The Free Thinker

If This is the Best Case They Can Make for Keynesianism...

... it must be even wronger than I thought. Krugman writes:

Financial markets are cheering the deal that emerged from Brussels early Thursday morning. Indeed, relative to what could have happened — an acrimonious failure to agree on anything — the fact that European leaders agreed on something, however vague the details and however inadequate it may prove, is a positive development.

But it’s worth stepping back to look at the larger picture, namely the abject failure of an economic doctrine — a doctrine that has inflicted huge damage both in Europe and in the United States.

The doctrine in question amounts to the assertion that, in the aftermath of a financial crisis, banks must be bailed out but the general public must pay the price. So a crisis brought on by deregulation becomes a reason to move even further to the right; a time of mass unemployment, instead of spurring public efforts to create jobs, becomes an era of austerity, in which government spending and social programs are slashed.

Krugman is conflating two quite different ideas here: (a) that the government (or the central bank) has to bail out banks to prevent a collapse of the financial system, and (b) that most governments need to retrench right now. Not only are the two ideas quite separable-- the government could bail out the banks and increase spending; or it could do neither-- but if anything, they are philosophically opposed. A comprehensive interventionist might advocate both; a libertarian would support neither. TARP is at this point not, I think, especially controversial among economists, so it's interesting that Krugman stakes out an anti-TARP position here. I'm glad of it: I think the anti-TARP view deserves more of a hearing than it has gotten. But how he would justify conflating TARP and austerity, I have no idea.

This doctrine was sold both with claims that there was no alternative — that both bailouts and spending cuts were necessary to satisfy financial markets — and with claims that fiscal austerity would actually create jobs. The idea was that spending cuts would make consumers and businesses more confident. And this confidence would supposedly stimulate private spending, more than offsetting the depressing effects of government cutbacks.

Some economists weren’t convinced. One caustic critic referred to claims about the expansionary effects of austerity as amounting to belief in the “confidence fairy.” O.K., that was me.

But the doctrine has, nonetheless, been extremely influential. Expansionary austerity, in particular, has been championed both by Republicans in Congress and by the European Central Bank, which last year urged all European governments — not just those in fiscal distress — to engage in “fiscal consolidation.”

And when David Cameron became Britain’s prime minster last year, he immediately embarked on a program of spending cuts in the belief that this would actually boost the economy — a decision that was greeted with fawning praise by many American pundits.

Now, however, the results are in, and the picture isn’t pretty.

This is ridiculous. First, one distinction which it's essential to make is that between (a) countries that could have borrowed more, such as the United States, at least in the short run, or Germany; and (b) countries that lost access to financing or were on the verge of doing so, like Greece, Italy, Portugal, Spain, and Ireland. The latter were compelled to adopt austerity, not on their own terms but on those imposed by the markets, and the sovereign debt crisis hurt them in other ways too. The former had flexibility to design austerity in the way that would do them the least harm. So it's fair to use the example of Britain, but not Greece, Latvia, etc.

Second, the results are certainly not in-- yet. The European debt crisis seems to have been resolved, finally, but only just. There's been no time for it to take effect. And in general, austerity is a policy oriented towards the longer term. One doesn't expect it to help over the long term, but over three, five, ten years. In the East Asian crisis of 1998, austerity was pursued, and the recession was very deep and painful; but there was a strong rebound a couple of years later; in Japan after the crash of 1989, Keynesian stimulus was pursued, and the recession became more or less permanent.

It would be much more reasonable to say that "the results are in" on the path that was taken in America, namely, not-austerity, but Keynesian stimulus, "and it ain't pretty." Stimulus has had more time to work. The European sovereign debt crisis is much less of an issue here. And Keynesian stimulus is supposed to work in the short run; that's the whole point. Of course, Krugman claims that America has pursued austerity, but that just underscores the uselessness of this conceptual framework. With deficit spending at 10% of GDP for three years, this is as Keynesian a fiscal policy as we've had in decades. If we were deficit-spending 20% of GDP and it didn't work, the Keynesians could always say, hey, it should have been 30%. Of course, the Keynesians can also deny that it didn't work: they can say it did work, because things would have been even worse. If they were worse, they can say they would have been even worse than that. If we were deficit-spending 20% and unemployment were 15% instead of 9%, well, they could say that if we had been deficit-spending only 10% of GDP, unemployment would have been 20%. Why they expect anyone should believe their counter-factuals when none of them foresaw the crisis is a mystery. More conservative, free-marketeer, rational-expectations type economists are more epistemically modest. All we know is that the economy has a natural tendency towards full employment, and the best bet is that if policy had been neutral (admittedly that's hard to define) it would probably have reverted to trend (admittedly that's also hard to define) in a few years. By that standard, Keynesian stimulus seems to have made things worse, and certainly hasn't helped much; and the marginal effect of Keynesian stimulus would probably have been even more harmful, since the marginal benefit of just about anything falls, and the marginal cost rises, as you get more of it. But that's just the best guess.

Greece has been pushed by its austerity measures into an ever-deepening slump — and that slump, not lack of effort on the part of the Greek government, was the reason a classified report to European leaders concluded last week that the existing program there was unworkable. Britain’s economy has stalled under the impact of austerity, and confidence from both businesses and consumers has slumped, not soared.

Maybe the most telling thing is what now passes for a success story. A few months ago various pundits began hailing the achievements of Latvia, which in the aftermath of a terrible recession, nonetheless, managed to reduce its budget deficit and convince markets that it was fiscally sound. That was, indeed, impressive, but it came at the cost of 16 percent unemployment and an economy that, while finally growing, is still 18 percent smaller than it was before the crisis.

So bailing out the banks while punishing workers is not, in fact, a recipe for prosperity. But was there any alternative? Well, that’s why I’m in Iceland, attending a conference about the country that did something different.

If you’ve been reading accounts of the financial crisis, or watching film treatments like the excellent “Inside Job,” you know that Iceland was supposed to be the ultimate economic disaster story: its runaway bankers saddled the country with huge debts and seemed to leave the nation in a hopeless position.

But a funny thing happened on the way to economic Armageddon: Iceland’s very desperation made conventional behavior impossible, freeing the nation to break the rules. Where everyone else bailed out the bankers and made the public pay the price, Iceland let the banks go bust and actually expanded its social safety net. Where everyone else was fixated on trying to placate international investors, Iceland imposed temporary controls on the movement of capital to give itself room to maneuver.

So how’s it going? Iceland hasn’t avoided major economic damage or a significant drop in living standards. But it has managed to limit both the rise in unemployment and the suffering of the most vulnerable; the social safety net has survived intact, as has the basic decency of its society. “Things could have been a lot worse” may not be the most stirring of slogans, but when everyone expected utter disaster, it amounts to a policy triumph.

And there’s a lesson here for the rest of us: The suffering that so many of our citizens are facing is unnecessary. If this is a time of incredible pain and a much harsher society, that was a choice. It didn’t and doesn’t have to be this way.

"Iceland let the banks go bust and expanded its social safety net." OK. But far more importantly, to-the-exclusion-of-everything-else importantly, Iceland has a floating currency and could devalue. Real wages could fall. For a tiny economy like Iceland's, trade is crucial. We always knew that improving competitiveness by devaluation can help a lot in a crisis.The East Asians did it in 1998, too. That's monetarism, not Keynesianism.

One supposes Krugman would use the best available arguments in favor of "the path not taken." If this is it, I was right to be dismissive.

The Debt Ceiling Battle Pays Off

Good news on the economy this morning:

The U.S. economy expanded at a much faster pace in the third quarter, growing 2.5% as consumers spent more on big-ticket items such as autos and businesses investment surged. Growth almost doubled the 1.3% rate of the second quarter. The U.S. was forecast to expand by 2.8% in the third quarter, according to a MarketWatch survey of economists. Consumer spending climbed 2.4%, the highest rate since the end of 2010, and business investment shot up 16.3%. Inventories, which subtract from gross domestic product, rose 1.9%. Excluding inventories, final sales of goods and services increased 3.6%. Inflation, as measured by the price index for gross domestic purchases, fell to 2.0% in the third quarter from 3.3% in the second quarter. Excluding food and energy, the index declined to 1.8% from 2.7%.

Particularly good news here is the spike in business investment. And note the timing: it seems to have been just as the debt ceiling battle was heating up, and then ending in a Republican semi-victory, that businesses decided to invest. It could be a coincidence, but my tentative interpretation would be that businesses saw the government finally getting its act together on long-term debt, and swung into investment mode.

Labor Share of Income Drops

An interesting chart on the trend in labor share of income, via TalkingPointsMemo:

Since this has been going on for a decade, it seems to reflect structural rather than cyclical factors. I think it's driven by the Information Age and automation, which reduces demand for labor and therefore its share of income. One or more of the following might reverse the trend:

• More investment, more capital formation, making labor scarcer relative to capital.
• Large-scale retraining of workers, and re-orientation of the education system to the skills that are most needed today.
• Strong and sustained economic growth.

Wiki Consulting (and Expert Networks)

A recent Facebook conversation made me want to post this idea I've had in one form or another for the past few months.

First, at an abstract level. When you get above the level of menial labor, a lot of the work of big organizations consists of conversations. Conversations in board meetings. Conversations in merger negotiations. Conversations in which someone is trying to sell something through persuasion. Conversations about strategy. Conversations about divisions of responsibility. Conversations that end in signing written contracts, or that comprise oral contracts. Conversations in classrooms, with clients, with consultants, in which a well-informed party is informing a poorly-informed one. Conversations in print, in academic journals or corporate financial reports. Some of these conversations have a very high dollar value. Why? What is worth paying so much for? For now let's just say quality in some sense. Conversations differ in quality, from stupid to lucid, from false to true, from irrelevant to crucially urgent, from vague to clear, from rambling to disciplined, from rude to polite, from trivial to very important.

Now, notice that the internet has created enormous new modalities of conversation. E-mail. Chatrooms. The blogosphere. Podcasts. Skype. Social networking sites. And sometimes the conversations that occur in these new contexts are very high quality. I noticed in college that chat, in particular, was sometimes better for deep, personal conversations than talking face-to-face. The reason was that you could write something and see how it sounded first, and then delete it, so you were more willing to take risks and go out on a limb. Since then, I've noticed that the blogosphere is often excellent for high-level intellectual discussions, sometimes better than academic journals. Of course this is very hard to measure, but my sense is that the quality of conversations that take place for free in the blogosphere, on Facebook, and in general through new media, are generally very often superior to the quality of conversations that take place in more traditionally structured environments where capital allocation decisions are made, and that there is an opportunity, so to speak, for "arbitrage"-- for buying, channeling, re-incentivizing various kinds of online conversations so as to inform decision-making and improve it, while cutting the costs of decision support.

If this is such a good idea, why hasn't it already been done? Well, it has, sort of, in "expert networks." So I want to study expert networks more, figure out what's gone well or badly and how they're likely to evolve. Interestingly, expert networks seem to be at the heart of a recent major scandal on Wall Street. The Wall Street Journal reports:

Hedge funds didn't wait for a guilty verdict in Raj Rajaratnam's insider-trading trial to tighten controls on the use of so-called expert networks.

The charges against Mr. Rajaratnam, founder of Galleon Group, and the testimony at his trial shed light on both a shady web of contacts at some prominent companies and on expert-network firms, which connect hedge-fund employees with industry specialists. He was convicted Wednesday on all 14 counts of securities fraud and conspiracy.

Mr. Rajaratnam's lawyer has described his client's strategy of researching stocks through a private network of individuals as building "a mosaic of public information about the companies he follows."

Hedge-fund managers, however, are re-examining how they develop and use expert networks, says Guy Talarico, chief executive of Alaric Compliance Services, a New York-based consultancy that advises private-equity and hedge funds on compliance matters.

"I'm going to assume that there will be a real decrease in the use of expert networks, because people will not want to run the risk of that exposure," he says.

Many hedge funds have already implemented more rigorous procedures, Mr. Talarico says. They are more carefully reviewing the experts' credentials and the training they have received on insider trading, he says. They are requiring compliance officers to listen in on calls between experts and fund employees and obliging the expert to agree to a fund's insider-trading restrictions, he says.

Still, Ron Geffner, a hedge-fund lawyer for Sadis Goldberg LLP in New York, says that Mr. Rajaratnam's conviction "shouldn't be viewed as a conviction of expert networks, but rather practices by certain individuals that went beyond their intended use."

"This is not the trial of expert networks, although it may seem this way," says Mr. Geffner, who is also vice president of the Hedge Fund Association, a trade group based in Aventura, Fla.

The Economist wrote about expert networks last June:

THE inside information she gave him was “absolutely perfect”, a former hedge-fund executive testified on June 6th. Winifred Jiau, a consultant for Primary Global Research, an “expert network” firm, is on trial for peddling confidential information about companies to traders.

Ms Jiau’s industry is also undergoing its own trial, of sorts. Expert networks are matchmakers that link clients with experts. A hedge fund that trades pharmaceutical stocks, for example, might use an expert network to find a doctor who can explain how a new cancer drug works. The network would set up a phone call and pay the doctor handsomely.

Such networks have recently caught the eye of American regulators, who fret that investors may be using them to ferret out illegal inside information. Since November more than a dozen people with links to expert networks have been arrested for insider trading.

The hullabaloo has spooked the industry. Some firms, such as Primary Global, may not survive. Others, such as Gerson Lehrman Group (GLG), which has not been accused of any wrongdoing, are looking for a way to distinguish themselves from tarnished rivals and win back business from jittery clients.

GLG is by far the largest network. In 2008 it generated two-thirds of the industry’s global sales of $433m, according to Integrity Research Associates, a consultancy. As clients switch from smaller networks to ones with stricter safeguards, GLG could grab an even bigger share of the pie.

But the business will be less lucrative than before. GLG’s clients spend on average $170,000 a year to subscribe to its database of 300,000 experts. This yields rich profits. But some hedge funds are suspending their use of such networks, for fear of falling foul of the law. Others are making their traders jump through legal hoops before allowing them to speak to an expert. A few are abandoning networks altogether, and finding their own experts. “It would be odd to think that doing research on your own or finding someone online and sending them a cheque is better than the framework we provide,” grumbles Alexander Saint-Amand, GLG’s boss.

GLG has invested in technology to help clients search its database of experts. Compliance chiefs can set filters and block some experts if they worry there may be a conflict of interest. GLG keeps a record of who talks to whom, about what, down to the minute, which they could easily hand over to prosecutors if asked. “If you want to sell inside information, this is a terrible place to do it,” says Mr Saint-Amand.

But there is still scope for things to go awry. Professionals can sign up for GLG without a background check. They have to sign an agreement not to share any material, non-public information, but GLG does not listen in to the calls to enforce this. Clients who are determined to do wrong probably can. For example, they can meet experts through a network and then set up a separate “consulting” relationship, which enables them to buy tips without GLG ever knowing.

Compared to expert networks, the model I have in mind is considerably more public. I'm thinking of the Wikipedia model applied to business. Firms jump in with a question, participants offer answers, firms give spot awards for good ones. Firms that are known to be good tippers get better advice, so that have an incentive to pay. Participants can start out "on spec" as it were, giving it their best shot and then hoping for handouts, but those with a history of saying smart stuff might bid on a question: "I'll comment for $1,000," or something. There might also be a rating system, where only experts that had beat certain metrics-- total volume of spot awards, total volume of thumbs-up from commenters, or perhaps resume details like years of experience, education, etc.-- would be authorized to comment.  And the whole thing would be out in the open. The disadvantage of this is that if a company wants to get an edge on its competitors, wikiconsulting might not work. Their competitors could see it. But I think a lot of firms face questions that are very customized to their particular lines of business and they might not be hurt a lot by doing their consulting in public.

An interesting question is how this would affect insider trading laws. If wikiconsulting became important, a well-reputed expert's thumbs-down would likely affect the stock price. They could exploit this by, say, shorting a stock, then pooh-poohing the company's latest idea, then covering the position at a discount after the share price takes a hit. The SEC might be able to mitigate this somewhat. The honor system would probably have to do some of the work too.

"Stories of deportation find an ear" (JSOnline):

Rosa Bautista broke into tears as she told a standing-room-only crowd of nearly 1,000 who filled St. Adalbert's Catholic Church on Sunday afternoon about how the father of her four children had been deported to Mexico City.

She's a U.S. citizen, and her children are, too, but the day before Good Friday last year, the man in their lives was deported, she said. He had been here nine years and worked as a roofer, Bautista said.

"I ask you, if you were in my shoes, would you like to see your family separated as we are?" she asked the crowd.

Edward Ike of Nigeria told of how he and his wife could bring only two of their four children with them because their U.S. sponsor couldn't afford the other two. That was in 2003. The 6-year-old son and 8-year-old daughter they left behind are now 11 and 13, he said.

"It broke our hearts, but we promised to bring them soon, as soon as possible," he said. "It has caused deep pain in my wife and myself."

He said at least now immigration is working on his case.

The stories were part of a "Families United" rally and prayer service sponsored by the Milwaukee Inner-city Congregations Allied for Hope and Jewish and Muslim leaders.

Milwaukee is the 12th stop in five-week, 20-city listening tour led by U.S. Rep Luis V. Gutierrez (D-Ill.), who said he wants others to hear the stories of what's happening to families and to influence President Barack Obama to bring about comprehensive immigration reform...

The listening tour is sponsored by faith groups and held in church sanctuaries because "churches are the places where immigrants are welcomed, cherished and defended," he said.

End the violence.

My Take on AD-AS

One of these daysI'm going to do a post on why I think the Keynesian cross model is worthless: sheer disinformation. Upon reviewing basic Keynesian macro before teaching it, however, I was relieved to notice that the aggregate demand-aggregate supply (AD-AS) model, though traditionally derived from the Keynesian cross, seems to be separable from it. AD-AS doesn't seem as desperately flawed as the Keynesian cross.

Still, the concept of "aggregate demand" puzzles me. It seems like an attempt to import into macro a brilliant model from micro-- the supply-and-demand model (not aggregate)-- that doesn't really have a clear meaning in its new environment. In AD-AS, the horizontal axis, which in micro is Q (quantity), is called "GDP," which is sort of like Q since GDP is sort of the quantity of stuff being made, while the vertical axis, which in micro is P, is interpreted as "the price level." As in the micro model, demand-- only now it's "aggregate demand"-- slopes down, and supply-- "aggregate supply"-- slopes up, and the place where the curves cross is called "equilibrium." The interaction of AD and AS is supposed to jointly determine the price level and GDP.

Now, to my mind, this whole analysis is thick with fallacies of composition. The P in a micro model is really a relative price. That is generally kept implicit, but the ceteris paribus assumption makes it so. What the Law of Demand (i.e., demand curves always slope down, never mind Giffen goods for now) really says is that if the relative price of a good falls, quantity demanded rises. But it doesn't make sense to speak of all relative prices rising. It's not clear to me why aggregate demand should slope down. I know the textbook reasons but they can easily be countered. It's not clear to me how the ceteris paribus assumption, which is the soul of microeconomics, can be applied here, or why the supply-and-demand model should have any validity without it. In micro, ceteris paribus locks demand and supply in place. The supply and demand schedules depend on other factors. In macro, there are no other factors for them to depend on, so I don't see how you justify treating them as exogenous. I might grant that a price level and/or GDP not at equilibrium is unsustainable, because it will cause inventories to pile up or run down. But I don't see why equilibration should take the form of price level and/or GDP moving, rather than AD and AS moving.

And yet so many economists that I like, and not just from any particular camp, i.e., left-Keynesians like Krugman, but Arnold Kling and Scott Sumner too, and also old Robert Lucas papers, use the concept of "aggregate demand." Why? Why the resilience of the AD concept in view of the valid critiques of it? I think the reason is that it's intuitive. In any recession, what a typical business sees is that demand is weak. They would like to sell more but can't. And it's not just one industry: lots of different industries see that at the same time. Not just one demand curve is moving unfavorably; lots of them are; and that's the cause of, or maybe constitutive of, the downturn. That's the kind of half-empirical-half-intuitive story that people want to find a way to tell.

OK. So let's say we want to salvage aggregate demand somehow. I'm still skeptical about drawing a downward-sloping AD curve. (Or an upward-sloping AS curve; I'll talk about AD but the argument cross-applies.) Where's the empirical evidence that AD slopes down in GDP/price level space? Yes, each individual demand curve slopes down. But products are substitutes for each other: a rise in the price of x boosts demand for product y. So if all prices rise, sellers lose demand from the rise in their own price, but benefit from the rise in price of competing goods. Also, every seller is also a buyer, and a higher price level should mean that customers have more money to spend. This is where the inapplicability of the ceteris paribus assumption is lethal. In the micro demand-supply model, you can raise the price but hold consumer incomes/assets constant. In the macro AD-AS model, that doesn't make sense.

So I was thinking about how to reformulate this, and here's why I start. AD exists, but forget the price level for the moment. AD can drive fluctuations. But AD depends on NNPVFGDP. In case you can't immediately decipher that never-before-seen acronym, it means nominal net present value of future GDP. It's the answer to the question "How much does everyone expected to earn (or spend) over the infinite future?" discounted by the relevant interest rate. The graph I want to draw is this:

No, that's not a mistake: AD is an upward-sloping function of NNPVFGDP, and AS is a downward-sloping function of it. And on the horizontal axis is spending / sales / real GDP. I'm not sure whether the quantity on the horizontal axis should include investment / saving or not.

Why NNPVFGDP? Well, because if people are rational and not (in the aggregate) credit-constrained, that's what AD should really depend on. (If some are credit-constrained, that might be partly offset by other non-credit-constrained people taking the effects of those credit constraints into account and adapting, though I'd have to think more about that one too.) Also, my hunch is that NNPVFGDP is actually to a considerable extent an exogenous factor in business cycles, a source of "shocks." Another hunch is that a substantial amount of the volatility in NNPVFGDP comes from political developments, stuff like war, revolution, or in democracies, public opinion-driven policy revolutions with large redistributive and efficiency ramifications, like the New Deal. But large NNPVFGDP shifts can also emerge from spontaneous market processes, from corporate groupthink and consumer fads and financial bubbles. By the way, NNPVFGDP is all about expectations, and it's not really measurable. This is theory. It might not lend itself easily to being taken to the data. NNPVFGDP also depends a lot on inflation and interest rates, since it's nominal and a net present value.

Why is AD upward-sloping? Because when people expected higher lifetime incomes (higher NNPVFGDP), they spend more.

Why is AS downward-sloping? There's one ironclad reason and a subtler one I haven't thought through properly yet. The ironclad reason is that if people expect higher lifetime incomes, one of the things they'll consume more of is leisure. They'll work less. That reduces the aggregate quantity supplied. The subtle reason is that businesses that expect higher demand in the future might produce less goods for current consumption and more for future consumption-- you see why I'm unsure whether to include investment in the quantity on the horizontal axis.

Something else to bear in mind. This is irritating but important. When I say that people will "work less," I don't necessarily mean they'll put in fewer hours in the office. Work is not just a way of earning money. People get satisfaction from work in itself. So when NNPVFGDP rises, people may shift from jobs that pay better to jobs they like better. I think this is important, but it would be very hard to tease it out of the data. However, the downward-sloping AS curve captures this in a way. Higher NNPVFGDP might mean people are less productive even though they work the same number of hours or even more. They have faith in the future, so they do more of what they like.

Why is real GDP on the horizontal axis? Two reasons. (a) Real GDP is what we care about so it's nice to have it in the chart. But also, (b) it seems realistic to me that sellers and buyers both make their plans in real terms. What real standard of living do I plan on having? What real production plans does a firm plan to execute? They also have expectations about prices, of course, but they make plans about real behaviors. So the AD schedule captures the real plans that people make as consumers, for the current period, given NNPVFGDP expectations; and AD captures the real plans that people and firms make as workers/suppliers/sellers, given NNPVFGDP expectations. And these plans might be inconsistent.

I think the slopes of these AD and AS curves could be much better defended than those in the traditional AD-AS model. There is much more reason to think that AD is an increasing function of NNPVFGDP than to think that it's a downward-sloping function of the price level. Likewise with AS.

OK, now suppose you're in equilibrium and there's a negative exogenous shock to NNPVFGDP. What happens? You end up here:

The drop in NNPVFGDP puts the economy out of equilibrium, with AS taking a higher value than AD. What this means is that sellers want to sell a lot more than buyers want to buy. That doesn't seem like a sustainable situation, but the graph doesn't tell you how it will get resolved. We canNOT assume that AD and AS stay put and equlibrium is restored by changes in NNPVFGDP and spending/sales/real GDP: as I said before, demand and supply are exogenous in micro because of the ceteris paribus assumption, which can't be applied in a macro model. There are lots of ways the disequilibrium situation might be resolved, such as:

1. Interest rates fall. The future is discounted less, so NNPVFGDP rises, and the economy moves up the AD curve and down the AS curve back to equilibrium.

2. Prices fall due to supply-side competition. If the price drop is expected to be temporary, this pushes AD out and AS down. If permanent, maybe NNPVFGDP rises. Either change might leave current GDP in about the same place.

3. Unemployment results in a destruction of economic capacity. AS moves down and NNPVFGDP falls.

There are a lot of combinations of these, and there are other possibilities. In general, a lot will depend on which prices in the economy are more and less flexible, or perhaps asymmetrically flexible: wages are said to be downwardly rigid for example. This version of AD-AS provides a framework into which a lot of other stories might fit.

It's clear how monetary policy works here. Suppose the Fed lowers interest rates. Then NNPVFGDP rises, since the relevant discount rate for future incomes is reduced. The catch is that the Fed can't necessarily control the relevant interest rate, since what matters for NNPVFGDP is mainly long-term rates, and the Fed directly controls only very short-term rates. The other catch is that the Fed might not be able to push nominal interest rates below zero.

How does fiscal policy come in here? Let's suppose it can't affect AD through the price level. Maybe it gives money to credit-constrained people and they buy more. That would push AD outward for any given level of NNPVFGDP. On the other hand, non-credit-constrained people might expect higher taxes, offsetting, maybe fully offsetting, or even more, the boost to AD. Maybe the government could bring the economy closer to equilibrium with highly distortionary policies that are meant to be temporary and don't affect NNPVFGDP too much. But it would be an equilibrium with lower GDP. This is a possibility suggested by the model; I'm not sure of the interpretation.

The verdict seems to be that monetary policy can work, fiscal policy can't.

OK, now what does the boom look like? Like this:

So in this case, AD is greater than AS: buyers want to consume more now than sellers want to supply them, given projected NNPVFGDP. This situation isn't too hard to resolve: either interest rates rise, or prices rise. That may be why booms don't seem to cause as serious problems as recessions.

This is very preliminary, I'm just brainstorming here, jotting down thoughts. It kind of seems like a better place to start. Maybe if I formalized it a bit, the intuitions would become clearer.

I'd Almost Forgot How Silly the Bush Critics Used to Be

Andrew Bacevich's introduction to Reinhold Niebuhr's The Irony of American History is a great example of the idiocy of Bush critics in the middle of the last decade. Samples

The illusions of Osama bin Laden find their parallel in the illusions of George W. Bush. Each of these two protagonists is intent on radically changing the Middle East. Neither will succeed, but in their efforts they engage in a de facto collaboration that causes enormous mischief and suffering...

What's striking here is the arrogance of the "neither will succeed"-- when Bacevich thinks that he's denouncing arrogance. Starting with the Arab Spring, things are turning out differently. The Bush administration certainly transformed Iraq-- no illusions there-- and now the germ seems to have spread. I don't expect Bacevich to issue any apologies.

Today [Niebuhr] summons us to toss aside what he calls "the halo of moral sanctity" and to disenthrall ourselves from the self-aggrandizing parable in which we cast America as liberator of the world's oppressed.

Liberator of all the world's oppressed? True, that would be overreaching. But it's not arrogant to think we can liberate one strategically selected country here and there. That's actually quite likely. It would be one thing if Bacevich said the Bush administration's view that Iraq could be liberated and democratized, though plausible, was unlikely to be vindicated by events. That would be a sensible view, and he would deserve only a mild degree of embarrassment for not being vindicated. But no, Bacevich sets himself up as an oracle, and thinks the Bush administration's idea is only worthy of a sneer. Well, Bush was right-- and the humiliation to Bacevich is proportional to his arrogance.

The collapse of the Bush administration's hubristic strategy for the Middle East would not have surprised our prophet [Niebuhr].

Bush's strategy for the Middle East did not collapse. It worked, mostly. And it was never hubristic. It was bold, to be sure. It was a gamble. But one doesn't have to have overweening pride in order to take risks. The hubris is all on the side of Bacevich and other self-appointed wise men.

The masterminds who conceived the Iraq War imagined that they could sweep away the old order and usher into existence a new Iraq expected to be liberal, democratic, and aligned with the United States. Their exertions have only demonstrated how little they understood Iraq's history-- along with the dangers of playing God.

The "masterminds" sarcasm is juvenile, and is a reminder of how mature and serious the Bush administration was compared to so many of its critics. The "playing God" jibe is ridiculous: America was conducting a military campaign, and establishing a new regime, as the British Empire did in dozens of places and America did in Germany and Japan and elsewhere, etc., etc. It doesn't take "God" to do what America was trying to do.

As for history, about half the countries on earth have established successful democracies in the 20th century after never having done so before. To think that Iraqi democracy was destined to fail because of Iraq's history-- not likely to fail, but destined to fail-- is just a proof of ignorance. The architects of the Iraq war were hoping that Iraq would be liberal, democratic, and aligned with the United States; but if "better than Saddam" was all they got, that's an improvement; and the odds of that were always very good.

Besides, a war with Iraq was sure to be a "cakewalk."

Naturally, no footnote is provided here in support of this claim.

The lesson is clear: it is time for Americans to give up their Messianic dreams and cease their efforts to coerce history in a particular direction.

A typical claim of the Bush Derangement Syndrome-affected sages of the last decade: pompous, oracular, contentless. Were we "coercing history in a particular direction" when we fought the Nazis? Of course, and on the other hand, of course not. The question is meaningless. We were defending ourselves; but we were also trying to spread justice and humanity among men. The two goals are hard to separate and it's better not to try to separate them.

One good thing the Obama administration has done: by basically just staying the course in foreign policy, it has legitimized the Bush record in foreign affairs, and taken the wind out of silly windbags like Andrew Bacevich.

Don't Soak the Rich

"We are the 99%."

The protests on Wall Street have succeeded in creating doubt about whether the degree of wealth and income inequality in this country is politically sustainable. Wealth and income in capitalist societies, and I think in non-capitalist societies as well, is invariably distributed so that the median voter is poorer than the average voter. This isn't a mathematically necessity but it's a strong empirical regularity. The large majority always has a certain brute force on its side, and in a democracy it has the votes too, to take from a small, wealthy minority and redistribute to itself. Ignoring the costs of the redistribution process itself (but those can be very very very large!), the median voter always stands to benefit in the very short run from a general redistribution of wealth. So how is it possible for there to be so many millionaires, and even some billionaires, without them getting mugged by the majority?

It's actually better, by and large, to let the rich keep (most of) their money, but the reasons why are subtle. First, the general case for property rights. Property rights are essential to freedom because they give individuals a certain range of freedom of action in which they can do what they like without worrying about what authorities or superiors think. Property rights also help to create the right incentives for people to work, save, invest, take calculated risks, start entrepreneurial ventures. I think people understand that in everyday life, but they have trouble applying the same principles when the amounts of money at stake are increased by three orders of magnitude or so. To have, say, $10 billion, seems like absurd excess. It's hard to see how any sane person could be motivated by money at that point anyway. (Actually, I think they're usually not, except as a way of "keeping score," so to speak.) Why let them keep it?

One reason is justice: they created a lot of value, they should enjoy the fruits of it. This applies more to some rich people than others. It may explain why there's so much anger at the big Wall Street banks and, at the same time, so much adulation for another uber-rich guy, Steve Jobs. People think that Apple really did a lot of good for the world, so they don't resent Jobs' wealth. People don't think the banks did so much good. Another reason is incentive: crazy as it seems, big money seems to motivate some very rich, talented people to work hard. And we want them to work hard, inventing, planning, inspiring, making decisions. Again, this argument seems more convincing in the case of Steve Jobs than of Wall Street banks. The trouble is that it's hard to tackle the undeserving rich without tackling the deserving rich too. More importantly, there's a trade-off between progressivity and efficiency in taxation, with the taxes that fall on the rich generally being the taxes that most distort the economy.

Since labor is more evenly distributed than capital, capital taxation seems, on the surface, an appealing way to redistribute from rich to poor. Yet a lot of economic research (e.g., Chamley and Judd) finds that the optimal rate of taxation on capital (corporate income, capital gains, and dividends) is zero. Why? One reason is that capital taxation reduces the incentive to save, and savings finance the investment that is crucial to economic growth. Less capital formation means less capital for workers to use on the job means lower wages. Capital taxation also tends to distort the way companies make decisions. For example, suppose Company A makes $1000 of profit one year, and Company B takes a $500 loss. Suppose further that the capital taxation rate (corporate income tax plus capital gains or dividend taxes) is 30%. If A and B remain separate companies, their total after-tax earnings are:

Company A    $1000 * (1 - 30%) =     $700
Company B    -$500                        -$500
Total                                            $200

Now suppose that the companies merge into one company, AB. Its after-tax earnings are:

Company AB    $1000-$500=$500    * (1 - 30%) =    $350

So the companies can reduce their tax bill and increase after-tax earnings by merging. Bear in mind that there may be no business advantage to the merger at all, no synergies to be exploited, no costs to be shared. If it's sufficiently obvious that the merger is just a tax dodge, the authorities might be able to stop it. However, in other cases a merger might actually make business sense. It will be hard for regulators to tell whether a merger makes business sense or not, if the companies themselves have an incentive to mislead them. Another problem is that companies may manipulate their income streams so as to "smooth" income inefficiently, to avoid taking losses one year and making profits the next, and paying positive taxes on the profits that are not offset by negative taxes on the losses, since the government doesn't reimburse companies for losses.

Capital taxation also distorts firms' capital structure. When firms pay interest on debt, that's not counted as income and not taxable; but when they pay dividends, those are taxable. That creates an incentive for firms to finance investment with debt rather than equity.

If we want zero or low capital taxes, we could still impose high taxes on high-end labor incomes. After all, the notorious salaries of the highest-paid CEOs are labor income. If you look at the history of tax rates, there were long periods when the top tax rates were over 70%, or even as high as 90% or more. Of course, in those days, CEO salaries were far lower than they are now, and you can see why: if you're going to be giving the vast majority of your high earnings to the government, you don't have much incentive to negotiate for a high salary. What will you negotiate for, then? I knew a professor who did empirical research on firms in Britain, and met with several CEOs. In one of the most appalling cases (but not atypical), the CEO had to stop the interview because the questions-- about production processes, accounting and profits; basic stuff a boss should know-- were too hard for him. But, as if to redeem himself, the CEO walked across the room and opened a cabinet full of whiskey and other alcoholic beverages, plus a TV with a huge screen. He boasted, when the board meets, they all sat around and watched sports and drank. And why not? If the government's taken away your incentive to work, and your competitors' incentives to work, too, you'll get lazy. I also get the impression that some bosses back then thought attractive and biddable secretaries were one of the perks of the job.

Conservatives used to look back to the 1950s as a golden age. Now that theme seems more common among liberals and progressives. For example, Paul Krugman writes in The Conscience of a Liberal that that time "stands revealed as a paradise lost, an exceptional episode in our nation's history." Those were the times when taxes on the rich were very very high. And the economy seemed to do fine, better than fine. It grew strongly throughout the 1950s and 1960s. Incomes were a lot more equal than now. Shouldn't we try to get back to that?

Not so fast. First, we have to remember the process by which incomes got so equal. It was terrible. The 1929 stockmarket crash and the Great Depression had a leveling effect, destroying many of America's great fortunes, but of course everyone suffered. It would be bizarre to suggest that the sky-high taxes of the 1930s, and the gangsterish experimentalism of the Roosevelt administration, didn't have something to do with why the Great Depression was so long and deep. And then World War II, though presumably necessary, was hardly an experience we would want to repeat.

Second, the strong growth of the 1950s and 1960s partly reflected favorable demographics: the population was a lot younger than now, more people were working. It was also a process of recovery from the 1930s. Contrary to popular belief, recent research finds that the Great Depression was a time of rapid technological progress, which slowed down in the 1950s and 1960s; the latter decades experienced faster growth, of course, but that was because the economy was using more of its capacity, not because capacity was increasing faster. That helps to explain why the 1970s went so badly: by that time, the country had lost its innovative momentum.

The 1950s and 1960s were indeed an exceptional time in the nation's history, and not entirely in a good way. We should not expect to be able to repeat them. We should not really desire to do so. To stay vibrant and innovative, capitalism needs to be a high-stakes game, and that demands tolerance for a very high degree of inequality in income and wealth. We should always remember too, that hardly any of the real poor, the poor by global or historical standards, live here. They live in Africa, in India, in Pakistan, in Bangladesh, in Egypt, in China, in Central America and Mexico, and so forth. In global terms, redistributing from the "1%" to the "99%" is redistributing from the very-rich to the quite-rich. There's no moral merit in that. If the "Occupy" protestors were demanding taxes on the rich to finance more foreign aid, that would be a perhaps misguided but morally creditable cause. Demanding handouts to the American middle class is not.

That's not to deny that the Occupy protestors might have, or might inspire, some good ideas. Megan McArdle proposes a debt jubilee for student loans. And the Fed probably should stop paying interest on banks' reserves at the Fed, even though that will hurt the banks which are struggling anyway. Interest on reserves just gives banks a reason not to do their job, which is to lend money out into the economy. It's these kinds of subtle policies that can sort the deserving from the undeserving rich, that can get the incentives for talented people right. But it's a bad idea to think about what we want income inequality to be, and then to try to get there through the tax code. It's better not to think about it too much at all.

Krugman writes:

Second, even for more academic research, the journals ceased being a means of communication a long time ago – more than 20 years ago for sure. New research would be unveiled in seminars, circulated as NBER Working Papers, long before anything showed up in a journal. Whole literatures could flourish, mature, and grow decadent before the first article got properly published – this happened to me with target zones back in the late 1980s, where my original 1988 working paper had spawned a large derivative literature by the time it actually got published. The journals have long served as tombstones, certifications for tenure committees, rather than a forum in which ideas get argued.

What the blogs have done, in a way, is open up that process. Twenty years ago it was possible and even normal to get research into circulation and have everyone talking about it without having gone through the refereeing process – but you had to be part of a certain circle, and basically had to have graduated from a prestigious department, to be part of that game. Now you can break in from anywhere; although there’s still at any given time a sort of magic circle that’s hard to get into, it’s less formal and less defined by where you sit or where you went to school.

I wonder if it's sustainable that major academic journals are behind subscriber firewalls. The impact of any article behind a firewall on public debate is reduced by a huge factor. If, say, the QJE got endowed by somebody to make its articles free to the public, would it shoot ahead of the AEA in impact, because bloggers would be more willing to link to its contents? How much could it recover in advertising-- or in submission fees for authors?

It would benefit the public. The progress of knowledge, too, I think.

Krugman classifies macroeconomists:

At this point the big freshwater-saltwater divide in economics is between real business cycle types, who believe that neither monetary nor fiscal policy “works”, and New Keynesians who believe that both work or at least can work. But there’s a sort of lesser divide between full IS-LM extended types and what to my mind is a somewhat confused position in which monetary policy is effective but somehow fiscal policy isn’t under any circumstances.

I'm not really a macroeconomist (yet) but I'm in the middle camp Krugman mentions. Monetary policy is effective, fiscal policy usually isn't, and is as likely to backfire as to succeed. It's a combination of sort-of Ricardian equivalence (government borrowing is offset by private saving because people anticipate future txes), public choice (politicians use stimulus as a pretext to pay off interest groups), and the long run just being more important than the short run. The economy is an amazing Hayekian machine, fragile though ultimately resilient, and fiscal stimulus distorts it, and the distortions do more harm than fiscal stimulus does good. I won't say there are no exceptions to this: Social Security privatization or some kind of patent buyouts project might be worthwhile forms of stimulus. Sorry, the evidence definitely leans against the notion that the 2009 stimulus did any good.

UPDATE: For evidence on the public choice problem with stimulus spending, see this infographic by Megan McArdle (not about the whole stimulus, just green energy). Her summary: "We're just sticking a green smiley face on the same old corporate welfare--and the government's less like a VC than a farmer slopping the pigs at the trough."