Last week, the Congressional Budget Office released a report claiming that the $814 billion "stimulus" has added 3.4 million net jobs.

...

Such implausible analysis does not come from actually observing the post-stimulus economy. Rather, it comes from Keynesian economic models that have been programmed to conclude that government spending injects new dollars into the economy, thereby increasing demand and spurring economic growth. In other words, these models are programmed to conclude that stimulus spending always creates jobs and growth, no matter how the economy actually performs.

Well, not quite. As I described in this post, there are a variety of ways in which multipliers are obtained. Oftentimes, the impacts are estimated either directly or indirectly, by estimating the marginal propensity to consume. The article continues:

But there is one problem with the government stimulus theory: No one asks where Congress got the money it spends.

Congress does not have a vault of money waiting to be distributed. Every dollar Congress injects into the economy must first be taxed or borrowed out of the economy. No new spending power is created. It is merely redistributed from one group of people to another.

It is intuitive that government spending financed by taxes merely redistributes existing dollars. Yet spending financed by borrowing also redistributes existing dollars today. The fact that borrowed dollars (unlike taxes) will be repaid some years later does not change that.

Here, I think Mr. Riedl is invoking Ricardian Equivalence, despite the fact that there is no empirical evidence, to my knowledge, that validates pure Ricardian Equivalence (actually, Ricardian equivalence wouldn't necessary hold for government spending on goods and services, anyway). Now, at this juncture, I thought that he might be invoking a real business cycle model, or an older, nonstochastic version of the RBC, namely a flex price Classical model. But then the next paragraph reads:

Some believe stimulus spending is the mechanism by which the Federal Reserve injects new dollars into the economy. Yet the Fed could run the printing press and then inject those dollars into the economy by buying existing bonds (with mostly inflationary results). It doesn't need an expensive stimulus bill to conduct monetary policy.

Accepting that the Fed can stimulate via monetary policy then implies either (1) sticky prices so an expansionary monetary policy can affect the real interest rate, or (2) a financial accelerator model such that collateral constraints or some other financial rigidity holds. In the latter case, it seems prima facie that Ricardian Equivalance cannot hold.

Next, I was thrown for a loop, because Mr. Riedl seems to conflate real saving and the monetary multiplier. He argues that government deficits can only be financed by foreign saving, private saving and "idle saving". This he describes thus:

Idle savings. The only government spending that truly increases current purchasing is the amount that would have otherwise sat idle in safes and mattresses. Those are the only dollars not already circulating through the economy as consumption, or through the financial markets as investment spending.

Idle savings are rare. People and businesses generally invest or bank their savings, where the financial markets transfer them to other spenders. Banks that receive savings either lend them out to a spender, or (when afraid to loan) invest them conservatively to earn some interest. They are not hoarding customer deposits in massive vaults (beyond the required cash reserves).

This is an odd conflation of saving, measured as a flow, and financial assets. But lets take the equation at face value, there is an incredibly counterfactual observation that there no reserves are behing held in excess of required cash reserves. According to the St. Louis Fed, excess reserves are now approximately $1 trillion dollars. Well, no need for facts to get in the way of a good polemic.

Mr. Riedl's main point is:

All government stimulus spending requires first borrowing dollars that would have otherwise been applied elsewhere in the economy. The only exception is money borrowed from "idle savings," which for reasons described above likely constitute a minuscule portion of the $814 billion stimulus.

As I've mentioned here and elsewhere, this is true in a full employment model. (I'm working off of textbook models; move to coordination models, or allow monopolistic power, and you have lots of other inefficiencies arising).

Mr. Riedl concludes:

Economic growth requires raising worker productivity to create more goods and services. Government stimulus spending represents a naive "magic wand" attempt to create purchasing power and wealth out of thin air.

No wonder the unemployment rate remains high.

Well, if we're in a Classical world, then there is no involuntary unemployment. If we're in a New Classical world, then whatever involuntary unemployment exists is not systematic. If there is involuntary unemployment, then there are resources that are not being utilized, and putting them to use naturally raises productivity (remember labor productivity is defined as output per man hour).

It pains me to say that Mr. Riedl is a graduate of the University of Wisconsin, in economics and political science.

Postscript: Here is Deutsch Bank's assessment of the impact of the ARRA on the growth rate of GDP.

Level impacts are depicted in this post. Here is CBO's latest assessment.]]> http://www.econbrowser.com/archives/2010/09/what_kind_of_mo.html http://www.econbrowser.com/archives/2010/09/what_kind_of_mo.html recession Menzie Chinn Wed, 01 Sep 2010 20:55:41 -0800 Even though the overnight interest rate has been stuck near zero for 20 months, are there options available to the Federal Reserve or the U.S. Treasury to bring longer-term yields down further? I have been looking into this question with Cynthia Wu, an extremely talented UCSD graduate student. We present our findings in a new research paper, some of whose results I summarize here.

One of the challenges plaguing this kind of research is the problem of endogeneity. There may be a correlation between bond supplies and interest rates, but is that because bond supplies affect interest rates, or because the Treasury or the Fed are responding to interest rates in deciding which maturities of Treasury securities to sell or buy? Our solution to this problem is to pose the empirical question in terms of a conditional forecast. Suppose you already knew today's level, slope, and curvature of the term structure of interest rates, and in addition to those values, I tell you today's 3 Treasury supply factors. How would the latter cause you to change your forecast of next month's interest rate for any given maturity? Our finding is that the Treasury factors make a statistically significant contribution across the yield curve.

We can summarize the implications of that forecast in terms of the following scenario. Suppose that the Federal Reserve were to sell off all its Treasury securities of less than one-year maturity, and use the proceeds to buy up all the longer term Treasury debt it could. For example, in December of 2006, this would have required selling off about $400 B in bills and notes or bonds with less than one year remaining, with which the Fed could have effectively retired all Treasury debt beyond 10 years. The figure below summarizes the implied average change in forecast for the 1990-2007 period as a result of this change for interest rates of various maturities. Yields on maturities longer than 2-1/2 years would fall, with those at the long end decreasing by up to 17 basis points. Yields on the shortest maturities would increase by almost as much. While our estimates imply that the Fed could make a modest change in the slope of the yield curve, it would not make any difference for the average level of interest rates.

Predicted change in next months yields (quoted in annual percentage points) as a function of weeks to maturity in response to Fed converting all its short-term holdings into longest available maturities, average values over 1990-2007. Source Hamilton and Wu (2010).

We then extended the framework to the case when, as at present, short-term interest rates are as low as they could go. Even though short term interest rates have been near zero since the end of 2008, longer term yields have continued to vary from week to week, as shown in the solid lines in the graph below. Our interpretation is that these fluctuations in longer-term yields come from investors' beliefs that short-term interest rates are not going to be stuck at zero forever. We suppose that investors attach a probability to escaping from the zero lower bound at various future dates, and that, when we do, short-term rates and the rest of the yield curve will revert to a dynamic behavior similar to that exhibited prior to 2007.

Actual (solid) and predicted (dashed) behavior of selected interest rates, weekly from March 7, 2009 to August 10, 2010. Rates shown (in order from top to bottom) are the 30 year, 5 year, 1 year, and 3 month.

We were then able to describe interest rate dynamics since the beginning of 2009 in terms of the historically estimated parameters along with three new coefficients, which correspond to the average short-term interest rate as long as we're stuck at the zero lower bound, the average new short-term interest rate once we escape from the zero lower bound, and a fixed probability of escaping in any given week. The red dashed lines in the figure above represent the predicted values from this model. This simple framework seems to do a pretty reasonable job of explaining interest rate movements over the past couple of years.

Moreover, the framework gives us the information we need to assess the effects of nonstandard open market operations under a zero-lower-bound regime. The figure below shows how our model implies that the forecasting relation described above would be different under the zero lower bound. The experiment here is the same as before-- the Fed sells off all its short-term Treasury holdings and buys an equivalent amount of long-term debt. However, under the zero lower bound, the effect on short-term interest rates all but disappears as a consequence of investors' beliefs that near-zero short-term interest rates are likely to persist for some time. Quantitative easing-- buying the longer-term securities with newly created interest-bearing reserves-- would have the same effect in our framework.

Predicted change in next months yields (quoted in annual percentage points) as a function of weeks to maturity in response to Fed converting all its short-term holdings into longest available maturities. Solid line: predicted response over 1990-2007. Dashed line: predicted response in 2009-2010. Source Hamilton and Wu (2010).

Hence our estimates imply that whereas an asset swap by the Fed could not reduce interest rates in normal times, under the present situation, it would succeed in driving overall interest rates lower. To take an illustration, the Fed's combined $1.1 trillion in mortgage-backed securities plus $300 B in new longer term Treasury purchases might have succeeded in driving 10-year yields 50 basis points lower than they would have otherwise been.

Although our estimates imply that the Fed could do more than it already has, in many ways the U.S. Treasury is the more natural institution to implement such a policy. According to the theoretical framework that motivated our measures of the Treasury risk factors, the average slope of the yield curve arises from the preference of the U.S. Treasury for doing much of its borrowing with longer term debt. For reasons presumably having to do with management of fiscal risks, the Treasury is willing to pay a premium to arbitrageurs for the ability to lock in a long-term borrowing cost. If the Treasury has good reasons to avoid this kind of interest-rate risk, it is not clear why the Federal Reserve should want to absorb it.

But, according to our estimates, if the Fed wanted to absorb more of this risk, it could reduce the slope of the yield curve further by doing so.

The full paper is available here. ]]> http://www.econbrowser.com/archives/2010/08/policy_tools_th.html http://www.econbrowser.com/archives/2010/08/policy_tools_th.html Federal Reserve James Hamilton Tue, 31 Aug 2010 15:51:05 -0800 With the consumer in the doldrums, residential investment unlikely to rebound in the near future, and government stimulus constrained by political gridlock, it's hard to see where the sources of aggregate demand will be. I'm going to extend Jim's search for silver linings in the latest GDP release.

One possibility is that domestic investment will take up some slack. As several observers have noted, corporations have been making substantial profits and have the wherewithal to invest, and yet are not. Of course, depressed investment in plant and equipment was true before the recession, in 2006 and 2007, so it's unclear why it should take the lead now.

One reason to think that nonresidential investment would take off is that gross investment is rising (17.6% q/q SAAR, roughly twice what MA forecasted back on 8/12), and contributed 2 ppts to GDP growth. Before anybody thinks this is some pollyana-ish prediction, I'll note that the rise only makes sense given the catastrophic and persistent decline in this category during the recession. Given depreciation, the real private nonresidential capital stock has probably been flat (recently released BEA data indicates that this series was flat going from 2008 to 2009, which is pretty remarkable). This observation links up with the negative (mechanical) contribution of imports on GDP growth that has been remarked upon.

Figure 1: Real GDP growth (blue), and contributions of Non-residential investment (red), exports (green) and imports (orange), SAAR, in percentage points. Source: BEA, GDP 2010Q2 2nd release.

The Composition of Imports and the Prospects for Exports

I think it's of interest to examine the components of the growth in imports since the trough, and what that implies for future growth. As I pointed out in a previous post, a large share of increase in imports is in the capital goods category.

Most observers focused on the surge in consumer goods imports, but considering slightly longer term trends, one sees a larger component associated in investment, presumably to build future production capacity.

Another observation is that exports have been contributing (once again, in a mechanical sense) to growth since the end of the recession (which I am assuming occurred at 2009Q2), although given vertical specialization, it's unclear how much.

What are the prospects for continued growth in exports? I use a standard error-correction specification:

Where exp are log real exports of goods and services, y^* is log foreign real GDP, and r is the log real trade weighted value of the dollar. The real foreign GDP variable is export weighted, through 2009Q4. I extended the series for 2010Q1-Q2 using GDP growth rates from the Economist and trade weights accounting for over 80% of US exports. The dollar index is the Fed's broad index, deflated by CPI. This specification is discussed in greater detail in this post.

Estimating this over the 1973Q4 to 2010Q2 period, one obtains a specification with an adjusted R² of 0.35, SER = 0.020. The implied long run income elasticity is 1.81, the long run price elasticity is unity, while the rate at which errors correct is approximately 8.3% per quarter. All the long run coefficients are statistically significant, using Newey-West standard errors. Box Q-statistics for 4 and 8 lags fail to reject the no serial correlation of residuals null.

I use the estimated specification to forecast starting 2010Q2, out to 2010Q3. The actual and forecasted (log) values are shown in Figure 3:

This forecast is consistent with exports contributing about 2.8 percentage points (SAAR) to overall growth in 2010Q3. The increase in real exports is 24.4% q/q on an annualized, substantially above Macroeconomic Advisers' forecast of 12.2% (8/12/2010). The predicted growth is being driven by the close correlation between the growth rates of exports and rest-of-world GDP, illustrated below.

The adjusted R² for this simple bivariate relationship is 0.23.

I don't want to make too much of this specific estimate based on the estimated ECM; the one standard error bound encompasses a 13.8% increase, close to the MA number.

What about the longer term? Clearly, in a time of tremendous uncertainty regarding growth prospects, it's foolhardy to try to project further into future. But one can see what firms abroad anticipate, by looking at what they're importing from us (i.e., what we're exporting). Figure 5 depicts the increases since 2009Q2.

The substantial increase in capital goods exports suggests to me that foreign producers are ramping up investment in anticipation of renewed growth. Of course, those expectations could very well prove very wrong (i.e., I have no slavish adherence to rational expectations).

Policy Implications

None of the foregoing should be construed to mean I think we're not in a rough patch. [0] In particular, there's not much to indicate resumed consumption growth, and government spending on goods and services is stagnant (real state/local spending 2.3% less than peak at 08Q3, even while population has risen 1.5% in log terms). (I.e., "fiscal mindlessness" persists) At the same time, monetary policy authorities are strangely reluctant to further extend expansionary monetary policy even as deflation appears more likely. [1] [2] So while the international economy might add some pluses, consumption behavior and policy [3] is exerting contractionary forces on the economy. Finally, returning to domestic (nonresidential) investment, aggregate demand has to be sustained in order to keep investment spending up; I'm pretty dubious tinkering with the user cost of capital will do the trick (see here).

Interesting side fact: The magnitude of the (absolute value of the) contributions of exports and imports to GDP is unprecedented in the past forty years. That outcome is consistent with increasing vertical specialization, discussed here and here.

Maturity structure of U.S. federal debt as of December 31, 2006. Horizontal axis: maturity in weeks. Black bars: face value of marketable nominal Treasury securities of that maturity, in millions of dollars. Red bars: imputed holdings of the System Open Market Account of the U.S. Federal Reserve.

The next graph provides a sense of some of the time-series variation, plotting the average maturity of debt held by the public for each month. Average maturity dropped temporarily in the mid-1990s and began a more significant and sustained decrease after 2002, rising again with big issues of long-term debt beginning in the fall of 2008.

Average maturity in weeks of nominal marketable Treasury debt held by the public, plotted monthly from Jan 31, 1990 to December 31, 2009.

Our database also includes other items that may be of interest to researchers, such as daily constant-maturity Treasury yields and some measures we developed from the maturity structure that both theory and empirical analysis suggests can be helpful for predicting changes in interest rates for different maturities. Click here to access the database.

For one thing, much of the revision down in GDP growth came from a downward revision in the estimated extent of inventory restocking during the quarter. Thus, whereas last month's numbers implied that real final sales grew at a 1.3% annual rate during the second quarter, today's estimate is that real final sales grew at a 1.0% annual rate-- not a very radical revision as far as the fundamentals are concerned.

The other important revision was that the growth in imports, which had already been an implausibly large drag on second quarter growth, is now estimated to have been an even bigger drag than at first claimed. Whatever the explanation for that is, our Federal Reserve Chairman does not expect it to be repeated:

Like others, we were surprised by the sharp deterioration in the U.S. trade balance in the second quarter. However, that deterioration seems to have reflected a number of temporary and special factors. Generally, the arithmetic contribution of net exports to growth in the gross domestic product tends to be much closer to zero, and that is likely to be the case in coming quarters.

Whatever you make of that, another detail that I found mildly encouraging is that the August BEA release provides us with the first estimate of gross domestic income for Q2. According to economic theory, gross domestic income should be exactly the same number as gross domestic product. In practice, since they are constructed in part from different sources, they are not exactly the same number, and the government faithfully reports their difference as an entry in the national income and product accounts known as "statistical discrepancy." By definition, we don't have a good theory of where the statistical discrepancy comes from or how to interpret it. But Federal Reserve economist Jeremy Nalewaik has argued that GDI is sometimes a better measure than GDP for tracking the business cycle. Because the "statistical discrepancy" entry has been shrinking over the last year, the rate of growth of GDI has been coming in a little better than GDP lately. GDI shows a 2.3% annual growth rate for the second quarter, or about the same rate as BEA had reported with their first estimate of GDP.

As long as I'm passing along the not-as-awful-as-we-thought spin on the economic news, I should also mention that the Fed's index of industrial production grew by 1% in July. That's 12% at an annual rate, if we were lucky enough to see it repeated for a whole year-- no danger of that, unfortunately. But the favorable industrial production numbers were likely a key factor that helped pull both the Chicago Fed National Activity Index and the Aruoba-Diebold-Scotti Business Conditions Index back up to zero, away from the alarmingly negative numbers with which both had flirted last month.

Source: FRED,

But will the growth in manufacturing continue? Computer sales, which had been one of the healthy economic sectors, appear to be softening, with Intel reporting today that it is now expecting third-quarter revenue of $11 B, down from an earlier anticipated range of 11.2-12. And Bill McBride notes that the weak manufacturing reports coming in at the regional Federal Reserve Banks likely portend a deterioration in national manufacturing indicators such as the PMI.

Source: Calculated Risk,

Here's how Fed Chairman Ben Bernanke summarized his outlook in Jackson Hole this morning:

Overall, the incoming data suggest that the recovery of output and employment in the United States has slowed in recent months, to a pace somewhat weaker than most FOMC participants projected earlier this year.... I expect the economy to continue to expand in the second half of this year, albeit at a relatively modest pace.

It seems that may be about the best that anybody hopes for at this point.

... we use an extensive dataset of 1,372 climate researchers and their publication and citation data to show that (i) 97-98% of the climate researchers most actively publishing in the field support the tenets of ACC outlined by the Intergovernmental Panel on Climate Change, and (ii) the relative climate expertise and scientific prominence of the researchers unconvinced of ACC are substantially below that of the convinced researchers.

In other words, the climate scientists that are better published tend to be convinced of anthropogenic climate change; moreover, the ones that are better cited also tend to be more convinced of ACC.

For those who are dis-inclined to read the article, but are worried about selection bias, here is the method by which the authors selected the sample of climate scientists.

To examine only researchers with demonstrated climate expertise, we imposed a 20 climate-publications minimum to be considered a climate researcher, bringing the list to 908 researchers (NCE = 817; NUE = 93). Our dataset is not comprehensive of the climate community and therefore does not infer absolute numbers or proportions of all CE versus all UE researchers. We acknowledge that there are other possible and valid approaches to quantifying the level of agreement and relative credibility in the climate science community, including alternate climate researcher cutoffs, publication databases, and search terms to determine climate-relevant publications. However, we provide a useful, conservative, and reasonable approach whose qualitative results are not likely to be affected by the above assumptions. We conducted the above analyses with a climate researcher cutoff of a minimum of 10 and 40 publications, which yielded very little change in the qualitative or strong statistically significant differences between CE and UE groups. Researcher publication and citation counts in Earth Sciences have been found to be largely similar between Google Scholar and other peer-review-only citation indices such as ISI Web of Science (20). Indeed, using Google Scholar provides a more conservative estimate of expertise (e.g., higher levels of publications and more experts considered) because it archives a greater breadth of sources than other citation indices. Our climate-relevant search term does not, understandably, capture all relevant publications and exclude all nonrelevant publications in the detection and attribution of ACC, but we suggest that its generality provides a conservative estimate of expertise (i.e., higher numbers of experts) that should not differentially favor either group.

Now, it seems despite the obvious relevance of global climate change to economic activity, some Econbrowser readers are skeptical of the link. For the skeptics, see these reports:

• National Research Council, Adapting to the Impacts of Climate Change. Free summary here.
• CBO, Potential Impacts of Climate Change in the United States (2009).
• Center for Strategic and International Studies, The Age of Consequences: The Foreign Policy and National Security Implications of Global Climate Change (2007)
• Cline, Global Warming and Agriculture: Impact Estimates by Country (2007).

That helps explain Federal Reserve Bank of Minneapolis President Narayana Kocherlakota's odd suggestion that markets misinterpreted the Fed's ever-so-slight monetary easing as a signal that the FOMC had big concerns about real economic activity going forward. I scratched my head when I first read Kocherlakota's remarks, since I had thought any surprise in the FOMC actions was that the FOMC seemed to be less worried than many private analysts. But if you believed, as Kocherlakota seems to, that the Fed has already done too much, his remarks might make more sense.

Another interesting aspect of the WSJ report is the process by which it got into the Journal in the first place: someone on the FOMC wants more of the internal FOMC debate out in public. And why might you want to do that, if you were on the inside? One objective might be to try to change the dynamics of the debate in hopes of hastening a resolution. Another would be to help the public understand the FOMC's recent minutes and communications like Kocherlakota's. And a third objective could be to begin the process of communicating that a change is in the works.

I have suggested that ongoing deterioration of economic conditions will be the critical factor that triggers the Fed's next move. On this, Exhibit A might be today's report that new Home sales set an all-time low in July. The good news, such as it is, would be that residential fixed investment was already so low that it accounted for only 2.5% of total second-quarter GDP.

Source: Calculated Risk

But in addition to the direct effect on GDP, there may also be financial ramifications of the new downturn in real estate. Today the Wall Street Journal reported:

Of the $1.4 trillion of commercial-real-estate debt coming due by the end of 2014, roughly 52% is attached to properties that are underwater, according to debt-analysis company Trepp LLC.

Add to these yesterday's report that existing home sales fell 27% in July from the downward-revised June numbers, with single-family home sales at the lowest level in 15 years. As usual, that's just what Bill McBride had told us was going to happen.

Source: Calculated Risk

Which is one of the reasons I pay attention to Bill's interpretation of the WSJ story on the FOMC debate: he reads it as paving the way for Quantitative Easing 2.

The biggest Keynesian stimulus in U.S. history was a bust.

Incredibly, some Keynesians who supported Barack Obama's $862 billion stimulus now claim it fell short of their goals not because the idea was flawed, but because the spending package was too small.

A 2002 study by economists Richard Hemming, Selma Mahfouz and Axel Schimmelpfennig of recessions in 27 developed economies from 1971 to 1998 found that increased spending by government had, in almost all cases, a barely noticeable impact, and sometimes a negative one. Heavily indebted countries that spent more in recessions grew about 0.5 percent less, relative to trend, than countries that didn't, the study found.

I wish Dr. Hassett had quoted additional parts of the paper because a lot of subtleties were omitted in his "summary" of the paper. In any case, I'll quote some additional passages from the same study (it's also an IMF working paper, by the way) to heighten the reader's awareness of exactly how relevant -- or irrelevant -- Dr. Hassett's quote is to the current episode:

Fiscal policy is Keynesian during recessions in closed economies, but the fiscal multiplier is quite small (i.e., it is unlikely to exceed unity).

...

However, these conclusions do not preclude the possibility that, where the circumstances are right, fiscal expansions can be an effective response to a recession. The right circumstances would feature some or all of: excess capacity; a closed economy or an open economy with a fixed exchange rate; big government; expenditure-based fiscal policy; and an accompanying monetary expansion.

Gee, well, I'd say there's slack in the U.S. economy. [1] I'd also conjecture that the US economy is pretty closed relative to the majority of other observations in the study. I think I heard there was an expenditure (as opposed to tax reduction) component in the ARRA. [2] And finally, I believe I have heard that current monetary policy is quite expansionary. [3] Apparently, Dr. Hassett was unaware that any of these conditions applied to the United States in 2009-10.

In addition, I do wonder why Dr. Hassett had to go back to 2002 to find a study (well, actually, an out-of-context quote from a specific study). In the intervening time, the IMF has conducted many large scale, cross country analyses of fiscal policy in advanced economies. [4] [5] [6] In addition, a number of surveys of the size of multipliers have been conducted and published. [7] [8]

I believe that think tank economists provide a useful purpose in providing diverse views in ongoing policy debates. However, in this case, I think I will forego Dr. Hassett's assessment, and put my faith in the assessments from private sector economists who do not have an ideological axe to grind. Below is Deutsche Bank's recent assessment of the impact of various fiscal stimulus measures on the level of GDP.

And below is a graphic from an earlier post that describes private sector assessments of the impact on GDP relative to counterfactual.

* For those who are not aware of the reference, this is the title of: James K. Glassman, Kevin A. Hassett, Dow 36,000: The New Strategy for Profiting From the Coming Rise in the Stock Market (1999). For context, the Dow closed today at 10,040.45.

Figure 1. Green line: Ratio of real value (in 2010 dollars) of S&P composite index to the arithmetic average value of real earnings over the previous decade, January 1880 to Aug 2010. Red line: historical average (16). Data source: Robert Shiller.

One reason that might be worth paying attention to is the following graph, whose blue line shows the annual rate of return you would have earned by buying stocks at any indicated date and holding on to them for the next decade. The green line (the price-earnings multiple) you would know at the indicated date, whereas the blue line (the return on stocks over the next decade) you wouldn't know until 10 years after the indicated date. What is pretty clear in hindsight is that those dates at which stocks were very richly valued turned out to be terrible times to buy. Anyone who was unfortunate enough to have decided to get into the stock market at the peak P/E in 2000 can testify that the most recent data have continued to confirm this century-long relationship.

Figure 2. Green line: Ratio of real value (in 2010 dollars) of S&P composite index to the arithmetic average value of real earnings over the previous decade, January 1880 to Aug 2010. Red line: historical average (16). Blue line: average compounded nominal rate of return on stocks purchased at the indicated date and held for ten years from that date. Data source: Robert Shiller.

But shouldn't we be comparing stocks not with a historical average, but instead with the currently very low yields available on alternatives like bonds? The next graph compares bond yields with stock yields, with the latter defined as the ratio of stock dividends to stock prices. Unlike the previous figure, this might appear to be a very unstable relation, with stock yields consistently above bond yields for the first half of the sample and consistently below for the next.

Figure 3. Black line: Ratio of nominal dividend paid on aggregate stock index two months earlier to current nominal stock price index. Orange line: yield on 10-year bond. Data source: Robert Shiller.

To understand what's going on with that last relation, we also need to factor in inflation. Apart from an impressive spike in the price level in 1917-1919 associated with World War I, the first half of the sample was characterized by stable or falling consumer prices (deflation) and the second half by steadily rising consumer prices (inflation). Bond yields and stock yields pull apart when there is inflation because, unlike bonds, a stock is a real asset. With inflation, the dollar price of the company's product should be going up, and with it the company's nominal profits and dividends. To be sure, there can also be important relative price changes, so that some sectors will see their costs go up relative to product prices, while those selling them those inputs may experience the opposite. But certainly in an overall inflationary environment, we should expect to see the dividend yield well below the bond yield. In fact, the dividend was not far enough below nominal bond yields at the peak inflation of the late 1970s to be associated with a rational valuation of stocks. This may have been one factor in the below-average price-earnings multiples of that period (low green line in Figure 2 in late 1970s), and people who bought stocks at that time were richly rewarded (high blue line in late 1970s).

Figure 4. Average annual inflation rate for four years ending at the indicated date. Data source: Robert Shiller.

Even in an environment of stable consumer prices, we would still expect to see dividends grow as a result of growth of the real economy. But in the deflationary episodes of the earlier part of the sample, the stock dividend yield was usually well above the corresponding bond yield. Investors regarded stocks as sufficiently more risky relative to bonds that they sought compensation for taking that risk in the form of both a higher immediate yield as well as prospects for future dividend growth.

The next graph takes a more detailed look at the most recent behavior of stock and bond yields. Over this more recent period we can also compare the stock dividend yield directly with the yield on Treasury Inflation Protected Securities, which is more of an apples-to-apples comparison than Figure 3. A buyer of stocks today is usually getting a higher immediate yield than on TIPS, in addition to prospects of future dividend growth. Just as they did in the 19th century, stocks as priced today should give you a significantly better return than bonds.

Figure 5. Black line: Ratio of nominal dividend paid on S&P500 two months earlier to current S&P500. Orange line: yield on nominal 10-year Treasury. Yellow line: yield on inflation-indexed 10-year Treasury. Data source: Robert Shiller and FRED.

But, now as then, stocks are also significantly more risky than bonds.

On the export side, the NIPA and trade data deviate a bit more (Figure 2), but what matters are the changes. And here the change in goods imports implicit in the 2010Q2 advance release differs from the change implied by the trade release, as shown in Figure 3. This is what is most troubling

Now, let's turn to the import side. Is it true that consumers are sucking in imports? Certainly, real goods imports jumped from May to June, by 155% on an annualized basis. But a single observation doesn’t make a trend, so I'll rely on the NIPA data which seems to match pretty well the trade data. Figure 4 depicts the components of non-oil goods imports. What is clear is that consumer goods do not vary that much; now, part of auto and auto parts is going to satisfy consumer demand as well, and here we do have some evidence in support of the hypothesis of the consumer going back to his/her old ways of sucking in imports.

In order to identify clearly how much of the bounceback in non-oil goods imports are associated with each category, one can normalize on the trough, which I will place at 2009Q2. This yields the following picture.

To me, this indicates that the story is a bit more complicated than at first glance appears. Capital goods constitute a large chunk of the import story. Now, it might be the case that these capital imports are being driven by investment to satisfy anticipated consumer demand in the future. Alternatively, the capital goods could be being imported to satisfy anticipated foreign demand.

Just to recap, here are the latest readings on personal consumption, and retail sales (the latter annualized).

Consumption hardly seems resurgent, so attributing the increase in imports to consumers means that one is assuming a very high share of imports to incremental consumption -- something I'm not sure makes sense. So, I think the book is still open on whether the consumer is going to drive the US back into a rapidly expanding trade deficit.

The recovery is proceeding as many economists earlier this year outlined that it would. It is a modest recovery, with mixed results. Yet, GDP is likely to expand at somewhere around a 3 percent rate through the remainder of the year.

And here's what Hoenig considered to be the most important part of his message, if we can judge by what was included in his dissenting opinion to the Fed's August 10 FOMC statement:

Voting against the policy was Thomas M. Hoenig, who judges that the economy is recovering modestly, as projected. Accordingly, he believed that continuing to express the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted and limits the Committee's ability to adjust policy when needed. In addition, given economic and financial conditions, Mr. Hoenig did not believe that keeping constant the size of the Federal Reserve's holdings of longer-term securities at their current level was required to support a return to the Committee's policy objectives.

There was much more in Hoenig's speech that one might choose to debate, but my inclination is that a key issue here is one of facts, not ideology. Either U.S. GDP growth for 2010 will end up above 3%, or it won't. And if, as many analysts fear, it won't, then I would expect Hoenig and the rest of the FOMC to respond.

Certainly Federal Reserve Bank of St. Louis President James Bullard is trying to communicate that the Fed needs to respond more if disinflation continues:

There has been disinflation. It has been at the low end of where I'd like to see it. For that reason I think we should supplement our quantitative easing program if we get further developments on that front. We should have a plan in place to take action if it moves lower.

My expectation is that Hoenig's forecast will prove optimistic, and that last week's modest easing is not the last we're going to hear from the Fed.

From the abstract of a paper coauthored with John Kitchen:

This paper examines the potential role for foreign official holdings of U.S. Treasury securities and the associated implications for Treasury security interest rates, international portfolio allocations, net international income flows, and the U.S. net international debt position, using a baseline outlook of current and projected U.S. budget deficits and growing debt. ...

... The analysis applies empirical results regarding the role of U.S. structural budget deficits and foreign official holdings of U.S. Treasuries in determining Treasury security interest rates. Although initial review of information suggests that the world portfolio could potentially accommodate financing requirements over the intermediate horizon, substantial uncertainty remains about the relationships among foreign official holdings, exchange rates, and trade; the potential effects of "crowding out" in the international portfolio; and how and whether world portfolio allocations would adjust to accommodate higher shares of U.S. assets.

We use the CBO assessment of the President's budget, and a key estimated relationship between the ten year - three month spread and the unemployment gap, inflation, structural budget deficits, and foreign official purchase of Treasury securities. Note that we presume that, contrary to some people's assertions, deficits matter. Actually, we estimate the relationship, and find that each percentage point of the structural, or cyclically adjusted, budget deficit raises the spread by 27 basis points. The fit is displayed in Chart 5.

There are a series of other relationships that are also estimated; earlier estimated versions of these relationships can be seen in the working paper version of Kitchen (Review of Int'l Economics, 2007). Here are the resulting implications based upon the CBO projections, and our estimated relationships:

The overall U.S. net international debt position and the associated net international income flows derived under the base case are shown in Charts 6 and 7. Under the base case, U.S. net international debt as a share of GDP nearly doubles over the 10-year projection period, increasing from about 20 percent of GDP to 38 percent. Net international income flows turn negative and steadily decline, from roughly +1 percent of GDP in recent years to about -1.9 percent of GDP by the end of the ten-year projection. That negative net international income flow represents a wedge between GDP and national income. Note that, even with the assumption in the base case of a gradually improving U.S. net trade position over the projection, the current account deficit would gradually widen, reflecting the increasingly negative net international income flows.

Chart 6, depicting the NIIP projection, is below:

It's of interest to compare this projection to others produced using similar approaches. Bertaut, Kamin and Thomas (2008) present a projection for NIIP to GDP of -65 percent by 2020. (The Bertaut, Kamin and Thomas paper was published in an IMF Staff Papers special issue, discussed here.)

We examine a couple of other scenarios, including: (1) if foreign official holdings of Treasuries grow at the same rate as nominal GDP, and (2) one percentage point higher inflation. The former implies Treasury yields 1.5 percentage points higher, while the latter implies the NIIP to GDP ratio would be 7 percentage points less negative.

Note that the results depend crucially on the coefficient on foreign holdings; if one used the larger coefficient obtained in Chinn and Frankel (2007) (in a different specification, and for a shorter sample), then the required increase in foreign holdings would be halved.

We conclude:

... although the general interpretation presented here and by other researchers is that the world portfolio could potentially accommodate the "required" increase in foreign funding of U.S. Treasury securities, it remains an open question whether such an increase would be forthcoming. Ultimately, measures that reduce the deficit by changing the trajectory of tax revenues and spending, particularly in the latter years of the horizon we consider and beyond, would mitigate the concerns about the financing of the U.S. budget and current account deficits.

In my own personal opinion, this means that over the medium to long term, we need to get the structural budget deficit close to zero. That cannot be done by ending unemployment insurance, rescinding the rest of the ARRA, or cutting food stamp programs. It can only be done by increasing tax revenues and dealing with entitlements. [1]

Click here to watch the movie.

Capital account openness has continued to rise over time, although with some retrenchment in the industrial countries in the past couple years.

It's important to recall that this index is a de jure, not de facto measure. Furthermore, it does not distinguish between inward and outward capital account restrictions. On the other hand, the index is useful because it covers the period 1970-2008, for 182 countries, and is updated over time.

This paper studies inflation dynamics during 25 historical episodes in advanced economies where output remained well below potential for an extended period. We find that such episodes generally brought about significant disinflation, underpinned by weak labor markets, slowing wage growth, and, in many cases, falling oil prices. Indeed, inflation declined by about the same fraction of the initial inflation rate across episodes. That said, disinflation has tended to taper off at very low positive inflation rates, arguably reflecting downward nominal rigidities and well-anchored inflation expectations. Temporary inflation increases during episodes were, in turn, systematically related to currency depreciation or higher oil prices. Overall, the historical patterns suggest little upside inflation risk in advanced economies facing the prospect of persistent large output gaps.

Empirical evidence

The author defines an episode of persistent large output gap (PLOG) as at least eight consecutive quarters of negative output gaps greater than 1.5 percent in absolute terms.

Figure 3 from the paper shows the impact of persistent, large output gaps on inflation.

One of the differences between the 1980s and 1990s (and now the 2000s), is that the initial level of inflation is typically lower. That is, in the current episode, we are hitting the zero inflation rate threshold. [0] Figure 9 (in the paper) presents evidence that the extent of disinflation is less during the 1990's, which could be consistent with either greater central bank credibility, globalization, or nominal/real rigidities. I'll pursue this last line further (although the globalization hypothesis has been examined here).

Theory, and the World at Near Zero Inflation

Does crossing the threshold from disinflation to deflation change matters, and why? I think so, and here I'm guided in part by an important paper by (Nobel laureate) George Akerlof, Bill Dickens, and George Perry, entitled "The Macroeconomics of Low Inflation," Brookings Papers on Economic Activity 1996(1), pp. 1-76.

We demonstrate the prevalence of downward wage rigidity in the U.S. economy and model its significance for the economy's performance. Downward rigidity interferes with the ability of some firms to make adjustments in real wages, leading to inefficient reductions in employment. With trend growth in productivity near recent rates, as the rate of inflation approaches zero, the number of firms constrained and the degree of their constraints increase sharply, as does this inefficiency and shortfall in employment. The difference in the sustainable rate of unemployment between operating with a steady 3 percent inflation rate and a steady zero percent inflation rate is estimated as 1 to 2 percentage points in our simulation model, and 2.6 percentage points in the empirical time-series model. The main implication for policy-makers is that targeting zero inflation will lead to a large inefficiency in the allocation of resources, as reflected in a sustainable rate of un- employment that is unnecessarily high.

Some might argue that the behavior that we model characterizes a regime that will change, that a determined zero inflation policy would break down wage rigidity. We have several thoughts about this. We suspect that wage rigidity is deeply rooted, not ephemeral or characteristic of a particular set of institutions or legal structures, although these may well help to codify it and expand the relations to which it applies. The psychological studies that we cite treat as fundamental the notions of fairness and worker morale that appear to underlie nominal rigidity. Historical studies find downward rigidity present well before the existence of modern labor market laws and institutions, although whether to the same degree cannot be established from the available evidence. We observe that rigidity breaks down at the firm level when firms are under extreme duress, a condition that employees can observe and are willing to respond to; and we account for this behavior in our model. But this does not imply that rigidity in the aggregate is susceptible to a permanent regime change following analogous macroeconomic conditions. In the Great Depression, when extreme duress became widespread, downward rigidity initially gave way, but it did not break down permanently. Eventually laws and institutions were strengthened to reinforce downward rigidity. The idea that rigidity represents a particular regime that will disappear if the appropriate policies are sustained would seem to have the sign wrong.

...

In other words, those who think that once people just believe that wages and prices can fall, then wages and prices will miraculously become flexible, and the world will approximate a flex-price New Classical model, might be disappointed.

Even if one doesn't believe the Akerlof-Dickens-Perry model is relevant, the observed historical correlations in the Meier paper suggest that near term inflation is not the thing we should be worried about.

Are Things Different This Time Around?

What about the disappearance of central bank credibility, with large scale asset purchases? Does that qualify these conclusions? Meier writes:

The above considerations leave open how much longer disinflation might continue in the period ahead, but at least suggest limited upside inflation risk. Against this, one could argue that the current episodes feature some unique characteristics that might generate inflationary pressures beyond what has been observed in historical precedents. One often-cited argument relates to central bank credibility in times of unconventional monetary policies and strained public finances. Its proponents question the optimistic view of Dwyer et al. (2010), whereby monetary policy has reached a unique degree of credibility that will keep inflation closely aligned with official targets. Instead, they argue that central banks have lost credibility of late. The claim is closely linked to the large-scale asset purchase programs launched by several advanced country central banks over the last two years. Indeed, with disruptions in many financial markets and policy rates exceptionally low compared to most historical PLOG episodes (Figure 18) -- and often constrained by the zero bound on nominal rates -- unconventional monetary policies have become commonplace.

Some critics of these policies argue that, by expanding their balance sheets and issuing large amounts of base money, central banks have sowed the seeds of future inflation; see Meltzer (2010). In and by itself, this contention is not very convincing, as there is no obvious, let alone automatic, link from higher base money to inflation, provided that central banks maintain control over policy rates.19 Consistent with this, empirical studies have found central bank asset purchases to have had a positive effect on asset prices, while broad money growth has remained very subdued (Figure 16) and medium-term inflation expectations have shown no signs of becoming unhinged; see Gagnon et al. (2010) and Meier (2009).

There is, however, one important caveat to this benign view. Even if unconventional policies should work only through rather standard channels, providing no magical short cut to either full employment or high inflation, there is a tail risk that the public might develop a different perception. As Borio and Disyatat (2009) put it, "market expectations and beliefs [are not necessarily] consistent with the underlying transmission mechanism." Inflation expectations could rise sharply, in particular, if the public suddenly lost trust in the central bank’s capacity or commitment to maintain price stability, causing a self-reinforcing currency crisis.

At this juncture, I'll just note that the five year implied inflation rate (drawn from Treasury and TIPS yields) is declining. [1]

Another caveat is that we can't measure the output gap well. I think that is a challenge to the empirics (as noted in the paper), although I doubt using a different, conventional, measure of the output gap would overturn the results. For more on the issue of measuring output gaps, see: [2] [3] [4]. ]]> http://www.econbrowser.com/archives/2010/08/downward_wage_r.html http://www.econbrowser.com/archives/2010/08/downward_wage_r.html inflation Menzie Chinn Thu, 12 Aug 2010 07:32:42 -0800