Judging by all the ads I saw on my commute this morning, Capital One has rolled out a new marketing campaign. At least half-a-dozen ads on my Metro car announced that Capital One offers interest rates that are five times higher than offered by their competitors:
And what is that 5x interest rate? Just one percent.
Such are times–and bank marketing–when short-term rates are almost zero.
Because they developed methods to help distinguish between cause and effect in the macroeconomy.
The Royal Swedish Academy of Science released a very readable account of their contributions here. Here’s the introduction:
The economy is constantly affected by unanticipated events. The price of oil rises unexpectedly, the central bank sets an interest rate unforeseen by borrowers and lenders, or household consumption suddenly declines. Such unexpected occurrences are usually called shocks. The economy is also affected by more long- run changes, such as a shift in monetary policy towards stricter disinflationary measures or fiscal policy with more stringent budget rules. One of the main tasks of macroeconomic research is to comprehend how both shocks and systematic policy shifts affect macroeconomic variables in the short and long run. Sargent’s and Sims’s awarded research contributions have been indispensable to this work. Sargent has primarily helped us understand the effects of systematic policy shifts, while Sims has focused on how shocks spread throughout the economy.
One difficulty in attempting to understand how the economy works is that the relationships are often reciprocal. Is it policy that influences economic development or is there a reverse causal relationship? One reason for this ambiguity is that both private and public agents actively look ahead. The expectations of the private sector regarding future policy affect today’s decisions about wages, prices and investments, while economic-policy decisions are guided by expectations about developments in the private sector.
A clear-cut example of a two-way relationship is the economic development in the early 1980s, when many countries shifted their policy in order to combat inflation. This change was primarily a reaction to economic events during the 1970s, when the inflation rate increased due to higher oil prices and lower produc- tivity growth. Consequently, it is difficult to determine whether the subsequent changes in the economy depended on the policy shift or on underlying factors beyond the control of monetary and fiscal policy which, in turn, gave rise to a different policy. One way of studying the effects of economic policy would be to carry out controlled experiments. In practice, however, varying policies cannot be randomly assigned to different countries. Macroeconomic research is therefore obliged to use historical data. The laureates’ foremost contribution has been to show that causal macroeconomic relationships can indeed be analyzed using historical data, even in cases with two-way relationships.
There are good reasons to believe that unexpected shifts in economic policy may have other effects than anticipated changes. It is not trivial, however, to distinguish between the outcomes of expected and unexpected policy. A change in the interest rate or tax rate is not the same as a shock, in the sense that at least part of the change might be expected. This is a longstanding insight in the context of the stock market. A firm which reports improved earnings and higher forecasted profits might still encounter a drop in its share price, simply because the market expected an even stronger report. Moreover, the effects of an unanticipated policy shift might depend on whether it was implemented independently of other shocks in the economy or was a reaction to them.
Sargent’s awarded research concerns methods that utilize historical data to understand how systematic changes in economic policy affect the economy over time. Sims’s awarded research instead focuses on distinguishing between unexpected changes in variables, such as the price of oil or the interest rate, and expected changes, in order to trace their effects on important macroeconomic variables. The questions which the laureates have dealt with are obviously interrelated. Although Sargent and Sims have carried out their research independently, their contributions are complementary in many ways.
Over at the New Republic, Bob Solow offers a thoughful review of Sylvia Nasar’s new book, Grand Pursuit: The Story of Genius. Along the way, Solow provides a characteristically clear explanation of what he views as John Maynard Keynes most important contribution:
Back then [in the 1930s], serious thinking about the general state of the economy was dominated by the notion that prices moved, market by market, to make supply equal to demand. Every act of production, anywhere, generates income and potential demand somewhere, and the price system would sort it all out so that supply and demand for every good would balance. Make no mistake: this is a very deep and valuable idea. Many excellent minds have worked to refine it. Much of the time it gives a good account of economic life. But Keynes saw that there would be occasions, in a complicated industrial capitalist economy, when this account of how things work would break down.
The breakdown might come merely because prices in some important markets are too inflexible to do their job adequately; that thought had already occurred to others. It seemed a little implausible that the Great Depression of the 1930s should be explicable along those lines. Or the reason might be more fundamental, and apparently less fixable. To take the most important example: we all know that families (and other institutions) set aside part of their incomes as saving. They do not buy any currently produced goods or services with that part. Something, then, has to replace that missing demand. There is in fact a natural counterpart: saving today presumably implies some intention to spend in the future, so the “missing” demand should come from real capital investment, the building of new productive capacity to satisfy that future spending. But Keynes pointed out that there is no market or other mechanism to express when that future spending will come or what form it will take. Perhaps God has not yet even decided. The prospect of uncertain demand at some unknown time may not be an adequately powerful incentive for businesses to make risky investments today. It is asking too much of the skittery capital market. Keynes was quite aware that occasionally a wave of unbridled optimism might actually be too powerful an incentive, but anyone in 1936 would take the opposite case to be more likely.
So a modern economy can find itself in a situation in which it is held back from full employment and prosperity not by its limited capacity to produce, but by a lack of willing buyers for what it could in fact produce. The result is unemployment and idle factories. Falling prices may not help, because falling prices mean falling incomes and still weaker demand, which is not an atmosphere likely to revive private investment. There are some forces tending to push the economy back to full utilization, but they may sometimes be too weak to do the job in a tolerable interval of time. But if the shortfall of aggregate private demand persists, the government can replace it through direct public spending, or can try to stimulate additional private spending through tax reduction or lower interest rates. (The recipe can be reversed if private demand is excessive, as in wartime.) This was Keynes’s case for conscious corrective fiscal and monetary policy. Its relevance for today should be obvious. It is a vulgar error to characterize Keynes as an advocate of “big government” and a chronic budget deficit. His goal was to stabilize the private economy at a generally prosperous level of activity.
A second characteristically Keynesian theme meshes very well with the first. In a complex economy, many business decisions have to be made in a fog of uncertainty. This is especially true of investment decisions, as already discussed: a lot of money has to be placed at risk today in an enterprise whose future success can only be guessed. (Much the same can be said of consumer purchases of expensive durable goods.) The standard practice is to focus on the uncertainty and think about it in terms of probabilities, which at least allow for an orderly analysis and orderly decision-making. Keynes preferred to focus on the fog. He thought that some of the important uncertainties were essentially incalculable. They would end up being dealt with in practice by a mixture of apprehensiveness, rules of thumb, herd behavior, and what he called “animal spirits.” The point of this distinction is not merely philosophical: it suggests that long-term investment behavior will sometimes be irregular, unstable, and given to doldrums and stampedes. Expectations can be volatile, and transmit their volatility widely. Passive or perverse policy can be dangerous to the economy’s health.
Solow thus credits Keynes with pioneering the “uncertainty” meme, although in a different sense than many commentators invoke it today.
His whole review is well worth a read if you are interested in the history of economic thought, including Fisher, Hayek, and Schumpeter.
P.S. Solow’s comments on Hayek are less enthusiastic than for Keynes, but he does note that “the Mises-Hayek critique of central planning was convincing (and clearly confirmed by subsequent facts).”
Over at Economic Principals, David Warsh summarizes 55 short papers about the big questions that face economics. Among the suggestions:
Most popular of the pitches, judging from the number of SSRN downloads, is, Why Don’t People and Institutions Do What They Know They Should?, by David Cutler, of Harvard University (a pungent exploration of the complexity of aligning incentives within and among organizations); followed by A Complete Theory of Human Behavior, by Andrew Lo, of the Massachusetts Institute of Technology(confront and reconcile inconsistencies across disciplines, complete with summer camps for newly-minted PhDs); Research Opportunities in Social and Economic Networks, by Matt Jackson, of Stanford University (study the patterns of interaction that most economic models abstract away); and Modeling and Measuring Systemic Risk, by Markus Brunnermeier, of Princeton University, Lars Peter Hansen and Anil Kashyap, both of the University of Chicago, Arvind Krishnamurthy, of Northwestern University, and Lo, of MIT (build network models and collect new and often sensitive data) .
…
In macroeconomics: Randall Krozsner, of the University of Chicago, offered a concise blueprint for improving the dialogue between financial economics and macro, beginning with more attention to economic history. Kenneth Rogoff, of Harvard, described a three-item wish list, including a better cost-benefit analysis of financial-market regulation. Martin Neil Baily, of the Brookings Institution, described a series of fundamental questions and appended a strong brief for evolutionary economics. Ricardo Reis, of Columbia University, suggested investigating more carefully the potential upside of transfer programs such as Medicaid, tuition assistance, disability insurance and early retirement for combating recessions. Glenn Hubbard, of Columbia, called for more modeling and estimation of fiscal policy multipliers “outside of the heat of battle of individual policy debates.” And Herbert Gintis, of the Santa Fe Institute, plumped for more agent-based modeling.
Read David’s entire post for many more.
Federal Reserve Chairman Ben Bernanke is often characterized as a inflation-monger. There’s just one problem with that criticism. As David Leonhardt demonstrates in the New York Times, when it comes to inflation, Bernanke is a piker compared to most of his predecessors:
Inflation has averaged just 2.3% under his leadership (as officially measured), less than under Greenspan, Volcker, Burns, or Miller and only slightly more than under Martin.
It’s conceivable, of course, that inflation will take off in coming years, and the critics will be proven right. At this point, however, that’s nothing more than speculation. And before you make that bet, keep one thing in mind. Bernanke is the first chairman to have the ability to pay interest on excess bank reserves. That’s a powerful tool for keeping reserves out of the marketplace if the inflation genie threatens to come out of its bottle.
The Fed’s quantitative easing programs did indeed lower interest rates, but more so for Treasuries and mortgage-backed securities than for other kinds of debt. Small businesses are overrated as job creators. Extended unemployment insurance does increase unemployment rates, but not that much.
Those are just a few of the findings from papers presented today at the Brookings Institution’s twice-yearly conference, Brookings Papers on Economic Activity.
Courtesy of a Brookings release, here are brief summaries of five papers discussed today:
In Recession and the Costs of Lost Jobs, authors Steve Davis of the University of Chicago and Til von Wachter of Columbia University find that when mass-layoffs occur in good economic times, men with 3 or more years of job tenure suffer a $65,000 loss in the lifetime value of their earnings (a fall of about 10%), relative to otherwise similar workers who retain their jobs. But in a recession, a similar shock causes workers to lose $112,000 in the lifetime value of their future earnings (or about 19%). The authors also track worker perceptions about layoff risks, job-finding prospects, and the likelihood of wage cuts, finding a tremendous increase in worker anxieties about their labor market prospects after the financial crisis of 2008. This heightened anxiety continues today, they find. Davis and von Wachter also show that prior economic employment models have been unable to address the facts about the earnings losses associated with job loss, yet those earnings impacts appear to be one of the main reasons that individuals and policymakers are so concerned with recessions and unemployment. Finally, they note that pro-growth policies may be the most efficient and cost-effective means available to policymakers to alleviate the hardships experienced by displaced workers.
In What Do Small Businesses Do authors Erik Hurst and Benjamin Wild Pugsley of the University of Chicago overturn the conventional wisdom about the role of small business, finding that they aren’t the job engine most believe them to be. Most small business owners neither expect nor desire to grow or innovate, but rather intend to provide an existing service to an existing customer base. Analyzing new survey data, the authors find that, instead, it is non-financial reasons — such as work flexibility and the desire to be one’s own boss – that are the most common reason that entrepreneurs start their own business. Hurst and Pugsley note this behavior is consistent with the industry characteristics of the majority of small businesses, which are concentrated among skilled craftsmen, lawyers, real estate agents, doctors, small shopkeepers, and restaurateurs. They conclude that standard theories of entrepreneurship may be misguided and result in sub-optimal public policy, suggesting that subsidies for small businesses may be better spent if they are targeted to businesses that expect to grow and innovate, rather than small businesses in general. They laud the partnership between the US Small Business Administration and venture capital firms as an example of strong targeted public policy.
In Unemployment Insurance and Job Search in the Great Recession, Jesse Rothstein of the University of California, Berkeley finds that recent extensions to the period in which the unemployed can draw unemployment benefits had a significant but small negative effect on the probability that eligible unemployed would exit unemployment, and that the effect is mainly concentrated among the long-term unemployed. Rothstein calculates that without those extensions, the unemployment rate would have been about 0.2-0.6 percentage points lower—a much smaller impact than implied by previous analyses, and that the long-term unemployment rate would have been even lower. He finds that half or more of these impacts are due to the unemployed remaining in the labor force rather than reductions in the chances of finding employment. As a result, Rothstein suggests that a generous extension of UI benefit in deep recessions should last until the labor market is strong again, thus giving displaced workers a realistic chance of finding new employment before their benefits expire.
In The Effects of Quantitative Easing on Interest Rates, Arvind Krishnamurthy and Annette Vissing-Jorgensen of Northwestern University show that the Federal Reserve’s recent quantitative easing (QE) programs (“QE1” and “QE2”) did in fact significantly lower interest rates on Treasury securities, as well as GSE bonds and highly rated corporate bonds. They also find that such programs affect interest rates differently depending on which assets are purchased: QE1, which involved the purchase of mortgage-backed securities (MBS) in addition to Treasury securities, significantly lowered MBS rates, whereas QE2, which focused exclusively on Treasury securities, had little effect on MBS rates. The authors identify several channels through which QE affects interest rates: first, QE increases the premium paid for assets with low-default risk (and thus lowers rates on these assets), by reducing the supply of such assets available to investors; second, QE drives down interest rates broadly by signaling a commitment by the Federal Reserve to keep interest rates low for a long period; and third, when QE involves purchases of mortgage-related assets, it lowers rates on such assets by affecting the price of mortgage-specific risk. Because QE does not affect all long-term interest rates equally, examining the impact of a QE policy that focuses on purchases of Treasury securities on long-term Treasury rates is likely to overstate the program’s impact on the long-term corporate and mortgage interest rates that all relevant to investment and housing demand. Interestingly, the results about having the Fed use its communication channel alone – that is, signaling its intentions – might be having a significant impact on rates without having the Fed actually take on the risks associated with increasing its balance sheet. The authors also conclude that expected inflation increased substantially due to QE1 and modestly due to QE2, implying that reductions in real rates were larger than reductions in nominal rates.
In Practical Monetary Policy: Examples from Sweden and the United States, Lars E.O. Svensson, the Deputy Governor of the Swedish Central Bank (Sveriges Riksbank) analyzes the actions of the U.S. Federal Reserve and the Swedish Riksbank during and after the summer of 2010, looking for evidence that perhaps central banks make mistakes. In that time period, both the Fed and Riksbank forecasts for inflation were below their target and their forecasts for unemployment were above the sustainable unemployment rate, suggesting that more expansionary policy was warranted. However, the Riksbank tightened policy while the Federal Reserve held rates steady. Although the Swedish economy developed better than expected, and the U.S. economy developed worse than anticipated, Svensson argues that these developments were the result of external factors — not, in fact, the nations’ respective monetary policies. The Riksbank benefited from higher-than-anticipated domestic and export demand, upward revisions of GDP data, and a lack of structural problems. On the other hand, the Fed had to contend with fiscal policy problems, a slower housing market recovery, and substantial downward revisions of GDP data. The author concludes that the Riksbank’s decision to tighten policy is difficult to justify, while the Federal Reserve’s decision not to tighten was appropriate, although there is also a case to be made that they should have eased more.
Which of the following nations recorded the strongest economic growth in the second quarter? France, Germany, Italy, Japan, or the United States?
This nice chart from today’s Wall Street Journal provides the answer (click for larger version):
The U.S. expanded at a tepid 1.3% annual pace in Q2, but that was still better than many other developed economies. Italy grew at a 1% pace, Germany at 0.5%, and France at 0.0%. And then there’s Japan, which contracted at a 1.3% pace.
The chart also nicely illustrates just how sharp the GDP declines were in late 2008 and early 2009. Both Germany and Japan, for example, had quarters in which economic activity contracted at a 15% annual pace or more. By contrast, the worst U.S. quarter saw declines at “only” a 8.9% pace.
Today’s housing data showed that the number of single-family homes under construction hit another record low in July:
Ten years ago, America’s home builders were in the midst of constructing 689,000 single-family homes. Five years ago, they were building 913,000 homes. Last year, they were building 278,000. And now that figure is down to a mere 243,000.
America’s job market has been down so long, today’s mediocre report looked like up.
The headline figures — payrolls up 117,000, unemployment rate down a tic to 9.1% — were better than most forecasters anticipated. That’s a relief.
And many details moved in the right direction as well. Revisions to May and June added another 56,000 jobs, the U-6 measure of underemployment ticked down to 16.1%, and hourly earnings were up 0.4%.
But we still need much stronger job growth if we are ever going to get America back to work. Both unemployment and underemployment remain stubbornly high:
(The U-6 measures includes the officially unemployed, marginally attached workers, and those who are working part-time but want full-time work.)
Tim Kane at the Kauffman Foundation is out with his latest survey of economics bloggers (full disclosure: I am both an adviser to the survey and a participant in it).
In light of today’s abysmal GDP report, the results for one question are particularly relevant:
The latest revisions shows that GDP growth in recent quarters was much lower than previously reported (e.g., only 0.4% in the first quarter versus the prior estimate of 1.9%). So score this one for the 44% of economics bloggers who answered “worse”. (I wrongly answered “same”.)
As always, it’s also fun to look at the word cloud of adjectives the bloggers used to describe the current state of the economy:
Uncertainty still dominates the middle of the nation, but weakness, vulnerability, and fragility have, unfortunately, being gaining territory.
For results from previous surveys, see this earlier post.
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