From Bad to Worse: Reaction to Arthur Laffer

Read the WSJ article by Arthur Laffer, "Get Ready for Inflation and Higher Interest Rates", at the following link:  http://online.wsj.com/article/SB124458888993599879.html

Mr. Laffer makes a convincing sounding arguement to contract the monetary base in order to stem the tide of inflation.  However, in his last paragraph he grazes over the "sharp pain of a deepened recession" that would result in the short run if money supply were contracted.  He seems to neglect a few key things: the expanded money supply is meant in the short run to get us out of the recession, and that the Americans who would feel the sharp pain of this are real people. 

Contracting the money supply is a tool that the Fed can use prevent inflation, and Mr. Laffer argues that the increased money supply we have now is not necessary in order for banks to lend out assets, so this will be fine.  He also says that a decreased demand for money (liabilities) will result in inflation and higher interest rates.  The short run inflation rate and interest rate increases will encourage economic growth, however.  It is favorable to the borrower to use the money for investments in this circumstance, since higher inflation rates in the future mean that the real value of the loan is now lower than when they originated it, though the nominal value stays the same.  Investment is a key aspect of stable economic growth in the long term future.  Contracting the supply at this point would put the borrower at a disadvantage and discourage investment.  High interest rates also increase savings investment.  Contracting the monetary base would greatly stunt economic growth, which is the key reason the monetary base was expanded during the recession in the first place.

Keynesian economists would say that the contraction of supply should only occur when the economy is consistently growing.  At that point, it would prevent too much growth and reduce inflation and interest rates, at a time where supply is high enough that inflation distortion and high interest rates are no longer needed as incentives to invest.

F/F and Government Bailouts

How was it that instritutions such as Fannie/Freddie were able to make bad choices?  And how, assuming they did not know about an inevitable government bailout, did they expect to make good on these decisions?  This seems to be a case of inflation and tax distortion (as well as other distorion) leading financial advisors and lenders to make what turned out to be wildly inaccurate predictions.  From what I have read and seen regarding the housing bubble, it seems that the sub-prime lenders for the most part weren't doing anything illegal, even though the lending sheme does resemble a ponzi in many ways.  Conditions were good for home investments: the dot-com bust steered investors toward a more "safe" home investment, increasing demand for housing.  Rising house prices increased supply of new homes all over the country.  Interest rates favored lenders.  Tax breaks and increased short term profits provided extra incentive.  More buyers lead to prices driving up at an alarming rate, though the recent reductions in inflation seemed to mask the extent that this was at (see some neat charts).  As the value of houses went up, lenders felt more secure in lending to sub-prime borrowers, aka those with low credit ratings.  Combine that with ARMs and confused buyers that are told that refinancing will be available before the payments go up, and disaster starts brewing.  When the interest rate on the ARM begins to float in a few years, and lenders actually can't refinance, the increase in mortgage payments puts many in default and prices go down.

The toll this took was huge, but not necessarily forseeable (although some economists were expressing doubts as early as 2004, when the rate of increase in house prices became clear).  Either way, a company that makes bad decisions in the free market sinks.  Before the gov't stepped in, F/F should have had to bail themselves out by selling assets to other firms until they had matching assets and liabilities.  That would really have cut them down to size!  Instead, the gov't injected cash into their systems so that they could maintain operations at their current levels and the promise of being paid back plus interest.  I hope this never happens again, although for practical purposes it does seem to have helped.  Paying morgages for households just seems to be in the gov't best interest at that point, since the money they pay keeps the F/F afloat so that they will be able to repay their debt to the public.  But if you think into it deeply enough, your tax dollars went toward keeping these companies from ruin and potentially sinking the economy, and they are also going toward maintaining these companies so that people can keep their homes.  Realistically, this merely rewards ppl who tried to live beyond their means and punishes others who pay a similar portion of their income toward a mortgage on a house they could actually afford.  The deadweight loss on the increase in property taxes-now or in the future-will also be bad for the housing market and increase the price paid up-front by homeowners who already couldn't afford their purchases, forcing them to dedicate a larger part of their income toward payments, even without govt help.  The results are that those getting help from the govt will not be able to actually build wealth or add to their investment (renovations and the like).  So in the long run the housing market will remain depressed for longer than if the invisible hand were allowed to guide without tax dollars in it, but in the short run it does seem to help.

Spend and Cut: A 1-2 Punch at the Recession

Deficit spending is a clear example of an economic problem-turned-political issue.  But long before the current political divide, funding of war efforts was a hot topic of debate among leading economists.  Mankiw (p 408) offers the two principal economic arguments debt financing of a war: smooth tax rates over time and shifting the burden to future generations.  These arguments look sensible, and more importantly, are an easy "sell" for any politician.  Deficit spending is popular but also a historically-demonstrated economic policy.  Part of Keynesian Economic Theory, deficit spending during a recession is a counter-cyclical fiscal policy to stem the tides of the business cycle (growth and recession); during booming economic growth periods, increasing taxes and cutting stimulatory spending are meant to slow growth and delay the inevitable recession.  According to Keynes, the government must play an active role in managing the economy in the short run and not wait for the 'invisible hand' to steer the economy in the long run.  This was because, as Keynes is famously quoted, "In the long run, we are all dead."  (SOURCE: Wikipedia.org and associated references.)  

Economists have generally agreed with the necessity of a stimulus package, despite differences in professional opinion on the role of government or what the package itself ought to contain.  (Source: Washington Post; source used elsewhere in this post as well.)  The stimulus package is also based in Keynesian counter-cyclical policy and has historical precedent.  The ability of an economic stimulus to actually stimulate the economy in the wake of deficit spending and recession is based on the "Keynesian Multiplier": Developed by Richard F. Kahn in 1931, a monetary outlay 1.) Is spent mostly on consumption and modestly put in savings, and 2.) The spending and investment allows businesses to grow and create jobs.  Data from the 2009 stimulus suggests a multiplier of 2.5, with the number dampening to equilibrium (multiplier of 1) over time.  The size of the government, and therefore the level of control it has over the economy, plays a key role in this as well.  A large government will be able to have a more rapid effect on market outcome but place a larger burden on each citizen to support this, and the burden would be further exacerbated by the fact that the stimulus is increasing a deficit that is already large and growing due to the war effort.  The government we have today accounts for almost 50% of the GDP.

The size of the government in and of itself is as large today as it has ever been, save during the WWII era when it spiked to the 50% level but then shruck back to pre-war levels shortly after.  Combine this with a large and growing war deficit, a deep recession, bank failures, job losses, and a trade deficit, and the historical precedents no longer add up entirely: The situation has gotten out of the Keynesian Economic hand.  The government has the capability to run the private sector market down too far; the debt is so large that future generations aren't just going to pay with taxes, inflation, and higher interest rates, but with major cuts to social welfare programs.  A recent CNN Research poll mirrored the new political and economist view that something else must be done besides the stimulus to help the economy- namely, cut government spending now to prevent larger cuts in the future.  Americans now overwhelmingly (81%) support cuts to foreign aid programs in order to reduce the deficit; they overwhelmingly (80-85%) are against significant funding cuts for imperiled social programs such as Social Security, Medicare, and Veteran's Benefits.  Aligned with popular sentiment, there are budget cutbacks with which most politicians and economists agree (see CNN.Money article).  Budget cutbacks are a recessionary measure of Classial Economics theory, which contradicts Keynesian theory in premise.  Even without theory, it seems quite contradictory to go borrowing a large amount of money for government outlay and cutting taxes to stimulate the economy, then looking to lower government influence and cut as much spending as possible.  Important to note in this case is that Keynesian counter-cyclical policy measures are only meant to be short run.  The stimulus is the jab at the recession, looking to increase demand and availability of investment capital to jumpstart growth.  As the multiplier reaches equilibrium, and the supply of savings has increased, the government then takes the cross-punch to the recession by shrinking in size and paying the deficit in order to make more savings available to the private sector again as well as preserve social welfare programs for the future.

 

OTHER SOURCES:  http://money.cnn.com/2010/06/03/news/economy/U.S._debt_impact/index.htm?iid=EL&iid=EL

http://faculty.chicagobooth.edu/john.cochrane/research/papers/fiscal2.htm

Helping increase demand versus increasing supply

Several years ago during an economic downturn, Range Rover, a British maker of sports-utility vehicles, ran an ad campaign in USA Today.  It announced its formula for ending the recession: "Buy Something."  Range Rover wanted you to buy their vehicle, but in any case, purchase something.  "Buy a microwave, a basset hound, theater tickets, a Tootsie Roll, something."  Anything to get the economy going again.

Range Rover no doubt had simple economics in mind when telling consumers to buy something: Buying increases demand, which will increase supply and therefore create jobs.  With the level of economic understanding that is commonplace among American consumers, buying things = supporting jobs of those that sell and manufacture them.  On the surface, it well appears that way: Candy sales during the recession are surging, creating jobs and making record profits comforting woeful Americans (see NY Times and Las Vegas Review-Journal articles).  Indeed, the NYT article is even titled, 'When Economy Sours, Tootsie Rolls Soothe Souls'.  Clearly, this shows how buying something is good for both you the consumer and for the economy.  But is that really all there is to it?

Lurking beneath the surface, money paid for the immediate comfort also has an opportunity cost.  A dollar spent on candy today could be $1.05 in one month if it had been saved.  That $1 of savings in a banking institution could have helped a new candy maker get a loan to buy manufacturing machinery and create many jobs in your own town.  It could also have helped buy a share of stock in a candy company, that would have used the investment capital to open a new processing plant and made your $1 worth $3 in returns.  Or it could have gone toward a US treasury bond, helping the government raise money for services such as medical care for the uninsured candy-eater that goes into diabetic shock.  It could even have gone toward buying a locally grown organic apple, helping the struggling apple farmers that live next door.

As a general rule, "people are greedy and impatient", as Dr. Bob wrote. (I laughed out loud at that when I first read it.)  To this end, a large part of the consumer base is also uneducated or under-educated in basic economics.  These consumers are the ones especially targeted by marketing for impulse items: they're ready and willing to buy and consume things they don't need or really value.  The immediate comfort and help for the economy that Range Rover suggests has an appeal to that very audience.  Using economic logic that is not wholly untrue, they have influenced the masses to the ready 'solution'- an effective marketing tool indeed.

The greedy impatient masses may be moved to do their part by increasing demand, but for it to work helping the economy, the companies they help must be able to raise capital in order to increase short term and long term supply of their products.  Without that, the demand will go back to equilibrium and the economy will end up no better off.  Those consumers who think purchases through and plan them are unlikely to be moved by "Buy Something" advertising, even though they might have the passing thought that the things they do buy are helping the economy out.  The latter group may well be the savers/investors.  The knowledgeable and prudent consumers are able to step in to provide capital and pave the way for long term exansion of the economy.  They are able to do this in several key ways: Saving in a bank or other financial institution or even in a piggy bank, and buying stocks and bonds.  Money in a savings account is money available to provide loans for capital investment, perhaps for a worker to buy a home in a candy factory town or a small candy business to open a new store.  Perhaps people will eventually take their savings out with interest to spend on a big-ticket high-end item such as a Range Rover or invest in a child's college education that otherwise they could not afford.  Stock and bondholders help the candy company raise capital outright and potentially increase their own wealth in the process as the company expands, thus helping the economy and taking advantage of mass consumerism at the same time. 

CPI and the Rat Race: Reaction to Paul Krugman

Read Paul Krugman's original article at: http://www.slate.com/id/1915/

On the qualitative front, there are a few key differences between 1950 and "today" (1996 in the article) that struck me as key to determining well-being.  Foremost, who was the so-called "average American" this article is really looking at?  I'm sure we all conjure up images of the suburban family with mom in an apron and bottled milk delivery, and indeed this may be what the majority of the experience was.  The average African-American family in 1950 was far far below this comfy ideal that people look at the 1950s as- they had Negro League Baseball and had to give up their bus seats.  Nearly all black people in the South experienced extreme mistreatment, segregation and prejudice, and there was a major uprooting as many migrated to urban areas up North in search of better job opportunities and possilibity of education.  There was little room in America for anyone not Protestant- Irish and Italian Catholics were treated as lesser people.  Lucille Ball was able to have a hit TV show in the 1950s but experienced a lot of public backlash for marrying a Cuban.  In 1950 the rate of marriage was up for both black and white Americans vs today.  But unlike white families, a majority of black children today grow up in families headed by a single mother (sources for much of this: Wikipedia and an in-depth journal article).  Athough there is now Affirmative Action, minorities are still less college educated, more likely to be at or below the poverty level, have higher rates of incarceration, experience racial profiling and other racism, and have lower access to health care.  Like 1950, blacks and other minorities still live overwhelmingly in urban centers, and in neighborhoods that are de facto racially separated. Many of these neighborhoods culturally have more of a community lifestyle.  Perhaps, as Krugman says, this is because they are nearly all at similar income levels.  This implies that quality of life on that measure has not really changed for minorities at all.  It also seems that CPI for the fast-growing, poor minority populations is likely what is driving the poverty levels down today.  Like Mankiw said, there might be 10 white people with all of the wealth and 90 minorities and that gives the same average as an even distribution, even though clearly it is not evenly distributed and the same people are being left out.

Second, in 1950 most families had only a single wage-earner.  This means that families felt financially secure enough to have Mom stay at home.  The average families in 1996 were headed by two wage-earners, and this would still only put some of those in the 20th percentile.  One could argue that if both parents worked for wages in 1950 the actual GDP, mean income, and the CPI would be much higher.  In the 1940s during WWII-era, many women were working in the US.  So it really was a sign of security and economic prosperity that women left the workforce by 1950. The amount of money spent on household expenses from 1950 to today has also increased at a high rate as well (interesting government census info source here).  So even with inflation not being as high as originally thought, parents today have to work harder in order to meet the basic needs of a family.

Well-being and the Recession

Recession, as defined, is a shrinkage in the GDP lasting 2 or more consecutive quarters.  The usual pattern in the Economy is for economic growth for an extended time (about 57 months) followed by about a 10-month shrinkage, creating a 67 week "business cycle" (see Article Database).  Directly preceeding a recession, current recession included, there is a period of what economist Kimberly Amadeo calls "irrational exuberance" (on her about.com blog).  The irrational exuberance period signifies the point at which the GDP has risen above the point of comprimise, and recession is the only way that it will be able to reach a point of rational growth again.

For example, the mortgage crisis occured when interest rates were too low and credit was being granted by banks too freely.  This caused a huge increase in GDP- as buying houses is an increase in capital investments.  Those involved must have been incredibly thrilled: What city bus driver wouldn't be thrilled to have a $250,000 home with no down-payment and "creative financing"? What financer wouldn't be excited to be handing out morgages and turning around to market securities using creative speculation?  (This was the situation as described by economist and noted author and housing bust expert Thomas Sowell.)  This was the point at which the GDP had risen too high for its own good, and people were getting far too carried away to realize that there was no sound basis for the economic growth.  Think of GDP growth vs irrational exuberance as being happy vs being happy on cocaine: one is an emotion based on reality and experience and may steadily grow through time, while the other is an instant, over-the-top manic happiness that has an artificial basis and is setting you up for a harsh comedown.

One of the principal lessons from this is that the GDP can't tell you whether or not the economy is actually headed in a good direction.  The periods of economic growth or even irrational exuberance show that for the most part people do believe in the economy and do value economic well-being as a meaure of fulfillment.  While volunteering or being a stay-at-home parent is not counted in the GDP, these pursuits are personally gratifying and represent that people are financially secure enough to afford doing those things, and therefore are silently tied to GDP.  However, when the government increased spending to clean up the aftermath of Hurricane Katrina, that increased the GDP but was a national tragedy.  And we are all aware of the pork projects that politicians are so fond of- workers were ready and willing to build the Bridge to Nowehere, but what is it really contributing to well-being?  US weapons dealing (notably Iran/Contra but debateably any and all other exports) is also increasing GDP but not necessarily making a positive contribution to well-being.  Maximizing the GDP, in essence, means that well-being may be high and many types of spending are contributing to GDP at high levels, although there is no indication whether this spending is helping society in the long run or whether it is leading us directly to another intense recession.

Management and the Market: An Overview

In a competitive market, managers are motivated by the ability to keep their own jobs and succeed in them by maximizing profits at market prices.  In essence, this means keeping costs down, and workers and supplies represent a lot of the variable cost in a firm.  When a market shrinks, laying off workers becomes (on paper) an easy way to trim costs, but much of the time this decision seems to be avoided if at all possible.  Practically speaking, this may do more harm than good if workers are trained and skilled in their jobs, though I think no one would disagree with letting workers go that consistently are performing poorly or lack the necessary skill set.  Public opinion of a firm directly influences business however.  Managers in competitive enterprises are therefore kept "honest" I think by the threat of losing shares of the market to companies that seem more fair to their workers.  This type of market seems to value employee satisfaction, and if absolutely necessary, socially responsible ways of cutting worker costs are used, including freezing of new hires, reducing overtime, putting workers on hourly wage and fixed hours, or reducing salaries and demading more hours. Rather than lose qualified workers or have them under-perform, managers now can see the marginal benefit of training seminars, buying birthday cake, recognizing achievements, etc.

For a monopoly, this all breaks down.  We all know about disgruntled Postal Workers and DMV workers, and from the management side, it makes sense: There is no other DMV in town to take their skills to and the jobs/benefits pay well enough that each worker could be replaced.  Furthermore, cutting costs by cutting workers would, at least initially, actually increase business.  For example, if the Celtics decided to lay off all of its ticket booth workers to lower ticket prices, people would probably buy more tickets.  However, there still would be a limit; if they started laying off everyone at the stadium, there would be no concession service and no T-shirts and no half-time entertainment etc and people would go less frequently because the experience wasn't too great.  But the managers in a monopoly basically aren't kept in line by public opinion the same way competitive markets are, and this is part of why people see them so unfavorably.  I think this becomes especially apparent when managers make cuts in the workforce to trim costs but don't take any sort of pay decrease themselves, like the US airlines did recently.  The public is well aware of this and doesn't take kindly to it, but the cheaper seats on flights keep customers buying more anyway.