Musings on economics, financial markets, politics, and philosophy…
US stock markets rallied 2-3% and crude oil jumped over 9% yesterday in reaction to the latest “plan to have a plan” and “agreement to agree on what has already been agreed” coming out of the EU.
I’m not convinced that this will amount to much more than another short term attempt to boost market confidence that rapidly deteriorates.
Everyone ought to just read the official statement (which is just slightly longer than one page in length) and ignore the speculation from the financial press.
Here are my key concerns:
Given the timing of the ESM itself as well as the timing of its power to provide direct assistance to banks along with the subordination issue, I think there is going to be enormous pressure over the next few months to expand both the duration and size of the EFSF while backburnering the ESM. Alternatively, some new “medium term solution” may emerge to fill the gap between the EFSF and ESM. It’s unlikely that matters will proceed along the lines currently proposed, with a smooth and seamless transition between the EFSF and ESM.
Yesterday, the EU agreed to provide Spain with a 100 billion Euro ($125 billion) rescue package.
The money will go into a fund called FROB (Fund for Orderly Bank Restructuring) modeled loosely after the US TARP prgram. The Spanish government will be responsible for paying back the loan, but they are constrained in how they can use the money; essentially, it has to be used to recapitalize their banks.
It appears this will calm the markets, but for how long?
Why is “calming the markets” always the proximate (and often the ultimate) goal? Spain has an overall unemployment rate over 24%, with unemployment levels hovering around 50% for the young. GDP growth was negative in 2009 and 2010, barely positive in 2011, and now has gone negative again for the first half of 2012 with consensus estimates for all of 2012 coming in around -1.5%. The housing market is in shambles after a boom and bust. Where are the plans to address crisis-level unemployment and jump start economic growth? Where are the plans to fix the housing market?
It’s interesting to note the similarities between Spain and Ireland, both of which pursued fiscally responsible policies prior to the financial crisis. Spain ran budget surpluses in 2006, 2007, and 2008. In 2009, Spain’s public debt was under 60% of GDP, well below the EU average. Even now, after the crisis, it only stands at around 68% of GDP. Like Ireland, Spain is not a tale of fiscal profligacy, it’s a story of a country that experienced the collapse of an asset price bubble followed by a banking crisis. Awhile back, Paul Krugman noted that Rogoff and Reinhart got the correlation between public debt as a % of GDP and economic crisis correct, but they had the causation reversed. An economic crisis causes public debt to skyrocket, not vice versa. Spain is a perfect example.
Where do we go from here? What will the political repercussions be, both in Spain and in the rest of the EU? Will Ireland and others demand a renegotiation of their bailouts to remove or reduce the austerity measures attached to them? What impact will this have on the Greek elections? Will the contagion spread to Italy next?
Lots of interesting discussion all around regarding neoclassical economics and DSGE models (see recent blog postings by Krugman, Keen, et al).
Let’s cut to the chase:
Between November 2007 and October 2009, the unemployment rate increased from 4.7% to 10.0% and the size of the workforce shrank by almost 9 million jobs. Many businesses closed or ran idle as sales plummeted.
What exactly caused almost 9 million jobs to be lost over a period of less than two years and output to tumble?
Did workers suddenly decide that they valued leisure over labor to a much higher degree than they previously thought and so voluntarily chose to stop working?
Did workers suddenly decide that they wanted significantly higher wages and so priced themselves out of the market?
Did real capital (plants, equipment, etc.) suddenly become less productive?
Was there some sudden change in technology that rendered production techniques LESS efficient?
Did the available physical quantity of some critical raw material suddenly plummet?
If the answer to the above five questions is “no, obviously not” then DSGE models not only failed to PREDICT the crisis, they are also incapable of EXPLAINING the crisis.
DSGE models rely on an exogenous shock to initiate a change in economic activity (downturn or upswing). Neither a fall in house prices nor an increase in oil prices counts as exogenous, these are simply markets in action (examples of exogenous shocks here would be tornadoes destroying homes or embargoes against oil producing nations). So where is the initial exogenous shock?
Once the initial shock (which still hasn’t been identified) occurs, DSGE models rely on various “frictions” to explain how the economy could remain in a depressed state for a period of time rather than immediately returning to a full employment equilibrium. Sticky wages are probably the most frequent friction assumed. Before we ask “why wages don’t fall during a recession” we should ask “why should wages fall”. Every first year econ student is told that the price of labor (the wage rate) is determined by supply and demand and that supply is determined by the marginal disutility of labor (the work/leisure tradeoff) and demand is determined by the marginal productivity of labor. Why should we simply assume that the “true” price of labor is suddenly lower than the market price and that the reason there’s a discrepancy is because wages are “sticky”? What if there is no discrepancy and the market price for labor is correct (one would think this would be an economist’s first reaction)? We are making the hidden assumption that pricing errors are the only thing that can cause a market to fail to clear. Back to the question of supply and demand – if we are going to argue that the price of labor should be lower, we need to explain why, in terms of the marginal disutility and marginal productivity of labor. In other words, either workers have suddenly become lazier or they have suddenly become less productive. Which is it and why?
I would like the DSGE proponents to clearly articulate the cause of the above, without reference to money, finance, or anything else outside the framework of their models. I want to see the “microfoundations of the crisis” if you will.
Krugman, DeLong, et al really need to hit this one head on.
I addressed this in what I thought was a much clearer manner some time ago:
To make it easier to grasp, I’ve put it all in one nice, easy to understand graphic:
This diagram is key to understanding the dispute between so called
freshwater economists and saltwater economists. When the former argue
in favor of Ricardian Equivalence, they are arguing that any increase
in consumption today necessitates a decrease in consumption in the
future. This is just another side of the argument that an increase in
consumption necessitates an equal decrease in investment or that an
increase in government spending necessitates an equal decrease in in
private sector spending.
Guess what? They are right IF the economy is operating at capacity
(on the frontier in the above diagram). They are wrong IF the economy
is operating below capacity (inside the frontier in the above
Freshwater economists make the assumption that the economy is always
operating at capacity (on the frontier). This is also the reason why
they dismiss the Keynesian multiplier out of hand. For an economy
operating at capacity, there is no multiplier effect, just a crowding
out effect, because the economy is already operating at its limit
given the existing constraints of resources and technology.
In effect, freshwater and saltwater economists are describing two
completely different worlds. The former are describing a world in
which all available factors of production (labor, capital) are fully
employed. The latter are describing a world in which there are
unemployed workers and idle capital. We can save the discussion of
WHY there are unemployed resources for another day. What matters now
is that we start with a model that describes the world as it is, with
the problem we’re trying to solve not assumed away.
The OWS protesters have gotten everyone’s attention now, and started a conversation (that probably should have taken place in late 2008 or early 2009, but better late than never); it’s now time to move from just occupation to an actual program for moving forward.
Get rid of all of the demands that aren’t related to the economy. Issues like animal rights, gay marriage, and other social issues are creeping into the conversation. They’re all fine issues that deserve a hearing of their own. However, with regard to what is trying to be accomplished here, they’re a distraction.
Have both a short term agenda and a long term agenda. We have a lot of short term problems right now. Many are symptoms of longer term issues. Both sets of issues have to be addressed, but sequence and priority is critical.
Keep the agenda points short and concise. Limit the number of them. Don’t get mired in the details.
Here’s a good starting point:
This is the sort of agenda that will resonate with the American people. The statistics on the decline of the American middle class are indisputable. When confronted with this, the 1% will have no choice but to remain silent or change the subject. Keep pushing.
“If you were president, and you received a call at 2AM stating that Greece has defaulted, the contagion has already begun to spread to several other European countries, and a number of large European banks are hours away from bankruptcy and about to trigger a repeat of the 2007-2009 financial crisis, what would you do?
“Before you answer, Mr. Candidate, understand the following. In 2008, the US exported $325 billion in goods and services to Europe; in 2009, that figure dropped to $258 billion due largely to the financial crisis and recession. That effect alone was enough to trim over a half a percentage point off of GDP growth, and Europe was not the center of that crisis. In this case, we could likely expect the impact on US GDP to be an immediate multiple of that. However, that’s not the biggest problem. The biggest problem is that US Money Market funds have nearly $1 trillion in exposure to European banks. Once again, the entire US financial system, and much of the world financial system, are roughly 24 hours away from complete collapse.”
“The Chairman of the Federal Reserve and the Secretary of the Treasury have been meeting all night and are prepared to brief you on the situation as well as lay out their plan for avoiding catastrophe. It involves extending unlimited liquidity lines to the ECB and other central banks as well as massive capital injections into the largest domestic banks. We have the chairmen of the SEC and CFTC along with the president of the NYSE on standby to dial in.”
The answers to this question should be quite illuminating for a number of different reasons. They will immediately demonstrate which candidates have a grasp of economic policy issues and which do not. This represents a crisis situation that demands a solution, and will demonstrate candidates’ capability to respond to an emergency. It is a specific question that demands specific answers, rather than ideology, handwaving, and spinning of past accomplishments.
The Fed is clearly aiming to do the minimum amount it thinks necessary in an effort to extend the effectiveness of its available tools. The other components of the expected action – a cut in the interest rate on excess reserves and a commitment to maintain the size of its balance sheet for an extended period are coming, just not yet. So are additional asset purchases. This is a mistake, and is reminiscent of Fed policy in 2007 – a quarter point cut here a half point cut there, until they woke up to the severity of what was happening around them.
Obama’s “pivot to jobs” was amazingly short – roughly one week in duration. Apparently, we’ve now returned to deficit reduction as the primary focus, with the President unveiling his new millionaire’s tax proposal. This is absurd. Deficit reduction is not the most important issue facing the country right now. In fact, it should be pretty close to the bottom of the list of priorities. When the economy has been growing at a rate >3% per year for at least two years AND unemployment is below 6% and, then we can focus on deficit reduction. Although I have a hunch that once we reach that point, there won’t be much to talk about since most of the deficit “problem” will have resolved itself. As of right now though, it’s a distraction, and anything we do to reduce the deficit will make the economy WORSE.
The official release has a good breakdown and details, so no need to reproduce that here.
$447 Billion Total
$253 Billion in tax cuts/credits
$194 Billion in spending
- Extend last year’s payroll tax cut for another year and increase the cut from 2% to 3.1%. $175 Billion
- Cut employers’ share of payroll taxes in half (from 6.2% to 3.1%) on the first $5 million in payroll (covers 98% of businesses). Eliminate employers’ share of payroll taxes entirely for any new workers or raises for existing workers, up to $50 million per company. $65 Billion
- Extend 100% expensing of new capital investment for businesses for one year. $5 Billion.
- New tax credit of $5600 to $9600 for each veteran hired.
- New tax credit of $4000 for each long term unemployed person hired.
- Direct aid to states to prevent layoffs of teachers, police, and firefighters. $35 Billion
- Modernizing public schools and community colleges. $30 Billion
- Investment in roads, rails, and airports. $50 Billion
- Infrastructure bank creation to attract private funds for additional investment. $10 Billion
- Project Rebuild, putting people to work rehabilitating houses, businesses, and communities. $15 Billion
- Expanding wireless broadband access to >98% of Americans.
- Reform and extension of unemployment insurance. $49 Billion
- Worker training programs. $5 Billion
There’s also a section on helping more Americans refinance at lower rates than are able to today.
My initial thoughts are it’s a decent plan. Highly focused on capital improvements and front loaded. Will have a positive impact, but is too small to reduce unemployment by more than about 1 percentage point over the next year and a half, and after that the stimulus effect peters out. The obsession with “paying for” the plan almost immediately after it ends will hurt the economy at that point. I don’t think a lot of politicians get the fact that stimulus is SUPPOSED TO increase the deficit, that’s how it works. My biggest concern is that it will not survive Congress intact – House Republicans will insist on stripping out almost all of the spending and probably on scaling back some of the consumer (as opposed to business) tax cuts.