The Free Thinker

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.

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.

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."

Did Technology Cause the Crisis?

I keep thinking about the title and abstract of this 2006 paper:

Are Technology Improvements Contractionary?

Yes. We construct a measure of aggregate technology change, controlling for aggregation effects, varying utilization of capital and labor, nonconstant returns, and imperfect competition. On impact, when technology improves, input use and nonresidential investmentf all sharply. Outputc hanges little. Witha lag of several years, inputs and investment return to normal and output rises strongly. The standard one-sector real-business-cycle model is not consistent with this evidence. The evidence is consistent, however, with simple sticky-price models, which predict the results we find: when technology improves, inputs and investment generally fall in the short run, and output itself may also fall.

I haven't read the whole paper, and didn't understand all that I read, and from what I did read, I was feeling a little skeptical about their empirical approach. Yet I keep being haunted by the idea that they might be onto the real explanation of the boom.

Think about when the Great Depression happened. There had just been a wave of technological change. New appliances. Radios. Electrification. Above all, cars. The two decades before 1929 were the age of Henry Ford. The Grapes of Wrath, which I've just been reading, has a Luddite streak. Steinbeck is particularly savage against the Caterpillar tractors that made his Okie farmers redundant. Was Steinbeck onto something? Was new technology the heart of the trouble?

I went to a Borders bookstore recently that was closing, and bought some 30 books at 70-80% off. I fear being made redundant myself one of these days. Why pay a professor to lecture 40 students a week when there's Khan Academy? How many white-collar professionals, how many bookkeepers, have been made redundant by computers? Newspaper classified ads are made redundant by Craigslist. Etc.

Maybe the economy just takes quite a while to find new things for all those people to do. And it makes some mistakes along the way. Like building too many houses.

As in the 1930s, we've fallen into a trap where dissatisfaction with the slow process of recalculation has given an opening to interventionist politicians, who don't do any good at all. Capital is on strike. But this diagnosis of the current problem, if I'm right about it, points to optimism about the future. The new technologies will shape a new lifestyle, they'll penetrate everything and improve it, the internet age, the age of smartphones/smart-everything, will accelerate and spread until the rising tide finally lifts all boats.

Keynes the Heretic

J.M. Keynes' admiring biographer, Robert Skidelsky, writes in Return of the Master:

In my biography of Keynes I called him an 'unusual economist.' I would now go further. Deep down, he was not an economist at all. Of course, he could 'do' economics-- and with the best. He put on the mask of an economist to gain authority, just as he put on dark suits and homburgs for life in the City. But he did not believe in the system of ideas by which economists lived, and still live; he did not worship at the temple; he was a heretic who learned how to play the game. In former times he would have been forced to recant, perhaps burnt at the stake. As it was, the freedoms of the exigencies of his times enabled him to force himself on his church. Only a person of colossal self-confidence, outstanding intellect and passionate concern for his countrymen and humankind could have set himself the task of rewriting a large chunk of the Western intellectual tradition. Yet this is what Keynes set out to do. One can only marvel that he got as far as he did. He mesmerized and fascinated his contemporaries; for thirty years after his death they lived in his intellectual and moral afterglow. But to the technicians who inherited his mantle his ideas seemed strangely alien to the main themes of their subject. They tried to assimilate them, but found it difficult and made a mess of it; and the next generation gave them up altogether. Orthodoxy won out; the economic temple was shaken, but still stood.

I find this very astute, though my attitude towards it a bit different. I might substitute "blinding egoism" for "colossal self-confidence," and it was a crisis of self-confidence, rather than the "freedom" of his times, which gave Keynes his opening. "Burnt at the stake" is gratuitous hyperbole: orthodoxies rarely do such things to heretics; I am almost tempted to say that genuine orthodoxies never do; certainly orthodox economists never have. It is far more typical for heretics to burn orthodox at the stake. This claim will be opaque to the typical modern person as regards the history of religion, but it is obvious enough in economics, where all the ideologically motivated murder has been the work of disciples of heretics like Marx, and never of Hayekian free-marketeers. But the word "heretic" is right on. "Heresiarch" would be even better, though perhaps general audiences would not understand it.

Let me draw attention to the fact that there is such a thing as "Keynesian economics," but one never (or hardly ever) speaks of "Marshallian economics" after Alfred Marshall, "Friedmanian economics" after Milton Friedman, "Arrovian economics" after Kenneth Arrow, "Fisherian economics" after Irving Fisher, or even "Smithian economics" after Adam Smith; Frank Knight, David Ricardo, J.S. Mill, Gary Becker, Francis Edgeworth, William Stanley Jevons, John von Neumann, Vilfredo Pareto, and Robert Lucas are others who I think shrewd insiders would probably rank as equal in brilliance with Keynes. (Actually it's subtler than that; some really informed people would probably rank them much superior, while many economists would give Keynes a small edge in deference to convention, but anyway. There is one other "economist," if he deserves the name, that has a school named after him: Karl Marx. But Karl Marx was so thoroughly wrong, and by now everyone knows it, that economists just ignore him. Keynes still has influence.)

Is it just that Keynes is more famous? I don't think so. It's that the most important contributions of Smith, Marshall, Fisher, Knight, Ricardo, Edgeworth, etc. are just mainstream economics. Their ideas were often very original. But one may say they fit into the existing framework of economic thought, and their ideas are now thought without reference to their originators. I think the heart of the matter is this: their ideas made sense, and that was what made them orthodox, for that is what an orthodoxy does, it makes sense. It may insist on certain mysteries (in economics the word "assumptions" is sometimes an allusion to these), but it does not force faulty logic on anyone. For that matter, it does not force its mysteries on anyone either. Frank Knight is an interesting case here, for he, too, was an irreverent and thorough skeptic about homo economicus, a radical who urged people (sarcastically?) to vote Communist, yet because of his humility and discipline he remained a representative of orthodoxy, the teacher of Milton Friedman, George Stigler, James Buchanan and Paul Samuelson.

Skidelsky said that Keynes' successors "tried to assimilate [his ideas], but found it difficult and made a mess of it." Not exactly. Keynes' ideas themselves were a mess. Hicks, Samuelson, and others made an order of them, to some extent; they codified and clarified and formulated and explained; but in the end this intellectual edifice dissolved. It was the proverbial house built on sand, or as economists sometimes say, a theory built without microfoundations. "New Keynesians" like Greg Mankiw salvaged what was worth salvaging; reactionary Keynesians today like Paul Krugman, Joseph Stiglitz, or George Akerlof are merely using Keynes' still-great name as cover for arrogant and politically-motivated revisionisms that would not stand up to critical scrutiny without it. The economics profession, I aver, simply responded to Keynes in the wrong way. It treated him as an oracle when it should have treated him as a provocateur.

I plan to back these claims up with a series of quotes from the General Theory (but I might not follow through, since there is always other business). But here's one to start with (from p. 164 of my edition):

For my own part I am now somewhat sceptical of the success of a merely monetary policy directed towards influencing the rate of interest. I expect to see the State, which is in a position to calculate the marginal efficiency of capital-goods on long views and on the basis of the general social advantage, taking an ever greater responsibility for directly organizing investment; since it seems likely that the fluctuations in the market estimation of the marginal efficiency of different types of capital, calculated on the principles I have described above, will be too great to be offset by any practicable changes in the rate of interest.

So essentially, Keynes seems to be advocating state control of the commanding heights of the economy. The government, not the private sector, should build factories. Why? Because the volatility of financial markets makes them unsuitable for allocating capital to its most productive uses. An economist as brilliant as Keynes is reputed to be would know better than to write this. Many countries have tried policies a bit like this since, especially in the Communist bloc and the Third World. The results are uniformly wretched: the capital is wasted, the products are lousy. Hayek, Mises, or I suppose Frank Knight could have guessed this in advance. They knew that the state is certainly not in a position to determine the best uses to which capital can be put; it lacks the data, which is fundamentally the subjective experience of consumers, and is revealed by the response of budget-constrained consumers to the price mechanism, and no other way; and anyway, it lacks the incentives to manage capital well. Meanwhile, Keynes much exaggerated the inefficiency of private financial markets. Indeed, I would be surprised if any important economist today would endorse this passage.

John Taylor, and is Spending Really Better than Tax Cuts and Transfers?

An excellent article on by John Taylor, entitled "An Empirical Analysis of the Revival of Fiscal Activism in the 2000s," in the JEL. His conclusion:

In sum, this empirical examination of the direct effects of the three countercyclical stimulus packages of the 2000s indicates that they did not have a positive effect on consumption and government purchases, and thus did not counter the decline in investment during the recessions as the basic Keynesian textbook model would suggest. Individuals and families largely saved the transfers and tax rebates. The federal government increased purchases, but by only an immaterial amount. State and local governments used the stimulus grants to reduce their net borrowing (largely by acquiring more financial assets) rather than to increase expenditures, and they shifted expenditures away from purchases towards transfers.

Some argue that the economy would have been worse off without these stimulus packages, but the results do not support that view. According to the empirical estimates of the impact of ARRA, if there had been no temporary stimulus payments to individuals or families, their total consumption would have been about the same. And if there had been no ARRA grants to sttes and localities, their total expenditures would have been about the same. The counterfactual simulations show that the ARRA-induced decline in state and local government purchases was larger than the increase in federal government purchases due to ARRA...

Others argue that the stimulus was too small, but the results do not lend support to that view either. Using the estimated equations, a counterfactual simulation of a larger stimulus package-- with the proportions going to state and local grants, federal purchases, and transfers to individuals the same as in ARRA-- would show little change in government purchases or consumption, as the temporary funds would be largely saved. Of course, the story would be different for a stimulus program designed more effectively to increase purchases, but it is not clear that such a program would be politically or operationally feasible.

More generally, the results from the 2000s experience raise considerable doubts about the efficacy of temporary discretionary countercyclical fiscal policy in practice. In this regard, the experience with the stimulus packages of the 2000s adds more weight to the position reached more than thirty years ago by Lucas and Sargent (1978) and Gramlich (1978, 1979).

Elsewhere, Taylor points out that these results are quite consistent with the permanent income hypothesis of Milton Friedman. Essentially, it pays to take rationality seriously.

What I'm thinking about is: does it make sense to say that a stimulus that consisted of direct government purchases, rather than of tax cuts and transfers, would have stimulated the economy more? How can we make sense of this?

The first thing to note is that direct government spending would still put money into the hands of the private sector, specifically, into the hands of workers, suppliers of materials, etc. To the extent that a transfers-and-tax-cuts stimulus transfers money to the private sector, a stimulus emphasizing new spending would have done the same.

The difference is that a boost to federal spending would mean that the private sector-- the workers and suppliers of materials with whom the government did business-- would have to do something in exchange for the money. For starters, assume that the government projects have no value in themselves. In that case, the private sector gets the same thing but has to jump through hoops to get it. Presumably they would do the same thing with the money-- save it. Worse, they might save more of it, because jumping through hoops for the money would have made them poorer.

Remember, ~90% of those who want to work are still employed. Considering how much job churn there is, and considering that the most energetic and resourceful people, who would be most useful on new federal spending projects, also tend to be those currently employed, it is a safe assumption that most of those who would work on stimulus-related public projects would be diverted from private sector jobs, not out of unemployment. So federal spending would depress other private sector activity in a way that tax cuts and transfers don't.

It's a different story if stimulus money were spent on projects with significant economic value. But here we get into the game of "picking winners," of which we've just seen the results in the Solyndra scandal. The truth is that allocating capital and labor to the most productive uses is a very difficult task, and the people, and maybe even more importantly the institutions and information networks, that are good at it, are high up in the commanding heights of the private sector. If there's no special reason why the private sector can't handle it, it's crazy to get the government involved. But there are such things as public goods, and if more spending on defense, or highways, contributed to the productivity of the private sector, stimulus might pay off.

I still like the idea of patent buyouts as stimulus. Patents are a second-best solution; it would be more efficient, in theory, to just pay the inventor and let anyone make the good, since the marginal cost of using a patent is zero. In a recession, let the government buy out lots of patents and release them into the public domain. That gets money out there and raises the productivity of the private economy in the long run.

But unless federal spending can provide a large boost to private sector productivity, its effects would be worse than the stimulus: equally ineffective in stimulating spending, but with extra distortionary effects on the economy. Taylor's piece is good news in a way though: it suggests at least that the stimulus didn't do much damage.

Analysis: Obama, Bernanke out of ammo to boost jobs, growth:

The United States has a jobs problem and there's not a lot President Barack Obama or Federal Reserve Chairman Ben Bernanke can do about it.

In the face of rising risks of a recession that could imperil his re-election chances next year, Democrat Obama wants Congress to extend a payroll tax cut and emergency unemployment benefits that are due to expire in December.

But the Republican-controlled House of Representatives is emboldened by budget concessions it made Obama swallow to lift the country's debt limit this week and he has little political leverage to win significant fresh spending to aid growth.

"Obama does not have much presidential persuasion left. He is running out of capital," said James Thurber, of American University's Center for Congressional and Presidential Studies.

Obama's political opponents have been openly scornful of the impact of two previous stimulus packages, which were accompanied by extraordinary measures by the Federal Reserve to kick-start the U.S. economy.

"It seems we've thrown everything at it. We've had QE1 and QE2, Stimulus 1 and Stimulus 2, and the unemployment rate is still 9.2 percent," said John Makin, an economist at the American Enterprise Institute in Washington. "Maybe there are just not many options here at this point," he said.

No, no, there's plenty we can do. First, we still haven't done enough of what we should have done at the beginning, namely, combine (a) deficit spending (but we've had plenty of that of course) with (b) strong action to bring the long-run fiscal situation under control, so that investors won't worry so much that profits from projects undertaken now will be confiscated. Adopt Paul Ryan's plans on Medicare. Raise the retirement age. Index Social Security benefits to inflation rather than wage growth, and maybe means-test them at the high end. Repeal Obamacare. The debt deal may help there, but we need to go further. And tax reform too.

Second, reform immigration already! Naturally when you're waging war against millions of productive workers, that's bad for the economy. The crisis started with a drop in housing prices, and a rise in housing prices would end it. And it's easy to get that: boost demand. Let in more home buyers. Give the people who are already here and living in homes-- and might buy them-- assurance that they can stay. I'll throw out a third one, borrowed from Charles Krauthammer, not to advocate it but just to show that there are options:

Charles Krauthammer: "An index of how spent he is sort of intellectually on the issue of jobs is the campaign speech he gave today, the fourth in 10 days, in which he pivoted, he did his pivot, and he announced five initiatives. Listen to them. Payroll tax extension: We already have that. Unemployment insurance extension: Already have that. Trade deals: He's had it for two and a half years and done nothing. Spending on more infrastructure: a perennial -- you know, more dams, more bridges and roads. And the last one, I love that. Here's the real new one that will get us out of our doldrums: patent process reform. Now that I think is the key to economic explosion, getting us out of 9 percent unemployment.

"He's out of bullets, he's out of arrows, he's looking for stones on the seashore. And it shows that he may want to have a jobs agenda, he may want to do a pivot -- there's nothing left in the cupboard. He did a huge Keynesian gamble, and it failed."

I don't know if the patent process reform I have in mind is the same as what Krauthammer/Obama are thinking of-- actually I'm sure it's not-- but I think the best form of fiscal stimulus would consist of patent buyouts. Let the government run auctions to buy a whole lot of patents (to make the auction genuine they only buy some of the patents people bid for), and then retire them, so that anyone can make the products in question. Prices of lots of goods drop, helping consumers. There are lots of opportunities for start-ups to make stuff that was proprietary before. And former proprietors of intellectual property find themselves losing revenue streams, and need to invest to get new ones. Now, I'm hesitant to actually endorse this approach, since it involves government spending. But it's not true that the government is out of options to stimulate the economy.

Capital Flight

Don't hold your breath (Time):

Half of Americans say they couldn't come up with $2,000 in 30 days without selling some of their possessions. Meanwhile, companies are flush: American firms generated $1.68 trillion in profit in the last quarter of 2010 alone. But many firms would think twice before putting their next factory or R&D center in the U.S. when they could put it in Brazil, China or India. These emerging-market nations are churning out 70 million new middle-class workers and consumers every year. That's one reason unemployment is high and wages are constrained here at home. This was true well before the recession and even before Obama arrived in office. From 2000 to 2007, the U.S. saw its weakest period of job creation since the Great Depression.

Nobel laureate Michael Spence, author of The Next Convergence, has looked at which American companies created jobs at home from 1990 to 2008, a period of extreme globalization. The results are startling. The companies that did business in global markets, including manufacturers, banks, exporters, energy firms and financial services, contributed almost nothing to overall American job growth. The firms that did contribute were those operating mostly in the U.S. market, immune to global competition — health care companies, government agencies, retailers and hotels. Sadly, jobs in these sectors are lower paid and lower skilled than those that were outsourced. "When I first looked at the data, I was kind of stunned," says Spence, who now advocates a German-style industrial policy to keep jobs in some high-value sectors at home. Clearly, it's a myth that businesses are simply waiting for more economic and regulatory "certainty" to invest back home.

The last sentence is exactly correct except for the "it's a myth that" part.  In 1990-2008, companies may have been outsourcing a lot, but US unemployment was quite low.  In the first half of that period, productivity growth accelerated and we were enjoying the best economic times in a generation.  In the last eight years of it, incomes were stagnant and gains in household net worth proved temporary, but we kept unemployment low while carrying the burden of two big foreign wars.  The job dearth is a new phenomenon, and the main reason is probably the increased political risk since 2008.

Pundits on the right are converging on a story. Here's John Podhoretz:

By now it is clear to everyone that the Obama administration bungled the 2009 stimulus package. The dispute now is over the reasons for its failure. The conventional wisdom is coalescing around a view crystallized in a column by Mr. Conventional Wisdom himself, Charlie Cook of the National Journal: “The administration’s initial response, the much-maligned economic-stimulus package, was far too modest and unfocused.”

Cook is a rational analyst, so it is striking that he is able to advance an argument that is, on its face, nothing short of demented. The idea that the 2009 stimulus, which cost $840 billion, could have been less “modest” and more “focused” does violence to the facts of very recent American history and to the arugments made for the stimulus by its advocates at the time.

Even at its “far too modest” size, the stimulus was, by leagues, the costliest such effort in American history. Its astounding price tag was justified during the debate over its passage by the fact that there was a genuine economic emergency that had to be addressed. And the mere fact of addressing it with enormous public resources was, we were told, enough to do the trick almost on its own. The central point of taking emergency measures, we were told, was precisely not to focus them but to cause them to wash over the economy as a whole.

How many times during that emergency were we reminded of the supposed wisdom of John Maynard Keynes, who wrote in 1930 that it was enough to employ a man to perform any task at hand to create the conditions for macroeconomic growth? Simply “to dig holes in the ground,” Keynes wrote, “paid for out of savings, will increase, not only employment, but the real national dividend of useful goods and services.” This is the famous “multiplier effect” we also heard so much about, according to which $1 in government spending would blossom into $3 of value for the entire economy. In effect, we were told by the most enthusiastic believers in the magic of the multiplier effect, that for $840 billion in spending, we’d get more than $2 trillion in economic activity.

It’s also important to remember that the stimulus wasn’t the first bite at the apple... The notion that Congress could have passed a stimulus bill twice the size of the one that did—Paul Krugman’s idea—was then and is now preposterous. Obama’s stimulus was as large as it could possibly have been, and the parlous results indicate it was vastly larger than it should have been.

The growing consensus is that Obama’s economic policies have failed, and precisely in the ways that those skeptical of the stimulus predicted.

And Martin Feldstein is blunt but, I think, fair:

The policies of the Obama administration have led to the weak condition of the American economy. Growth during the coming year will be subpar at best, leaving high or rising levels of unemployment and underemployment.

The drop in GDP growth to just 1.8% in the first quarter of 2011, from 3.1% in the final quarter of last year, understates the extent of the decline. Two-thirds of that 1.8% went into business inventories rather than sales to consumers or other final buyers. This means that final sales growth was at an annual rate of just 0.6% and the actual quarterly increase was just 0.15%—dangerously close to no rise at all. A sustained expansion cannot be built on inventory investment. It takes final sales to induce businesses to hire and to invest.

The picture is even gloomier if we look in more detail...

How has the Obama administration contributed to this failure to achieve a robust and sustainable recovery?

The administration's most obvious failure was its misguided fiscal policies: the cash-for-clunkers subsidy for car buyers, the tax credit for first-time home buyers, and the $830 billion "stimulus" package. Cash-for-clunkers gave a temporary boost to motor-vehicle production but had no lasting impact on the economy. The home-buyer credit stimulated the demand for homes only temporarily.

As for the "stimulus" package, both its size and structure were inadequate to offset the enormous decline in aggregate demand. The fall in household wealth by the end of 2008 reduced the annual level of consumer spending by more than $500 billion. The drop in home building subtracted another $200 billion from GDP. The total GDP shortfall was therefore more than $700 billion. The Obama stimulus package that started at less than $300 billion in 2009 and reached a maximum of $400 billion in 2010 wouldn't have been big enough to fill the $700 billion annual GDP gap even if every dollar of the stimulus raised GDP by a dollar.

In fact, each dollar of extra deficit added much less than a dollar to GDP. Experience shows that the most cost-effective form of temporary fiscal stimulus is direct government spending. The most obvious way to achieve that in 2009 was to repair and replace the military equipment used in Iraq and Afghanistan that would otherwise have to be done in the future. But the Obama stimulus had nothing for the Defense Department. Instead, President Obama allowed the Democratic leadership in Congress to design a hodgepodge package of transfers to state and local governments, increased transfers to individuals, temporary tax cuts for lower-income taxpayers, etc. So we got a bigger deficit without economic growth.

A second cause of the continued economic weakness is the president's emphasis on increasing tax rates. Although Mr. Obama grudgingly agreed to continue the Bush tax cuts for 2011 and 2012, his budget this year repeated his call for higher tax rates on upper-income individuals and multinational corporations. With that higher-tax cloud hanging over them, it is not surprising that individuals and businesses do not make the entrepreneurial investments and business expansions that would cause a solid recovery.

A third problem stems from the administration's lack of an explicit plan to deal with future budget deficits and with the exploding national debt. This creates uncertainty about future tax increases and interest rates that impedes spending by households and investment by businesses. The national debt has jumped to 69% of GDP this year, from 40% in 2008. It is projected by the Congressional Budget Office to reach more than 85% by the end of the decade, and to keep rising after that. The reality is even worse since ObamaCare alone will cost more than $1 trillion in its first 10 years. The president's boast that his health legislation would not "add a dime" to the national debt was possible only by combining that increased spending with proposed new taxes and with projected cuts in Medicare spending that will never occur...

The economy will continue to suffer until there is a coherent and favorable economic policy. That means bringing long-term deficits under control without raising marginal tax rates—by cutting government outlays and by limiting the tax expenditures that substitute for direct government spending. It means lower tax rates on businesses and individuals to spur entrepreneurship and investment. And it means reforming Social Security and Medicare to protect the living standards of future retirees while limiting the cost to future taxpayers.

Martin Feldstein seems to have more faith in stimulus in general than Podhoretz, but thinks the "multiplier" is less than one (or less than zero, depending on how you define it). Which also looks bad for Keynesian theory. And Jonah Goldberg piles on:

"Now, my administration has a job to do as well, and that job is to get this economy back on its feet," President Barack Obama declared on July 14, 2009, in Warren, Mich. "That's my job, and it's a job I gladly accept. I love these folks who helped get us in this mess and then suddenly say, well, this is Obama's economy. That's fine. Give it to me."

OK. It's yours.

The unemployment rate then was 9.5 percent. It's now 9.1 percent, well above the 8 percent cap that the administration advisers projected under the stimulus bill. But that's not the amazing part. According to a White House report written by economic advisers Jared Bernstein and Christina Romer in January 2009 in support of the bill, if we had passed no stimulus package at all, the unemployment rate would have topped out at around 8.8 percent in the last quarter of 2010.

If only.

Instead, we got Obama's vital "investments." Since his speech in Warren, we've spent another $2.8 trillion in borrowed money. Presumably, we could have cut the unemployment rate by four-tenths of a percentage point more cheaply than that?

Meanwhile, we've accrued a total of $3.7 trillion in debt on Obama's watch, while losing 2.8 million jobs. That doesn't sound ideal either.

But what do I know?

The more salient point is that Obama acts like he knows everything. From Day One, this White House has been cocksure about how to get us out of the economic ditch. In every major relevant speech, Obama has stuck with a consistent message: We know what to do and the Republicans don't. "I will not sacrifice the core investments we need to grow and create jobs," Obama insisted yet again in his April budget speech...

No president "runs" the U.S. economy, but this president talks like he does more than any I can remember. And yet, none of his economic promises or predictions has panned out.

Obama deserves all this for his failure to deal with the long-term budget deficit if nothing else. But Keynesian theory also deserves it. In particular, the "multiplier" idea needs to bite the dust. Keynes argued that if the government spends $1, someone will get that $1, save say 10%, spend $0.90, someone else will get that $0.90, save say 10%, spend $0.81, so the total spending will be a lot more more than the original $1. Wrong. (a) Savings don't just disappear, in a healthy economy they will be invested. (b) Savings rates are endogenous, and if people see that the government is borrowing on an enormous scale, they'll save more to offset the anticipated tax increases. In the short run, since some people are credit-constrained, more government spending may raise total spending, in the short run. But it might leave it constant, or even-- because other people, who are not credit-constrained, anticipate paying more than their fair share of the extra future taxes and raise savings by more than the government raises spending-- reduce it. In any event it is not likely to raise it by much. And in the long run it just distorts the economy and makes us poorer. If there are ways to spend that raise long-run GDP, fair enough. It might be a good idea to concentrate that spending in bad times. But generally, fiscal stimulus just doesn't work. We shouldn't really have expected it to.

It Would Be a Hard Survey to Design

Nato argues in a response to my last post:

The constant references to sentiment don't seem to include links to actual surveys, but rather to people the author talks to. The counterfactual asseverations don't seem to come with any actual support. Krugman et al. can (and do) claim that the stimulus was much smaller than it should have been according to their calculations, and that seems to be a plausible and natural defense of the mismatch between claims of benefit and results. There's a significant chance that the defense is wrong, but it's not special pleading.

Now, I think this is quite wrong, and let me see if I can explain why. For conservative critics of Obama's economic policy, the counter-factual is some kind of mean reversion. The idea is that the economy has a sort of equilibrium state or equilibrium trend, and that when the economy deviates from trend, it tends to move back to it, if policy does nothing. If policy seeks to prevent deviations from trend, and deviations from trend do not occur, that suggests that maybe policy is preventing them, that is, policy is helping to smooth the business cycle, to make the economy more stable. That might have seemed true, say, in the 1990s. If, on the other hand, the economy stays a long way below trend for a long time, the counter-factual is that the economy would be on or returning to the trend, and the first hypothesis to consider for why it is not doing so is government policy. So the main basis for the counter-factual presumptions is simply the historical trend, though other evidence is nice, too, if it is available.

By contrast, it's difficult to express the kinds of assumptions that must underlie Krugman's argument for a bigger stimulus without undermine its plausibility. Thus, you might say that if there had been no stimulus, we would have been even slower to get out of the recession. To claim that, one must either deny that the economy has any inherent tendency to revert to trend, or claim that something has suddenly made that tendency inoperative. That claim is destitute of the kind of historical induction which underlies the conservative position. If one does accept that there would be a natural reversion to trend, then the counter-factual presumption has to be that the economy would have been recovering if government policy did nothing, and it's not recovery but the feebleness of the recovery that must be regarded as the result of the stimulus policy. If this is granted, one might still argue that the effects of stimulus are non-linear, that a relatively small (though still quite large!) stimulus had a negative result, but a larger stimulus would have had a positive result. But if the effects of stimulus are non-linear, it seems more likely that the effects of stimulus get worse at the margin, that the "low-hanging fruit" are picked first, and more spending means less valuable public-sector prrojects and more displacement of private sector activity. So I think Nato is quite to think that the critics of Obama's policies are more to blame for unsupported counter-factual asseverations than Krugman, it's the other way around. All Krugman has to support his claims that a bigger stimulus would have worked are deductions from a Keynesian theory that has not fared well theoretically or empirically in recent decades, and which the apparent failure of a smaller Keynesian stimulus further undermines.

However, what prompted this post is the following:

I have not yet encountered any that weren't based on assumed counterfactuals and dubious claims of sentiment. I have sometimes argued with these, and sometimes not, but it seems each time I've challenged them, the writer either retrenches somewhat or doubles down on the 'sentiment' point without offering additional evidence.

When I responded to this with a link to a survey showing pessimistic sentiment among households, Nato objected that it was "household sentiment about the economy, not businesspeople about the government." Well, but businesspeople are householders too, no? Still, it got me thinking about what the ideal instrument would be to test the hypothesis that businesses' reluctance to hire reflects heightened political risk.

First, what you'd really want to do would be to write a questionnaire and then go back in time and ask people the same questions in 2007, then ask them in 2011, and compare answers. If you just have the answers today, they would be hard to interpret. Suppose 95% of businesspeople say they are worried about higher taxes. Well, maybe businesspeople always know there's a chance taxes will rise, and always try to be ready for it. If, on the other hand, 25% of businesspeople say they're worried now, but only 10% did in 2007, that would provide strong support for the political risk hypothesis. Unfortunately, you can't do that, and it's very likely that many of the questions you would want to ask now, no one would have thought of asking in 2007, because the politico-economic environment has changed in such unanticipated ways. For example, we might now want to ask: "Do you sometimes take into account the possibility of future government bailouts when you make business decisions? How?" Who would have imagined in 2007 that that could be an important question to ask businesspeople?

Second, what is your sample, and how do you weight it? If your sample is of "firms," represented by, say, CEOs, a big problem is that firms vary hugely in size and are not of anything like equal importance. So, do you interview the bosses of Fortune 500 companies, or mom-n-pop stores, or something in between? If you interview firms of different sizes, do you give firms of greater size greater weight? Once you do that, though, your statistics start to become strange. What are you actually reporting? You can't say "55% of bosses said that..." Your number might accurately be stated as "55% of firm value is represented by bosses who said that..." Worse, there will be so many different weird schemes you could adopt to deal with the problem that people could suspect you of manipulating the results, and someone else using the same data but adopting a different, and equally defensible, weighting procedure, might find a different result. And yet, if 95% of bosses don't think at all about government bailouts, but 5% have switched from productivity-maximization to rent-seeking in the past five years, and especially if those 5% are highly placed, that might explain much of the deterioration of the economy.

Or is it businesspeople you want to interview at all? Maybe the businesspeople are as confident as ever, but they can't get credit to expand because the people with the money are worried about political risk. How would you find that out? You'd need a sample of bankers or investors. Also, remember that the sample of businesspeople is endogenous. Some people might be businesspeople now because they got thrown out of jobs by the recession and so tried self-employment instead-- or because they are politically well-connected and found that a more useful asset in a more interventionist time. Others may have been businesspeople two years ago and aren't now because their businesses went bust in the recession. More subtly, some people would have been businesspeople but for the recession, that is, they had business ideas but didn't pursue them because the environment seemed unfavorable. Or conversely, they might have planned to abandoned self-employment, then decided to stick with it because the times were unfavorable to looking for a salaried job. In short, if businesspeople are your sample, the sample is endogenous. How do you deal with that? (Some of these people might not even be in the country: immigrants who went home, or didn't come, because of the bad economy.)

There might be clever ways to deal with these statistical problems. But I think the demand for "evidence" in the form of polls or surveys might be a little hasty. There's merit in just grabbing stylized facts and thinking about them. The economy's performing way below trend. Why? Obamacare and the removal of the Bush tax cuts are going to cause substantial tax hikes for the rich, and Obama still seems to think there's room for more. How does that affect the incentives of entrepreneurs and investors today? No one seems to understand Obamacare, what obligations it places on employers and individuals, how it's going to affect prices. How is that going to affect hiring decisions? Corporations have been making big profits in the past couple of years, and P/E ratios are low. If capital's earning a lot, why don't people want to make more of it by investing? Political risk makes a lot of puzzle pieces fit together.