Tuesday, July 06, 2004

Columnist Watch: Krugman Get's Less Shrill

Wandering back to his area of expertise, Krugman (NYT) has a solid column. It also will generate little controversy or attention. There's little reward for just being consistently right and having a great track record. The reward for being a shrill partisan that is wrong but praises the "right" causes is great however.

In the spring, it seemed as if the pace of job growth was accelerating: in March and April, the economy added almost 700,000 jobs. But that now looks like a blip — a one-time thing, not a break in the trend. May growth was slightly below the Clinton-era average, and June's numbers — only 112,000 new jobs, and a decline in working hours — were pretty poor.

What about overall growth? After two and a half years of slow growth, real G.D.P. surged in the third quarter of 2003, growing at an annual rate of more than 8 percent. But that surge appears to have been another blip. In the first quarter of 2004, growth was down to 3.9 percent, only slightly above the Clinton-era average. Scattered signs of weakness — rising new claims for unemployment insurance, sales warnings at Target and Wal-Mart, falling numbers for new durable goods ordershave led many analysts to suspect that growth slowed further in the second quarter.

And economic growth is passing working Americans by. The average weekly earnings of nonsupervisory workers rose only 1.7 percent over the past year, lagging behind inflation. The president of Aetna, one of the biggest health insurers, recently told investors, "It's fair to say that a lot of the jobs being created may not be the jobs that come with benefits." Where is the growth going? No mystery: after-tax corporate profits as a share of G.D.P. have reached a level not seen since 1929.

What should we be doing differently? For three years many economists have argued that the most effective job-creating policies would be increased aid to state and local governments, extended unemployment insurance and tax rebates for lower- and middle-income families. The Bush administration paid no attention — it never even gave New York all the aid Mr. Bush promised after 9/11, and it allowed extended unemployment insurance to lapse. Instead, it focused on tax cuts for the affluent, ignoring warnings that these would do little to create jobs. [emphasis added]

While Krugman ladles the blame liberally (get the pun?) on Bush, the thing that interests the oldman is why Economists allowed themselves (with the exception of the independents and those like Paul who are dyspeptically disposed against Bush) to be misled in their "consensus" that the economy was recovering? Okay we had one quarter of blowout GDP growth, the warning bells should have been screaming about inflation for the last year, money supply growth has been erratic and sickly at best requiring constant infusions, prices in the real world were skyrocketing instead of the make-believe world of the CPI, underlying statistics like job growth were inflated by statistical ad hoc adjustments, and other economic indicators like durable goods should have been sending up smoke signals that the optimists were smoking something stronger than tobacoo.

The scary thing is that the long term damage to the economy hasn't been seen yet. What is it? The Economist details what is a likely scenario for the future given our present fiscal and economic policies.
High real growth—so long as deflation is of the good sort—requires high real interest rates. If rates are too low, people borrow too much and spend it badly: what Mr King calls “happy investment rather than good investment”. For a given level of nominal interest rates, a fall in prices will deliver the appropriate level of real interest rates. But by cutting nominal rates to prevent deflation, the Fed has reduced the real rate of interest too much.

Evidence that this has been the case comes in two forms. The first is that borrowing has ballooned in America in recent years. Any reduction in the indebtedness of American firms (under immense pressure from the capital markets) has been more than matched by borrowing by consumers and the government. Even though interest rates have been so low, the proportion of household income that is spent on servicing debts is at record highs. The government's stock of debt has been rising rapidly: this year, its budget deficit is likely to be 4.7% of GDP. This is why America's current-account deficit has been rising: as a country, America borrows too much.

Here is where the second piece of evidence comes in: what Americans spend their money on. If money is too cheap, then rates of return will fall, companies will tend to use capital rather than labour, and people will spend money on riskier assets; on things that have little to do with underlying economic growth; and on things that are in short supply. As it happens, this is a decent description of America in the past few years. Companies have been slow to hire workers even as the economy has bounded along; and workers' share of national income is very low. The low cost of capital has, moreover, encouraged speculation in risky assets, such as emerging markets, or—closer to home, as it were—property. And, yes, with all that money sloshing about, it has also pushed up inflation a bit.

When economic growth is fuelled by asset prices and debt, pushing up interest rates is likely to have an effect only in so far as it affects expectations about the prices of those assets. This creates huge problems for policymakers. Will a small rise in rates have a small effect (because, say, expectations about further rises in house prices are so entrenched)? Or a big one (because people expect more rate rises)? Whatever the answers to these questions in the short term, at some point, says Mr King, attitudes towards asset prices and debt will have to change.

There is thus a distinct danger that by pushing real interest rates back to where they should have been in the first place, monetary tightening will reveal the economic recovery to have been more fragile than most think—and threaten a hard landing and the malign sort of deflation that the Fed was so keen to avoid. This could even mean that rates need to fall next year, not rise. And with rates so low and budget deficits already high, America's economic armoury is much depleted.

The question many people (including Brad Delong) asked is "Well ... clearly we are looking at initial signs of a housing bubble, but what is the Fed supposed to do? Raise interest rates?"

The answer is unequivocally: "Yes!!!".

The flaw in the thinking is that there is a straight inverse proportional relationship between employment and interest rates. The higher the interest rates the more the downward pressure on employment, so goes the argument and so the reverse must be true - lower interest rates must increase employment. The real answer is that it is true sometimes, but there is a point of diminishing returns.

The answer can be shown clearly by examining the case of Japan. The BOJ in response to the crash of the eighties bubble lowered interest rates (eventually) to zero to "fight deflation". What happened however is that companies that had dysfunctional balance sheets and managements, refused to restructure their operations and borrowed money from compliant banks that refused to cut off their credit line. With zero percent interest and a large backlog of (accounting inflated) assets from the buying binge of the eighties, the companies were capable of averting bankruptcy for close to two decades. There was no incentive because interest rates were too low.

Because the creative-destructive cycle of asset liquidation and reinvestment was not allowed to occur, these companies not only tied up (and asset-stripped) perfectly good asset reserves but they sucked up all the liquidity that the BOJ was pumping into the economy and prevented new companies from taking their place. This was because even though they were losing money they could always borrow more to stay in business. And no profitable business can afford to compete with companies that don't have to worry about losing money on their deals. The money losing companies can always afford to undercut their profitable competitors to maintain market share. Because hey they can always just buy more money.

In a similar way if interest rates had been reasonable, yes there would have been less liquidity injected into the American economy but not so much cash flow would have been diverted to asset inflation speculation. Times would have been harder, but that would have forced companies out of business and allowed new ones to take their place or the remaining ones to become healthier. Survival of the fittest. The proper response would have been increasing State fiscal aid and supplying more unemployment benefits to tide people over until the economy restructured itself.

It's just like a forest. In a healthy forest ecosystem there has to be small fires every once in a while to keep things normal. Preventing these small burns leads to a situation where cataclysmic and massive fires rage out of control. It also makes the forest sickly.

Of course people are going to suffer in all the job losses, but the entire economy is healthier for it afterwards. The social insurance of extended unemployment benefits and job-retraining is the proper response, and not excessively low interest rates. This is the way to handle a cyclical economic restructuring.

Keeping interest rates from going too low not only improves price stability and guards against deflation, but it minimizes asset speculation that would divert even more money than the Central Bank introduces into the economy into bidding on risky assets. With interest rates higher, solid investment opportunities are likely to be attractive and will improve normal business investment - namely job creation. So the case for not dropping interest rates very low is quite solid. Yes less money will be introduced into the economy but much more of it will go toward long term balance-sheet repairing activities. So it's necessary to strike a proper balance rather than flooding the economy with money that will in the short term boost things more but in the long term prevent full recovery and independence from central bank stimulus.

However the central banks of the world seem to have lost sight of basic intervention guidelines.

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