Tuesday, May 31, 2011

News and Newspapers

Brad Delong does a bit of thinking about what sort of news inputs the internet needs:
What Kind of News Does the Net Need?

I really am not sure.

Look at http://washingtonpost.com/ right now. The lead economic story is Robert Samuelson, "Europe’s recovery at the abyss." Where is the value added in the article?

The net-based news ecology would do absolutely fine without it: "Greece could tip Europe into crisis" is not news, is not analysis, is not insight.

The second story is by Alan Fram covering a speech by Cass Sunstein at the American Enterprise Institute. There is nothing in it that you couldn't have gotten from a one-pager from Sunstein's office.

...For my issues, I think Bloomberg is a very valuable input into the net-based news ecology. I think that Associated Press is valuable. There certainly is an important role for Ezra Kleins and Steven Pearlsteins and aggregators and curators to play.

But otherwise? The value added is not coming from the "regular" reporting-based news-gathering structure. it produces: "Obama proposes revamping regulations to aid businesses", "Greece could tip Europe into crisis", "‘Insourcing’ effort still under fire despite Pentagon’s gradual retreat from plan", and "As the host of November’s summit in Hawaii, the Obama administration is trying mightily to restore the relevance of Asia-Pacific Economic Cooperation forum."

Until newspapers figure out how they have gotten themselves into a box in which, as one senior journalist told me, "on the average day I learn more from Ezra Klein's weblog than from the entire national news staff of the New York Times," they will have no idea how to climb out of the crate into which they have crawled.
Brad has very helpfully crystallized a vague thought that I've had for some time. I was recently discussing the NY Times' paywall with a friend, and I mentioned that I haven't yet gotten around to subscribing, even though I'm a rather voracious consumer of "news" and have been a regular Times reader for about 20 years. So naturally I was asked if I miss it, and why I don't subscribe, and what I read instead. And I realized that I haven't really missed it yet, and that that is because my intake of traditional articles in newspapers has been declining for a couple of years now.

Take the wire services and basic market reports (e.g. from Reuters, the AP, Bloomberg, Marketwatch, etc.), add a large helping of commentary and analysis from a number of blogs (including several operated by professional news organizations and newspapers), and I get a far more interesting, insightful, and useful flow of daily information than the major online newspapers generally provide. So I suddenly realize that I completely agree with Brad (and I'm sure that this has been very obvious to lots of other people for a long time as well): newspapers have a much bigger problem than simply managing the transition from paper to web-based distribution -- traditional newspaper writing is simply becoming increasingly irrelevant.

Saturday, May 28, 2011

Simple Foods: Pizza

Perhaps instead of "pizza" I should have called this edition of Simple Foods: "Olive oil and sea salt flatbread topped with roasted Mediterranean vegetables and a blend of cow, sheep, and buffalo milk cheeses." But it's the same thing either way, and it's something that, in its essence, is incredibly simple yet incredibly good. Flatten out some dough, top it with cheese and anything else that tickles your fancy, apply very high heat for a few minutes, and you have a great meal.

How simple can pizza be? Some of the classics have just four or five ingredients, such as dough, cheese, tomatoes, basil, and olive oil. (A friend points out that if I count the ingredients for the dough then the list would be a couple of items longer... but I'm going to hope that she'll let it slide this time.) I sometimes succumb to the urge to use a whole bunch of different toppings, but I find that I usually enjoy the pizza more -- as well as each of its constituent parts -- when there aren't too many of them.

How varied can pizza be? According to my definition (yours may vary), pizza has to have dough that's been pressed flat with some cheese on top, and it has to be baked at high heat... but other than that there really are no rules. Which is why pizza has the amazing ability to be infinitely customizable. And that versatility means that just about anyone could create a pizza that would personally satisfy them as a complete meal.

My favorite part about this particular simple food, however, is the way each bit (or bite) of the pizza brings its own thing to your mouth. One bite carries the crunch of the crispy crust. Another zings the tongue with the saltiness from an olive, anchovy, or piece of meat. Here we have a burst of green, there a burst of sweetness or spice, and throughout the calming, unifying ether of the warm, soft cheese.

Italian foods often do a great job of surprising and entertaining your senses with different flavors with each bite, which is one of the reasons I'm such a fan of the cuisine in general. And with a good pizza you also get those great textures (soft, toothy, crunchy) and the ability put an entire and very personal meal on a single piece of bread. So what's not to like?

Friday, May 27, 2011

Comparing Two Approaches Toward Deficit Reduction

In response to my point that severe austerity is a difficult, costly, and largely counterproductive way to solve a government deficit problem during a time of economic weakness, several readers have asked me what the alternative is. In a word, it's patience.

Economic growth is the single best cure for budget deficits. When the economy does well, tax revenues rise and the deficit falls. A major cause of the budget deficit in the US is the economic downturn. (The other principal culprit is the tax cuts of 2001 and 2003.) And as the economy recovers, the deficit will fall substantially on its own accord, just as it did during the recoveries of the 1980s and 1990s.

To illustrate my point, let's go back to Austerityland. Recall that GDP in Austerityland was $100/year and the budget deficit was $10/year, or an unacceptably high 10% of GDP. Let's also assume an initial debt/GDP ratio of 60%. Suppose that the Austerity Party proposes addressing the budget deficit problem by cutting $5 from government spending in their first year in office and another $5 in their second year in office. (They incorrectly believe that cutting $10 over two years will be sufficient to erase the $10/yr budget deficit.)

Now suppose that there is a rival party: the Growth Party. (Maybe we could call them "The G Party"?) They propose addressing the budget deficit problem through patience. Let the economy grow, they argue, and skip the sharp austerity measures. Instead, just keep government spending constant for a few years, so that spending is gradually brought more in line with tax revenues but a sharp fiscal contraction is avoided.

The results of these two approaches for addressing the country's deficit and debt problem may surprise you. Making a few reasonable assumptions (which are specified below, for those of you who are interested), we can compare the effects of these two alternatives on real GDP and on the debt/GDP ratio. The results are summarized in the chart below.

At the end of the fifth year, the country will still be running budget deficits under either approach (though they'll be somewhat smaller under the austerity program). It will also have a roughly similar amount of debt under either scenario, at approximately 75% of GDP. But the path the country followed to get there will be very different depending on which policy they pursued.

Under the austerity program, the country will have experienced a sharp recession (and possibly deflation), so that by the fifth year the average family will still have less real income than they did before the austerity program. Under the growth program, on the other hand, income will have increased steadily, so that after five years the average family's annual income will be almost 20% higher in real terms than under the austerity program -- while the government's debt burden is no greater. (Of course in year 6 the government may decide to change its policies under either scenario.)

Given this choice, which policy would you vote for?

Note that this exercise assumes the following:
1. The tax rate is 25% and fiscal multiplier is 1.5.
2. The real (i.e. inflation-adjusted) interest rate on government borrowing is 2.0%.
3. The inflation rate averages 0% per year under the austerity scenario and 2.0% per year under the patience scenario.
4. The economy experiences a real growth rate of 3.0% per year in both scenarios (not including the effects of fiscal policy).

More Effects of Austerity in the UK

The outlook for the UK in the midst of its austerity program looks worse and worse. From the FT this morning:
Why the British economy is in very deep trouble

Here’s something for the Chancellor and the Office for Budget Responsibility (OBR) to chew on: a warning from Dr Tim Morgan, the global head of research at Tullett Prebon, that the deficit reduction plan won’t work and the UK is headed for a debt disaster.

Morgan says sectors that account for nearly 60 per cent of UK economic output are critically dependent on debt (public or private) and set to contract rather than expand. This will render economic growth implausible and means the burden of public and private debt will prove too heavy for the nation to carry:
Over the past decade, the British economy has been critically dependent on private borrowing and public spending. Now that these drivers have disappeared – private borrowing has evaporated, and the era of massive public spending expansion is over – the outlook for growth is exceptionally bleak.

Sectors which depend upon either private borrowing or public spending now account for at least 58% of economic output. These sectors are now set to contract rather than expand, which renders aggregate economic growth implausible. And, without growth, there may be no way of avoiding a debt disaster.

...Short of almost unthinkably drastic restructuring, there may be no way out of Britain’s low-growth, high-debt trap.
Not surprising, but still depressing.

Animal Spirits

...Or what economists mean by "herding behavior."

Thursday, May 26, 2011

The Effects of the 2009 Stimulus Package

The CBO has just updated their estimate of the impact that the stimulus package enacted in the US in early 2009, the American Recovery and Reinvestment Act ("ARRA"). I've summarized the conclusion in the chart below. The blue line shows actual real GDP (incorporating today's updated figures from the BEA for 2011:Q1), while the red line shows what would have happened in the absence of the ARRA.

(Note that to construct this chart I used the average between the CBO's high and low estimates of the impact of the ARRA.)

The impact was significant, and at its peak in 2010 the ARRA was responsible for creating between 1.3 and 3.3 million additional jobs for unemployed Americans.

To generate this estimate, the CBO relied primarily on "versions of the commercial forecasting models of two economic consulting firms, Macroeconomic Advisors and Global Insight, and on the FRB-US model used at the Federal Reserve Board." In other words, the CBO is using the type of macroeconomic models that businesses rely on to understand the macro economy, which means that the models have effectively been "market-tested".

A technical note about multipliers: the CBO's estimate embodied various different multipliers for different components of the ARRA. Those multipliers were drawn from the results of published, peer-reviewed empirical research, and ranged from a low of +0.2 for one-time tax cuts for upper-income people, to a high of +2.5 for direct purchases of goods and services by the federal government (or transfers to state governments to do the same). If we add up all of the additional output that will have been created in the US between 2009 and 2011 thanks to the ARRA (in other words, the area between the two lines in the chart), we get a total of about $750 billion in additional production in the US. Since that's approximately equal to the amount of money that the ARRA will have cost the federal government for those years, we find that the ARRA had an average multiplier of about +1.0.

Wednesday, May 25, 2011

Discretion versus Rules

Paul Krugman ponders which measure of inflation would be the best for central bankers to use when setting policy. Should it be headline inflation? Core inflation? Wage inflation? Some "supercore" measure of inflation? (I'm picturing it sitting at the FOMC meetings in a blue business suit with a discreet red cape.)

As I have done my own pondering on the subject, I keep coming back to the thought that really, none of those measures is adequate by themselves. Sometimes you need to pay attention to wage inflation, but sometimes you don't. Sometimes you need to worry about the headline rate, but sometimes you don't. In my view, it's the job of a good central banker to assemble lots of different types of data, develop a complete picture of the economy composed of many brushstrokes, and set policy accordingly.

In other words, I think that there's a good argument to be made for modifying the rules-based approach to monetary policy-making most central banks have tended toward over the past 10 or 15 years in favor of a more discretionary approach. I know, this is close to heresy in the world of monetary policy economics. But consider the strict rules-based approach of the ECB compared to the somewhat more discretionary policy-making approach of the Fed. Is it obvious to you that the ECB has been better at monetary policy than the Fed? No, it's not to me, either...

The main counter-arguments to a more discretionary approach to monetary policy-making are: (a) strict rules help to insulate central banks from political pressure to do the wrong thing; (b) rules help to anchor inflation expectations; and (c) in the absence of rules, if a central bank is unlucky enough to get a "bad" central banker, it will get "bad" monetary policy.

But (a) can happen equally in the presence or absence of rules. (B) is very well understood by now, central bankers know how important inflation expectations are, and those expectations are going to be based on the central bank's actual policies anyway, not the central bank's "rule". And (c)? Do you really want to argue that the quality of central bank policy-making has been irrelevant to the Fed or the ECB? A central bank can opt for bad rules just as it can opt for bad policies. And I think it's quite clear that some central banks do their job better than others, even when they are supposedly just following "rules".

To be even more explicit: I think that the Fed has done a pretty good job of monetary policy in recent years, while the ECB has not. So a bit of discretion has done better than a strict rules-based approach. And I don't think that's a coincidence.

Tuesday, May 24, 2011

Slow Recoveries

Stefan Karlsson disagrees with my argument that the current very slow recovery in the US is quite satisfactory for the owners of corporations. His criticism centers on the fact that recessions are bad for companies because they result in underutilized capacity and thus depress margins. And I agree. It's quite true that companies don't like recessions (which is exactly what I wrote in my previous post on this subject). However, my point was that the owners of corporations do benefit from slow, relatively jobless recoveries, such as we saw after the recessions of 1991 and 2001, and what we're now seeing after the Great Recession of 2008-09.

Think of it this way. There are two countervailing effects at work during the business cycle: the size of the pie is changing, and the way that pie is divided between workers and firms is changing. A recession makes the pie smaller, but a high unemployment rate means that firms get to keep a larger share of that smaller pie. My argument is that there may be times when an increase in the size of the slice going to firms more than makes up for the fact that the pie isn't growing very fast.

Since these two forces work in opposite directions, this is ultimately an empirical question. So let's look at the data. The chart below shows nonfinancial corporate profits in the US as a percent of GDP and in real (inflation-adjusted) dollar terms since 1980. It seems clear that companies did better during the weak recoveries of 1992-96 and 2002-06 than they did during the strong recovery of 1982-4.

There's nothing particularly surprising or profound about the idea that corporate profits do best in the first part of a recovery; that is well understood. But the dramatic increases in profitability during the recoveries from the 1991 and 2001 recessions suggest that something was different about them.

I would argue that the difference is that those recoveries were very slow in the US. If we pair the notion that corporate profits do best in the initial stages of a recovery together with the table at right, then I think we get a good explanation for what we have observed, which is stagnant worker compensation and strong corporate profits. Recoveries from the past 3 recessions in the US have happened relatively slowly compared to typical recoveries in the 1950s through 1980s, and with only very gradual improvements in the labor market. And this has helped corporations keep the majority of the productivity gains of their workers for themselves.

In other words, the "good times" for corporations have tended to last much, much longer during recent recoveries than they did prior to 1990. And when combined with the fact that the relative bargaining power of workers is weak during this particular phase of the business cycle, this has had the effect of substantially changing the share of worker productivity that has been returned to workers in the form of higher compensation in the US.

This has two significant implications. First, it's certainly not a stretch to say that the owners of US firms are probably quite content with the slow pace of the current recovery. Second, this reasoning suggests that gaining a better understanding of why recoveries in the job market are so much slower now than they were prior to 1990 may be an important step toward understanding the relatively poor growth of average worker compensation in the US over the past 20 years. Could the stagnation in median household income in the US be in part the result of these very slow recoveries? It's an intriguing line of thought to pursue...

Monday, May 23, 2011

Beating a Dead QE2

I thought I had suffered through enough of these types of stories over the past six months to last me a lifetime, but apparently not. Hasn't this innocent, blameless, and very dead horse been beaten sufficiently by now? And yet... some masochistic streak in me forces me to read it:
QE2 was a bust:
Economic data is worse than before

BOSTON (MarketWatch) — It‘s cost $600 billion of your money. And it was supposed to rescue the economy. But has Ben Bernanke’s huge financial stimulus package, known as “Quantitative Easing 2,” actually worked as planned?

QE2 is being wound down in the next few weeks. Fed Chairman Ben Bernanke has said it has left the economy “moving in the right direction.” But an analysis of the real numbers tells a very different story.
I've only snipped the first two paragraphs from this story, but that much is enough to contain two fundamental and oft-repeated errors which I've resisted commenting about in the past, but can resist no longer.

Correction #1. You can't tell if QE2 worked by simply looking at actual economic data. Why? Because you need to compare it to something. So in order to tell the effects of any particular policy you have to compare actual economic data with what would have happened in the absence of the policy. I have yet to see a critic of QE2 attempt to make the correct comparison.

Correction #2. QE2 didn't cost anything. Nothing. Nada. All that happened was that the Fed bought a bunch of long-term assets. The money didn't disappear. The Fed still has that $600 billion; it's just in the form of long-term bonds now.

Oh, and then of course this column makes the other common mistakes about the Fed's purchases of long-term assets, implying that QE2 is the same as money creation (which it isn't), and that it has caused inflation (which it hasn't). Okay, time to stop reading.

Thinking about Contagion in Europe

Greece has been hogging all of the stories regarding the euro-zone debt crisis, but this morning Alphaville notes that there have been some wider tremors in European financial markets in recent days. The Dread Pirate Contagion is threatening to set sail and once again terrorize the high seas.

How likely is the crisis to spread in a meaningful way to Spain or Italy? That is, of course, one of the most important questions we can ask about this entire mess, because if investors lose confidence in the debt issued by those governments in any serious way, then Greece, Ireland, and Portugal will seem like mere footnotes by comparison.

In order to get a feel for how likely contagion is in this situation, it's helpful to carefully think through the possible mechanisms by which the crisis could spread to Spain and Italy. And I think it makes sense to think about two different categories of transmission mechanisms: "spillover effects", and what I will call true "contagion".

Spillover Effects: I think of spillovers as situations in which events in one country affect the underlying macroeconomic fundamentals of another country. In other words, a financial crisis in Country A may affect the “real” economy of Country B, for example by a fall in exports from B to A. The negative impact on Country B's economy could then make it harder to support a given exchange rate or debt burden, causing a financial crisis in Country B.

Contagion: By contrast, what I think of as true "contagion" is a situation in which events in Country A cause a speculative attack or crisis in Country B even though the macroeconomic fundamentals in that country have not changed and may not otherwise warrant concern. I think that this matches the situation in Europe right now, because the concern is not that events in Greece will have a significant impact on Spain's GDP or tax revenues; rather the concern is that events in Greece will spark a sudden change in the market demand for Spanish financial assets (which may then in turn impact the real economy of Spain, of course).

What could cause the crisis to spread to Spain or Italy? More generally, why does true contagion happen, so that when Country A has a financial crisis, it sometimes (though certainly not always) spreads to nearby Country B? Here are a few mechanisms that have been explored in the literature:
  • A common external shock: whatever initially triggered the crisis in Country A also impacts Country B, and may therefore start a crisis in Country B for the same reasons.
  • The “wake up call”: the crisis in Country A makes investors take a closer, more critical look at their portfolio, and thus makes them more likely to dump all assets of countries even remotely similar to Country A just to be on the safe side.
  • Information cascades/herding behavior: investors look at the behavior of other investors to gather information, and specifically to get clues about how risky a particular class of assets might be. So once a few people start heading for the exits everyone follows in a rush.
  • Liquidity concerns among common creditors: when creditors expect losses in part of their portfolio due to a financial crisis in Country A, they may become forced to quickly sell of other parts of their portfolio -- including assets from Country B -- in order to maintain sufficient liquidity.
  • Cross-market hedging among common creditors: when creditors see the riskiness of part of their portfolio rise due to a financial crisis in Country A, they try to balance that out by decreasing the overall riskiness of the rest of their portfolio, so they sell assets from any countries not seen as safe havens.
In the case of Greece and Spain, however, I feel like I could make a pretty good argument against each of these possible mechanisms, particularly given the way that the Greek crisis has been unfolding relatively slowly for over a year now. I won't go into each of my counterarguments right now (maybe later), but suffice it to say that none of these possibilities convinces me that we should expect a Greek default to translate into a sudden sell-off of Spanish government bonds.

It bears much more thinking about... but for now, and despite my conviction that events in Greece are going to end with default and a Greek exit from the euro-zone, I'm oddly optimistic about Spain and Italy. I simply haven't heard a convincing reason for why we should expect Greek default to be contagious. I'm very open to suggestions, though, so feel free to try to persuade me otherwise...

Saturday, May 21, 2011

Why a Bad Job Market is Good News for Some

Mark Thoma reminds us of the striking gap that has opened up between the productivity of labor and the compensation paid to labor. The problem, in a nutshell, is this picture:

Whereas classic labor market theory suggests that when workers become more productive firms should bid up the price of labor by a similar amount, that has clearly not happened over the past 25 years or so. Over the past 10 years, for example, average labor productivity in the US has increased by about 30%, but average labor compensation has only grown by about 11%, meaning that roughly one-thirds of the gains in labor productivity went to workers and the other two-thirds went to the companies that employ them.

Frank Levy and Tom Kochan set out a list of factors that they believe have caused this divergence (pdf of their draft paper). They focus on structural and institutional factors that will seem very familiar to anyone who has read or thought about middle-class wage stagnation more generally:
  • technological change
  • globalization and international trade
  • declining unionization and collective bargaining
  • declining value of the middle wage
  • "financialization" of the economy, including financial deregulation
  • "fissurization" of the labor market
Then also briefly mention that the Great Recession has just made matters worse by creating such a tough labor market for job applicants.

While some of the structural and institutional causes cited by Levy and Kochan probably may have had some effect, I actually think that this last item -- the state of the job market -- is the single most important factor of all of these, and can by itself explain most of the divergence between labor productivity and compensation.

Take a look at the following chart (which I've posted before). The blue line shows how much of the gains in labor productivity in the US that workers were able to capture in the form of higher compensation. So for example, during the 7 years leading up to 2010, workers received about $0.40/hr, or 40%, of every $1.00/hr that their productivity rose. The remaining $0.60/hr went to the companies that employed them. The red line, meanwhile, shows what the average employment rate in the US was during the previous 7 years. From 2004-2010 it averaged about 6.4%.

I've color-coded the periods in the graph to divide it into periods when the unemployment rate was falling and periods when it wasn't. (It's quite striking that over the past 50 years there were only three green periods when the labor market showed sustained improvements.) And it turns out that the periods of falling unemployment rates match up almost exactly with periods when workers were able to demand a larger share of their productivity improvements. In other words, only when the job market experiences sustained improvement does the enhanced bargaining position of workers translate into compensation growth that comes closer to the growth in labor productivity. Conversely, when the job market is getting worse, then firms can keep more of the gains in the productivity of their workers.

There are two implications of this. First, I don't actually think that the structural and institutional changes highlighed by Levy and Kochan are enough to explain the divergence between labor productivity and compensation. I don't even think they're the primary reasons for it, though some of those factors probably were contributing ingredients. Simply looking at the condition of the labor market explains much of it. It's all about supply and demand.

Second, this opens up an interesting line of reasoning, one that is certainly not new but which this data reminds us of. If a bad labor market means that workers get a smaller share of the productivity they bring to their employers, then the owners of companies will have a strong preference for a weak labor market. Firms don't like recessions, of course -- it's hard to make money when your sales are falling. But companies do enjoy the way that a very slow recovery in the job market can allow them to keep wages down, and thus keep a larger share of the output of their workers for themselves.

I had previously been thinking about the resistance from Republicans to further stimulus purely in terms of politics; they don't want Democrats to do well in 2012, and therefore are happy with a weak recovery. But there's a good financial reason for the owners of capital (who tend to support Republicans) to prefer the weak recovery, too: the weak labor market ensures that firms will be able to keep the majority of productivity gains for themselves.

On the bright side, this means that the policy prescription is really quite simple: jobs, jobs, jobs.

UPDATE: Calculated Risk provided a good exposition on this theme a couple of weeks ago that's worth reading, if you haven't already: Employment: A Dirty Little Secret.

UPDATE #2: For more on this, see Slow Recoveries.

Thursday, May 19, 2011

Is the ECB Pushing Greece Out of the Euro-Zone?

This is not a story that instills confidence in a happy outcome:
The ECB goes all-in

Central bank brinkmanship in full display this Thursday:
FRANKFURT (MNI) – If Greece were to restructure its sovereign debt, its bonds would cease to be accepted as collateral by the European Central Bank, Executive Board member Juergen Stark said Wednesday, according to an ECB spokesman on Thursday.
These are the liquidity operations which have acted as a lifeline to Greece in recent months, with Greek bank borrowing from the European Central Bank still hovering around €87bn at the end of March.

Or as RBS’s Jacques Cailloux puts it, Stark’s warning is… :
“This is the last card in the hands of the ECB in warning about the implications of a restructuring.”
It's clear that the ECB is adamantly opposed to any restructuring of Greek debt. It's also becoming increasingly clear that they are willing to sacrifice the Greek banking system if they have to. What's not clear to me is why.

A few possible reasons come to mind.
  1. The ECB is afraid that the big European banks (primarily French and German) would not be able to support the losses that would result from the restructuring of Greek debt. (Though estimates I have seen suggest that such losses would not be overwhelming to the system, even if they require a bit of government-assisted bank recapitalization...)
  2. The ECB is afraid of contagion, i.e. afraid that restructuring Greek debt would somehow surprise the market and suddenly make market participants realize that debt restructurings could be possible for Ireland or Portugal.
  3. The ECB is concerned about the losses it will take on its own balance sheet. (Though really, a central bank is in business not to make money, but rather to watch over the banking system for the greater good...)
  4. The ECB thinks that the destruction of the Greek banking system may be a fitting punishment for Greece, and may thus act as a good deterrent to combat the danger of moral hazard that the restructuring could engender.
I'm sure there are other possible explanations, but these are the ones that immediately come to me.

Regardless, the implication seems to me that the ECB is effectively pushing Greece out of the euro-zone, and ensuring that Greece will have to create its own currency once restructuring happens. As I've argued previously, once the euro-based Greek banking system is destroyed (which is what the ECB is saying will happen if Greece restructures its debt), then it will quickly become obvious that the best way to get the Greek financial system moving again will be to create a new Greek currency. Similarly, if the ECB is really going to stop acting as the lender of last resort in Greece (which is also what they're threatening to do), then that role will have to be assumed by the Central Bank of Greece. But the CB of Greece won't be able to do much as a lender of last resort for euro assets; the only way it will really be able to do that effectively is if it creates a new domestic currency, for which it can then credibly take on that role.

Really, is there any way in which the ECB's pronouncements and actions this week are helping the situation? I really can't see it. And so, I wonder: is the ECB actively trying to push Greece out of the euro-zone? And again, if so, why?

Naturally I don't really know the answer to that, but here's one very simple possible explanation: the ECB wants to make it clear to everyone that any euro country that defaults on its debt will effectively be dismissed from the euro-zone.

Japan's Earthquake Recession

It was reported yesterday that Japan's economy shrank at a fairly rapid rate in the first quarter of 2011. Real output was down almost 1% during the quarter. This was in large part due to the effects of the earthquake; if significant pieces of your economy are simply not doing anything for a month, then of course the total output you produce during that time is going to be low. Some expressed surprise at the bad report, but even two months ago this GDP report was quite predictable.

The interesting question now, as Alphaphille suggests, is whether this will turn out to be a "temporary" recession. My answer is yes.

Two effects will mean that output in Japan will begin to recover quite strongly. First, manufacturing companies that were forced to stop doing business in the weeks after the quake are already trying to churn out extra output to make up for shipments that were delayed or missed in March and April. Countless manufacturing facilities around the world rely on inputs from Japan and were forced to slow or stop production as that flow of inputs stopped. (That's the likely explanation for the fall in manufacturing production in the US in April, by the way.) Now both the Japanese suppliers and their customers are scrambling to make up for that lost production.

Second, the Japanese government is slowly but surely embarking on a massive rebuilding effort in the affected area. This will probably amount to a fiscal stimulus of several percent of GDP in total. Even though this will be spread over the next few years, I think we'll already begin seeing significant effects of this stimulus in the second half of 2011.

One bright note: at least the disaster didn't happen in Austerityland, where politicians would probably respond by trying to cut government spending in the hope that confidence fairies would come to help in the rebuilding efforts...

Wednesday, May 18, 2011

Some Simple Deficit Reduction Arithmetic

Here’s a short lesson about something that every policy-maker should have learned in Macro 101, but apparently has been forgotten by many of them.

Suppose we are in a country that is running a large budget deficit but, for whatever reason, decides that it needs to dramatically reduce it. Take your pick of examples, because there are plenty to choose from: Greece, the UK, the US...

Suppose that the country – let’s call it Austerityland – has a GDP of $100/year, and a budget deficit of $10/yr, or 10% of GDP. And suppose that the government decides it wants to get the deficit down to 5% of GDP. How can it get there?

No, the answer is not “cut spending by $5/yr”. Nor is it “raise taxes by $5/yr”. And last but not least, it is also not “enact a combination of tax increases and spending cuts that total $5/yr”. To see why, let’s do just a bit of arithmetic.

To keep things simple (and to make it particularly relevant to the three examples mentioned above), let’s focus on the strategy of trying to halve the budget deficit primarily through spending cuts. So the government of Austerityland decides to cut spending by $5/yr. What happens?

Recall that GDP is the sum of spending on final goods and services by domestic consumers, domestic businesses, and the government, along with net exports:
GDP = C + I + G + (X – M) = Y. Recall as well that GDP is, for our purposes, the same thing as income (Y).

If G is reduced by $5 in Austerityland, the first thing that happens is that GDP falls by $5. But then a bunch of secondary effects kick in, including:
  • C falls, since individuals in the economy have seen their income drop by $5. This makes GDP fall even further. This is called the “multiplier effect”, and it means that the total fall in GDP is likely to be substantially greater than $5. (Empirical research seems to usually show that the government spending multiplier is in the neighborhood of 1.5, implying that the net fall in GDP will be around $7 or $8.)
  • If interest rates are positive, they will tend to fall as demand diminishes, which could boost spending by businesses. But if interest rates are already at zero (as they are effectively are in the US), they will not fall, and we get no boost to private investment.
  • Tax revenues fall as income falls. If the effective marginal tax rate on income is 25% and income falls by $4, for example, then tax collections will fall by $1.
So, what is the budget deficit in Austerityland after a $5 reduction in government spending? If we assume a relatively modest multiplier of 1.5, and a tax rate of 25%, then we get:

ΔG = -$5
ΔY = -$7.5
ΔT = -$1.875

And the new deficit is now $6.875, which is 7.4% of the new level of GDP. Wait, I thought we were trying to get the deficit down to 5% of GDP? What happened?

What happened is that we’ve missed our target, by quite a bit, due to the multiplier effect and the fall in tax revenues that resulted from the shrinking economy. In fact, just a bit of simple algebra allows us to figure out that government spending in Austerityland will have to be cut by about $9 in order to reach a budget deficit target of 5% of GDP. In other words, the government will have to cut spending by almost twice as much as it initially thought it would in order to reach its deficit target.

(When that happens, by the way, GDP will fall from $100 to around $86. Yes, that’s a 14% drop in output. But hey, at least we’ve hit our deficit reduction target!)

Somehow, this simple exercise in macroeconomic math seems beyond the reach of policymakers around the world.

  • Many Republicans (and some Democrats) in Washington continue to believe that they can close a $1 trillion deficit by simply cutting $1 trillion in spending, and are apparently hoping to use the debt ceiling vote to do exactly that.

  • The Cameron government in the UK embarked on an austerity program last year to try to reduce its budget deficit, and now mysteriously keeps missing its deficit reduction targets as the UK economy shrinks.

  • The Greek government was forced into enacting a number of austerity measures last year, and... surprise, surprise... is now missing its deficit targets.

Why do people keep getting surprised that austerity doesn't work as well as hoped to reach budget deficit targets? I know, I know, there are people who argue that basic Macro 101 has it all wrong. Even people who know better (ahem, Douglas Holtz-Eakin) somehow allow ideology to get them to make the bizaare claim that when income goes down, people will actually increase spending. Confidence fairies and all that.

But when basic Macro 101 both makes good theoretical sense and also fits what we actually observe, it's really time to start looking for your handy Occam's Razor. I wish I could take more satisfaction from the fact that mainstream macroeconomics, as it has been taught to first-year college and university students around the world for decades, does such a good job explaining what we see happening across the globe today...

UPDATE (May 27): To see an alternative, much less destructive way to get a deficit and debt problem under control, see this post: Two Approaches Toward Deficit Reduction.

UPDATE (May 25): New data from the UK continues to show that the British austerity program is having exactly the effects predicted by this model. From the Financial Times today:
On the brink of a British double-dip

Dramatic, we know. But the ONS has confirmed the economy grew only 0.5 per cent in 2011′s first quarter after its 0.5 per cent fall in 2010′s last three months... confirming a double-dip in GDP in absolute terms over the period...

More worrying is the fact that sectors which previously pushed recovery forward are now definitely double-dipping.

Here’s Howard Archer of IHS Global Insight:

On the expenditure side of the economy, there was a very worrying drop of 0.6% in consumer spending in the first quarter, which reflected the pressure on spending power coming from elevated inflation and muted wage growth. Consumers also faced high unemployment, elevated debt levels, and a weak housing market.

Also worryingly, business investment plunged 7.1% quarter-on-quarter, which hardly fuels hopes that it can be a major growth driver going forward.

But the thing with re-balancing is — the Treasury wants private investment to fill the hole that will be left by government cuts to spending. It’s not happening.
No, it's not happening. But it's not really surprising that private spending isn't filling the gap left by reduced government spending, given that income is falling...

Tuesday, May 17, 2011

Manufacturing Recovery: an Update

Mike Mandel is not convinced that US manufacturing is really doing particularly well:
There’s been a lot of happy talk recently about the revival of U.S. manufacturing. ...Truly, I’d like to believe in the revival of manufacturing as much as the next person. Manufacturing, in the broadest sense, is an essential part of the U.S. economy, and any good news would be welcome.

Unfortunately, the latest figures do not back up the cheerful rhetoric.
He cites and presents two pieces of data. First, he shows that recent revisions to the figures on factory shipments in 2009 indicate that manufacturing output fell by more than initially belived during that year. Second, he shows that US imports of goods have risen rapidly over the past year.

But neither of these observations really tell us anything about whether US manufacturing is recovering unusually strongly. Yes, it now seems that the downturn in manufacturing was even more severe in 2009 than the data had initially suggested. But that is a different issue from whether manufacturing has done surprisingly well since then.

And it is equally true that US imports have risen by a lot lately. But that also tells us very little about how US manufacturing is doing, because (a) a huge chunk of US imports are petroleum, which has nothing to do with manufacturing, and (b) it makes no sense to look at imports without also looking at exports. A better way to use trade data to gain insight into how US manufacturing is doing is to look at the overall trade balance (exports minus imports) for non-petroleum goods. Looking only at imports is a little like trying to tell how well someone is doing by tallying up their expenses without looking at their income.

As I've argued before, US manufacturing has done far better during this recovery than what we've grown used to seeing over the past 30 years. The fact is that that real output of the US's factories has climbed at a surprising rate over the past two years. The following chart compares the recovery of US manufacturing output (measured by the FRB's Industrial Production series) in the wake of the most recent recession compared to the two previous recessions. (Update: the chart now incorporates today's data release for April 2011, which undoubtedly reflects some effects of the earthquake in Japan.)

Yes, it's true that the 2008-09 recession hit US manufacturing extremely hard. But it's also true that it has bounced back much better than from the previous two recessions. It's all relative, of course -- but I do think that it's okay to feel cautiously optimistic about US manufacturing performance given what we've seen over the past year or two.

Monday, May 16, 2011

Policy Mistakes and the Euro-Zone Debt Crisis

In a pair of recent posts, Jeff Frankel brings some clear thinking to the euro-zone debt crisis. First he identifies three big mistakes made by European leadership that directly contributed to the crisis.
  1. "Mistake number 1 was the decision in 2000 to admit Greece in the first place."
  2. "The second mistake was to allow the interest rate spreads on sovereign bonds issued by Greece (and other periphery countries) to fall almost to zero during the period 2002-2007... [encouraged by the fact that] the ECB accepted Greek debt as collateral, on a par with German debt."
  3. "The third mistake was the failure to send Greece to the IMF early in the crisis."
I completely agree with this list. I would possibly add a fourth big mistake, however: underestimating how the debt crisis has the potential to rock the foundations of the EU's political institutions, and as a result, allowing the default policy response to political indecision to be "close-our-eyes-and-hope-for-the-best".

In a new post today Frankel offers a sensible suggestion for the ECB going forward:
[I]t is not too late to apply the lesson of mistake number two: to adjust the ECB policy of accepting the debt of all member states as collateral. This is the policy that short-circuited warning signals that the private markets would otherwise have sent via interest rates during 2002-2007.

My proposal: The eurozone should adopt a rule that whenever a country violates the fiscal criterion of the Stability and Growth Pact (say, a budget deficit in excess of 3% of GDP, structurally adjusted), the ECB must stop accepting that government’s debt as collateral... the result of such a re-classification would be the re-emergence of sovereign spreads of moderate magnitudes, in between the extremes of the 2002-07 lows and the 2009-11 highs (see chart). The interest rate premium would send a message far more credibly, forcefully, and promptly than any warning that any Brussels bureaucracy will ever turn out.
This is a reasonable suggestion, and one that actually stands some chance of being adopted by the ECB.

Mistakes #1 and #3 will be far, far harder to find solutions for, however. What those two mistakes have in common is that politics trumped economics in each case. So the only real way to prevent similar mistakes from happening again will be to change the EU's institutions in such a way that decisions are no longer shaped entirely by political considerations, to the exclusion of serious economic and financial considerations. But given the fact that the EU (as well as the euro-zone) has at its heart always been a political creature, I wouldn't hold my breath for that to happen.

We're Number Two?

A week ago I wrote about my subjective impression that Western Europe has passed the US in terms of economic development. It turns out that that impression is generally supported by the data. The question now is what to make of it all.

The Story in the Numbers

First, the official national income statistics show us that:
  • The US still has more national income per person when comparisons are made using PPP exchange rates (which are meant to adjust for differences in price levels between countries); however...
  • A huge fraction of that higher income in the US goes purely to health care and education spending, leaving less disposable income for the US to spend on everything else;
  • When current exchange rates are used (which measures international purchasing power), Americans are simply poorer than Western Europeans even according to national income data; and
  • What's more, such data likely overstates how well off the US is, since the US's relatively unequal distribution of income means that median individuals in the US do even less well compared to their European counterparts. (It's tough to get many reliable international statistics about the median, which is why this analysis was generally forced to use means instead.)
But just looking at national income data in isolation is insufficient, so I also assembled a variety of other indicators of economic well-being. Those indicators also generally confirm the suspicion that Western Europe is now "richer" than the US. To make the comparison even more striking, the data shows that Western Europeans enjoy a standard of living surpassed by no one in the world while also having hundreds of extra leisure hours per year compared to Americans. Not a bad combination!

(If you want to make comparisons related to health care, by the way, Europe also clearly does better than the US. For some examples, see these international comparisons of health statistics, or data presented last week by Ezra Klein on the performance of health care systems.)

So it does indeed seem that Western Europe is now generally better off than the US. Note that this was not always true -- I would say that the US was equally well off 20 or even 10 years ago, though the US has always made very different choices regarding what to do with its available resources (something that should really be thought of as a separate question). But now, for the first time in my life, I am actually convinced that the US does not enjoy the highest standard of living in the world.

20th Century Convergence, 21st Century Divergence

A generation ago, the US was indisputably the richest and most advanced country in the world. And for decades after the second world war, Western Europe had been playing catch-up. "Convergence" is the term economists use to describe that process of catching up to the leading economy, and much of Europe's economic growth during the second half of the 20th century can be described by that term.

But some time around the turn of the millenium I think that convergence was complete. And since then, the continuing improvements in living standards in Europe, and the stagnation of living standards in the US, have meant that convergence has actually become divergence, with Western Europeans pulling ahead of Americans in their quality of life.

Why has this happened? The most striking systematic difference between the European economies and the US is the role played by the government. And I think that's exactly where we need to look for an explanation. Specifically, I would argue that the fundamental problem is that the US has for years been skimping on the types of crucial long-term investments that help economies develop, such education and infrastructure, while European governments have more actively sought to shape the future and prepare their countries for it. And that difference is now gradually translating into more affluence for Europeans, and stagnation for Americans.

Government Has Its Uses

The fact is that even the most orthodox, classical economic theories recognize that there are such things as public goods, as well as goods that may not be traditional public goods but still have positive externalities. We know that such goods are underprovided by the private sector. And that means that there is a role for the government to step in and provide the things that the free market doesn't provide enough of on its own. Education and infrastructure are classic examples of such goods.

Government spending can therefore very tangibly improve a country's economic well-being and growth prospects. Government regulation can correct market failures. And in situations where multiple equilibria are possible, the government can play a crucial role in helping an economy reach the "good" equilibrium. (For one particularly relevant example of the latter, it's worth re-reading Paul Krugman's old column about the amount of time that Europeans are allowed to spend with their friends and family compared to Americans.)

The importance of having a well-functioning government that isn't afraid to invest in the future has always been clearly recognized in development economics. How many underdeveloped countries can you think of that have pulled themselves out of poverty without significant government involvement and investment, after all? But I think that an important implication of this comparison between the US and Europe is that government spending -- which Europeans are simply not afraid of the way that Americans seem to be right now -- continues to be an important ingredient in the development of even the most advanced countries.

This conclusion is supported by a recent empirical study by James Alm and Janet Rogers, "Do State Fiscal Policies Affect State Economic Growth?" (pdf). Their data shows that states whose governments spend more -- particularly on education -- enjoy greater prosperity. And the same logic can be applied at the national level. European countries have been better at making productive government investments in their citizens and their cities, and they are now reaping the rewards.

In other words, while most people would agree that it is possible to have too much government spending and involvement in the economy, it must logically also be true that there is such a thing as too little government spending. And to me, it's clear that the US has crossed the line into that latter category.

Fearing the Future

Given that current state of things, it's interesting to think about what the future might hold. And that's where I get deeply, deeply discouraged.

Let's put it this way: if you were in a country that used to be the richest in the world but had recently been passed by other countries that are now more advanced or well-off, would you:

(a) decide to try to change the situation, and respond by making investments in things that will renew and sustain economic growth and development into the future, such as education and infrastructure; or would you

(b) respond by further reducing long-term investment, cutting the resources devoted to educating your population and to updating your out-moded and deteriorating infrastructure.

The US currently seems to be making choice (b).

I feel as though many Americans (or at least a very vocal and politically effective group of them) have grown afraid of the future. Afraid to recognize that change and growth can be managed, assisted, and improved upon when faced with collective confidence and creativity. Afraid to remember that the government, as a result of its unique ability to look far into the future and to consider the well-being of society as a whole, has an important role to play in making that future a better one, and improving the lives of its citizens. And so, as a result, it won't surprise me to see the US-European divergence continue for quite some time.

Sunday, May 15, 2011

Simple Foods: New Potatoes

In another installment of the very occasional series, "Simple Foods", today it's about new potatoes. I've been thinking about them ever since an amazing dining experience I had recently while visiting relatives in Oxford, England. The location is significant because in England it is now the season for new potatoes.

So what? Potatoes are available all the time, right? Ah, no. That's where you're wrong.

Okay, well, technically you're right. Potatoes are indeed available all the time. But new potatoes -- those young potatoes that are harvested within a week or two of the plant's blossoming in the late spring -- are entirely different from potatoes eaten during the other 50 weeks of the year. New potatoes have a satisfying toothiness, yet are somehow still soft and delicate, and deliver a sweetness that carries just a hint of green. My preference is to eat them simply, scraped with a knife and then boiled in salty water, perhaps then sprinkled with parsley, and eaten with a bit of butter for each bite.

They're delicious. Because they have to be eaten within a day or so of harvest (the sugars in the harvested potato quickly begin turning to starch, changing its flavor and consistency into that of a normal potato faster than you'd think), they pretty much have to be local. And, best of all/worst of all, in their finest incarnation new potatoes are only available for a couple of weeks each year, though exactly which weeks depends entirely on where you are.

Is there any other type of food that changes so dramatically in its character during the harvest period? I don't typically think of peaches harvested early in the season being completely different from peaches harvested late in the season, or find myself able to tell if a bowl of rice came from an early picking or a late one.

In my case, the new potatoes I've been thinking about formed the backbone for that incredible, simple meal prepared by my aunt. The potatoes, some thick slices of delicious smoked salmon, tender local asparagus (also right in season), plenty of butter, and that's all it took. It was all fantastic... but it's the new potatoes that I keep thinking about...

Saturday, May 14, 2011

The Mechanics of Greek Default

For those of you thinking about how a (probably inevitable) Greek default might work, take a look at Barry Eichengreen's piece this week at Project Syndicate. I can't think of any economist more knowledgeable about issues of international finance than Eichengreen, so when he describes the mechanics of default, it's worth paying close attention.

The Full Brady

BERKELEY – Financial markets are increasingly certain that a Greek debt restructuring is coming, and European policymakers fear the worst. ...But there is also a best-case scenario, where Greek debt is restructured in a way that doesn’t threaten the banking system.

The simplest way to achieve this would be to require banks exposed to southern European debt to raise more capital. ...But Europe’s track record does not inspire confidence that the next round of tests will be much more rigorous than the last. Raising capital is expensive. This encourages stakeholders to deny, rather than acknowledge, problems.

Plan B would extend the maturity of Greece’s debt. ...But this would still leave Greece with an impossibly heavy debt burden. A reduction in that burden of 40%, whether in the form of reduced interest or principal, is needed to bring the debt-to-GDP ratio to below 100%, a level at which the country has some hope of meeting its payment obligations.

Fortunately, there is another way: emulate the Brady Plan, under which commercial banks, together with the United States, the International Monetary Fund, and the Paris Club of sovereign creditors, restructured and took haircuts on the debt of Latin American and Eastern European governments at the end of the 1980’s. Two of my Northern California neighbors, Peter Allen and Gary Evans – both veterans of the Brady Plan – have explained how a similar plan could be implemented today...

...So, rather than worrying that they might be approaching a Lehman Brothers moment, European policymakers would be better off designing a Greek debt deal tailored, like the Brady Plan, to avoid this fate.
Read the whole piece for all of the juicy details...

Friday, May 13, 2011

Comparing Europe and the US: Alternative Measures of Economic Well-Being

Yesterday I went into some detail regarding official national income statistics and what they tell us about income differences between the US and Western Europe. And in particular, I drew attention to some of the limitations of those aggregate income statistics. So given the fact that GDP or National Income is a very imperfect way to compare economic well-being, what other data can help us to get a sense for which side of the Atlantic is doing better?

The point of the last post was that we should not rely on any one single indicator to judge who’s more advanced, but rather assemble a variety of measures and build a composite sketch from their collection. So here are some brushstrokes that help us to paint a more complete picture.

Hours of work (source: OECD):

This one was noted by several commenters, who are quite correct that the difference in time spent at work makes a significant difference to well-being. Europeans certainly manage to have a lot more time to spend relaxing with friends and family than Americans do (family values, anyone?), and furthermore Europeans have generally chosen to take a larger share of their increased wealth in the form of time away from the office over the past 20 years.

Access to broadband (source: World Bank):

It surprises me that the country that leads the world in internet technology lags in broadband internet access out of this group.

Investment in transportation infrastructure (source: Int'l Transport Forum):

No surprise that the US woefully underinvests in rail transportation, except perhaps for the magnitude of the difference. (Though if you ever ride Amtrak, then perhaps even that is unsurprising.) Europeans are convinced that rail travel is efficient and comfortable, while Americans... clearly aren’t.

But the fact that the US also isn't keeping up with Europe in maintaining roads does surprise me a bit. Since the US depends so heavily on road transport as the backbone of its transportation infrastructure, as well as for daily commuting purposes, I would have guessed that the US put more resources into roads than European countries. But now that I see this data, and think about the rough-and-tumble driving experiences and long commuting times that one regularly faces across the US, then I realize that better and safer roads (in addition to better rail transport, of course) are actually a significant reason why Western Europe may feel like it's better functioning, more modern, and, well, richer than the US. For more on this, you might want to check out a recent Economist article about the US's shabby transportation infrastructure (the source for the chart to the right).

Money spent on what the OECD defines as “Recreation and Culture” (source: the OECD's PPP benchmark survey):

Germans seem to be particularly stingy when it comes to spending on culture and recreation, and I don't have a good theory to explain that one...

Finally, just for fun (and because this seemed of particular interest to numerous readers), here’s a rather unscientific look at what vacations cost in Europe compared to the US. I’ve tried to match up vacation pairs that are roughly comparable in terms of distance and style, all vacations are for 7 nights, and I’ve listed the second-lowest price that I found for each search using Orbitz for the US and Thomas Cook for the UK and France.

Vacation Affordability:

This casual comparison suggests that my assertion the other day that international travel (by which, for Europeans, I mean outside of Europe) is more affordable for Europeans than Americans was not unreasonable, though actually the differences are not really very large. Obviously this is not a scientific comparison, but it’s fun to see nevertheless. (And again, note that this is a case where the relatively weak dollar has a direct impact on the relative wealth of Western Europe compared to the US.)

The particular measures I’ve looked at are generally consistent with my sense that Western Europeans are now, on average, "richer" than Americans. But of course, I had to choose which indicators to try to find data for, and naturally I opted to research the types of indicators that I personally think are important reflections of a country’s economic well-being. Others may have very different opinions about that, however, and thus believe different indicators would be better. (For example, if you think having more cars per household is a good measure of well-being, I'm sure the US would trounce these European countries.) Feel free to suggest some other types of data to look at, or even send me your own comparisons, if you like. If I get some interesting other measures, I’ll put them up in a follow-up post.

The Higher Cost of Higher Education

Ryan Avent draws our attention to a debate going on this week about the extremely high price of education in the US. To focus the conversation he asks "Is higher education a bubble?" In partial answer to the question he writes:
It's much harder to talk about a bubble in education than it was one in housing. In housing, there was a clear metric: prices, in absolute terms and as a ratio of just about everything, were soaring. And there was a clear debate: are these increases justified by some real economic shift or are they a bubble associated with new mortgage products and loose credit. In higher education, the questions are much more difficult.
I agree, but I would put it even more strongly: it is simply not possible that the high cost of higher education in the US is a bubble the way that the housing market was a bubble, because it is not really possible to have "bubbles" for things that are not assets -- at least not the way we traditionaly understand the meaning of the term "bubble".

A speculative bubble, such as we saw with housing during the mid 2000s or with the US stock market in the late 1990s, is usually defined as a situation in which the price for something becomes detached from its underlying true value because people suppose that they will be able to resell the item for an even higher price at a later time. With real estate, for example, people paid more than houses were worth in 2003-06 (and often more than they could afford) because they assumed that they would be able to resell the house in the future for an even higher price than they paid for it. Once you think you will be able to resell something in the future at a higher price, then you become willing to pay more than its underlying value would actually recommend.

But with services such as education, there's no way to store the purchased item and resell it later. So drawing an analogy between price increases for services and price increases for assets doesn't really work.

Instead, if we want to understand why competition doesn't seem to work to bring down the price of education, we need to think in terms of market failures, just as market failures explain why competition doesn't work to bring down healthcare costs in the US. The types of market failures that may exist in the market for higher education are likely to be different from those that permeate the market for health care, but they still exist. And understanding exactly what they are will be the key to understanding the high cost of higher education.

Thursday, May 12, 2011

National Income Comparisons between Europe and the US

As a follow-up to the previous post on my purely subjective perception that Europe seems to be passing the US in terms of economic development, I've been exploring some different ways to compare living standards between the two. The obvious place to start (at least when you're an economist) is with national income statistics.

The first chart below shows one simple way to compare income across countries; it shows net national income (that's the income earned by the various factors of production in the economy, after the loss of used-up capital equipment has been accounted for) in per capita terms. To put them in a common currency to make a cross-country comparison more meaningful, I converted all figures to US dollars using PPP exchange rates, which (in theory) should take into account the differences in relative prices between countries.

This picture shows that, according to national income statistics, the US is definitely the richest country of the handful I've selected for this analysis. However, the gap has closed somewhat over the past 20 years, in part because real per capita income growth was so lousy in the US during the 2000s.

However, I don't think this is nearly sufficient as a comparison, for a couple of reasons. First, it doesn't pass the smell test. Do we really think that the average family in the Netherlands today is less well off than the average family in the US was in 1990? That seems pretty unlikely to me.

Part of what's going on is that, if we're interested in understanding the international purchasing power that residents of each economy had, then we should really use actual exchange rates instead of PPP exchange rates. Actual exchange rates tell us how much stuff someone who gets paid in one currency -- dollars, for example -- could buy if they are shopping in the international marketplace (either as a tourist or an importer) rather than the purely domestic market.

The next chart shows what has happened to the relative purchasing power of people in the same handful of countries. And what this shows is that the continental European countries have indeed become significantly "richer" relative to the US over the past 10 years. This is the result of the strengthening of the euro relative to the dollar over that period, which more than offset the gains enjoyed by the US during the 1990s that resulted from good economic growth and a strong dollar.

What this means is that, for example, a person earning the average income in the US was able to buy about 28% more goods and services internationally in 2010 than they could in 1990. Meanwhile, a person earning the average income in Germany was able to buy about 55% more stuff in 2010 compared to 1990. This suggests that an important part of my subjective perception that Europeans have gotten richer than Americans in recent years is simply due to the weakness of the dollar and strength of the euro. (Note that this is an important facet of the ongoing rebalancing process wherein the US is getting better at living within its means.)

But I think there's another, more fundamental problem with these sorts of simple national income comparisons across countries. In particular, most economists would agree that GDP is actually a pretty poor measure of welfare, if used in isolation. It may be the single best indicator we have of economic well-being, but that doesn't mean it's a particularly good one.

Consider some events that would increase a country's GDP: an epidemic that causes health care spending to rise; an environmental disaster that requires expensive cleanup; a crime wave that leads to increased policing and detention; a decision to build a million houses and then blow them up as a spectacular fireworks display. All of these would boost GDP -- but would that mean that they made the country better off?

Since national income can rise as a result of things that most people would agree are probably not particularly "good", if you're trying to get an understanding of cross-country differences in welfare you will have to use additional measures. Stay tuned for some examples...

UPDATE: To illustrate exactly what I mean, I'm adding one more chart. The graph below shows Net National Income per capita for the same countries in 2008, using actual exchange rates to convert them all into dollars. So the US had about $41,000 in total net income per capita, Germany about $38,000, and the Netherlands a bit over $43,000. Next, I've taken spending data from the OECD's 2008 PPP Benchmark survey, and broken out how much residents of each country spent on health care and education. That's the red portion of each bar. The remainder is what individuals in each country had to spend on everything else. So, for example, on average people spent about $9,500 per capita on healthcare and education in the US in 2008, leaving about $31,500 available for all other types of goods and services.

Interestingly, people in the US actually had less national income left to spend on things other than healthcare and education than in any of the other countries. So even though the US's GDP looks higher than most other countries, a good chunk of that is actually an artifact of the US's high health care costs. Whether US residents receive more health care services than residents of these other countries is another question... but the result is that the US has fewer resources available to spend on the other things that produce well-being for individuals than any of these other countries. And that is certainly consistent with casual observation.

Oh, and as noted by a commenter, we haven't even gotten into issues of income distribution...

Tuesday, May 10, 2011

Thoughts on Europe, the US, and Fearing the Future

I'm back in the US after several days in Europe. So you can expect the regular posting to resume soon. But as I get back to my daily routine in the US, I keep coming back to one new and surprising (at least to me) thought: when I travel from Europe back to the US, it now feels like I'm returning to a country that is slightly, but noticeably, less advanced.

Having family there, I've been traveling to Western Europe regularly for as long as I can remember. I've also spent some time living there. And up until recently I've always had the vague and purely subjective sense that Europe and the US were roughly equally developed -- equally rich, if you want. Europeans chose to distribute their resources differently, opting for smaller apartments and fewer cars, while using those resources to enjoy more pleasant towns and cities, and more time with family and friends. But in general, I always felt like countries on both sides of the Atlantic were basically similarly advanced, with if anything a slight edge going to the US.

Over the last year or two, however, my perception has changed. I've begun to get the distinct (albeit also purely subjective) feeling that Europeans are simply better off than Americans. That Western Europe is now more advanced than the US.

What has caused this change in my perception? That's the question I'm asking myself today. I'm not entirely sure what the answer is, but let me throw out a few of the contrasts that are simmering in my mind: trains that run on time; clean and well-maintained private and public spaces; reliable wireless data services; state-of-the-art transportation facilities and infrastructure; lack of anxiety about health care costs; relative affordability of vacations abroad for average people; ambitious and far-sighted public works projects; efficient and modern cities (even when they contain many centuries-old buildings) that incorporate modern technologies and simply work.

For me, these sorts of details somehow add up to a sense that Western European countries are energetically and confidently moving ahead, are not afraid to plan for the future, and are even looking forward to actively creating it. By contrast -- with the notable exception of its aggressive development of internet technology -- the US seems preoccupied with figuring out how to preserve things the way they've always been, to resist the process of change. And that is exactly the opposite of how I used to feel when I traveled across the Atlantic in the 1980s or 90s.

Okay, yes, I am of course exaggerating the differences to make my point. And I am more familiar than most people with the statistics that one could use to measure those differences, so maybe I'll sift through some of the data to find out what objective support exists for this vague feeling I have. I'm also acutely aware of the many enormous problems -- not to mention policy blunders -- confronting the EU and individual European governments, so don't think that I'm blind to the problems there.

Nevertheless, I can't help being struck by this purely subjective sense that there is a new and growing gap between the US and Europe when it comes to both the quality of life and the willingness to look fearlessly into the future. To me, it just feels different now.

Monday, May 02, 2011

Feel the Stimulus

Last week's release of first quarter GDP figures for the US confirmed what we already knew -- the government sector of the US economy is shrinking, and this is putting a sharp drag on economic growth.

During the first 3 months of 2011 the US economy grew at a rate of only 1.8%. This disappointing figure was substantially the result of cutbacks in government spending. If spending by all levels of government in the US had remained constant, the first quarter GDP growth rate would have been about 2.9% instead.

The following picture shows how much government spending has contributed to - or deducted from - economic growth in the US in each quarter since the start of 2009. Do you see that massive and sustained fiscal stimulus? No, neither do I.

To put this in context, let's take the longer view. The next chart shows government spending on final goods and services, broken into federal vs. state and local spending, since 2001. The shaded area marks the time since early 2009, when we supposedly were the beneficiaries of fiscal stimulus.

Actually, in light of this picture, and particularly considering the steady contraction in state and local government spending since early 2009, I feel almost impressed that the US economy has done as well as it has done against this headwind.

One of the biggest reasons that the US economy has done at all well in recent quarters is the relatively good performance of US net exports. Excluding petroleum imports (which have surged in recent months in dollar value, even though they have remained roughly constant in physical quantities), net exports from the US are doing better now than any time in the past 15 years. And for that we can thank (in part) the decline in the dollar. The following picture illustrates.

The dollar's decline (which essentially happened from 2002 to 2008) has helped to make US exports more competitive. The improvement in the US's net export position is also a reflection of the ongoing rebalancing that had to happen after the bubble years; as individuals in the US have been gradually paying down debts and fixing their balance sheets, this has helped to reduce the international borrowing needs of the US as a whole, which translates into a smaller deficit in net exports for the US.

So, to sum up, the situation seems to be this right now: despite the best efforts of the government sector to torpedo economic growth in the US, the international sector is working hard to help sustain economic growth. It's almost exactly the opposite of what many people would have predicted a couple of years ago.