## July 13, 2009

### Pre-ARRA, How Badly Did Macroeconomic Forecasters Overpredict GDP and Employment in 2009Q1?

There's been a lot of breast beating over the fact that the Administration underestimated the severity of the downturn. From this has come a lot of confused argument -- sometimes not internally consistent -- over whether this invalidates the usefulness of the stimulus package, whether the stimulus worsened the economic outlook, etc. I'll dispense with the clearly economically illogical arguments and try to tease out what is the "surprise" element in the 2009Q1 figures, and from that infer how much worse the economy was relative to what private sector forecasters predicted, conditional upon the passage of the ARRA.

(This is a slightly different observation that since essentially none of the stimulus packages expenditures occurred within the first quarter [0], it's disingenous to argue the stimulus won't work based upon data that extends to only four months after the bill's passage).

First, define "surprise" as the deviation of the ex post value of X from the ex ante value:

Xt - ε(Xt | Ω t-1)

Notice the information set Ωt-1 does not include information that arrives between date t-1 and date t. Further note, I've used ε to denote subjective rather than mathematical expectations. If subjective expectations equal mathematical expectations, then one is using the rational expectations hypothesis, so that forecast errors are i.i.d. The rational expectations hypothesis is not an uncontroversial assumption (for instance, the efficient markets hypothesis is a joint hypothesis combining a particular asset pricing model and rational expectations), but for the sake of exposition, I'll use it here.

Xt - E(Xt | Ω t-1)

Now, let X be GDP. There is an additional complication that the data are sampled more frequently than the data are reported, i.e., GDP is quarterly while these expectations are measured by the WSJ at the quasi-monthly frequency. I'll ignore that subtlety as well, as it pertains more to the time series properties of the measured errors, than the surprise element in 2009Q1 GDP.

In order to get a feeling for the information and views roughly contemporaneous with the analysis of ARRA's effects, let's examine measured GDP as of 30 January, and the mean forecast from the WSJ survey of forecasters for early February. The early-February forecast incorporates the data and information used in the Administration's forecast -- actually a little more, since their data set ended in January (see this discussion of the Troika forecasting process here). Crucially, by this time, it was pretty well acknowledged that some sort of stimulus bill in the \$800 billion range would be passed. Now, compare against actual GDP recorded as of the end-June 2009 in the 2009Q1 final release. The difference between the February forecast and the actual reported is the output surprise (relative to early February 2009 data).

Figure 1: Log real GDP 2008Q4 advance (blue), 2009Q1 final (teal), WSJ mean forecast from February 2009 survey (red inverted triangle) and from Jul 2009 survey (green triangle), all in Ch.2000\$ SAAR. Dashed gray line at NBER defined recession start date. Source: BEA GDP releases of 30 Jan 2009 and 25 June 2009, and WSJ February and July surveys, and NBER.

The gap between actual and expected was 0.85 ppts (calculated as a log difference). In other words, GDP turned out to be lower by nearly one percentage point than expectations conditioning on the passage of the stimulus bill. That is a quantification of how much worse the economy was (in GDP terms) than anticipated, according to private sector forecasters. (This means that individuals who ascribe the worse-than-expected performance of the economy to the stimulus package cannot look to the ex post GDP realizations for support for their arguments.)

In growth rate terms, the mean forecast from the early-February WSJ forecast was for -4.7% SAAR growth (q/q calculated in log differences), while the actual outcome was -5.7% (4.6% and 5.5% in base period terms).

Because the entire predicted trajectory for the economy is (approximately) shifted down, 2009Q2 output is roughly the same level below what was anticipated based on February data -- that is 0.88 ppts (log terms).

One can do a slightly more formal analysis to see how nonfarm payroll employment is affected by this "news". Run a regression of first log difference of nonfarm payroll employment on current and 3 lags of log first differenced GDP.

Δ(nfp t) = -0.002 + 0.323 Δ y t + 0.201 Δ y t-1 + 0.152 Δ y t-2 + 0.171 Δ y t-3 + ut (equation 1)

Adj-R2 = 0.74, SER = 0.0026, Mean Dep.Var. = 0.0043, DW = 0.90, Sample = 68q1-08q4

Then use this to dynamically forecast out-of-sample using the WSJ mean February forecast for 2009Q1 and 2009Q2. The resulting actual (blue) and implied (red) are depicted in Figure 2 below.

Figure 2: Nonfarm payroll employment, seasonally adjusted, in thousands (blue), and out of sample dynamic forecasted NFP using WSJ February mean forecast for GDP, and equation (1) (see text). Thick gray lines denote plus/minus 2 standard error bounds. Dashed gray line at NBER defined recession start date. Tan shaded area denotes forecast period. Source: BEA, Employment Situation, June release, NBER, and author's calculations.

The point forecasts suggest that 1.16 million of the average 2009Q1 NFP level is associated with the lower than anticipated GDP, and similarly 1.74 million of the average 2009Q2 level. Since there is estimation error involved in relating NFP to GDP, I've included the forecast plus 2 standard errors and minus 2 standard errors (which is bigger than the plus/minus 2 standard error bands often depicted in VAR analyses). The actual employment level is below that which can be explained by estimation error.

One critique (of many possible) is that the estimated link between GDP and employment is over-stated as it includes data from the late-1960s and 1970's. In order to address this concern, I re-estimate equation (1) using data conforming to the period of the "Great Moderation", i.e., 1985Q1-08Q4, and to the analogous dynamic forecast for 2009Q1-Q2. This results in a 1.2 million gap instead of a 1.7 for 2009Q2.

I don't claim that this is the only way of conducting the analysis, and looking at counterfactuals. But doing all this has been fairly straightforward and (I hope) transparent to anybody with some small knowledge of macroeconomics and econometrics, and a willingness to think a little. Hence, I hope we can move beyond using forecasts based on early-January data, compare against outcomes realized today, and declare this or that policy ineffective. Please.

For a survey of the recent missives on the stimulus package, and the advisability of a new one, see the Economist's Free Exchange.

Posted by Menzie Chinn at July 13, 2009 01:03 PM

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Professor Chinn,

I think you make a persuasive argument about the main flaw in the stimulus-opposition's arguments. However, my question is: exactly what form should the additional stimulus take? Should it be a 'automatic stabiliser' in the form of additional aid to states like California and others, or should it be discretionary?

My impression of the first stimulus bill was that it was largely discretionary, and for this reason not much of the money has yet been spent. I think this is where stimulus-critics have some merit in their arguments: if the first stimulus was largely discretionary and exhausted all stimulative spending possibilities for 2009 and 2010, then there's not much left to be done in a second discretionary stimulus. However, if there are still good near-term options available to be funded by a second stimulus, that just speaks to the poor design of the initial stimulus package that passed them over in favor of ineffectual spending years later (again, I am referring to DISCRETIONARY stimulus).

I think the pro-stimulus camp's arguments would be improved if they argued that a second stimulus was required on non-discretionary grounds. The current debate between pro- and con-stimulus people does not, in my opinion, make this distinction clear.

I'd be interested to hear your thoughts on this (and thanks for taking the time to do this)

Alan

Posted by: Alan at July 13, 2009 04:46 PM

One point which cannot be avoided is the implication of the Obama stimulus plan schedule, which presumed to spend the bulk of its cash in 2010, even as it was estimating a peak to unemployment in 2009.

Effectively, it appears, the administration wanted a big headline number - \$878B - but never thought that number would be needed.

Which causes me to wonder if the stim package was not just some sort of con job.

Posted by: Charley2u at July 13, 2009 07:53 PM

Thanks for the interesting post. I address it a little on my blog.

I'm not sure if I agree with one of your claims. If GDP is a percentage point lower than what was expected conditioning on the expected passage of the stimulus, why does that mean that "individuals who ascribe the worse-than-expected performance of the economy to the stimulus package cannot look to the ex post GDP realizations for support for their arguments"?

In fact, I don't see how it supports either a pro or anti-stimulus argument. GDP could be worse than expected because the economy was worse than the consensus, the stimulus did not live up to the Obama administration's expectations, or the very, very small chance the stimulus had a negative effect (none of these are mutually exclusive).

You make a good point when you states that very little of the stimulus was spent in Q1, and thus should have little effect on Q1 GDP. I can see how that means it's not right to look at Q1 numbers and conclude the stimulus was ineffective, but not the logical conclusion you make.

Posted by: BHE at July 13, 2009 10:45 PM

Which causes me to wonder if the stim package was not just some sort of con job.

You are still wondering about that?

This stimulus is the biggest barrel of corrupt pork in human history (even adjusting for inflation).

This is shameless rewarding of the left at the expense of normal people.

Posted by: Heterosexual at July 14, 2009 12:19 AM

Menzie wrote:

I'll dispense with the clearly economically illogical arguments and try to tease out what is the "surprise" element in the 2009Q1 figures, and from that infer how much worse the economy was relative to what private sector forecasters predicted...

There were many people who saw the economy in serious trouble but most of them were outside this circle Menzie has drawn.

I made a comment in an earlier post that there were many analysts who predicted the recent credit crisis and decline, and Menzie challenged me to name names. Because my knowledge of the coming decline came from many sources and I did not record them, I had a difficult time answering him as clearly as I would have liked. Dirk Bezemer of the University of Groningen in the Netherlands has written a paper entitled:
“No One Saw This Coming”
Understanding Financial Crisis Through Accounting Models
http://mpra.ub.uni-muenchen.de/15892/1/MPRA_paper_15892.pdf

In his paper he makes the following important observation.

The credit crisis and ensuing recession may be viewed as a ‘natural experiment’ in the validity of economic models. Those models that failed to foresee something this momentous may need changing in one way or another. And the change is likely to come from those models (if they exist) which did lead their users to anticipate instability.

This is especially important for Keynesian economics because Keynesians claim to have the answers, yet not one Keynesian saw this coming from their models.

Below is a list of those from Appendix A in the paper who actually made specific predictions of the crisis based on their models. There are many more who predicted this based on classical economic analysis but these fit Bezemer's model. Now I know that Menzie will take issue with some of the names because they actually have jobs rather than being paid by a state academic institution but this is a good cross section of disciplines. There are even some professors on the list.

Dean Baker,
US co-director, Center for Economic and Policy Research
“ …plunging housing investment will likely push the economy into
recession.” (2006)

Wynne Godley,
US Distinguished Scholar, Levy Economics Institute of Bard College
“The small slowdown in the rate at which US household debt levels are
rising resulting form the house price decline, will immediately lead to
a …sustained growth recession … before 2010”. (2006). “Unemployment
[will] start to rise significantly and does not come down again.” (2007)

Fred Harrison,
UK Economic commentator
“The next property market tipping point is due at end of 2007 or early
2008 …The only way prices can be brought back to affordable levels is a
slump or recession” (2005).

Michael Hudson,
US professor, University of Missouri
“Debt deflation will shrink the “real” economy, drive down real wages, and
push our debt-ridden economy into Japan-style stagnation or worse.”
(2006)

Eric Janszen,
US investor and iTulip commentator
“The US will enter a recession within years” (2006). “US stock markets are
likely to begin in 2008 to experience a “Debt Deflation Bear Market”
(2007)

Stephen Keen,
Australia associate professor, University of Western Sydney
“Long before we manage to reverse the current rise in debt, the economy
will be in a recession. On current data, we may already be in one.” (2006)

Jakob Brøchner Madsen & Jens Kjaer Sørensen,
Denmark professor & graduate student, Copenhagen University
“We are seeing large bubbles and if they bust, there is no backup. The
outlook is very bad” (2005)” The bursting of this housing bubble will have
a severe impact on the world economy and may even result in a recession”
(2006).

Kurt Richebächer,
US private consultant and investment newsletter
writer
“The new housing bubble – together with the bond and stock bubbles – will
invariably implode in the foreseeable future, plunging the U.S. economy
into a protracted, deep recession” (2001). “A recession and bear market in
asset prices are inevitable for the U.S. economy… All remaining questions
pertain solely to speed, depth and duration of the economy’s downturn.”
(2006)

Nouriel Roubini,
US professor, New York University
“Real home prices are likely to fall at least 30% over the next 3
years“(2005). “By itself this house price slump is enough to trigger a US
recession.” (2006)

Peter Schiff,
US stock broker, investment adviser and commentator
“[t]he United States economy is like the Titanic ...I see a real financial
crisis coming for the United States.” (2006). “There will be an economic
collapse” (2007).

Robert Shiller,
US professor, Yale University
“There is significant risk of a very bad period, with rising default and
foreclosures, serious trouble in financial markets, and a possible recession
sooner than most of us expected.” (2006)

Posted by: DickF at July 14, 2009 05:31 AM

"Now, let X be GDP. There is an additional complication that the data are sampled more frequently than the data are reported, i.e., GDP is quarterly while these expectations are measured by the WSJ at the quasi-monthly frequency. I'll ignore that subtlety as well, as it pertains more to the time series properties of the measured errors, than the surprise element in 2009Q1 GDP."

Is there a one paragraph "Reader's Digest" overview of how to treat this complication? Do you do some sort of square root scaling of the variance of the GDP number to make it time scale consistent with the expectations number?

Posted by: Robert Bell at July 14, 2009 05:38 AM

"Hence, I hope we can move beyond using forecasts based on early-January data, compare against outcomes realized today, and declare this or that policy ineffective. Please."

Should we not also consider the stated goal of the stimulus in comparison to the results. The stimulus was sold as desperatly needed in order to stave off high unemployment. Two of the goals were to keep unemployment below 8% and provide shovel ready jobs to put people to work.

Even if those goals were unrealistic, the bill was sold to accomplish both. Regardless of the current spin that the stimulus is working as intended, those goals were not meet. Perhaps the real goals were different: providing pork during the 2010 election cycle for democrats.

Posted by: Neal at July 14, 2009 07:05 AM

Just for grins I have collected a group of quotes from Paul Krugman. I post them below for those who need a chuckle.

German Interview, undated

http://www.pkarchive.org/global/welt.html

"During phases of weak growth there are always those who say that lower interest rates will not help. They overlook the fact that low interest rates act through several channels. For instance, more housing is built, which expands the building sector. You must ask the opposite question: why in the world shouldn't you lower interest rates?"

May 2, 2001

http://www.pkarchive.org/column/5201.html

I've always favored the let-bygones-be-bygones view over the crime-and-punishment view. That is, I've always believed that a speculative bubble need not lead to a recession, as long as interest rates are cut quickly enough to stimulate alternative investments. But I had to face the fact that speculative bubbles usually are followed by recessions. My excuse has been that this was because the policy makers moved too slowly -- that central banks were typically too slow to cut interest rates in the face of a burst bubble, giving the downturn time to build up a lot of momentum. That was why I, like many others, was frustrated at the smallish cut at the last Federal Open Market Committee meeting: I was pretty sure that Alan Greenspan had the tools to prevent a disastrous recession, but worried that he might be getting behind the curve.

However, let's give credit where credit is due: Mr. Greenspan has cut rates since then. And while some of us may have been urging him to move even faster, the Fed's four interest-rate cuts since the slowdown became apparent represent an unusually aggressive response by historical standards. It's still not clear that Mr. Greenspan has caught up with the curve -- let's have at least one more rate cut, please -- but the interest-rate cuts do, cross your fingers, seem to be having an effect.

If we succeed in avoiding recession, this will mark a big win for let- bygones-be-bygones, and a big loss for crime-and-punishment. And that will be very good news not just for this business cycle, but for business cycles to come.

July 18, 2001

http://www.pkarchive.org/economy/ML071801.html

"KRUGMAN: I think frankly it's got to be -- business investment is not going to be the driving force in this recovery. It has to come from things like housing, things that have not been (UNINTELLIGIBLE).

DOBBS: We see, Paul, housing at near record levels, we see automobile purchases near record levels. The consumer is still very much in this economy. Can he or she -- or I should say he and she, can they bring back this economy?

KRUGMAN: Well, as far as the arithmetic goes, yes, it is possible. Will the Fed cut interest rates enough? Will long-term rates fall enough to get the consumer, get the housing sector there in time? We don't know"

August 8, 2001

http://www.pkarchive.org/economy/ML082201.html

"KRUGMAN: I'm a little depressed. You know, inventories, probably that's over, the inventory slump. But you look at the things that could drive a recovery, business investment, nothing happening. Housing, long-term rates haven't fallen enough to produce a boom there. The trade balance is going to get worst before it gets better because the dollar is still very strong. It's not a happy picture."

August 14, 2001

http://www.pkarchive.org/column/81401.html

"Consumers, who already have low savings and high debt, probably can't contribute much. But housing, which is highly sensitive to interest rates, could help lead a recovery.... But there has been a peculiar disconnect between Fed policy and the financial variables that affect housing and trade. Housing demand depends on long-term rather than short-term interest rates -- and though the Fed has cut short rates from 6.5 to 3.75 percent since the beginning of the year, the 10-year rate is slightly higher than it was on Jan. 1.... Sooner or later, of course, investors will realize that 2001 isn't 1998. When they do, mortgage rates and the dollar will come way down, and the conditions for a recovery led by housing and exports will be in place.

October 7, 2001

http://www.pkarchive.org/economy/ML071801.html

"Post-terror nerves aside, what mainly ails the U.S. economy is too much of a good thing. During the bubble years businesses overspent on capital equipment; the resulting overhang of excess capacity is a drag on investment, and hence a drag on the economy as a whole.

In time this overhang will be worked off. Meanwhile, economic policy should encourage other spending to offset the temporary slump in business investment. Low interest rates, which promote spending on housing and other durable goods, are the main answer. But it seems inevitable that there will also be a fiscal stimulus package"

Dec 28, 2001

http://www.pkarchive.org/column/122801.html

"The good news about the U.S. economy is that it fell into recession, but it didn't fall off a cliff. Most of the credit probably goes to the dogged optimism of American consumers, but the Fed's dramatic interest rate cuts helped keep housing strong even as business investment plunged."

August 2, 2002

http://www.nytimes.com/2002/08/02/opinion/dubya-s-double-dip.html?scp=4&sq=krugman%20mcculley%20bubble&st=cse

"To fight this recession the Fed needs…soaring household spending to offset moribund business investment. [So] Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble."

Posted by: DickF at July 14, 2009 07:43 AM

charley2u: I don't understand your comment. Figure 1 in the original Romer-Bernstein document, posted here, contradicts your assertion. Please also consult this post showing projected CY2010-11 output gap, which seem pretty big to me, so that even if most spending takes place in FY 2010 (FY runs Oct-Sept) that's not such a terrible thing [0]).

DickF (5:31 am): Hmm. Think you should ask Nouriel Roubini what he categorizes himself as. You might also want to refer to Chinn (2005), written by a person you seem to categorize as a Keynesian...Gee, I'm already at two Keynesians. Would you wish to revise and extend your blanket assertion?

Robert Bell: It's not the magnitude of the number itself (I've converted the numbers to levels to make forecast comparisons, in this case) that's an issue. Think about making forecasts at time t-3, t-2, t-1, but only observe X at t-3, and t, for instance. Then the errors X-E(X|t-3), X-E(X|t-2) must be correlated. On the other hand, if comparing data sampled and observed at the same frequency, then under rational expectations, the errors should be i.i.d.

Posted by: Menzie Chinn at July 14, 2009 07:50 AM

BHE: As of early Feb., one has an information set incorporating passage of the stimulus bill, if not with 100% certainty, then pretty high. Then you have the actual realization of GDP. You can decompose the "surprise" into a part that it "new" information regarding the state of the economy, and "new" information regarding stimulus composition and effectiveness. I set the new information regarding the latter at near zero. You could try your own decomposition; I'd welcome finding out your conclusions.

Posted by: Menzie Chinn at July 14, 2009 07:56 AM

Menzie,

What are the possibilities potential GDP has actually shrunk due to the nature of the recession (more structural vs. cyclical), and therefore the output gap may be smaller.

This may be important in regarding the need of a second stimulus. Certainly, when the Romer & Bernstein paper came out, the forecasts they used (developed by the Bush Administration) probably did not envision a current -6.1% output gap.

If a recession disrupts the flow of capital to labor (or significantly disrupts the flow of labor due to sectoral adjustment), it seems this would justly lower potential GDP using the CBO's methodology.

For example, there's one economist who suggests using a price-index/inflation output gap. Using the short-run Phillips Curve, inflation is a sign that not as many idle resources are laying fallow. I believe his model puts the output gap at -2.1%.

Nevertheless, it might seem the current CBO potential GDP may be the best approach, given the disadvantages of the other existing models. Given the tendency for random shocks to determine long-term trend growth estimates if one were to use a price index/inflation estimator, for example.

Posted by: Lance at July 14, 2009 09:24 AM

DickF: Just for grins I have collected a group of quotes from Paul Krugman. I post them below for those who need a chuckle.

Dick, if you are just going to shamelessly cut and paste someone else's work from the Mises Institute, you shouldn't claim it as your own. However, considering the source, I'm not surprised you would be embarrassed by it.

http://blog.mises.org/archives/010153.asp

Posted by: Anonymous at July 14, 2009 09:30 AM

Alan,
I think the pro stimulus camp would get a boost if they mention the best qtr of gdp growth over the last two years was the second qtr 2008, which was the same qtr the Bush stimulus checks went out. Had they made the stimulus longer (such as a payroll tax holiday) until much need public works/infrastucture projects kicked in we could have maintained positive gdp growth all along. Unfortunately lack of understanding of a floating rate currency prevails in Washington.

Posted by: markg at July 14, 2009 09:31 AM

The general problem is that people have more interest expense as a portion of their take-home pay than they're comfortable with for their flat or falling wages. How does the stimulus spending we will see address this key problem?
I see the policy as pushing interest rates higher than they otherwise would be and therefore keeping property values down (and people underwater). At the same time banks are squeezing their good borrowers with fees etc., and putting them at risk to offset their bad bets. And we're doing nothing to clear up the red tape and reduce the costs of building new proven energy tech. In fact we're working on increasing the costs and regulation and subsidizing production of tech that doesn't pass the cost/benefit check yet. This means less certainty in input operating costs and reduced consumption and investment all around, greater so than the expected increase in energy costs.

Posted by: aaron at July 14, 2009 10:01 AM

Lance: A reasonable question. The estimate you're citing is by John Williams at the SF Fed. In a previous post, I've cited the OECD's estimate of the impact. You'll also note the trajectory of CBO's potential is also bending downward, in part because of a projected reduction (relative to previous) in TFP growth and capital accumulation (as investment is lower). Whether that conforms to your views is of course a separate matter.

For an alternative New Keynesian estimate, see also this post, and references contained therein.

Posted by: Menzie Chinn at July 14, 2009 10:34 AM

Again, the most important point is under-discussed.

The 'Potential GDP' line is now very, very far ahead of reality. Either that has to get adjusted down, or we have to have a full year of 8% GDP growth just to catch up (like happened in 1983).

Also, the spread of electronics into the economy will decouple the notion that GDP and prosperity are tied. If the same product is available a year later for half the price, a customer's purchasing power rose, even if GDP contribution from the product fell. I think that is happening as well, in the 2-4% of the US economy that is high-tech.

Posted by: GK at July 14, 2009 01:46 PM

1. Given the structure of the ARRA in focusing on infrastructure investment in the context of multiple layers of government bureaucracy (notwithstanding the "shovel ready" adjective), I can't imagine why anyone really expected any effects from ARRA until at least this quarter and more likely 4Q09.

2. The WSJ economist consensus is a consensus largely of economists working in the financial sector who are most likely to benefit if the economy grows. Hence, their models and their minds are pre-disposed to GDP & employment growth.

3. More broadly, the economic models used by the financial sector and the USG have demonstrably been badly flawed, first, in projecting the downturn a year and a half ago, and now in predicting a return to growth. Why would one think they would get this right in January--or now?

There are a few financial analysts and economists who have gotten the course of the economy and its many facets right over the last two years, probably starting with Nouriel Roubini. One should ride the horse that's winning, not the consensus which, by definition, is mediocre and leaves you far back in the pack.

Posted by: Terry at July 15, 2009 07:16 AM

Terry: Interesting points. Regarding point (2), I'm in inclined to agree, but don't know of any specific statistical study that verifies the point. See this post.

Regarding point (3), I disagree. As I observed, the "surprise" exists regardless of whether rational equals subjective expectations. The interpretation differs. But for my argument that there was a serious deterioration in market outlook going from early Feb to July stands irrespective of your observation (you can look to WSJ early-March survey for verification).

Posted by: Menzie Chinn at July 15, 2009 08:18 AM

Analysis like this is the main reason that I consider Economists to be even less useful than astrologers. Economists spend so much time staring at numbers and trying to find curves that describe them that they forget (or ignore) the fact that their data aren't the result of some mathematical equation waiting to be discovered, but are the sum of millions (or billions) of people each making dozens of decisions per day. This is the economy.

The problem begins when economists start loving their numbers too much and confuse correlation with causation. We wind up with PhD-level cargo cult analysis. In this case, the reason for increasing unemployment is simple: the government is scaring the crap out of business. The rule of law is even more subservient to the whims of politicians than it has been in the past (GM / Chrysler bankruptcy proceedings, anyone?). We're facing very significant tax increases in the near future, and the politicians are being even more disingenuous than usual when describing how it will pan out (how badly we're going to get screwed). With the "card check" legislation in the pipeline we're faced with uncertainty as to whether we'll be able to easily adjust our workforce to economic and other business conditions. Those of us who are strongly affected by the value of the dollar are deeply concerned about the government borrowing money with its printing press.

Any downturn creates opportunities for well-run companies to expand, but right now the uncertainty is exceptionally high. There are some opportunities that are irresistible under these circumstances (I just expanded one company this year), but for the most part we're looking at mountains of potential problems offset by a bunch of politicians and their pet economists saying "don't worry - trust us."

Businesses don't like uncertainty. More uncertainty = more conservative management. We're going to wait and see how things shake out before risking what capital we have left. There's no surprise here; we're just (mostly) rational people making (mostly) rational decisions.

Posted by: Evil Red Scandi at July 15, 2009 09:11 AM

Evil Red Scandi: With such a high opinion of economists, I am driven to wonder why you are reading an economics blog.

Posted by: Menzie Chinn at July 15, 2009 09:42 AM

Anonymous,

If you will recheck you will see that the quotes were more than just those on the Mises site though I did find most of them there because it was such a good collection. But Krugman has been dispensing this poison since he drove Thailand into econmic distress in the early 1990s. Krugman is probably the most dangerous man in the last quarter of the 20th Century and continues with the same bilge in the 21st. Hopefully he has been so discredited that no one other than the Nobel committe will take him seriously.

Mentioning the Nobel Prize, it took a double hit recently: Al Gore, the biggest economic con-man our world has ever seen, and Paul Krugman, destroying economies left and right.

I am still adding to my Krugman collection BTW because he is such a hoot.

Here is one I just recently found from 1998.

“The way to make monetary policy effective is for the central bank to credibly promise to be irresponsible – to make a persuasive case that it will permit inflation to occur, thereby producing the negative real interest rates the economy needs.”

Posted by: DickF at July 15, 2009 10:23 AM

DickF: I am still adding to my Krugman collection BTW because he is such a hoot.

Here is one I just recently found from 1998.

ï¿½The way to make monetary policy effective is for the central bank to credibly promise to be irresponsible ï¿½ to make a persuasive case that it will permit inflation to occur, thereby producing the negative real interest rates the economy needs.ï¿½

Krugman was talking specifically about the liquidity trap that Japan found itself in in the 1990s but he would probably say the same about the current economic crisis in the U.S.

Everyone understands that to stimulate the economy that businesses want low interest rates, but it is real interest rates that matter, not nominal interest rates. In a liquidity trap the Fed can only reduce the discount rate to zero -- it can't go negative. Let's assume that banks borrow at zero and lend at 5% nominal. If there is deflation of 3% then the business' real interest rate is 8%, which is too high to stimulate investment. Another way to think about it is that because of deflation, a business will delay building a factory because it can build more cheaply later as costs deflate.

To get out of a liquidity trap the Fed needs to lower interest rates. It can't lower the nominal rate below zero but it can lower the real rate by increasing inflation. If the bank borrows from the Fed at zero and lends at 5% with inflation at 3%, then the real cost to business is only 2% and they are more likely to invest in new production. When there is deflation the only way the Fed can convince businesses that inflation is around the corner is to flood the economy with money, what Krugman jokingly calls promising to be irresponsible. That is because what under normal circumstances would be called irresponsible, in a liquidity trap, is the responsible thing to do. In extreme cases inflation can lead to negative real borrowing rates -- for example 2% nominal interest with 3% inflation. That was the situation Krugman was prescribing for in Japan in the 90s.

Posted by: Joseph at July 15, 2009 12:03 PM

DickF, if you listen to Krugman's Robbins Lectures, which can be downloaded from the LSE website, he admits that he was wrong in the mid- to late-1990's. The proximate impetus for such an admission is the current recession, and the next proximate is Japan in the 1990's.

Indeed, Krugman now believes that the past 30 or so years of macroeconomics has not only been a waste of time; it has been affirmatively harmful in terms of our understanding.

And this is what sets him apart from Republican hacks like Mankiw.

Posted by: SavageView at July 15, 2009 12:47 PM

Thanks for the reply. I understood the major point of your augment, but got a little confused with his conclusion. I said, "You make a good point when you state that very little of the stimulus was spent in Q1, and thus should have little effect on Q1 GDP. I can see how that means it's not right to look at Q1 numbers and conclude the stimulus was ineffective..." From what you said in the reply, I take it that's about what you meant (GDP was lower that what was anticipated due to errors in forecasting, and not an ineffective stimulus). Sorry Menzie, I guess I misunderstood what you wrote.

Posted by: BHE at July 15, 2009 05:35 PM

SavageView,

I would have more sympathy with Krugman if he was no longer spewing the same thing.

The Mises site pointed me to this from July 15,2009, just a few days ago.

…government deficits, mainly the result of automatic stabilizers rather than discretionary policy, are the only thing that has saved us from a second Great Depression.

How can anyone claim with a straight face government deficits are "automatic stabilizers."

I appreciated his apology now we need repentance.

Just for the record Mankiw is almost as bad only from a different direction.

Posted by: DickF at July 16, 2009 07:02 AM

MENZIE--

Thanks for your feedback on my comment above. I read the piece you linked to and think it affirms my view on (2) above (ie--financial sector economist pre-disposition to growth).

I was, however, confused by this statement re (3): "As I observed, the "surprise" exists regardless of whether rational equals subjective expectations. The interpretation differs."

To me, expectations are a combination of subjective and rational factors--whether it's the gifts I'll receive at my next birthday or economic growth. I simply don't know how one can reasonably split the two.

"Rational" models (economic and otherwise) are based (we'll say) on a series of equations derived from data (correlations, etc). But the models themselves are based on assumptions and the assumptions (including what is included and excluded from the model's calculations, much less how it is treated in the modeling process) are largely based on subjective characterizations. This is especially true in economics (which has been more befuddled in the last two years than any of us would like to admit) where pre-dispositions to "free market" solutions or government intervention so thoroughly shape arguments and, ultimately, models.

My bottom line is that models, and socially-based economic models in particular, all have a highly subjective element to them and that their forecasts (or expectations) are an indivisible mix of the subjective and rational.

Posted by: TerryAs I observed, the "surprise" exists regardless of whether rational equals subjective expectati at July 16, 2009 08:35 AM

John P. Hussman, Ph.D.
President, Hussman Investment Trust

10-15-2007:
"There are only a handful of historical periods that fall into this syndrome of conditions: December 1972, August 1987, July 1998, July 1999, December 1999, March 2000, and October 2007.
All of the prior instances were followed by steep market losses. When the declines were not abrupt, they were protracted. There is not a single counter-example."

Posted by: Bill Martz at July 17, 2009 09:44 AM

Macroeconomic models fail to make meaningful predictions when aggregate measures no longer really aggregate in the manner that they did earlier in the time series. This material flaw underlies macroeconomics in general and limits its value in policy making in times of change.

Posted by: simone at July 18, 2009 09:47 AM