial Palace in Tokyo were worth more than all of California. Ginza district land reached $139,000 per square foot.
But in 1989 the bottom fell out. Stock prices fell 50 percent from 1989 to 1990 and even more in following years. Tokyo home prices fell 90 percent. The crash wiped $25 trillion (in 2008 dollars) off of Japanese balance sheets.
The government treated the crash as a cyclical problem, lowering interest rates and increasing spending on vast public works projects. Japan went from having one of the lowest rations of national debt to GDP among industrialized countries to one of the highest.
Yes, the Bank of Japan was hesitant and erratic in money supply increases. Yes, there was poor coordination of fiscal and monetary policies. But overall, Japan had no lack of Keynesian stimulus. Yet its economy stagnated for more than a decade.
Japan's problems were structural. The economy depended too much on exports stoked by an undervalued yen. RElationships between financial institutions and corporations were too cozy and fraught with conflicts of interest. Financial regulators encouraged hiding losses than writing them off. Major corporations and banks could not go bankrupt, no matter how insolvent. An appreciating yen drew in more foreign investment than the country could absorb.
Traditional monetary and fiscal stimulus addressed none of these problems. Rather it made a bad situation worse.
President Bush repeatedly says that the U.S. economy is fundamentally sound, implying that current problems are merely cyclical. Is he correct? Will the fiscal package that he and other elected officials from both parties propose fix things?
At a very fundamental level and over the long term, the U.S. economy has great strengths. We have enormous natural resources. We have enormous natural resources. We have extensive private and public infrastructure. Most importantly, we have a hard working, skilled, creative and enterprising labor force. There is no bar to our long-term prosperity.
But in the medium term, we are ignoring important structural problems. For three decades, general government spending has exceeded general revenue by large margins - through booms as well as recessions. But the way we finance Social Security obscures the size of the general federal deficit. The national savings rate has fallen to near zero despite repeated tax cuts intended to boost savings and investment. Lenders market credit more aggressively than in any other country or era. Capital markets have created myriad complex and poorly understood financial instruments and new players, such as hedge funds, that are more difficult to regulate. We borrow hundreds of billions abroad while cheap imports suppress consumer inflation, even though the money supply grows faster than output, year after year.
If we ignore such fundamental underlying problems and expect cheaper money and a larger federal deficit to provide a quick fix, we are likely to be disappointed.
St. Paul Pioneer Press
Thursday January 24, 2008 1C
Politicians and journalists are missing a key question when talking about ongoing U.S. economic problems: Is the current slowdown in economic activity and decline in asset prices cyclical or structural? Without answering that question, much public discussion is pointless.
Cyclical economic events result from the business cycle, the historical pattern of fluctuation in output, employment and inflation. Structural ones stem from longer-term shifts in the underlying framework of an economy.
This distinction is often applied to types of unemployment. Autoworkers laid off for a few months because auto sales drop during a recession are cyclically unemployed. The thousands of boilermakers let go in the 1950s as railroads shifted from steam locomotives to diesels represented structural unemployment.
The cyclical-structural distinction also applies to budget deficits. If tax receipts fall below outlays solely because a sluggish economy redues income - and sales-tax revenue, the deficit is cyclical. However, if a deficit persists at full employment and high output, the problem is structural.
The key question right now is wehther our economic problems are primarily cyclical - resulting from a long-established (even if not perfectly regular) pattern ofincreases and decreases in output, employment and prices. Or are our problems more fundamental and long-term?
Policies commonly deemed appropriate responses to business-cycle problems - manipulating the money supply, interest rates, taxes and government spending - are ineffective in addressing structural challenges. Indeed, they may make the situation worse rather than better.
We are in the same quandary as Japan was in 1989. That country faced an asset price bubble much greater than ours. Japanese stock prices rose by a factor of five in the 1980s. Real estate price increases were even more extreme.
At prevailing exchange rates, the grounds of the Imperial Palace in Tokyo were worth more than all of California. Ginza district land reached $139,000 per square foot.
But in 1989 the bottom fell out. Stock prices fell 50 percent from 1989 to 1990 and even more in following years. Tokyo home prices fell 90 percent. The crash wiped $25 trillion (in 2008 dollars) off of Japanese balance sheets.
The government treated the crash as a cyclical problem, lowering interest rates and increasing spending on vast public works projects. Japan went from having one of the lowest rations of national debt to GDP among industrialized countries to one of the highest.
Yes, the Bank of Japan was hesitant and erratic in money supply increases. Yes, there was poor coordination of fiscal and monetary policies. But overall, Japan had no lack of Keynesian stimulus. Yet its economy stagnated for more than a decade.
Japan's problems were structural. The economy depended too much on exports stoked by an undervalued yen. RElationships between financial institutions and corporations were too cozy and fraught with conflicts of interest. Financial regulators encouraged hiding losses than writing them off. Major corporations and banks could not go bankrupt, no matter how insolvent. An appreciating yen drew in more foreign investment than the country could absorb.
Traditional monetary and fiscal stimulus addressed none of these problems. Rather it made a bad situation worse.
President Bush repeatedly says that the U.S. economy is fundamentally sound, implying that current problems are merely cyclical. Is he correct? Will the fiscal package that he and other elected officials from both parties propose fix things?
At a very fundamental level and over the long term, the U.S. economy has great strengths. We have enormous natural resources. We have enormous natural resources. We have extensive private and public infrastructure. Most importantly, we have a hard working, skilled, creative and enterprising labor force. There is no bar to our long-term prosperity.
But in the medium term, we are ignoring important structural problems. For three decades, general government spending has exceeded general revenue by large margins - through booms as well as recessions. But the way we finance Social Security obscures the size of the general federal deficit. The national savings rate has fallen to near zero despite repeated tax cuts intended to boost savings and investment. Lenders market credit more aggressively than in any other country or era. Capital markets have created myriad complex and poorly understood financial instruments and new players, such as hedge funds, that are more difficult to regulate. We borrow hundreds of billions abroad while cheap imports suppress consumer inflation, even though the money supply grows faster than output, year after year.
If we ignore such fundamental underlying problems and expect cheaper money and a larger federal deficit to provide a quick fix, we are likely to be disappointed.
Friday, February 22, 2008
PP: Quick fix is beyond government's power
Edward Lotterman: Quick fix is beyond government's power
St. Paul Pioneer Press
Wednesday January 23, 2008 Pg 1A
Don't put too much hope in the Fed's latest cut in its target interest rate or in any eventual fiscal stimulus package on which President Bush and Congress may agree. The ability of government to offset swings in employment, output and prices is much more limited than many people think, especially when dealing with a $14 trillion economy that is highly enmeshed with the rest of the world. At least that is my humble opinion.
The economic news this week has been dramatic. Several Asian stock markets fell more than 10 percent in two days. In an unscheduled meeting, the Federal Reserve's policymakers cut its target for the federal funds interest rate an unprecedented three-fourths of a percentage point, from 4.25 to 3.5 percent. Meanwhile, the president, Congress and sundry presidential candidates are falling over each other with proposals for "fiscal stimulus."
The situation raises many questions: Just what can government do to solve growing economic problems? Should the Fed cut interest rates even further? Is the danger of inflation real? Will rebates, further tax cuts or greater government spending forestall a recession?
Unfortunately, economists have different views on these issues, depending on the degree to which they are convinced by competing economic theories. John Maynard Keynes (1883-1946) argued government can manipulate four variables - taxes, government spending, the money supply and interest rates - to ward off recessions or curb inflation. Monetarists, led by the University of Chicago's articulate and energetic Milton Friedman (1912-2006), saw government tromping on fiscal and monetary gas and brake pedals as not only doomed to failure but also inherently harmful. So did a later group called "rational expectationists."
Virtually all economists agree on one thing: A central bank can control inflation if it does not let the money supply grow too fast. Prime Minister Margaret Thatcher of Great Britain and U.S. Fed Chairman Paul Volcker proved that.
What economists don't agree on is how well government policies can ward off a recession and on the relative usefulness of monetary policy (money supply and interest rates) compared to fiscal policy (government taxing and spending).
The historical record is mixed. Many argue that military spending wasa the primary factor in ending the Great Depression. Others point to the tax cuts enacted after John F. Kennedy's assassination as a success story of fiscal stimulus that worked. Some view the 2001 Bush tax cuts as having increased consumer spending, even though their stated purpose was to encourage long-term investment.
But there are many counter-arguments or examples. Rising spending on the Vietnam War was probably a bigger stimulus than the Kennedy-Johnson tax cuts. And in 2001, the Fed increased the money supply, pushing short-term interest rates to historic lows at the same time the Bush tax cuts took effect.
Moreover, after most industrialized countries overtly adopted Keynesian policies in the 1950s, many experienced increases in inflation even during recessions with high unemployment. Such "stagflation" dominated the 1970s and baffled both political parties.
Richard Nixon expolicitly proposed fiscal stimulus in 1971 and 1972 even as he cynically kept the lid on inflation with wage and price controls. Both inflation and unemployment soared a year later. Neither Gerald Ford nor Jimmy Carter could settle on a coherent response for either inflation or unemployment, and the nation suffered.
The 1980s demonstrated that the Fed could tame inflation if politicians were able to tolerate a harsh recession in the short term. Moreover, a stable price environment fostered investment by households and businesses.
But human nature leads central bankers into temptation. As memories of the 1970s inflation faded in the go-go years of the 1990s, arguments for faster money growth and lower interest rates overwhelmed calls for prudence. The Fed needed to lower interest rates to help out banks wracked by bad loans on commercial property. It needed to stop contagion from Asian financial crises or from Russia or Brazil.
Then, when the U.S. economy slowed in 2000, monetary expansion seemed necessary. People agreed it was even more true after Sept. 11.
Overall, we nearly doubled the money supply since the mid-1990s, while the real economy grew by about 50 percent. Such easy money clearly created many of the problems we face today.
Some say that calls for even lower interest rates mimic Will Rogers' sarcastic query "If stupidity got us into this mess, then why can't it get us out?" Moreover, as the Fed increases the money supply to lower interest rates, the value of the dollar tends to slide compared to other currencies.
Fiscal stimulus packages are even more fraught with difficulty.
Politicians love to step on the gas pedal, increasing spending and cutting taxes. They are especially quick to call for fiscal largesse in election years. The unemployment rate is never low enough or growth fast enough for a congressman facing reelection.
Politicans never want to step on the brake pedal, even when inflation gets out of control as it did in the 1970s. Moreover, the time lags in getting tax and spending bills through Congress are such that the economic effects often arrive too late. In many cases, they make business cycle fluctuations more extreme instead of dampening them.
At this juncture, the impulse to try anything with some plausible chance of success is powerful. Easier money and an even looser federal budget may ameliorate a bad, and worsening, situation. But the monetary, budgetary and trade imbalances that have accumulated over the years are large and difficult to resolve. Americans should not delude themselves with the idea that there are quick and easy fixes.
St. Paul Pioneer Press
Wednesday January 23, 2008 Pg 1A
Don't put too much hope in the Fed's latest cut in its target interest rate or in any eventual fiscal stimulus package on which President Bush and Congress may agree. The ability of government to offset swings in employment, output and prices is much more limited than many people think, especially when dealing with a $14 trillion economy that is highly enmeshed with the rest of the world. At least that is my humble opinion.
The economic news this week has been dramatic. Several Asian stock markets fell more than 10 percent in two days. In an unscheduled meeting, the Federal Reserve's policymakers cut its target for the federal funds interest rate an unprecedented three-fourths of a percentage point, from 4.25 to 3.5 percent. Meanwhile, the president, Congress and sundry presidential candidates are falling over each other with proposals for "fiscal stimulus."
The situation raises many questions: Just what can government do to solve growing economic problems? Should the Fed cut interest rates even further? Is the danger of inflation real? Will rebates, further tax cuts or greater government spending forestall a recession?
Unfortunately, economists have different views on these issues, depending on the degree to which they are convinced by competing economic theories. John Maynard Keynes (1883-1946) argued government can manipulate four variables - taxes, government spending, the money supply and interest rates - to ward off recessions or curb inflation. Monetarists, led by the University of Chicago's articulate and energetic Milton Friedman (1912-2006), saw government tromping on fiscal and monetary gas and brake pedals as not only doomed to failure but also inherently harmful. So did a later group called "rational expectationists."
Virtually all economists agree on one thing: A central bank can control inflation if it does not let the money supply grow too fast. Prime Minister Margaret Thatcher of Great Britain and U.S. Fed Chairman Paul Volcker proved that.
What economists don't agree on is how well government policies can ward off a recession and on the relative usefulness of monetary policy (money supply and interest rates) compared to fiscal policy (government taxing and spending).
The historical record is mixed. Many argue that military spending wasa the primary factor in ending the Great Depression. Others point to the tax cuts enacted after John F. Kennedy's assassination as a success story of fiscal stimulus that worked. Some view the 2001 Bush tax cuts as having increased consumer spending, even though their stated purpose was to encourage long-term investment.
But there are many counter-arguments or examples. Rising spending on the Vietnam War was probably a bigger stimulus than the Kennedy-Johnson tax cuts. And in 2001, the Fed increased the money supply, pushing short-term interest rates to historic lows at the same time the Bush tax cuts took effect.
Moreover, after most industrialized countries overtly adopted Keynesian policies in the 1950s, many experienced increases in inflation even during recessions with high unemployment. Such "stagflation" dominated the 1970s and baffled both political parties.
Richard Nixon expolicitly proposed fiscal stimulus in 1971 and 1972 even as he cynically kept the lid on inflation with wage and price controls. Both inflation and unemployment soared a year later. Neither Gerald Ford nor Jimmy Carter could settle on a coherent response for either inflation or unemployment, and the nation suffered.
The 1980s demonstrated that the Fed could tame inflation if politicians were able to tolerate a harsh recession in the short term. Moreover, a stable price environment fostered investment by households and businesses.
But human nature leads central bankers into temptation. As memories of the 1970s inflation faded in the go-go years of the 1990s, arguments for faster money growth and lower interest rates overwhelmed calls for prudence. The Fed needed to lower interest rates to help out banks wracked by bad loans on commercial property. It needed to stop contagion from Asian financial crises or from Russia or Brazil.
Then, when the U.S. economy slowed in 2000, monetary expansion seemed necessary. People agreed it was even more true after Sept. 11.
Overall, we nearly doubled the money supply since the mid-1990s, while the real economy grew by about 50 percent. Such easy money clearly created many of the problems we face today.
Some say that calls for even lower interest rates mimic Will Rogers' sarcastic query "If stupidity got us into this mess, then why can't it get us out?" Moreover, as the Fed increases the money supply to lower interest rates, the value of the dollar tends to slide compared to other currencies.
Fiscal stimulus packages are even more fraught with difficulty.
Politicians love to step on the gas pedal, increasing spending and cutting taxes. They are especially quick to call for fiscal largesse in election years. The unemployment rate is never low enough or growth fast enough for a congressman facing reelection.
Politicans never want to step on the brake pedal, even when inflation gets out of control as it did in the 1970s. Moreover, the time lags in getting tax and spending bills through Congress are such that the economic effects often arrive too late. In many cases, they make business cycle fluctuations more extreme instead of dampening them.
At this juncture, the impulse to try anything with some plausible chance of success is powerful. Easier money and an even looser federal budget may ameliorate a bad, and worsening, situation. But the monetary, budgetary and trade imbalances that have accumulated over the years are large and difficult to resolve. Americans should not delude themselves with the idea that there are quick and easy fixes.
Sunday, September 23, 2007
Bush can't be Keynesian supply-sider
The following appeared in the Sept. 23, 2007 issue of the St. Paul Pioneer Press and was written by Ed Lotterman. A link to the story may be found here.
It is too bad the Old Testament prophet Elijah never passed through Washington, D.C. His challenge to the Israelites in 1 Kings 18, "Choose ye this day whom ye will serve," is a powerful argument against holding two diametrically opposed positions at the same time. Unfortunately, that is a common occurrence in our nation's capital.
Confusion is evident in the White House response to Alan Greenspan's criticism of administration fiscal policies. Defending President Bush, Press Secretary Dana Perino said, "in late 2000, we were headed into a recession, and tax cuts were the prescribed remedy."
Perino is correct. Tax cuts are a prescribed remedy for a recession - if you are a Keynesian. But George W. Bush did not run for office as a Keynesian. He ran as a supply-sider. Supply-side economists are the most diametrically opposed to Keynes of any school of economic thought. The very name "supply-side" is a rejection of the demand-side jockeying John Maynard Keynes advocated.
Supply-side economists argued that trying to micro-manage an economy by manipulating consumer spending was short-sighted and counterproductive. Keynesian tromping of economic gas and brake pedals to regulate demand harms rather than hurts, they said.
Focus instead on the supply side of the economy, they argued. Reduce regulation of economic activity. Increase incentives for saving and investment. That means lowering high marginal income tax rates and taxes on investment earnings from interest, dividends and capital gains. The object is to increase investment. That requires more savings and, thus, less current consumption.
That was the platform on which George W. Bush ran for office in 2000 and was his rationale for tax cuts in 2001. But by the 2004 election, his arguments had changed. Cutting taxes was needed to spur household consumption. That is back to pure Keynesianism.
The problem is that if you cut taxes to spur demand because the economy faces recession, you have to raise them to curtail demand when it really gets rolling. That should have happened two years ago, but the administration showed no willingness to implement the other half of Keynes' prescription.
Just as ancient Israelites could follow Yahweh or Baal, you can be a Keynesian or a supply-sider. But you cannot be both.
Confused economic policy is not original to the Bush administration.
Jimmy Carter's economic advisers were dyed-in-the-wool Keynesians.
But the Carter White house never could decide if it needed to spur the economy to lower unemployment or retard it to cut inflation.
We ended up with the worst combination of both inflation and unemployment in decades.
It is too bad the Old Testament prophet Elijah never passed through Washington, D.C. His challenge to the Israelites in 1 Kings 18, "Choose ye this day whom ye will serve," is a powerful argument against holding two diametrically opposed positions at the same time. Unfortunately, that is a common occurrence in our nation's capital.
Confusion is evident in the White House response to Alan Greenspan's criticism of administration fiscal policies. Defending President Bush, Press Secretary Dana Perino said, "in late 2000, we were headed into a recession, and tax cuts were the prescribed remedy."
Perino is correct. Tax cuts are a prescribed remedy for a recession - if you are a Keynesian. But George W. Bush did not run for office as a Keynesian. He ran as a supply-sider. Supply-side economists are the most diametrically opposed to Keynes of any school of economic thought. The very name "supply-side" is a rejection of the demand-side jockeying John Maynard Keynes advocated.
Supply-side economists argued that trying to micro-manage an economy by manipulating consumer spending was short-sighted and counterproductive. Keynesian tromping of economic gas and brake pedals to regulate demand harms rather than hurts, they said.
Focus instead on the supply side of the economy, they argued. Reduce regulation of economic activity. Increase incentives for saving and investment. That means lowering high marginal income tax rates and taxes on investment earnings from interest, dividends and capital gains. The object is to increase investment. That requires more savings and, thus, less current consumption.
That was the platform on which George W. Bush ran for office in 2000 and was his rationale for tax cuts in 2001. But by the 2004 election, his arguments had changed. Cutting taxes was needed to spur household consumption. That is back to pure Keynesianism.
The problem is that if you cut taxes to spur demand because the economy faces recession, you have to raise them to curtail demand when it really gets rolling. That should have happened two years ago, but the administration showed no willingness to implement the other half of Keynes' prescription.
Just as ancient Israelites could follow Yahweh or Baal, you can be a Keynesian or a supply-sider. But you cannot be both.
Confused economic policy is not original to the Bush administration.
Jimmy Carter's economic advisers were dyed-in-the-wool Keynesians.
But the Carter White house never could decide if it needed to spur the economy to lower unemployment or retard it to cut inflation.
We ended up with the worst combination of both inflation and unemployment in decades.
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