Is the Fed out of bullets? Can/Should it do more?

a friend asks...

First off, I certainly do believe the Fed is by no means out of bullets. This is, of course, a longstanding debate -- originally it was Keynes vs. Milton Friedman -- on whether monetary policy can be effective in a liquidity trap. The demand for money has increased a lot, which means declining velocity and a money multiplier less than one. More monetary stimulus in the form of quantitative easing tends to wind up back at the Fed in the form of excess reserves. This clearly makes the going more difficult, and since the Fed is not used to managing the economy except by using the Federal Funds rate, any economy that is very nearly liquidity-trapped could benefit from fiscal stimulus. Yet, the impact of QE is clearly greater than zero -- every time it has been announced, in the US and elsewhere, it has made an impact on markets -- exchange rates and bond yields, which is enough evidence to know that it "works". Recently, even when the Fed has merely hinted at doing more, the markets have responded in a big way. In addition, the Fed has a number of other options at it's disposal, virtually all of which have already been proven to move the dial. I.e., they could cut the discount rate. (When they foolishly raised this rate to .75 in the beginning of 2010, the dollar strengthen and borrowing costs rose...) They could cut the Federal Funds rate all the way to zero (everyone agrees this works...). They could target the longer rates instead of doing QE. And they could promise to keep the Federal Funds rate at zero through the middle of 2013 -- no matter what (the recent language, far weaker, had a big impact on markets...). They could, and should, announce that their inflation target is 2% (not at or just below 2%), and that they will do whatever necessary to hit that rate. They could raise their inflation target to 2.5% (or higher). They could set a nominal GDP target. Or announce that they, like the Australians, will do "price level targeting" where, if inflation is below there target, as it has been for years, they will try to overshoot it so that on average they hit their target. They could try to flatten the yield curve "Operation Twist", or trade their short-term treasuries for agency/sub prime debt. They could target a weaker dollar (although this is usually thought to be Treasury's job, and I wouldn't necessarily recommend this, but it's a clear option). And they could cut the interest rate they pay to banks to hold reserves at the Fed, or even go negative. That's already 14 different things the Fed could do, and all of them are more-or-less proven. Now, this may all seem fairly obvious, and it is, but you'd be surprised at how many top economists, including, unfortunately, those on the FOMC, do not grasp this, and equally surprising how often you read that the Fed is almost out of bullets, with no actual evidence in support of such a thesis: http://www.nytimes.com/2011/09/03/business/economy/almost-out-of-tricks-fed-may-train-sights-on-longer-term-rates.html.

Re: Do we want the banks to lend? In short, yes, we do. A related question is: Do we really want consumers to spend? Obviously, consumers borrowed too much and need to pay down their loans. But when they all try to save at once, no one is spending, and then incomes are falling and consumers need to increase their savings rate even more... Same holds true for the banks. If none of the banks are lending, then consumers aren't taking out loans to buy houses, and then the economy is depressed and more houses are underwater and more mortgages are in foreclosure... Paying interest to banks on Fed holdings was probably meant as a back-door bank bailout. This isn't quite as atrocious as it sounds -- good banking regulations usually give banks both carrots and sticks -- easy, but limited profits but stiff regulations to ensure the stability of the system, and this is probably meant to be one of the carrots. Given the macro benefits, I don't think cutting the rate paid to banks would necessarily be negative on net for the banks, but I also think the Fed should do a range of things at once -- use language, cut the Federal Funds rate to zero, cut the discount rate, announce an inflation target of 2.5%, promise to hit that target, etc. If the Fed stimulated the economy, and inflation became a problem, the Federal Reserve, once again, has no shortage of weapons with which to fight inflation. Worrying about inflation now is exactly like having your house catch fire and worrying about the carpets getting wet when the fire trucks show up... For example, one thing the Fed could do, if the banks start to lend out too much of their excess reserves, is simply for the Fed to raise its reserve requirements. This would stabilize banking and reduce inflation. But thinking about exit strategies now seems premature... We're Japan, and just like Japan we are likely to have a depressed economy indefinitely, unless monetary policy suddenly gets better, which just isn't in the cards for this group of FOMC members.

Yglesias has this right...

Nominations Oversights May Be Obama's Biggest Sin.

Especially if we throw Ben Bernanke into the mix...

Worse than I thought...

“Most of the economic policies that support robust economic growth in the long run are outside the province of the central bank,” he said.
...
"The recent data have indicated that economic growth during the first half of this year was considerably slower than the Federal Open Market Committee had been expecting, and that
temporary factors can account for only a portion of the economic weakness that we have observed. Consequently, although we expect a moderate recovery to continue and indeed to strengthen over time, the Committee has marked down its outlook for the likely pace of growth over coming quarters. "With commodity prices and other import prices moderating and with longer-term inflation expectations remaining stable, we expect inflation to settle, over coming quarters, at levels at or below the rate of 2 percent, or a bit less, that most Committee participants view as being consistent with our dual mandate."

And yet the Fed does nothing. Awesome.

Jackson Hole is Here

Always dangerous to make a prediction of an event which is very close to happening, but I think Krugman has it correct -- whatever Bernanke announces today it will be too little. And, the underwhelming nature will be be immediately apparent. If I were Fed Chair, I would announce that short-term rates would stay at zero through the middle of 2013 no matter what, that I would allow temporary (but only very mild) overshooting of the 2 percent inflation target, that I would cut the Federal Funds rate all the way to zero, that I would cut the discount rate to .5. And none of this involves the "controversial" QE, which Bernanke could, and should, also adjust upward.

I disagree with Krugman on the importance of political pressure from the right. Here's a revelation: although obviously the criticism of Bernanke coming from the right is backwards, the criticism actually comes because Bernanke has done a poor job guiding the economy. If the economy were increasing at a 4 percent annual rate, I think we would find generally less criticism of Bernanke, and more support and pushback on fringe critiques from the media at large. And deservedly so.

What really is holding back Ben Bernanke is the five other Republicans on the FOMC, and the even the Democrats on the committee, not all of whom have been vocal supporters of less passive monetary policy -- even in private.

Also, I think the Woodford opinion piece in the FT was a bit off-base. If doing more QE were a mistake, it really would be only for political reasons, and Woodford is profoundly wrong to suggest otherwise.

Look, QE works, in part, because market participants see that if the Fed is being more aggressive buying more bonds over the next six months, then it's unlikely that they will raise rates anytime soon to fight inflation. In other words, it affects expectations about the future. The logic that more QE "just ends up as excess reserves" may sound true, but is deeply flawed. Look, Treasuries are just assets -- like any other assets. Suppose the Fed were to buy up all the Treasuries on the planet. Doing so would almost certainly lead to negative interest rates. As yields fell, yes, more money would be held at the Fed as excess reserves, but also some of it would slosh over into corporate bonds, the stock market, and other assets, such as real estate. And lower long-term yields would reduce borrowing costs.

In addition, as this blog has stated repeatedly, whenever QE has been announced, it has made an impact on prices. This is evidence that QE works.

Woodford writes that "The problem is that, for this theory [QE] to apply, there must be a permanent increase in the monetary base." But of course, that isn't literally true. If the Fed started now buying up all of the Treasuries on the planet, yields would fall -- probably the moment such a plan was announced. The need for such purchases to be irreversible is a purely imaginary need born of Woodford taking his play economic models too seriously, but more probably misunderstanding them. The guy might be a great theoretician, but his insights do not transfer to the conduct of real world economic policy.

To show QE "doesn't work" he writes about how Japan's experiment failed because it wasn't permanent. But Japan never actually did much QE at all -- just $300 billion, and then reversed it when their economy got better. Now, although I am a major proponent of QE, I think they did too little for it to have worked, but as soon as they reversed it, their economy did slip into recession. Hence, there's absolutely nothing you can point to from the Japanese dealings with QE which would lead you to conclude that QE doesn't work.

Woodford also sees harm in more QE: "But a further round of easing could actually do harm, by giving policymakers an excuse to avoid taking actions that would do more to help the economy." I think this ignores the political dynamic in the Congress -- the Republican party has every incentive to see that economic growth is dismal next year.

Instead, Woodford tells us that what we need is "clarity" from the Fed. But the Fed has already been clear -- it will act if we face an actual recession. Decades of Japan-style slow growth are just fine. I don't really agree with Woodford that the Fed's become harder to read... they've been pretty predictable thus far. Perhaps Bernanke will prove me wrong?

Dear NYT: The Fed is Impotent, but only by Choice

Catherine Rampell asks "How much more can the Fed help the economy?" and answers that "there are reasons to believe the Fed’s remaining tools may be losing their potency."

However, the evidence she offers is weak. Yes, we're close to the zero lower bound on the Federal Funds rate, but there's really no evidence that all of the other various options the Fed has at its disposal wouldn't work. As written on this blog numerous times, QE announcements and hints have moved markets every time, as did Bernanke's simple statement that he would keep the funds rate low through the middle of 2013 if conditions warrant.

Instead of looking at QE's impact on market prices, Rampell bases her argument around economic performance:

“It’s hard to make the argument that QE2 was a rousing success or we wouldn’t be on the verge of seeing QE3,” the economists at RBC Capital Markets wrote in a client note. “The market may very well get what it seems to desire, but we believe there is no magic bullet here.”

But of course, by this logic, those 7 Federal Funds rate cuts in 2008, when the rate went from 4.25 to 0-0.25 by Q4, 2008, when GDP fell at an 8.9 percent rate, were particularly unhelpful.

Rampell writes that "Twice now the Fed has engaged in large-scale asset purchasing, a process known as quantitative easing." As if two interventions in the past three years is somehow uncharacteristic, especially given that the interventions were split by an increase in the discount rate -- an increase which strengthened the dollar and caused longer-term treasury yields to rise. In normal times, the Fed tinkers with the Federal Funds rate extensively -- in 2008, for example, the Fed cut the Federal Funds rate 7 times, and the discount rate 8 times. In the first 7 months of 2011, by contrast, the Fed made almost no changes to its policy stance whatsoever, despite discovering an economic reality very different from its forecast.

In fact, since 1971, in no three year period has the Fed ever tinkered so little with policy (see here) as it has since the beginning of 2009. This is more than a bit strange given the wide chasm between recent Fed forecasts and economic reality.

The ECB is Crazy

Via Matt Yglesias, FT Alphaville has a nice graphic showing how ECB rate increases -- responding to mostly temporary commodity price shocks -- have triggered the recent phase of the Euro-debt crisis. It would have been very unlikely for Italy and Spain to have gotten into trouble without the past two rate increases.

At FT Alphaville, Joseph Cotteril quips that "On the bright side, at least the ECB left more room to cut rates?" Yet, of course, the ECB has always had room to cut rates, as at no point in the past three years did the ECB's main policy rate fall below 1 percent, while Eurozone core inflation has remained below 2 percent and Eurozone GDP is still roughly 2 percent below its 2007 peak. Although it's commonly thought that Ireland, Portugal, and Greece would be in trouble regardless, one really does have to wonder what the Eurozone would look like if Lars Svennson were setting rates. Germany has an output PMI consistent with GDP growth of less than .5%. Had the ECB been targeting German GDP growth successfully at 3% over the past few years, things would look quite different. Instead, German GDP the past 4 quarters is not even 1 percent larger than the pre-crisis peak -- so of course the Euro is in crisis.

And yet, there has been very little public pressure for the ECB to change its ways.

Don't Get Too Excited About Jackson Hole

Markets are apparently getting excited about the prospect of more intervention from the Fed. They would do well to temper those expectations, given that the most critical hard economic data -- unemployment and inflation -- point toward a Fed doing less, not more. CPI was up .5% in July, with even the core up .2%, and up 1.8% over the past 12 months, means that the Fed would be reluctant to do much more regardless of unemployment. And payroll employment was up 117,000 in July -- a bad number for most Fed's, but promising given the past few months, which means Bernanke will stand pat.

I was, admittedly, surprised at the July inflation numbers, as reduced inflation in automobiles stemming from the tsunami was already built in, and the increase in the core rate fell only from .3% to .2% in July, due to countervailing increases in the price of services, including shelter.

This is the highest the 12 month change in core inflation has been for over 2 1/2 years. I definitely don't see the Fed doing more. In fact, I would expect Bernanke to give stern warnings about an exit strategy if inflation doesn't slow in the coming months (which, I predict, is likely).

Seeds, Germs, and Slaves

Longtime readers of this sight will know that TV is a big fan of, what I call, the Diamond-Crosby-Kamarck-Sachs theory of development. Hence, I'm looking forward to reading Thomas C. Mann's updating of the utterly brilliant Alfred Crosby book "Ecological Imperialism" with "Seeds, Germs, and Slaves", reviewed in the NYT here.

From the review, it looks like it may be an interesting book of anecdotes, but it's not clear what new big theoretical insights the book contains... And so I can sigh, as my thunder may not have been stolen just yet!

Economists for Obama no Longer Advocating for Obama...

Economists for Obama reacts to the debt-deal with this:

Yuck.

That's what I have to say about President Obama's capitulation to the hostage-taking ways of congressional Republicans.

I suppose I might change my mind, but after watching the President give in to the Boehner-McConnell blackmail axis, I don't imagine I'll be spending much of my time advocating his re-election. Assuming he's the Democratic nominee, which I do, I'll vote for Obama, because the alternative will still--somehow--be worse. But I really can't see how, in good conscience, I could defend the economic policies of a guy who has signed on to fiscal contraction in the midst of a major downturn. And that's leaving aside the President's apparent lack of understanding of the importance of bargaining from strength. So much for all that poker expertise he's supposed to have.

What a shame.

I think this is completely wrong-headed. Although I think Obama could have gotten a better deal, and should not have agreed to this, one of the key details is that it cuts budgeting authority by just $22 billion in 2012. That should reduce GDP growth by just .3 percent. Obviously, that's not the direction we want to move in, but that alone should have limited impact. My sense is that anything after 2012 will need to be ratified by future Congresses. I'm not really clear on how much "inertia" the deal will create, but I don't see how this deal is grounds to dramatically reinterpret one's support for Obama. The President could likely have gotten smaller cuts in 2012, but would have been really hard-pressed to get a small increase. Should the president have threatened default over $20 billion in 2012 spending? That seems like a judgment call...

The other issue here is, say Obama had gotten $100 billion in stimulus spending. I suspect, in that case, the Fed would not have changed its language at the last meeting (after which, two year Treasury yields plummeted). In short, not clear that fiscal policy mixed with a Fed that just isn't willing to play ball is the answer here.

A Note on the Texas Unmiracle

Never too late to chime in on the Texas Unmiracle, which Paul Krugman wrote a column about, and then blogged, twice.

One particularly interesting aspect of The Texas Unmiracle is actually to look at jobs gained by sector, particularly comparing "free-market" Texas with "socialist" California during the recovery. Turns out that from it's employment trough in early 2010, California has gained 209,000 jobs, less than Texas's 349,000. Yet, 61% of the difference came from government employment alone. That's right, Texas added nearly 28,000 government jobs over this period, while California's government bled 57,600 jobs. The other main differential job gain was in "mining and logging" -- a sector which has bounced back nationally. And Texas employs 10 times as many workers in this sector to begin with... These two sectors, combined, already explain 93% of the difference in jobs gained.

Of course, one should keep in mind that California is a larger state, and so it "should" have gained about 40% more jobs. But of course, the differential jobs in government, mining and logging, and the impact of higher oil prices, and one would expect that differential gains in these sectors would feed into retail and construction.

Hence, to the extent that Texas has done well owes to the growth of government employment.

(All data SA, from BLS.)

Blame it on the Fed...

Because the Fed is simply not impotent at the zero lower bound.

There are a number of options the Fed now has, and market reactions, theory, and common sense all suggest that they can be effective. The Fed can cut the discount rate. When it raised the discount rate in 2010 -- for mysterious reasons since core inflation has remained below target for 3.5 years now -- the dollar rose and the stock market retreated, as theory suggests it should. The Fed can do more QE. Whenever the Fed has hinted recently at QE, the markets have responded in a big way, and when the Fed has tamped down the possibility of doing more, the markets have reacted negatively. The Fed can use language to be more explicit about the duration of the zero interest rate policy. When the Fed said it would keep rates low through the middle of 2012, 2 year government bond yields plummeted. And when QE has been announced anywhere -- the US, Japan, or Europe -- it has caused currency depreciation and lower yields on government bonds.

The Fed could also stop paying interest to banks on reserves (or go negative), it could target lower long-term rates, and it could promise to continue doing QE until core inflation hits 2%. Instead of doing domestic QE, the Fed could increase its holdings of foreign currency, or it could target state and local debt, to make it easier for local governments to borrow. In short, there is no reason to think that the Fed is "out of ammunition". Yes, more QE would tend to wind up in excess reserves, but it also pretty clearly changes prices. And prices matter.

Unfortunately, in private conversations, some of the members of the FOMC itself believe that the Fed is tapped out. (Actually, their beliefs are incoherent, as these officials conceded QE affects both bond yields and the dollar.) Prominent members of the administration also believe that the Fed can do little. This, probably more than anything else, explains the reluctance of the administration to fight for its Fed appointments.

The implication of a Fed that is quite clearly not tapped out is that the current state of the economy is the Fed's doing. As this blog made clear, monetary policy has been unnecessarily tight since the beginning of 2009, when the Fed inexplicably started contracting its balance sheet in the midst of the worst recession since the Great Depression. In 2010, it decided, prematurely, and despite nary a hint of inflation, to raise the discount rate. Then, when the economy faltered, it decided to postpone action until after the election. And now, once again, with the economy performing much worse than it had anticipated, with inflation still below target, with markets falling and with stimulus phase-out and state and local budget woes promising to subtract 3% of GDP growth the next 4 quarters, the Fed responds by effectively doing nothing.

Although no one's talking about it, the handling of your Fed appointments, and little else, might have been what sank your administration. Yet, there still is time. There are two FOMC seats open, and a third opens up in January. Make the most of these appointments, and you will beat Rick Perry. Continue to dawdle, or make more poor choices, and you are asking for a tough, tough reelection fight.

Announcement: Thorstein Veblen Now Able to Blog

Good news: Thorstein Veblen is now cleared, once again, to blog.

This blog will resume shortly, and could hardly come at a better time -- with economies mired in liquidity traps on both sides of the Atlantic (and Pacific), with another recession looming, and with the possibility, Mr. President, that you will last only one term.

Mr. President, you are now trading at 50.7 on intrade. Sure, online prediction markets aren't perfect, but still, given the state (and likely future state) of the economy, 50.7 sounds like it might be a short sale to me. 50.7 is a wake-up call.

Announcement

This is TV's personal assistant, reporting on behalf of TV.

I am proud to announce that Thorstein Veblen will resume blogging from the middle of next week. His current duties prevent him from commenting publicly, and so he has been biting his tongue for quite literally months now, but can hardly wait to resume giving advice to this President, who has never been more in need of advice as he is at the moment. Though the economic problems facing the nation are immense, the solutions are actually quite simple. Stay tuned to find out!

-TVs assistant

Words from Our Sponsors...

Given chosen field -- graduate student, public service, and blogging, none of which pay much, T.V. is not above selling advertising space on this blog. It's far easier for me to rationalize time spent blogging when I'm getting paid for it (if only a little)... Hence, there may occasionally be pretty obvious ad's on here...

Announcement

Due to conflicts of interest arising from my current employment, this blog will come back to life in mid-August, 2011.

Thanks to all my loyal readers who've written in over the years. I'm still doing fine -- I've just had major career developments.

I've had a number of interesting experiences, and new research interests and insights that I'm eager to share. Stay tuned for this fall.

Yours, T.V.

Cost Increases in Higher-Ed

Marginal Revolution and Matt Yglesias both take swipes at the reason behind huge cost increases in higher education, and what can be done about it. I agree with Matt that a big part of the problem is the so-called Baumol effect, in which teaching a 90 minute lecture has, at least historically, not really been subject to any large productivity gains at least since the chalkboard -- it still takes 90 minutes. It might turn out that there could be future productivity gains here -- if Paul Krugman decides to offer his lectures, via webinar, to students at universities all over the US, and then to test the students electronically (or via local TAs), there could be some cost reductions. However, I don't see this type of thing catching on in any big way anytime soon, although Brad DeLong has/is reportedly trying something similar at the UCs, in part because most college faculty have a vested interest in seeing that this does not happen. Yglesias' idea of credentialing sounds like a really good one to me. I remember when I was first considering applying to Econ Phd programs, I really needed to take lots of math classes as quickly as I could. I probably should have considered University of Phoenix, but instead I was just forced in to taking a bunch of math classes one semester (since there were few offered in the summer), but was severely limited in how many courses i could take by the fact that the finals for these courses were limited to a five-day finals period. With 3-4 days to prepare for each final, I might have been able to take 7 or 8 courses over a six month period, but instead what happened was that I had to take three finals in a 24 hour sequence, got really exhausted midway, and didn't do as well I might have had I had more time. Obviously, this is inefficient. However, once gain, it's not clear that changing this state of affairs would be a good idea for most universities. If students can take more classes per semester, they could then graduate sooner, pay less tuition, and feel less of a bond to the school.

One under-rated factor in the cost of college tuition, especially at the higher end of the market, is that students tend to be fairly insensitive to prices, and there is no perfect competition among schools. There is only one Harvard, and thus it has market power to charge more than Yale. At the higher end, this cost insensitivity must arise in part due to trends in inequality in America. The sons and daughters of hedge fund managers will just choose the "best" university they can get in to, and it will be an investment that will be worth it, largely due to the signalling value. Hence, it would now likely make sense for most prestigious public schools such as UC Berkeley, to simply raise their tuition in order to compete for better faculty, better athletic coaches, and better facilities in order to rival Stanford. And given the state of inequality and the American quest for status, top universities could probably raise their tuition substantially before having to worry about reduced enrollment. At some point, of course, students will go to cheaper options (especially in a recession), but I'm quite curious what the data say about what happens to enrollment when tuition rises. I suspect schools find that raising tuition almost always raises revenue, and on a 1 for 1 basis (schools like Berkeley are going to fill their enrollments...)... Until this ceases to be the case, there will likely continue to be rapid appreciation in the cost of higher-ed, and no real productivity gains. What's more, due to the signalling value, ever more Americans will spend huge chunks of money to collect even more MBAs and other degrees of dubious value.

It's a prisoner's dilemma scenario, and the only solutions are likely to be heavy-handed centralized intervention. On the positive side, education, when done well, really is priceless, and so an ever-increasing share of GDP spent on it is not exactly the world's greatest evil.

And now a word from our cash advance company: A payday loan is a small, unsecured, high interest, short-term cash loan. On some occasions these loans can be used to pay for higher education. At AAApaydaycash the cash will be sent to your account same day. Applying for these loans is easy, fast and 100% secure.

Budget Craziness...

OK, Mr. President, I think that proposing budget cuts in advance of the Republican onslaught, given the sheer craziness of our media and given the unfortunate state of public opinion, was likely shrewd and necessary political posturing. However, you should be aware of how wrong it is on the merits.

First, let's consider the factors which generally go into determining what the marginal cost of public funds are. Because taxing the populace engenders disutility and discourages work (although not as much as you might think), raising $1 of revenue "costs" society more like $1.05 to $1.10. (This needn't be the case, if policymakers got serious about shifting taxes to gasoline and carbon rather than work or savings, this could be substantially reduced.) Secondly, spending, at the margin, is borrowed. This usually means that the actual cost is even higher. Yet, now the government floats 5-year Treasuries at 2% interest -- an historically low borrowing rate. Meanwhile the Fed predicts nominal GDP growth at 5% over the next few years. Hence, any money the government borrows now will simply be easier to pay back down the road, as a percentage of GDP. This should lead us to discount the marginal cost of government spending at present.

Lastly, and most importantly, are the Macro implications of spending. An additional dollar of government spending is expansionary, and therefore increases inflationary pressure. This raises interest rates, and it also is likely to engender a reaction from the Federal Reserve, who would respond by raising interest rates/keeping rates higher than they otherwise would, in order to keep inflation under control. Hence, there is no effect on overall output, although government spending "crowds out" private investment. In normal times, this is another factor for why we should want the government to be as small as possible. However, now short-term treasuries, the Fed's usual mechanism for controlling interest rates, is stuck at the zero lower bound. Given that core inflation is now at 1.0% for the past 12 months, and expected to be roughly 1.3% for 2011, and given that unemployment is at 9.0%, the Fed would "normally" respond by cutting interest the interest rates, which in this case are unfortunately pegged at zero. The current Fed has been very slow to change course or respond to events, and have largely taken a very passive, wait-and-see attitude to the current economic malaise. During the "we're all gonna die" phase in the wake of the Lehmann collapse, the Fed pumped $1.5 trillion into the economy. Over the following two years, on net, the Fed has done roughly nothing, while inflation has, predictably, stayed at bay and unemployment, predictably, has stayed high. Hence, every additional dollar the government spends now is not likely to be offset by the Federal Reserve -- at least not completely. Not only that, the money that the government spends will increase employment, and will be spent in turn. The CEA formerly used a fiscal multiplier of 1.5, but in a depressed economy, this is likely to be quite conservative. A multiplier of 2 is likely to be more realistic.

Hence, in normal times, $1 of government spending might "cost" $1.20 or so, now we should discount this marginal cost by two factors. The first by the degree to which repaying debt becomes easier in the future, and the second to which that spending increases the size of the economy. Hence, MB - MC = $2 - $1.20*(.97^5) => spend money now! This implies that the marginal cost of public funds, at present, is at an historic low and certainly less than the marginal benefit of government spending, even when we assume that said government spending has no inherent intrinsic benefit, and so cutting spending now makes less sense than at any time in US history since 1937.

But no one in the media apparently understands this, and so it is too much to ask that you stand up for more spending. But what you should keep in mind is that, if you agree to a budget cut of some sort, that it will hurt the economy -- aside from the bad created by cutting government programs and freezing the salaries of federal workers, who are already underpaid and who will stand to lose more talent to Wall Street as a result. And since there will be negative consequences for the economy, it is absolutely imperative that you attach two sensible Fed appointments to whatever compromise you reach.

If not, and despite a rash of good economic news in recent months, our Japan-style economic malaise could well continue for another few years, just as China continues to get rich...

From the Mailbag...

Anonymous writes in: "I'm curious -- why do you think Obama's new gang will be any better?"

Simple, because Obama's new gang does not include Larry Summers! I think that really does imply that the new gang will at least be less-bad than before. One of the under-rated mistakes that the administration made was not changing course on the stimulus once it became as clear as day that it was just going to be too small. That was a Larry Summers-type mistake. I don't think there will be any major changes in policy however, and anyway, with a Republican House Gene Sperling and the new economic team is way more limited in what they can do to influence the economy than was Larry Summers and the old economic team.

The Torch Has Passed...

As everyone is well aware, as of last month, Larry Summers is no longer a part of this administration. Hence, the name of this blog had become a touch anachronistic. While the original mission of the blog -- to see to it that Larry Summers get to spend more time with his family -- has been accomplished, the overall vision of having a Democratic President who makes smart Economic Policies (or at least policies that aren't terrible), is unchanged. While the torch has been passed to a new set of Economic Advisers, the need to keep heat on these people persists. And so, this blog is now devoted to providing Economic Policy advice for President Obama, free of charge.

I plan to continue blogging both sporadically and in an unpredictable manner. The past year has been an interesting one both personally and professionally, and it is very difficult to judge in advance how much time I will actually be able to spend blogging. However, I will continue to hold forth on key issues as I see fit.

Special thanks to all of my advertisers and loyal fans, famous and infamous, who have written in over the years. 2011 is going to be a great year!

About those Fed Appointments...

So, as far as I can tell (disclaimer: I know nothing about how the Senate works), to get Peter Diamond confirmed Reid would need 60 votes to file cloture. I have this on good word from a bar conversation I had last night with a fit blonde Senate staffer (I'd recommend her for WH intern, btw). Her view was, some horse-trading could probably get him through -- come to think of it, you should have attached that to the tax cut.

And now your administration has another appointment to make with Kevin Warsh stepping down.

Your White House needs to move on both of these ASAP. There's an argument to be made that this is the single biggest thing you could do to help the economy in the next couple years, much less your own reelection prospects.

Larry Summers, in retrospect

Not really any surprises in Peter Baker's article on the White House economic team. Still slightly annoying that reappointing Bernanke and waiting so long to fill the Fed vacancies doesn't register at all, much less as clear and critical mistakes. Always breathtaking how little those who cover economics for the NYT actually know. Peter Orszag comes out looking awful -- caring about the short-term budget deficit is actually counterproductive in a severe recession/liquidity trap. Summer's ability to get others to lie for him continues to be amazing -- the White House spokesman who said Summers didn't ask for a car when others have said he did. Summers looks to have been on the right side of the Auto bailouts, Goolsbee on the wrong side (which we already knew, but is still a bit troubling, as Goolsbee still has Obama's ear).

I'm still curious how the $900 billion that Summers & Romer thought were prudent got turned into just $825 in the ask to Congress. Annoying Baker still quotes the "$800 billion stimulus" when it was actually $700 net of the AMT patch. If political considerations were really why Summers & Romer went small on the stimulus, then why didn't they do it in patches (like, insist the AMT get done separately, or put a chunk of stimulus in the budget/health care)? Or make it conditional on the economic performance? And why did they pretend for the next year and a half that they had gotten the stimulus exactly right?

The answer is, of course, that Larry Summers cares about Larry Summers. Larry Summers is brilliant -- he doesn't make mistakes of this nature. Therefore, there was to be no altering of the stimulus once it was a done deal -- even once it was clear to all that the stimulus was too small. And especially since it was clear from day 1, that would have just wounded Summer's pride all that much more. Admitting a clear mistake on what was actually a conceptually simple issue would have demystified Summer's supposed brilliance, and so he had to hang on. And that's how the Democrats lost 61 seats.

I'm actually somewhat hopeful that Obama Economic Team II will be a touch better...
but step #1 would be to move heaven and earth to get Peter Diamond confirmed. I'm not getting that vibe from the WH...

Robots and Wages...

What is the impact of Robots on Wages? Yglesias linked modeled behavior .

My take, of course, is that it's impossible to say but that if there are specific jobs robots can do, then there is likely to be short-term wage pressure on those jobs. In the long run, however, I'd discount the idea that this will necessarily have a huge impact on wage inequality. Turns out robots can probably never do the type of face-to-face, human-like interaction which will only become more valuable in the future. Jobs like being waited on, having your house cleaned, getting a massage... Jobs for which the demand will increase more than 1 for 1 with GDP per capita... (I really doubt massage chairs reduced demand for actual massages...) Second point is, robots fall into the "extremely high TFP" category generally, which means they could be subject to digital camera or computer-like price declines, quickly becoming affordable for rich and poor alike.

Long story short is that even cheap-labor replacing technological advance alone necessarily carries no implications for wage inequality. (Could go either way...)

The interesting thing from the Modeled Behavior post was the view that the income difference between the US and Mexico is only due to a change in institutions. Hence, they argue, take a housekeeper in Mexico, put her in LA, and voila, because of the better institutions in LA, she can now clean more houses because she's more productive, thanks to the unique institutions in LA, such as good traffic, that Mexico cannot replicate.

Of course, that is not the case. She would get paid more for the same work because the US is far wealthier than Mexico, and because Americans are wealthier, we can afford to pay more for a housekeeper. Also, there are relatively fewer unskilled workers in the US, so of course the demand-and-supply yield a different equilibrium. The income-level difference could, of course, be primarily a story of institutions, but it need not be the proximate cause of the wage differential any more than the wage differential between Delaware and West Virginia (at $64k to $26k, is similar to the difference between the US $45k and Mexico $15k is necessarily due to institutions. Human capital, history, trade costs, and historical trade costs could all be factors as well...

Larry No More...

This Administration just got better...

The Euro...

OK, the Euro, as a common currency, has probably not increased trade much, if at all. The basic logic -- separate fiscal authorities, and less-mobile labor markets in the US -- mean that it's clearly less desirable to have a common currency than in the US.

And yet, is this factor at the core of the European problem now? See Krugman's latest.

I tend to think this is just a small part of the problem, albeit larger for the smaller countries within Europe... Since those are higher risk countries, they get double-whammied having their currency float with Germany, meaning that they can't save themselves by devaluing in times of trouble.

But, the real problem, make no mistake, is that Jean-Claude Trichet and other European central bankers are complete fools. His big fear over the past few years has been inflation, a fear which has proven to be unfounded. Had the smaller, poorer countries been able to devalue, then Germany would be doing comparatively worse. But Germany isn't doing well, even though their currency has been much cheaper (thanks to being pegged to troubled countries), which isn't what we'd expect according to the Euro-was-a-bad-idea-and-is-at-the-heart-of-it mess...

The Euro might have been misguided, but the real idiots are Europe's monetary authorities...

Contrast this with Japan. Japan is also not doing well. Hasn't done well for nearly a generation. Should we therefore conclude that Shikoku and Tohoku, heck, the entire Inaka secede from the Yen? Actually, might not be a bad idea... But yet, that the Kanto and Kansai regions, and Japan's economy over all, have not done well imply that a good bit of the blame lies with Japan's foolishly conservative central bank, not the monetary policy decision of Chiba.