Recommended economics writing
Mar 8th 2011, 21:54 by R.A. | WASHINGTON
TODAY'S recommended economics writing:
Mar 8th 2011, 21:32 by R.A. | WASHINGTON
MUCH of the recent discussion about innovation, unemployment, wages, and robots is best viewed as a continuation of the discussion of Tyler Cowen's new book, "The Great Stagnation". In this weeks issue of The Economist, the Economics focus reviews and discusses Mr Cowen's book. Here's part of the conclusion:
The divergence camp seems to have the better arguments. Productivity improvements eliminated many middle-skilled American jobs just as emerging-market industrialisation undermined the position of low-skilled workers. After adjusting for these factors there may not be much wage stagnation left to explain. Nor is it clear that innovation has slowed. The evidence of improvement is all around. Communication is dramatically cheaper, easier and better than it was just a decade ago. Kitchens may look much as they did 30 years ago but living rooms and desktops look remarkably different. Innovation plateaus have been identified before, often to the later embarrassment of their spotter.
To advance the discussion, we asked the economists at Economics by invitation to weigh in on the book, and we offered Mr Cowen (a forum member) the opportunity to address our response and others'. He wrote, in part:
Most of the debate has focused on a slowdown in technological growth, namely that my grandmother saw more progress in her life than I have in mine. A no less important part of the argument is that educational progress—especially at the K-12 level—has slowed down as well. (This also makes us less effective or efficient as consumers, I should add.) High school graduation rates are lower today than a few decades ago and that evidence is very difficult to counter. It also suggests that what I call “The Great Stagnation” and what the reviewer calls “The Great Divergence” are not completely separate or opposed phenomena...A lot of countering points provide a long list of innovations, from the iPod to new and better olive oils. In most typical household budgets, housing, education, and health care are very important. Higher prices in those areas, above what productivity gains can justify, are driving much of the progress slowdown. Don’t be distracted by gadgets, however fun they may be, or however much they disproportionately benefit American intellectuals and media...Don’t be distracted by the internet. It’s a wonderful development, but its mature existence has coincided with the worst macroeconomic decade since the 1930s. It has yet to pay off on a major scale. It will, but this will take decades. Economic commentators tend to underestimate lag times when it comes to long-run technological developments.
Do click through and read all the contributions to the discussion; they're quite good. I appreciated the answer from Hal Varian, currently the chief economist at Google: He points out that kitchen technology hasn't changed much in 30 years. That may be true, but expenditure on dining out has more than doubled (in nominal terms) since 1990. How long did it take me to find that out? About 5 minutes on Google. How long would it have taken me to find that out 30 years ago? A lot, lot longer.Costs of communication and computation have tumbled. William Nordhaus at Yale University claims that computing performance has increased by a factor of 1 to 5 trillion since 1900, which represents a compound growth rate of 30-35% for a century. Since 1940, the growth rate has accelerated to 50% a year.It's not that the growth in benefits from technology has stagnated. Quite the contrary, it's the growth in costs that have stagnated. And that's a good thing!
It's a debate I continue to find fascinating and enriching.
Mar 8th 2011, 19:41 by R.A. | WASHINGTON
IN THIS morning's edition of his "Wonkbook" newsletter, Ezra Klein directed readers to news pieces about the developing proposal for a foreclosure settlement with America's big banks. Mr Klein added: For all that the economy is improving, housing remains a huge drag, with legitimate estimates suggesting we've still got as many as 11 million foreclosures in the pipeline. "The number one reason for nervousness about the economy in the next six to nine months is the foreclosure crisis," Moody's economist Mark Zandi told me last week.
That strikes me as way off the mark. Austerity? Sure. Monetary tightening? No question. European crisis? Oil prices? Real issues. But housing? No, not really.
That isn't to say that things in housing markets are lovely. Prices may fall a bit more nationally. Inventory remains high nationally, and very high in some markets. Lending standards are still tight and could stay that way for some time. There are 11m households with negative equity in their homes (but NOT, as Mr Klein's memo suggests, 11m likely foreclosures). Conditions aren't pretty.
But here's why housing isn't the threat Mark Zandi suggests it is: none of the above comes as any surprise. The residential investment contribution to GDP has been awful since the beginning of 2006. It simply can't get much worse. In the third quarter of last year, residential investment came in at a $329.8 billion annual rate. It hasn't been that low in nominal terms since the first quarter of 1996. For housing to threaten recovery, residential investment would need to fall substantially from that level. And that's very, very hard to imagine. Indeed, it's basically impossible to imagine such an outcome unless some other, more pressing threat sends the American economy back into deep recession. And in that case, the thing to watch out for isn't housing, it's the more pressing threat.
Similarly, we could imagine falling housing prices impacting household consumption when home values were high and home equity lines of credit were expanding rapidly. But households long ago began reducing consumption to pay off existing home equity loans. It's hard to see what would make this process accelerate substantially. And finally, one could imagine a financial market channel, but here, too, it's difficult to be too pessimistic. American banks are in far better shape than they were in 2008 and far more of the country's bad loans have been acknowledged. It's far more likely that causation would run from crisis elsewhere, to financial market pain, to housing collapse than from housing to finance to the real economy.
This is my general view: that if housing markets go suddenly south it will be the result of, rather than the cause of, some other economic calamity.
In a very important way, the fact that housing is no longer a dire threat to the economy is bad news for the subset of America that remains in the grip of severe housing pain. A few charts at Calculated Risk illustrate the problem. About one in four
households with a mortgage are underwater, which sounds bad. But the overwhelming majority of underwater debt
is held by the 12% of mortgage holders who are more than 25% underwater. And negative equity (and especially serious negative equity) is highly concentrated
in just a few states, namely, Nevada, Arizona, Florida, Michigan, and California.
The housing collapse will continue to mean serious problems for the finances of impacted households, which will include wrenching foreclosures and bankruptcies. It will mean neighbourhood deterioration and other problems for places where foreclosure activity is highest. But because this is no longer a national problem, these concerns will fall off the map. Legislators in Washington have zero interest in helping the underwater homeowners of Nevada, which will earn them Tea Party ire in their home states without much helping their local economies.
Mar 8th 2011, 17:52 by R.A. | WASHINGTON
FEW relationships in life are as tight as that between rising oil prices and increasing complaints about commodity speculators. Nation reporter Chris Hayes sees the cost of oil going up and unholsters his anti-speculation column:
In the wake of the price explosion in the summer of 2008, a bubble that extended to all kinds of commodities, including copper and wheat, a number of observers from George Soros to Hedge Fund manager Michael Masters to former Commodities Future Trading Commission staffer and derivatives expert Michael Greenberg concluded that the underlying supply-and-demand fundamentals couldn't account for sharp rise in prices. In the first six months of 2008, US economic output as declining while global supply was increasing. And even if supply and demand were, over the long run, pushing the price of oil up, that alone couldn't explain the massive volatility in the market. Oil cost $65 per barrel in June 2007, $147 a year later, down to $30 in December 2008 and back up to $72 in June 2009.The culprit, they concluded, was Wall Street speculators.
First, it's not true that American output was falling in the first half of 2008; GDP declined in the first quarter but rose in the second. Second, the oil market is global. While American output stagnated in early 2008, growth in places like China continued to soar and demand for commodities followed. Indeed, the fundamental trend in commodity prices, including oil, over the past decade has been a general upward movement as demand growth outstrips supply growth. Third, the fact that price increases span commodities undermines the argument that speculation has played a major role, because prices for commodities that don't trade on these markets have risen alongside those that do.
Fourth, the wild swings in price after July of 2008 aren't evidence for speculation either. As prices rose supply ramped up on a lag. Not all of the world's marginal supply can be turned on at the flick of a switch. But in the fall of 2008, the global economy fell off a cliff. Demand plummeted in the face of rising supply and prices tumbled. But by 2009, supply and demand were more closely aligned, and the global economy was recovering. There's no mystery here. And fifth, the easiest and most effective way to speculate on the price of oil is to leave the stuff in the ground, and there's not a thing the American government can do about that.
It's not impossible that financial market shenanigans have added a bit to the tops and bottoms of market swings. But America's vulnerability results directly from the fact that it uses a massive amount of a scarce resource that other people also want to use. As convenient as it is to blame the nasty bankers for causing this particular economic pain, the fact is that the problem isn't financial markets, it's American consumption.
Mar 8th 2011, 17:19 by R.A. | WASHINGTON
ONE of the most frustrating things about policy debate is the way in which arguments about efficiency are often interpreted and responded to as arguments about values. A defence of congestion pricing, for instance, will often get one labeled as anti-car. The value-oriented arguments become very intense when one makes arguments about the relative economic benefits of different kinds of places. And so it's not really suprising
that an Ezra Klein post praising Ed Glaeser's work on the economic strengths of urban agglomerations hit a nerve with Department of Agriculture Secretary Tom Vilsack. Get to talking about how cities are associated with high productivity levels and incomes, and about how urban tax revenues subsidise inefficient policies like massive agriculture subsidies, and people from rural areas may begin to feel that they're being personally slighted. What is interesting is just how hollow these complaints ring when properly addressed.
Mr Vilsack has a conversation with Mr Klein, and Mr Klein sets him straight. I could quote the entire thing, but you should just read it yourself. Here is one interesting excerpt:
EK: Let me go back to this question of character. You said again that this is a value system that’s important to support, that this conversation begins with the fact that these people are good and hardworking. But I come from a suburb. The people I knew had good values. My mother and father are good and hardworking people. But they don’t get subsidized because they’re good and hardworking people. TV: I think the military service piece of this is important. It’s a value system that instilled in them. But look: I grew up in a city. My parents would think there was something wrong with America if they knew I was secretary of agriculture. So I’ve seen both sides of this. And small-town folks in rural America don’t feel appreciated. They feel they do a great service for America. They send their children to the military not just because it’s an opportunity, but because they have a value system from the farm: They have to give something back to the land that sustains them.EK: But the way we show various professions respect in this country is to increase pay. It sounds to me like the policy you’re suggesting here is to subsidize the military by subsidizing rural America. Why not just increase military pay? Do you believe that if there was a substantial shift in geography over the next 15 years, that we wouldn’t be able to furnish a military?TV: I think we would have fewer people. There’s a value system there. Service is important for rural folks. Country is important, patriotism is important. And people grow up with that.
I'll add a few comments. First, it may be that the economists who understand the economic virtues of city life aren't doing a sufficiently good job explaining that it's not the people in cities that contribute the extra economic punch; it's the cities or, more exactly, the interactions between the people cities facilitate. It's fine to love the peace of rural life. Just understand that the price of peace is isolation, which reduces productivity.
Second, the idea that economically virtuous actors deserve to be rewarded not simply with economic success but with subsidies is remarkably common in America (and elsewhere) and is not
by any means a characteristic limited to rural people. I also find it strange how upset Mr Vilsack is by the fact that he "ha[s] a hard time finding journalists who will speak for them". Agricultural interests are represented by some of the most effective lobbyists in the country, but their feelings are hurt by the fact that journalists aren't saying how great they are? This reminds me of the argument that business leaders aren't investing because they're put off by the president's populist rhetoric. When did people become so sensitive? When did hurt feelings become a sufficient justification for untold government subsidies?
Finally, what Mr Klein doesn't mention is that rural voters are purchasing respect or dignity at the price of livelihoods in much poorer places. If Americans truly cared for the values of an urban life and truly wished to address rural poverty, they'd get rid of agricultural policies that primarily punish farmers in developing economies.
Mar 8th 2011, 15:24 by R.A. | WASHINGTON
AXEL WEBER may not get it, but the villagers of Mugardos do:
A small town in northern Spain has decided to reintroduce the old Spanish currency - the peseta - alongside the euro to give the local economy a lift.Shopkeepers in Mugardos want anyone with forgotten stashes of the old cash at home to come and spend it. It is nine years since the peseta was official currency in Spain. But Spain's economic crisis has forced some to be inventive. The hard times have seen thousands of businesses close and more than two million jobs go.More than 60 shops in Mugardos, a small fishing town in Galicia on Spain's northern coast, are accepting the peseta again for all purchases, alongside the euro.
Recommended economics writing
Mar 7th 2011, 22:16 by R.A. | WASHINGTON
TODAY'S recommended economics writing:
Technology and employment
Mar 7th 2011, 22:11 by R.A. | WASHINGTON
CONTINUING the discussion of the relationship between technological progress and employment, Tyler Cowen links to a paper by Robin Hanson. Here's the abstract:
A simple exogenous growth model gives conservative estimates of the economic implications of machine intelligence. Machines complement human labor when they become more productive at the jobs they perform, but machines also substitute for human labor by taking over human jobs. At first, expensive hardware and software does only the few jobs where computers have the strongest advantage over humans. Eventually, computers do most jobs. At first, complementary effects dominate, and human wages rise with computer productivity. But eventually substitution can dominate, making wages fall as fast as computer prices now do. An intelligence population explosion makes per-intelligence consumption fall this fast, while economic growth rates rise by an order of magnitude or more. These results are robust to automating incrementally, and to distinguishing hardware, software, and human capital from other forms of capital.
The horse is the most useful ally to the man preaching technological unemployment. Society used to employ millions of horses. To see one now you have to go to a racetrack or a farm. But horses aren't people. Most of them can't even talk. We don't care if huge swathes of the horse population are unemployed, we don't rely on horses to provide final demand for goods, and we can't send useless people off to be turned into meat. Horses are also more limited creatures than people. They're good at pulling. Once horses weren't needed for pulling, we couldn't use them for sewing or filing. But people are remarkably flexible.
So if we observe human wages falling dramatically due to technological substitution, we would expect lots of people to find themselves employed doing other things that humans can do, but which they used to be too expensive to do. Ultimately, humans may do lots of things that machines could
do, but for which it's cheaper and easier
to employ a person.
One problem that could develop, however, is nominal wage stickiness. If human wages are sticky, then someone rendered unemployed by new technologies may struggle to find new work (perhaps he is uncomfortable accepting a wage dramatically lower than what he used to earn, or perhaps the positive wage at which he can find employment is below the minimum wage). And if workers can't find employment at dramatically lower wages, then prices for important services won't fall—if haircuts continue to cost $20 rather than $0.50, then an ultra-low wage lifestyle will be less sustainable. More people will opt for unemployment and reliance on whatever charity and government support structures exist.
So one potential diagnosis of the situation is that the unemployed are simply demanding too much compensation. An alternative take is Paul Krugman
's: workers are less able to capture the gains to capital than they used to be, and so they can no longer afford to buy services from each other at inflated prices.
I previously cited Mr Cowen's remark that increased worker bargaining power and higher negotiated wages would simply accelerate the process of worker replacement. But maybe it's the case that if workers aren't able to capture some of the returns to scarce factors, then a highly unstable level of inequality results.
Mar 7th 2011, 19:33 by R.A. | WASHINGTON
A QUICK follow up to the previous post: Europe's troubles aren't simply connected to the current debt crisis. Obviously, that is the most pressing issue, as a story in the current print edition notes:
A more fundamental rethink is needed. It may be better to bite the bullet of default, starting with Greece. A recent report from Bruegel, a think-tank, concluded that Greece had become insolvent, called the current wait-and-see approach “a dubious strategy” and said that restructuring was necessary. The main objection to such a policy is the risk of destabilising the European banking system. But that risk could be contained, the authors argued, if banks’ weaknesses were addressed following new stress tests, which get under way this month and whose results will be published in June. The idea of resolving the debt crisis through restructuring may still be anathema in official European circles, but it won’t go away.
But that's not the only problem the currency area faces, as a new San Francisco Fed note
makes clear. Have a look at two images from the piece. First:
German workers produce a lot for what they cost relative to workers elsewhere in Europe. One reason why this is true is that Germany very effectively reduced wages in the years after reunification through a period of extremely lacklustre growth (encouraged by the Bundesbank). Meanwhile, peripheral wages soared after the introduction of the euro as new capital inflows fueled property booms and government borrowing. The two regions are now very out of step.
We have some idea how this might normally be resolved. The currencies of the relatively unproductive countries would fall, tamping down domestic consumption and making exporting industries more competitive. But that can't happen within the euro zone. Another possible solution would involve large-scale migrations from the periphery to Germany (and other economies in similar situations, like the Netherlands), but migration is harder within Europe than within the culturally homogenous American economy. Northern economies might also take steps to reduce labour mobility if a truly large migration began.
So what's left? Only a grinding reduction in real wages within the peripheral countries, more or less undoing the shifts in real exchange rates that precipitated the crisis. This is where the ECB's current policy path is so destructive. Germany's tighter labour market has been experiencing some long overdue wage growth, while wages are declining in places like Ireland (and marginal wages are declining faster). The ECB's reaction to this is, apparently, to rein in German wage growth through monetary tightening. The euro zone has asked peripheral nations to run a grueling disinflationary marathon, and the ECB is now running ahead and carrying the finish line ever farther away. Given the situation, the runners may eventually decide to just give up.
Mar 7th 2011, 18:38 by R.A. | WASHINGTON
CALCULATED RISK publishes a list of downside risks to growth today. Second on the list is this: The European financial crisis has been on the back burner, but yields are still elevated and there are key Euro Zone meetings scheduled in March - including a special eurozone debt crisis summit scheduled for Friday, March 11th. Ireland is asking to renegotiate the terms of their bailout, Greece debt was downgraded this morning, and Portugal is probably next in line. And the European Banking Authority has now launched the next round of bank stress tests. I expect this to be front page news again soon.
The Greek downgrade is a lagging indicator; bond yields have been trending up in Greece, Ireland, and Portugal, and all are at or near crisis highs (as is Italy, disconcertingly, but not Spain, encouragingly). In the end, Greece, Ireland, and Portugal will all probably need to have their debts—not just their bail-outs—restructured. And Europe will also have to deal with the serious weaknes in some of its banks as part of this process.
Of course, you know what I'm going to say next: the ECB is making all of this worse. The euro has been rising lately thanks to Jean-Claude Trichet's signal that the euro zone will be offering higher rates than other large rich world economies within the next month or so. But that's not a good sign for struggling peripheral countries.
The good news for America is that it's probably less vulnerable to a euro-zone crisis than it used to be. The bad news is that there are other things on Mr Risk's list. But obviously, the poor policy unfolding in Europe will wind up being hardest on Europeans themselves.
Technology and employment
Mar 7th 2011, 17:02 by R.A. | WASHINGTON
PAUL KRUGMAN has set the agenda for the blogging world today with a post (actually published on Saturday, but not all economics bloggers write on weekends) called Falling demand for brains? and charmingly illustrated with zombies. Mr Krugman begins by linking to an old and excellent piece of his, written from the perspective of 2096 and built around the conceit, "that information technology would end up reducing, not increasing, the demand for highly educated workers, because a lot of what highly educated workers do could actually be replaced by sophisticated information processing". He then writes: So here’s the question: is it starting to happen?Today’s Times has an interesting and, if you think about it, fairly scary report about how software is replacing the teams of lawyers who used to do document research. And then there’s Watson, of course, who — which? — can beat almost everyone except my Congressman at Jeopardy. Getting a bit more serious, Larry Mishel wrote recently about the overselling of education, pointing out that the college wage premium, after rising sharply in the 80s and 90s, has stagnated lately...In my mind this raises several questions. One is whether emphasizing education — even aside from the fact that the big rise in inequality has taken place among the highly educated — is, in effect, fighting the last war. Another is how we have a decent society if and when even highly educated workers can’t command a middle-class income. Ezra Klein has a related worry:
How do you keep morale up in an economy when more people are simply less necessary than they used to be?
Are people less necessary to the operation of the economy than they used to be? I don't think so. As far as I know, people currently represent 100% of final demand; machines aren't yet out there purchasing goods for their own consumption. Without people there is no economy. That's as true as it's always been.
The problem is that people are less necessary on the supply side but as important as ever on the demand side. How could this happen?
There are several potential explanations, but let me return to Mr Krugman's archives. In an old Slate piece, he took apart William Greider's argument that manufacturing productivity growth would lead to rising unemployment. Nonsense, replied Mr Krugman. This should almost never happen. Almost never:
But wait--what entitles me to assume that consumer demand will rise enough to absorb all the additional production? One good answer is: Why not? If production were to double, and all that production were to be sold, then total income would double too; so why wouldn't consumption double? That is, why should there be a shortfall in consumption merely because the economy produces more?Here again, however, there is a deeper answer. It is possible for economies to suffer from an overall inadequacy of demand--recessions do happen. However, such slumps are essentially monetary--they come about because people try in the aggregate to hold more cash than there actually is in circulation. (That insight is the essence of Keynesian economics.) And they can usually be cured by issuing more money--full stop, end of story. An overall excess of production capacity (compared to what?) has nothing at all to do with it.
At present, Mr Krugman seems to argue a different case. He suggests that worker bargaining power has fallen in recent decades, and this has led to stagnating wages for ordinary workers. But why should this lead to a mismatch between supply and demand? We can assume that richer earners have a lower marginal propensity to consume, such that transferring money from rich to poor produces more consumption. But as Tyler Cowen points out, this should ultimately exacerbate the supply-side problem:
Trade unions, even if they could become strong again (which is hard to see), would likely accelerate this process of substituting capital for labor, rather than counteracting it. A one-time union wage premium, even if it does not come at the expense of other workers, will put only a small dent in the long-term trend.
But what about the monetary argument Mr Krugman makes? What if the problem is simply that monetary policy has been too tight, and this has steadily eroded the demand side of the equation? Scott Sumner nods in this direction
. In a recent post he compared recent recoveries to the v-shaped employment comeback in the early 1980s. There's no real mystery to the joblessness of recent expansions, he says: they're directly related to slower nominal and real growth rates. Over a similar time frame, the labour force participation rate
plateaued and then fell in America (and the rate for those under 55 fell even more). As David Leonhardt documented
last week, median wages for male workers have been falling sharply over the past few decades, largely because the share of men earning no income at all has risen.
This argument has another advantage over the bargaining power explanation—it makes sense across the rich world. Tyler Cowen frequently points out that a "squash-the-middle" explanation for stagnating wages in America runs aground when one realises that other rich world countries—including some with far more union-friendly governments—experienced similar slowdowns over similar time frames. But one can make a strong case that monetary policy has been systematically too tight in America, Europe, and Japan.
Mr Leonhardt also does a nice job showing
that labour market pain hasn't been focused on all middle-skill or middle-wage workers. Those who have kept their jobs during the latest recession, for instance, have done all right. College graduates have continued to earn pay increases, despite the broader economic pain.
So perhaps the story here is not that we've reached some point where technological improvement condemns a growing rank of workers to uselessness. Perhaps the story is that firms use recessions to realise productivity gains and get rid of surplus workers. And in recent recoveries, central banks have allowed growth to recover to trend, but have not permitted a strong period of catch-up growth of the sort that would facilitate re-employment of cast-aside workers. Instead, those workers linger on the fringe of the workforce until they become essentially unemployable.
Maybe that's not it at all. But there is a consistency to the data that's suggestive. And if this is the case, then a sub-2% inflation target is costlier than is widely believed, given the apparent reluctance of central bankers to take extraordinary action when rates get near zero.
Mar 7th 2011, 15:29 by R.A. | WASHINGTON
AUTHORS tend to like "best of" lists that rank publications in various categories. If your site makes the list, you feel grand. If it doesn't, well, they're clearly using some bizarre criteria no one cares about, and anyway someone else is always publishing some other set of rankings some of which include you which obviously means they're the correct ones. Time
's list of top financial blogs
necessarily leaves out some very worthy members of the online economic community, but it includes Free exchange so its creators were clearly doing something right.
The best part of the list, however, is the fact that Time
got economic bloggers to write the review portion of the list. Marginal Revolution's Tyler Cowen—one of the blogging world's leading lights—was very kind in contributing thoughts
on Free exchange. And readers, he mentions you: "the comments section attracts educated, intelligent remarks".
I couldn't agree more. So take a bow, all. You make the blog more entertaining to read and more fun to write.
Recommended economics writing
Mar 6th 2011, 20:01 by R.A. | WASHINGTON
TODAY'S recommended economics writing:
Mar 6th 2011, 15:29 by A.S. | NEW YORK
DISCOUNT rates are normally not a sexy conversation topic. But when it comes to measuring just how underfunded state pensions are, things do get heated. Because each future pension payment is discounted, the larger the discount rate you use, the smaller your estimated liability (which is the sum of all the discounted payments). So the fact that many states use an 8% discount rate (the expected return they use to estimate their assets) means states can claim smaller liabilities (and that they are be better funded) than if they used the yield on treasuries or municipal bonds.
Financial economists believe it is inappropriate (to put it mildly) to use your expected asset return as your discount rate. That's because it does not acknowledge risk. Normally when you’ve promised a series of payments, the rate you use to discount liabilities reflects the risk a payment will not be made. This is true for several reasons. Primarily, when markets are down money is scarce. Your portfolio has probably fallen in value, just when it’s hard to secure credit. In this state, making a payment is much more expensive. To ensure that you have enough money, no matter what happens to markets, your discount rate should be lower than your expected asset return (unless they are both the risk-free rate). That is why private sector defined-benefit plans use the high grade corporate rate to discount their pension liabilities. Considering that state pension promises are often guaranteed by state constitutions (you will probably see bond defaults before a pension is not paid) it’s baffling that state pensions use their expected asset return as their discount rate. That means states do not account for risk when estimating their funding ratio, and they invest (heavily) in risky assets.
has decided this is not a problem because state pensions can smooth funding shortfalls across different generations of retirees. An individual is stuck with whatever their portfolio value is when they retire. Any defined-benefit pension can smooth good and bad markets across people retiring at different times. If things get really desperate, states and municipalities can increase taxes or issue debt to make pension payments. But as even Mr Baker points out, pension funds had to reduce contributions after the crisis because state budgets were squeezed and there was little scope to raise taxes. States also have a harder time raising money in down markets. And in practice, the ability to smooth funding across good and bad markets is undermined by human behaviour. Many public plans did not make full contributions
when there was a bull market and their funding ratios were high. This all suggests that ignoring risk when calculating pension obligations is, at best, irresponsible.
Much of the blog chatter on this paper has focused on whether the 8% return assumption is too high. Perhaps; no one knows for certain. But that is the whole point: when you invest in risky assets you don’t know what the future return will be. It is important to account for that uncertainty. According to Josh Rauh and Robert Novy-Marx:
Of course, if only the expected value matters for investing state pension funds, there is a wide range of even riskier investment strategies under which states could call their pensions fully funded while holding substantially less assets than they currently do. For example, under the current accounting standards, state governments could ostensibly meet their obligations using futures contracts on the stock market to maintain a leverage ratio of 10-to-1. The expected annual return of this strategy is roughly 90 percent, so state pension funds would only need to invest about $750 million today to have a mean asset value of $9.45 trillion in 15 years time. This strategy “frees up” $1.94 trillion (essentially all) of assets currently sitting in public pension funds. After paying off all pension obligations along with the entire $0.94 trillion in state bonds, the states could distribute $1 trillion, or more than $3,500 for each of 280 million American men, women, and children — all while maintaining a “fully funded” pension system! This "Modest Proposal" highlights the absurdity of the government accounting rules
I am not sure what point Mr Baker is trying to make. Is he blaming the fact that state pension are under-funded on Wall Street and the pension fund managers who did not consistently deliver a positive return? Again, that’s ignoring that risk is the operative word in risk premium. Or, is he just trying to throw water on the idea that state pensions are under-funded and may pose a serious burden to taxpayers? Either way, the numbers just don’t add up.
Recommended economics writing
Mar 4th 2011, 20:11 by R.A. | WASHINGTON
TODAY'S recommended economics writing:
Mar 4th 2011, 18:54 by R.A. | WASHINGTON
THE blogger Kantoos has put together
a nice illustration of why European Central Bank President Jean-Claude Trichet's decision to begin tightening monetary policy (and the market reaction to his comments
yesterday indicate that the tightening has already begun) is such a bad idea.
The two upward sloping lines are actual nominal GDP (or total spending or aggregate demand) and the nominal GDP trend. The green line is the departure of actual NGDP from trend. And what we observe is that total spending dropped substantially during the recession, then resumed growing at a pace below trend, such that catch-up would occur approximately never. And amid this state of affairs the ECB is now tightening. Despite the ongoing debt crisis and despite austerity across the euro zone. Kantoos writes:
There are no words I could publicly use to describe this failure of monetary policy.
I'm sure that leaders in Greece, Ireland, Portugal, and Spain are thinking the same thing.
Kantoos makes one other point that's close to my heart: if you want to return to normal, hawkish policy as quickly as possible, the best strategy is to make policy as aggressively expansionary as possible. Sweden's central bank adopted a strongly expansionary policy, actually using a negative interest rate, and the Swedish economy is now roaring ahead. And now the Swedish central bank is tightening, appropriately. Many people want America's government to rein in its fiscal deficits and are upset by the fact that government bond yields remain low. Former Budget Office head Peter Orszag argued against QE2 on the grounds that Fed efforts to bring long-term interest rates down a few basis points would reduce the perceived bond market pressure on Congress. But that small difference in rates is nothing compared to the jump that will occur when the private sector's demand for credit grows strongly. And the best way to return to that world is by making monetary policy appropriately accommodative.
The faster you get out of the hole, the sooner you can go back to worrying about the stuff you normally worry about (the things central bankers positively relish worrying about). But Mr Trichet has opted instead to grab a shovel and start digging. And he will place the euro zone under extraordinary pressure as a result.
Mar 4th 2011, 17:34 by R.A. | WASHINGTON
SPEAKING at a conference, Ford Motor Chairman Bill Ford expressed his worry that the likely increase in global automobile ownership, from today's 800m vehicles to between 2 and 4 billion cars, could doom the world to a fate of global gridlock:
“Where are these people going to go? Where are those cars going to go?” Mr. Ford asked in an interview Thursday at the Wall Street Journal’s ECO:Nomics conference here.Already, he says, daily commutes in Beijing can last five hours – and that’s when motorists don’t bog down in multi-day traffic jams as they did last summer.“People in Los Angeles and New York think they’re in gridlock,” Mr. Ford says. “It’s nothing like what they have seen already in other parts of the world.”As more of the world’s population moves into big cities, the answer to traffic congestion won’t be building more roads, Mr. Ford says, because there won’t be any space.“This is going to be a real drag on global growth unless we solve it,” he says.
The great hope, Mr Ford says, is technology. In the future, vehicles will be able to communicate with each other, helping cars to find alternate routes and cut traffic. Let's hope so, because otherwise there will be no way for New Yorkers to avoid sitting in crippling congestion. NO WAY AT ALL.
Let's set aside for the moment Mr Ford's puzzling ignorance of things like buses, subways, bicycles, and feet. What is the actual problem here? Mr Ford suggests that the real downside to traffic is that it prevents critical trips from happening in a timely fashion. Gridlocked cities are unable to ship goods around or deliver people to hospital, and it's important that those things take place.
One might go so far as to say that some trips are more important than others. An ambulance carrying a seriously ill passenger needs to use the road more than the fellow driving two blocks to buy a coffee. So, too, does the person trying to get to a job interview. What's needed is some way to make sure that the important trips get made. One potential solution is to build more roads—just keep on adding new lanes until one of them is free enough to let the ambulance through. The problem with this is that modern cities tend to use up all available land. This is true in dense downtowns, where it's generally considered unwise to knock down office buildings to pave new roads. And it's true in suburbs, where the local homeowners typically aren't too excited to have new roads on their property. So in most cases, new roads are out.
What's needed then is a way to make sure the less important trips are not made, or are delayed, or are taken using some other mode of transportation. But how to do this? If there were an omniscient central planner, she could simply ring up the sort-of hungry guy who decides he may as well drive to get that burrito and tell him to wait a bit. But sadly, no central planner can know which people need to go where when and how much value should be attached to each trip. Only the individuals themselves know this.
But wait! What if there were a way to auction off the right to use the road at various times? Then it would be clear that the winning bidders placed the most value on the use of the road at the time for which they purchased the right! People who didn't need to drive as much simply wouldn't bid as much as others, and would instead handle their particular need in some other way. Enterprising companies could even bid on slots in order to run buses, on which people not willing to pay to drive alone could ride for less money.
Of course, an auction would be difficult to coordinate. But perhaps the market could be set up like a grocery store, in which prices are set to match supply and demand and are adjusted if one outstrips the other. A toll could be placed on a roadway, raised if traffic bogs down, and reduced if there's spare capacity. Then the roadway wouldn't be congested, and it would be clear that in most cases the people placing the most value on use of the road were in fact the ones using the road. Genius!
I'd love to take credit for this brilliant idea, but it's actually quite old and already in use in various places around the world. Singapore's system is rightly famous, though not apparently famous enough for Mr Ford to have heard of it.
Well, ok, so let's say this system is adopted everywhere, so that there isn't any traffic and people are all efficiently moving their travel demand around. Population and wealth will continue to grow. Demand for travel will rise, and tolls will go up. Eventually, the tolls will reach extremely high levels, such that only the wealthiest can afford to travel on a regular basis. Other citizens will be able to get around by taking buses (which will themselves become more expensive) or by living more densely so that more destinations are within easy walking or biking distance. But fixed supply will become a constraining factor on economic activity.
Ah, but there is a solution. Those rising tolls? They generate a pool of money. And as tolls rise, it will be increasingly clear on the busier routes that tolls are high enough to cover the cost of new construction. But where should such new construction take place? Well, some existing transportation right-of-way can be repurposed for higher capacity vehicles. A roadway lane, for instance, could be closed off and used for a light-rail line that can carry more passengers per hour.
But if tolls continue to rise, then it will become sensible to dig. New subway lines will generate net economic benefits, new capacity will facilite growth, and the world will still have managed to avoid congestion.
Not every city will reach this equilbrium, of course. In some places, a small toll at rush hour and a few buses will be enough to keep traffic running smoothly indefinitely. In China, where cities of 50 million people are supporting very rapid income growth, high tolls and substantial new transit construction will be the order of the day. But it's just not the case that the world must bog down in permanent congestion. And neither does the world need fancy new technology, although technologies may improve the way the above systems function. The silver bullet that will help the world keep moving is just an economic approach to transportation demand and infrastructure construction.
Mar 4th 2011, 15:15 by G.I. | WASHINGTON
THE phrase “new normal” is usually used to explain the persistence of underwhelming economic data, such as today’s employment numbers. Nonfarm employment rose 192,000 (or 0.1%) in February from January, but that was after a sluggish, weather-depressed 63,000 gain in January (which was revised up from 36,000). Over the two months employment advanced an average of 127,500, in line with the last five months.
Many economists will say that 127,500 is just a neutral number, only enough to keep up with population growth. This, then, is the new normal: an economy that grows only fast enough to keep unemployment from rising, not strong enough to create the jobs needed to bring unemployment down.
The only problem with this story is it’s not an accurate description of reality. The unemployment rate is falling: to 8.9% in February from 9.0% in January and 9.8% last November. For some reason, we seem to be able to get unemployment down with far lower rates of job creation than in the past. Why?
There are two possible explanations. First, blame the data. Nonfarm employment is derived from a big survey of employers, while the unemployment rate is derived from a much smaller survey of households. The two often diverge. Indeed, measured by the household survey (adjusted for population controls), employment has risen an average of 419,500 in each of the last two months, more than triple the rate of the payroll survey. That’s why the unemployment rate has fallen.
However, I’d be careful before chalking it up to the data. Such differences are common. Household employment is extremely volatile and big swings tend to cancel each other out over time. Since March of last year when the job market bottomed out, employment growth has averaged a little over 100,000 per month according to both surveys.
This suggests we need a second explanation for why such unimpressive job creation has succeeded in pulling down unemployment. The labour force, the share of the working-age population that either works or wants to work is growing at a strangely subdued rate. Participation (the share of the working age population in the labour force) is supposed to rise during recoveries as previously discouraged workers return to the job hunt. Instead, it’s fallen, to 64.2%, unchanged from January and down from 64.9% last March.
Perhaps employers are reluctant to hire given their ability to squeeze more out of their existing work force. After all, initial unemployment insurance claims continue to drop, evidence that layoff activity has slowed, and manufacturing overtime hours jumped to 3.3 hours in February, the highest since early 2008.
But if lack of hiring were the problem we should see it show up in either the actual or hidden unemployed. In fact, the U-6 unemployment rate fell to 15.9% in February from 16.1% in January and 17.1% in September. This figure includes everyone who is officially unemployed plus everyone who wants to work but either has given up looking, didn’t look that month, or is working part time but would prefer full-time work.
So if the new normal was slow growing employment, the new new normal is a slow growing labour force. Put the two together and the unemployment decouples from the overall health of the economy. Why? Perhaps the Great Recession has permanently diminished work opportunities for big swathes of the work force, in particular prime-age men. Perhaps America is now experiencing an echo of what older Europe and Japan already have: a demographically driven slowdown in potential growth. Or perhaps it’s one of those temporary statistical mysteries that will disappear soon.
Enough dreary long-term analysis. There were lots of good short-term signs in the report suggesting that the recovery, though hardly a barn-burner, is intact. Manufacturing employment continues to outperform, rising 33,000 or 0.3%. Total private employment was up 222,000; state and local payrolls dropped 33,000. The average workweek was unchanged at 34.2 hours.
Hourly earnings did not grow, so the yearly increase fell back to 1.7%. Even if gasoline is about to lift inflation, it’s hard to see a wage price spiral developing.
Mar 4th 2011, 14:11 by A.P. | LONDON
IF YOU had to pick the most systemically risky financial firms in America, which would be in your top three? Bank of America? Citigroup? MetLife? The first two would be in most pundits' watchlists, but few would be likely to pick out the insurance firm. Yet MetLife occupies just that position in a ranking
put out by Viral Acharya, Thomas Cooley, Robert Engle and Matthew Richardson of the Stern School of Business at New York University.
The academics criticise initial proposals by the Financial Stability Oversight Council (FSOC), America's new guardian against systemic risk, on how to identify the firms it should worry about. Those proposals largely focused on the size of institutions, designating firms with more than $50 billion in total assets as systemically important. The NYU authors reckon that the critical thing to measure is not size but how closely connected an individual firm’s risk is to the rest of the financial sector. And the best measure of that connection is how big a proportion of the sector’s aggregate undercapitalisation in a crisis is attributable to an individual firm.
That sounds sensible. The worst-performing firms during the crisis burned through far more capital than the average financial institution. If the industry as a whole is holding a reasonable amount of equity, then these outliers are the ones to watch. The authors then propose a calculation for working out which firms represent the biggest risk as follows:
- First, it estimates the daily drop in equity value of this firm that would be expected if the aggregate market falls more than 2%. This is called Marginal Expected Shortfall (MES). The measure incorporates the volatility of the firm and its correlation with the market, as well as its performance in extremes. These are estimated using asymmetric volatility, correlation and copula methods similar to those in other sections of VLAB (for econometric details see Brownlees and Engle 2010).
- In a second step this is extrapolated to a financial crisis which involves a much greater fall (eg, 40%) over a much greater time period (six months).
- Finally, equity losses expected in a crisis are combined with a measure of the financial firm’s leverage (LVG), measured using current equity market value and outstanding measures of debt, to determine how much capital would be needed in such a crisis. A firm is assumed to require at least 8% capital relative to its asset value.
The authors claim that this method would have produced a top ten in July 2007 including Citigroup, Merrill Lynch, Freddie Mac, Fannie Mae, Bear Stearns and, yes, Lehman Brothers too.
Mr Acharya and his colleagues have been prolific and illuminating in their response to the financial crisis to date, and there is a lot to like about their approach. It recognises the interconnections between financial firms. It incorporates market signals, rather than just relying on regulatory benchmarks. And it nibbles away at the “boundary problem”, by naturally including non-banks like Metlife, AIG and Prudential Financial.
But there are problems, too. First, it only nibbles at the boundary problem, because it restricts its field of vision to publicly listed firms. A large hedge fund caused the system to wobble in 1998, and the same could happen again. Clearinghouses could be a huge source of systemic risk as more derivatives migrate to them, for instance, but looking at the financial performance of their owners may not be the right way to capture that risk.
Second, as the authors acknowledge, the measures are subject to gaming—remember the Repo 105 transactions that Lehman is supposed to have used to bring down their reported quarter-end leverage ratios. Third, despite the academics’ dismissal of the FSOC’s focus on size, their method is also biased toward the bigger institutions: correlations between individual firms and the overall market are likely to increase for larger firms because they feature more heavily in index-tracking products.
And fourth, the crisis was destructive to many firms because solvency worries led to liquidity problems. Lumping classic insurance businesses, whose liquidity profile is much more stable, in with the banks glosses over this important source of risk. Call it the MetLife distinction.
Recommended economics writing
Mar 3rd 2011, 21:59 by R.A. | WASHINGTON
TODAY'S recommended economics writing:
The European Central Bank's message
Mar 3rd 2011, 18:41 by P.W. | LONDON
THE central banks of Britain and the euro area have held their policy rates at rock-bottom levels since March and May 2009 respectively. At some time they would have to come off the floor, but who would make the first move?
With consumer-price inflation at 4% in January, double the target 2% rate, and due to surge still higher in coming months, the Bank of England had seemed the most likely to take the lead. By contrast, euro-wide inflation was 2.4% in February, not that much above the target of "less than but close to 2%" set by the European Central Bank (ECB).
Moreover, the balance of voting on the Bank of England’s nine-strong monetary policy committee has already been moving towards a rate rise. Until this year, Andrew Sentance had been a lone voice calling for the base rate to increase from 0.5% to 0.75%. But in January he was joined by Martin Weale and in February by Spencer Dale, the bank’s chief economist, the latter two voting for a quarter-point rise while Mr Sentance plumped for a half-point increase.
In a speech today
Charles Bean, the deputy governor for monetary policy, who had voted last month to keep the base rate at its emergency low of 0.5%, said that if anything inflation might be a bit more persistent than the bank’s latest projections, which suggests that he might be inclined to switch sides. Even so, the earliest that a rate rise seems likely is in May not least since Mervyn King, the bank’s governor, is in no hurry to tighten policy, arguing that temporary factors have driven up inflation, which should subside next year because of spare capacity.
It now looks as if the ECB will get there first, following today’s remarks
by Jean-Claude Trichet. The ECB left its main policy rate unchanged at 1%, but the bank’s president said in the press conference that a move next month was "possible". He also deployed the term "strong vigilance
" being warranted to contain upside risks to price stability, a signal for the cognoscenti that "possible" means "probable".
The surprise now will be if the ECB does not carry out a move so heavily semaphored. It would not be the first time that the bank has erred on the side of hawkish caution. In July 2008, it tightened policy in what turned out to be a misjudgment based on worrying too much about inflation expectations and too little about the fragility of the economy during the financial crisis.
But now the ECB may have another reason to show its inflation-fighting mettle. The bank has reluctantly been dragged into the euro-area’s sovereign-debt crisis through its decision last May to start buying the bonds of the countries in trouble. That’s all the more reason for its governing council to show that it has not lost the plot on its central mission of keeping inflation at bay.
Retail in India
Mar 3rd 2011, 17:56 by S.C. | LONDON
IN THE weeks leading up to India's annual budget, a familiar scene plays out in the country's media. Financial pages and news channels are full of advice and wish lists from corporate executives, economists and the occasional "common man" on what they would like to see in the budget. This year was no different. But one sector in particular—global retailers such as Walmart and Tesco—had high hopes that the country would finally allow foreign investment into "multi brand retail stores" or supermarkets and department stores.
It is easy to see the attraction to the Indian market. The share of trade (inclusive of wholesale and retail in the organised and unorganised sectors) in the country's GDP is around 15%. Estimates put the retail industry's size at just $450m of which only a tiny fraction, 5%, is organised. But rapid economic growth in the past decade has increased the disposable income of the middle class. It is this urban consumer that the global chains are eyeing.
Opening up the retail space to foreign investment would help in overhauling the country's antiquated supply chain. Shortcomings in the distribution systems have created huge differences between wholesale and retail prices. Inefficiencies are common. The government estimates that 40% of the fruit and vegetable production in country is lost due to inadequate storage and transport infrastructure. Waste of this magnitude, troubling in the best of times, is appalling as the country battles double-digit inflation
Yet, despite a consensus among policymakers that opening up of the retail sector to foreign investment has benefits both in the near and long term, the government shied away from reaching a decision. The reason behind the hesitation is the political clout of existing traders. An estimated 35m people or 7.3% of India’s workforce, are employed in the unorganised retail sector. The traders have been very vocal about their opposition to any form of organised retail and have regularly conducted mass protests and ransacked supermarkets to make their sentiments known. They fear that the arrival of big-box retailers will price the corner grocery stores out of business. There is some truth to this. As this article
notes, the advent of an organised retailer can lead to reduced sales in the first year. But after a few years the stores are more or less back to where they started.
Any decision that affects such a large workforce needs to be taken carefully. But the government has been mulling this question for over four years now. During this time the Indian economy has been denied the gains that result from increased competition and improved efficiencies in the supply chain. Holding hundreds of millions of consumers hostage to the fears of one group, however loud, is not a viable solution.
Mar 3rd 2011, 15:46 by R.A. | WASHINGTON
I WROTE yesterday that rising European inflation associated with increasing commodity prices may soon prompt a move by the European Central Bank. The ECB did not announce a rate increase today, but it did signal that one would be occuring soon—if not next month, then almost certainly in May:
European Central Bank President Jean-Claude Trichet said the ECB may raise interest rates next month to fight accelerating inflation pressures.An “increase of interest rates in the next meeting is possible,” he told reporters in Frankfurt today after the central bank left its key rate at a record low of 1 percent. “Strong vigilance is warranted,” Trichet said, adding that any increase would not necessarily be the start of a “series” of moves.
The warning came as the ECB raised its forecast for consumer price inflation in 2011 to between 2.0 and 2.6%—hardly runaway price growth. I can't help but think this is a very bad idea. As I wrote yesterday, this will both tighten policy for peripheral economies (some of which are still contracting) facing very high unemployment, and retard the process of internal rebalancing by quashing wage increases in Germany. But it will also boost the value of the euro—indeed, today's announcement already has the euro up against the dollar—which will place a drag on total euro-zone exports. All this at a time when the European debt crisis remains a serious threat, when bond yields in Greece, Ireland, and Portugal are at or near record highs, and when the European banking system remains extremely vulnerable
. Oh, and continent-wide austerity plans are only beginning to ramp up.
Maybe things will turn out all right. But the euro-zone economy is currently facing many threats, of which inflation is among the least dangerous. It's hard to avoid concluding that Mr Trichet's message today has made it substantially more likely that the euro zone will face a serious shock, perhaps within the next few months.
Global house prices
Mar 3rd 2011, 12:32
Our interactive overview of global house prices and rents
Is housing the most dangerous asset in the world? Any explanation of the recent financial crisis would have the property boom in America as Exhibit A: according to Robert Shiller, an economist and bubble-spotter, house prices were virtually unchanged in real terms between 1890 and the later 1990s, before almost doubling in the ten years between 1997 and 2006. Because buying a house usually involves taking on lots of debt, the bursting of this kind of bubble hits banks disproportionately hard. Research into financial crises in developed and emerging markets shows a consistent link between house-price cycles and banking busts.
The Economist has been publishing data on global house prices since 2002. The interactive tool above enables you to compare nominal and real house prices across 20 markets over time. And to get a sense of whether buying a property is becoming more or less affordable, you can also look at the changing relationships between house prices and rents, and between house prices and incomes.
Recommended economics writing
Mar 2nd 2011, 21:42 by R.A. | WASHINGTON
TODAY'S recommended economics writing:
In this blog, our correspondents consider the fluctuations in the world economy and the policies intended to produce more booms than busts.
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