Tyler Cowen links to a brief, frank symposium on the economics of climate change. Many of the responses, particularly from Lomborg and Tabarrok are fascinating. But, unfortunately, there are a few big myths about the economics of climate change that seem so obviously true but are dangerously false. Take Otaviano Canuto, Senior Advisor to the World Bank, for example:

The economist’s solution to climate change can be summarized in a single statement: “get the prices right!” This means taxing fossil fuels proportionately to the amount of carbon they release, in order to correct the problem that corresponding negative spillovers of their use are not reflected in their market prices. Incentives in favor of more climate-friendly technological innovations would also be reinforced. Subsidies to these innovations, as well as to avoid deforestation would also help, as potential benefits of these mitigating factors would in turn become appropriately embedded in their reduced costs.

First of all, one would imagine that the World Bank could put its money where its mouth is and stop flying its officials in first class on taxpayer dime. Second of all, “taxing fossil fuels proportionately to the amount of carbon they release” is only enough under the assumption that the revenues will be spent on undoing the damage of the initial emission. (There are a few exceptions to this which I’ll get to later). If Canuto noted this as a start he would be on sound economic footing, but like so many in this debate he misses a nuance in the way externalities work.

To see why imagine the effect of a $25/ton tax on carbon. We know this would increase gas prices by just over 25 cents. If $25 was the “spillover cost” of carbon, the climate would be robust to large increases in drilling efficiency. But let’s say there’s a breakthrough in refinery technology and a substantial increase in available petrol, putting a strong downward pressure on costs such that the tax becomes a majority of the price itself. Would the carbon tax be enough in this case? Well, it depends what you’re doing with it. A good, if brute, measure of spillover may be the cost of recapture. Therefore, the tax is enough if and only if the government is spending the money on a large scale recapture program undoing the ills of the initial emission. Otherwise, the decrease in costs of production would increase supply and hence emissions beyond a sustainable level.

It is always useful to consider various parametric limits in assessing the validity of one’s claim. In doing so we discover hidden assumptions that never make their way to public consciousness. Textbook economics is tricky. Whether a spillover is intimately connected with your definition of social costs and the implications for your revenue thereof.

Of course, this assumes that the socially optimal level of carbon is effectively zero. In fact, there is a carrying capacity and the optimal level, economically speaking, probably exceeds this carrying capacity. The initial capacity emerges from the Earth’s innate ability to absorb emissions along with uncertainty that more is always worse. That the optimal capacity exceeds this level is a result of a positive discount rate along with the fact that future generations – due to improvements in technology – will be richer than us. Therefore, under perfect generational smoothing, we endow our children with superior technology and a shittier earth.

But neither of these change the fundamental premise that pricing carbon “at its cost” will hardly ever be enough (unless, as other more intuitive commenters noted, green technology becomes competitive in its own right). For one, the last sentence in the previous paragraph should make uncomfortable your moral sensibilities – for axiomatic reasons. More importantly, the economic models that are needed to quantify such ambiguous statements are really crappy.

As Robin Harding writes in the Financial Timeseconomic models of climate change fail the limit test with flying colors. Standard models suggest output would only be reduced by half for warming over twenty degrees Celsius in magnitude. To get some perspective, the rest of the academic community is freaking out about an increase of two degrees. Therefore, by the rule of seventy, our kids will be better off than us if the Earth warms twenty degrees and we grow at a measly 2% a year. You would be right to laugh.

Of all the answers that actually say something of substance, Larry Summers has the one that I find most practically challenging. I think he misjudges the political landscape of the United States. Cap-and-trade failed in 2009 – truly a “moment of great opportunity” – not because of deep forces against its passage but primarily because the Obama administration decided socialized healthcare was its priority and secondarily because of the Massachusetts mistake that is Scott Walker. Permit trading has something a carbon tax does not. That is, it’s not a tax. In America, that gets you very far. It’s why second best alternatives like banning incandescent bulbs or regulating fuel efficiency work, but simple taxes do not.

But I think he misses one more thing. Practically, we are more likely to have a system that both subsidizes and taxes carbon before we have one that does neither. Yes, we should phase out fossil fuel subsidies and tax breaks. This is a bit like the problem with sugar subsidies. Mancur Olson’s The Logic of Collective Action is a must-read for this. Oil subsidies have very low average costs but remarkable concentrated benefits that make “big energy” a powerful lobby in both parties. Big energy will also loose more from a repeal of our most inefficient subsidies than it will from a broad based carbon tax. Therefore, one is distinctively easier to fight. In fact, big business in general may yield to a carbon tax if they know a larger decrease in subsidies is not immediately to follow. Poor Americans loose out on this one but it is hard to argue that subsidy without tax is better than subsidy with tax.

Therefore while Summers is unimpeachable in his economic logic, public choice concerns dominate. Here’s to the second best.

Permit trading has many benefits a tariff does not. For one, we are far better at estimating the effect of carbon than calculating its price (and, as noted above, we would not use the revenues from a carbon tax appropriately to begin with). But more importantly, it isn’t a tax, and it isn’t as “leaky”. A relatively important component of a broad carbon tax at the level we need it (probably around $100 to the ton) is subsidizing the poor. Under a carbon tax, this ends up undoing part of the tax and is counterproductive. On the other hand, under a permit trading system, the government can guarantee a fixed number of permits to each household from its initial “stock” which would simply increase the cost of luxury carbon.

But ultimately, economists need to step up on climate change. It is more than a textbook example of externalities and far more nuanced than many simple accounts make it to be. It is also far more harmful than many of their models suggest (consider the limits). Economic logic sometimes fails. It was, if I recall, Larry Summers who prevailed over Gore and Browner, convincing Bill Clinton not to follow a more aggressive reduction in carbon emissions wary of economic consequences. (Not a criticism of Summers – just one of his decisions).

Lomborg makes a lot of sense in the snippet of the linked symposium. Subsidizing basic research and hoping for the best is our only real option. But, in general, he doesn’t acknowledge scientific realities that clash with his optimism and occasional myopia. Indeed, climate change hurts the poor more than anyone and, when the water runs dry, probably more than anything else he worries about. But, even within his economic frame, an ideal, international, permit trading system would be the most beneficial. Think about what would happen if each of us were limited to some level of carbon output. The west would need far more than this limit, and poor Africans would need far less. Money is going to flow in one direction and, given the need for carbon in the west, would be enough to replace the inefficient foreign aid already in place. An international carbon marketplace is the ideal cash transfer – something economists should be killing for.

I believe in economics and, indeed, the value of economists. They are unfortunately neglected in important policy decisions which – independent of any political affiliation – may be cited as a cause for much hardship over the past thirty years. But if an astroid was about to crash into New York City, we wouldn’t ask economists to create a poorly-founded model of its costs. We would tell NASA to do whatever it can to save us. Economists need to stop telling us what the program for change should be, but rather identify the most efficient means of implementing a program scientists already deem necessary. Otherwise we’ll end up with nonsense like CAFE standards and Cash-for-Clunkers. Otherwise, we’ll end up with an absolute mess of leftism that is Greenpeace and organic, anti-GMO activism claim climate change for its own. Now that is scary.

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Earlier today Matt Yglesias borrowed a chart from Thomas Piketty’s new book noting that public assets remain above public debt. This chart actually underestimates the strength of our balance sheet.  A more striking image is the ratio of our gross national product (GNP) to our gross domestic product (GDP).
 
Image 
 
 
The left axis here is a pretty narrow range, so the dynamics aren’t as extreme as they first seem, but what you’re seeing is that the GDP-GNP ratio is at it’s highest pint in history and continues to rise. What does that mean? Remember from Econ 101 that the GNP = GDP + American income on foreign assets – foreign income on American assets. In essence, the ratio I’m graphing shows that over the past decade net inflows have grown substantially faster than GDP, despite the skyrocketing debt. (Since GNP/GDP = 1 + (net payments)/GDP In fact, you would expect precisely the opposite phenomenon, more so than ever before as our deficits are increasingly financed by foreign savings (interest payments to domestic pension funds cancel out). As Wikipedia recites basic economic wisdom:
 
Similarly, if a country becomes increasingly in debt, and spends large amounts of income servicing this debt this will be reflected in a decreased GNI but not a decreased GDP. Similarly, if a country sells off its resources to entities outside their country this will also be reflected over time in decreased GNI, but not decreased GDP. This would make the use of GDP more attractive for politicians in countries with increasing national debt and decreasing assets.,
 
It’s worthwhile asking yourself what exactly national debt represents – a claim on future income. This graph suggests that our claim on everybody else’s future income is way higher than their claim on our income. You should be scratching your head – why are emerging markets throwing money at us when the domestic return on capital is far more attractive? They are lending us really cheap credit so that we can recycle that to our firms which then invest in foreign equities earning a huge premium. That should sound pretty familiar to you, because it’s basically how Wall Street made all of its money. America, basically, is a huge hedge fund.
 
But for the Federal Government, this isn’t a problem. We can always roll over our debt since the dollar is sovereign. We can actually make some pretty insightful observations taking the perspective that the government is a big bank. We could theoretically sell our foreign assets to repurchase our own debt (or, since we don’t have a sovereign wealth fund, tax our citizens more, which is the same thing) which is less volatile than emerging market equities (and isn’t subject to any currency risk). But we’d then be short emerging market, which means we would pay the risk premium rather than earn it. 
 
The in-built short term volatility isn’t actually a big deal, either. In the long-run, equity indices are pretty well correlated with economic growth, and everybody else will grow faster than us on average. That leaves liquidity risk, but because the Federal Reserve exists even that is negligible. The currency implications of this are even more mind bending still. For most countries, a depreciation has a negative wealth effect – that is we can buy less on the international market than before in real terms. But the more our own inflows are denominated in foreign currencies, the less obvious this link becomes. That gives monetary policy more space as higher inflation would be a lot less detrimental for us than any other country.
 
People are happy to pay a premium for safety. We should be happy to earn that spread. 

One of the biggest skills I’ve gained writing an economics blog is dispassionate writing and thinking. Sure, we all have ideologies and spirit, but a common thread across good writing is relatively sterile analysis. For me, that means not writing about things that truly incite me (beyond an intellectual curiosity). Like the criminal justice system. Or elephants and their poachers.

But as Ferris Jabr writes, “to look an elephant in the face is to gaze upon genius”. It is abundantly clear to me that the problem is largely economic, and therefore something that I should at least try to blog about without expletive passion (of which there is plenty elsewhere). I hope more economists publicly and privately advocate market solutions to the poaching problem – because the government, unsurprisingly, lacks the necessary competence in basic market design and incentive formation.

Economics is a constructive field, and is therefore concerned with efficient means of building a market. The task at hand is efficiently destroying a market. That is very difficult. It’s not really possible argue whether a market is driven by supply or demand, but for reasons I’ll outline, it is fair to assume restricting demand should be the primary tactic.

African governments unfortunately lack the competence, wherewithal, and and will to fight monied (probably Chinese) interests in any meaningful way. The investment necessary in good law enforcement to prevent large poaching networks is something that Africa will not have for a long time. And, anyway, that money is better spent on education and infrastructure. African countries shouldn’t have to drain the public purse because of foreign demand that dwarves its national wealth. More importantly, the production function will remain cheap so long as poachers need to kill elephants to put food on their children’s plate. And who can blame them? Poaching wouldn’t be a problem if elephants roamed American prairies as they do African forests. But Africa is no America, and any real effort should start with demand.

A ban is the crucial first step, but easily circumvented (in the United States, for example, you can only purchase ivory that is at least a hundred years old – but how hard is it to forge the necessary documents), especially if the punishment isn’t commensurate with the potential reward.

Enforcement is also ridiculously expensive. Police officers and the DEA waste billions trying to stop people from smoking crack, but the results are a complete joke. Sure we don’t have the brightest people spending that money (to say the least), but enforcement costs are non-trivial, especially without a culture that supports the cause (If everyone was a murderer, police officers couldn’t do a thing about it).

Civilizing people is a long process. It took centuries for humans to see the moral flaws with slavery – a far more heinous crime – and the socioeconomic forces in emerging markets to flaunt wealth is strong; without a government that really cares it is unlikely we’ll get anywhere. So molding culture is out of the question (in the time period we have, which isn’t that long).

In contemplating a solution, I couldn’t but think of George Akerloff’s “A Market for Lemons”, one of the best pieces of economic intuition and analysis I’ve had the pleasure of reading. Without getting into the details, the import of his paper is that a market can break down  under a little information asymmetry.

Policymakers and conservationists need to stop auctioning horns and burning stockpiles of ivory, they need to create this asymmetry. And it’s not hard. By virtue of being a black market, there isn’t a good organized body that can consistently verify the quality of ivory in general. Sure, it’s easy to access, but ultimately there’s a lot of supply chain uncertainty.

There is a cheap way to exploit this. The government, or some general body that has access to tons of ivory, should douse (or credibly commit to dousing) the tusks with some sort of deadly poison, and sell the stuff across all markets. Granting some additional complexities, the black market could not differentiate between clean and lethal ivory, and buyers would refrain from buying all ivory in fear. The market would be paralyzed. It is analogous to Wall Street during a bank run, and probably stronger given that lives – and not just portfolios – are on the line. And it’s far cheaper than anything we’re trying to do now. (As a commenter notes, another smart method would be to flood the market with uncertainty of authenticity, but this is a lot harder to achieve, and possibly very expensive).

It sounds like a batshit crazy idea, and it probably is, but it’s not morally that much worse than what we have now (that is even completely ignoring the cruelty of purchasing ivory in the first place). The human suffering of the current system is immense, with many poor Africans threatened or bullied into poaching under the threat of death. Moreover, many African governments – in a Hail Mary effort to combat the Chinese economy – have draconian penalties for those caught poaching. I would only transfer that risk from producer to consumer, suggesting the trade, ethically, is weakly superior at least.

It is hard to imagine such a fragile market functioning with a competent organization trying to fool it. It wouldn’t even require governmental support (though may be illegal). If you’re a mess about the ethics of poisoning people, we can try the flu instead.

This is, like unemployment, a moral, social, and political problem. And, like unemployment, it has an economic solution. I don’t know if what I’ve outlined could actually work in practice (though I am somewhat confident that a well-thought out try, with the proper support, would make a difference). But I do know that without aligning incentives and goals we have no hope. It’s time for better ideas than burning stockpiles or auctioning hunts.

A number of people have commented on a new paper from Robert Gordon, professional pessimist. Many people have identified the specific issues with the logic in this essay. But I think it’s important to discuss a central problem with the very idea of Gordonesque gloom.

First, distinguish between positive and negative pessimism. If NASA were to tell us, with great confidence, that an astroid will strike Earth tomorrow there is no case for disdain. This is a scientific judgement and, at least philosophically, would be akin to standing in front of a speeding train and claiming that it won’t hit you. That is not the sort of pessimism that concerns us. But Gordon is making a much more powerful claim, a pessimism about what won’t happen – that our entrepreneurs cannot create another industrial revolution, that we’ve pretty much done the most we can with robots, and artificial intelligence is limited to the grocery store.

This requires a certain knowledge about the trend of technological progress and the economic value thereof. Gordon knows much more about the former than most and may well be the reigning expert on the latter. Unfortunately that doesn’t help us out. Because, believe it or not, most any of us can make this claim without any technical skill and little more than economic knowledge.

If you knew that some form of AI was going to revolutionize the world, and that building it is tractable, there’s a good chance it already exists or will be built relatively soon. Because that’s all you need to know to make a profit from basically nothing (patent the idea and rent the rights out when someone who can build it builds it). But it’s very rare that we make something from nothing so most of us, like Gordon, don’t see anything great about the future.

But that only means that me, you and Gordon don’t know what that invention will be, not that some arbitrary such invention won’t be. So Gordon is claiming that the space of all future invention is limited and the costs of finding the marginal source of technological growth are limited and, equivalently, that he knows the space of all future growth.

That’s a rather strong claim. He rather strongly asserts that the last three stagnant decades are a better indication than the last century. Choosing the postwar boom may be an outlier but, accordingly, so too would choosing a bad period like the past fifty years arbitrarily. By claiming that he understands growth will slow, Gordon implicitly declares that he understands the mechanics of future innovation. 

But that isn’t the case with optimism. As statisticians will tell you, proving a positive is possible. You an always say “something may exist that we can’t even comprehend” – how could you disprove that. It’s not objective, and you’re not going to make money off this belief but it just isn’t as philosophically flawed as a belief in perpetual stagnation.
 
Most discussion about our economic future – on the scale Gordon speaks – has been horribly wrong (read a certain John Maynard Keynes’ Economic Possibilities for our Grandchildren) and claiming that there won’t be a new digital revolution tomorrow (or even in the next decade) is trivial. In fact, a central tenet of efficient markets is that you can’t keep beating the market and those who do are probably just lucky. (If we had growth denominated bonds Gordon could literally beat the market). 
 
The probably here is key. Maybe you’re a financial trader and play golf with a certain Janet Yellen. Or maybe you heard about Steve Jobs’ cancer before anybody else. But here there’s a clear source of the insider information. 
 
Unfortunately you and me can’t be insiders with God. 

No tiger mom would have let her daughter publish this piece for a fifth grade project, let alone in the New York Times. Amy Chua, in a little under 3000 words, explains her theory of power and prosperity in modern America. Absent from this essay, however, is a single reference to any scientific study. Not only does the article exclude any hyperlinks – appalling for any serious journalism in the 21st Century – it refers to several anonymous “studies” without providing any information about the authors, making it well-nigh impossible for a reader to track it down. 

The form is bad, but the message is worse. Chua and Rubenfeld (who, surprise surprise, extol Asians and Jews) argue that Asian success is largely a function of a superiority complex tempered by deep insecurity and a low discount rate, that is delayed gratification. They argue that initial wealth disparity is largely irrelevant:

The most comforting explanation of these facts is that they are mere artifacts of class — rich parents passing on advantages to their children — or of immigrants arriving in this country with high skill and education levels. Important as these factors are, they explain only a small part of the picture.

In fact, it would be comforting if the propensity towards prosperity could be captured in three, wishy-washy traits shared by a large group of people. Reality is much more complicated, as the authors surely understand, and a host of other factors do matter. Responsible journalism would demand that Chua and Rubenfeld at least acknowledge the limitation of this argument in this form, but readers are not made aware of any competing explanations.

The facts are also pretty shaky. The authors contend:

Today’s wealthy Mormon businessmen often started from humble origins. Although India and China send the most immigrants to the United States through employment-based channels, almost half of all Indian immigrants and over half of Chinese immigrants do not enter the country under those criteria. Many are poor and poorly educated. Comprehensive data published by the Russell Sage Foundation in 2013 showed that the children of Chinese, Korean and Vietnamese immigrants experienced exceptional upward mobility regardless of their parents’ socioeconomic or educational background.

The words here quietly pull wool over the eyes of a casual reader. Half of Indian immigrants do not enter the country under the intense criteria of employment-based channels. That means half do. I wonder what percent of caucasian, black, or latino children have parents that work in jobs important enough to qualify for such visas. The figure is certainly well below 50%.

While some Indian emigre are definitely “poor and poorly educated”, even the immigrants who enter without a Bachelor’s degree face the hard climb out of India to begin with. The initial culture and characteristic of Indians who have the wherewithal to pay for a ticket to the United States and the gumption to take that risk sets this group far apart from the immigrant culture. An observer need only walk through London – to which the entry barriers for an Indian are (or at least used to be) substantially lower – to see that the rich Indians of America are a lucky exception, not the rule.

It is interesting to compare the fate of Indians – who are by far the richest ethnicity in the United States, earning on average more than $85,000 annually – with their Sri Lankan, Pakistani, and Bangladeshi compatriots who earn $65,000, $61,000, and $46,000 respectively. Cultural differences are a natural explanation, but Indians are closer to all of these groups than they are with caucasians suggesting that there is something else going on. Of course, if one is inclined to think that this story is about Indians in general (as opposed to Indian-Americans) he need only see that Sri Lanka is twice as prosperous as India, Pakistan is not all that much poorer, and Bangladesh, while a little poorer, fares better on many social indicators.

This tells us that there’s something special about the type of Indians that make it to America. Whether it be education, intelligence, or an entrepreneurial spirit, it would be ridiculous – in the words of Chua and Rubenfeld – to compare this attribute to this group’s some stereotypically-selected characteristics not shared by caucasians.

It would be remiss to discuss Indian-American success without considering medical professionals, an oddly protected class. Wikipedia tells me that 35,000 Indians are physicians which is fivefold larger than what would be expected from a random distribution. However, the American Medical Association (approximately a cartel) and inefficiently strong health-related regulation prevent the equilibrium rate inflow of medical professionals keeping the wage rate of doctors artificially high, suggesting that many Indians benefit from an artifact of the law rather than some cultural force.

Groups rise and fall over time, and that may even be for the reasons suggested in the article. But by the authors’ own logic, the United States should be scared shitless of Japanese and Korean prosperity – surely these countries, with their laborious education and work ethic, must be more prosperous? New York Times readers may be interested to learn that the average American earns a whole $20,000 more than the Koreans, despite our “failing” school systems and complacence. Some may be tempted to argue that this is largely due to affluent immigrants, but remember that Caucasians earn at or above the national average.

Children of successful immigrants, like myself, are in many ways as privileged as blue-blooded protestants. And, similarly, many of us feel every bit as entitled (we work hard, but I doubt many of us think that we’ll actually ever earn $46,000 a year by the time we have kids). While at an archetypical level it may appeal to speak of certain traits – superiority, insecurity, and self control – shared by many successful immigrants, this is informed by neither theory nor evidence, but rather someone’s wish to project her idea of success onto a group as a whole.

Ultimately, some parts of this article are unimpeachably accurate. No doubt that attaining power and prosperity demands hard work, patience, and confidence. This is common sense, and not in any significant way restricted to immigrants. The authors further a sad misconception among liberal elites – that immigrants work hard while complacent Americans watch TV. This couldn’t be farther from the truth. Americans – particularly the stagnant middle – are among the most hard working (even overworked) in the world. Moreover, these workers are also incredibly productive by international standards, bringing in over $60 per hour on average.

I conclude by agreeing with Chua’s conclusion. It is crucial for America as a political entity to rekindle a sense of urgency and insecurity vis-a-vis China, but this is not at all a mirror of similar conclusions they draw to Americans as a cultural group. China’s ascendence is almost irrelevant on a per capita basis, where even the 80th percentile of urban workers hardly hold a candle to the 20th percentile of all American workers. China’s relevance is predicated on the control this one political entity has on such large a group of people.

More importantly, America’s glory to which the authors allude, while supervised by a sense of insecurity, was almost entirely political. Bipartisan consensus let America fight, and indeed win, the Cold War by putting a man on the moon, passing landmark civil and social legislation, and overseeing the most rapid rise in living standards in the country’s history. But, if anything, Americans work harder today while politicians flounder. This is a story of politics, not people.

I am open to disagreement on this issue, and a piece with actual references may be a nice start.

Monetary offset has been on my mind for a while now. Scott Sumner (among other market monetarists) are running victory laps (and to an extent, rightfully so) considering the relatively healthy growth last year despite significant fiscal drag. There’s no doubt, as stock and bond market reactions prove, that monetary policy has been helpful. But both the theory and empirics behind a strong and automatic offset – as favored by market monetarists – is weak. I should preface this by noting I’m largely in agreement with the market monetarist argument for nominal income targeting.

Let’s imagine (for now) that the zero bound did not bind – whether that be through the efficacy of unconventional monetary tools, a higher inflation target, or a Herculean ability for the Fed to handcuff its own hands years into the future and convince the market that it threw away the key. Standard economic theory supposes that in this world fiscal policy does not determine the price level given an inflation-targeting central bank arguing that if the government increases its budget and hence aggregate demand, the central bank will increase rates to maintain credibility. Hence government spending cannot decrease unemployment.

If we’re talking about totally discretionary stimulus this may be true. But consider a government that offers generous unemployment insurance (UI) with reemployment credits or guarantees employment (either generally or in a recession). Soon after recession, the government institutes very long UI and, in doing so, increases its primary deficit from 2% to 10%. Let’s say hysteresis effects are minimal and expansionary policies don’t simultaneously increase aggregate supply. Expansionary spending then, by Law of the Excluded Middle, either increases the price level or it does not. Given an upward-sloping supply curve (depressed as the economy might be), the former case is more likely. Monetarists argue that an independent central bank offsets policy in one of the following ways:

  • By force of expectation, given its credibility to an inflation target.
  • By being more cautious with its stimulus programs (or halting them altogether, depending on relevant magnitudes) than the counterfactual without stimulus or deeper austerity.

It feels like the first point used to be more popular than it is now, given that the Fed has zilch credibility on its inflation target (by definition, if it had any credibility, long term expectations wouldn’t be as low as they are). The second point is pretty fragile given behavioral features, decentralization of central banking decisions, and the need to have a precise ability to estimate price level elasticity of aggregate supply if it is low (which it is in a weak economy).

So after the government promises insurance to layoffs and credits to employers who hire said layoffs the central bank estimates the effect this has on the price level and accordingly decreases the rate at which it purchases assets. This creates a new wave of unemployed workers – that, after all, is the core of monetary offset models – which would require even more deficit spending to finance the promised unemployed benefits. This would require an even greater offset, requiring even more stabilization.

In this case two things can happen. Either the value of a credit default swap on Treasuries increases, as the market starts loosing confidence that we can service future deficits, or prices rise as markets expect the Fed to monetize deficits in an effort to prevent default. In a world where bond yields and CDS values aren’t soaring, the only possible conclusion is that the Fed stops offsetting government spending.

In fact, to the extent the market knows the Fed would never let the government default, the Fed’s offset would be offset by expectations of its future relaxation of its offset. This sounds a lot like the fiscal theory of the price level, and in some sense it is, but the distinction is that there must be some mechanism in place that requires the government to increase its deficit in response to monetary contraction. If there was no such mechanism – i.e. fiscal policy was only a one time, discretionary cash hand out – monetary policy could offset austerity perfectly well. (A helicopter drop of money and cash hand out financed by bond buying is actually the same thing, so offset could be surgically precise, as both Keynesians and monetarists agree). The only way fiscal theories could work in this environment is a government that engages in discretionary policy every time the central bank tightens policy which is unrealistic and, by definition, not rules-based. So the possibility of hyperinflation from ARRA was well, nonexistent.

There are second order effects too. If the interest elasticity of government spending is higher than the interest elasticity of investment (and studies suggest that this is probably the case), much of the benefit from easier money comes from cheap finance to beneficiary governments, reducing net outlays. Therefore tighter policy would decrease both the government’s primary and non-primary balance. This, by the way, is not negligible – the United States may face $75 billion in increased debt servicing to finance the same level of operations.

If the political situation is such that the government may only engage in a certain level of deficit spending (either by law as in Europe or institutional arrangement as in the US) offset would require the government itself to tighten its budget.

The point of the post so far is that monetary offset cannot be as theoretically sound as its proponents make it seem. There are multiple sources of positive and negative feedback, and actual results depend on the precise role of each which itself depends on the complex slew of automatic stabilizers, central bank learning mechanisms, and so forth. However, as outlined above, that economic conditions today resemble that setup seem unlikely given the preponderance of automatic stabilizers.

The empirical case for full monetary offset is stronger, but still wanting. Yes growth was a lot stronger than some Keynesian models suggested. That itself doesn’t mean anything, especially for anyone that (like me) believes in an at least approximate efficient market hypothesis. No model that can predict growth can exist. The question is whether growth today violates the Keynesian story. Perhaps a macroeconometrician will answer this better than I, but frankly the magnitudes don’t justify that explanation either. While fiscal drag was unfortunate, the United States certainly didn’t succumb to the same austerity as Europe and within the margin that it did plenty of other factors, including an improving supply side, can explain strong growth beyond monetary offset. As for Europe, where’s the offset?

Let me end this post with a final example which captures the point of the above reasoning. Imagine the government guaranteed employment at below market wage rates as a primary automatic stabilizer. In a recession, as deficits increase, monetary offset would force a growing number into government employment. The logical conclusion would be a huge deficit and huge government work force, but not unemployment by virtue of the government’s promise to employ. The only way total GDP would be affected would be a decreased output per worker, a supply-side phenomenon because the government makes for a bad employer. But supply-side concerns are not market monetarists’ concern. Is there any model with guaranteed employment monetary offset decreases total employment?

Of course, deficits would never get so out of hand before the central bank stopped offsetting. But even monetarists agree that monetary offset would not increase employment, only government deficit. By virtue of that transfer of liabilities, the private sector is allowed to deleverage which itself increases aggregate demand.

The feedback loops here are just way too complicated for the simple monetary offset story to be true.

Late Addendum: Scott Sumner comments on his blog (in response to another):

I’ve always argued that zero is a sort of benchmark, a starting point in the analysis. If the fiscal stimulus is large enough to bankrupt a country, then for fiscal theory of the price level reasons I’d expect a positive multiplier. In not (i.e. in the US) I expect the multiplier is zero on average, but may be above or below zero for the reasons you indicate. What matters is the expected multiplier, not the actual multiplier, and I see no reason to expect a multiplier that is significantly different from zero. In 2013 we saw about what I expected.

That’s fair enough. But the point here is bankruptcy conditions are non-negligible with automatic stabilizers. Not in general, but certainly if the offset is persistent (that is if the “expected multiplier” remains at or near zero).

Paul Krugman notes that persistent unemployment hurts the employed as well by decreasing their bargaining power, citing the low (voluntary) quit rate as evidence. This is an interesting claim with compelling evidence – wages grow a lot faster for everyone when unemployment is low.   But there’s something peculiar about the the recent recovery – it’s relatively powerless. Let me explain. Both the early and late 2000s recessions have been followed by so called “jobless recoveries” where output rises a lot quicker than employment. One would expect that this would be correlated with slower increase in bargaining power (using quit rate as a proxy) though there is no way to be sure, the JOLTS dataset we use to measure these things only goes as far back as the turn of the century.

But one would at least guess that a recovery in power would be in line with a recovery of the labor market. Using quits and unemployment as the relevant proxies, this would be incorrect:

Image

The above is a simple graph of unemployment and quit level since 2000. Economic theory predicts that sharp falls in output and employment should be followed by proportionally rapid recoveries (the so-called “v-shaped” recession). It is a well-known fact that the late 2000s recession hardly followed this pattern. But the way quits and unemployment differ in their respective dynamics is interesting. Even though the decline in unemployment after 2007 was hardly proportional to the crash, at least it was quicker – that is a higher absolute slope – than the early 2000s. Conversely, not only did quits fall much faster in 2007, they also recovered – in absolute and relative terms – much more slowly!

If you crunch the numbers you’ll see that after 2001 unemployment fell 30% as quickly as it picked up. The same figure for 2007 is 20%. So it’s slower, but at least comparable. On the other hand, in 2001 quits recovered 64% as quickly as they fell whereas for 2007 that figure stands at an anemic 28%. Quits after 2001 picked up at 0.61 points (indexed to 2007) every month, but only 0.43 points in 2007, despite the much sharper crash.

Some of this is not surprising. While a deeper recession would normally be followed by a deeper recovery, there are limitations on the extent to which this relationship can hold, especially noting second order effects of hysteresis and market inflexibility. But some of this is definitely surprising. Using the figures above, unemployment recovered almost 70% as quickly in 2007 as it did in 2001. Without some important structural changes, that figure would be in the same ballpark for relative quit recovery, which only stands around 40%.

Qualitatively this means the willingness of workers to quit their jobs is far less than the unemployment rate would indicate, even using the standards of the 2000s, which weren’t by any measure amazing years for labor. If JOLTS went as far back as the Clinton years we would probably see an even stronger relationship between quits and unemployment, something that’s falling apart.

So now I should answer the proverbial “what does this mean”. There are a number of candidate explanations. Loyal readers know that I’m not hostile to a partially structural read, but even that can’t explain everything, because structural arguments generally accept that unemployment rate (as opposed to employment level or participation rate) is a broadly accurate read of the economy, and that much of labor force exit is due to an aging population (or technology, or whatever). I haven’t looked at the numbers, but if we looked at the above data using employment-population ratio instead of unemployment, the late and early 2000s may not look so different.

Ultimately if we are to believe that the structural power relationship in the labor market has not changed noticeably since 2000, unemployment rate grossly overstates the pace of labor market recovery, and the Fed should not even be thinking about tightening of any type. On the other hand, to the extent that unemployment rate is a good gauge of overall labor market health, workers have seen a pretty substantial fall in their bargaining power since 2000 (and remember this is independent of employment levels, unless there are some severe nonlinearities in the data).

Another explanation comes to mind, though given the magnitude it is unlikely. Tyler Cowen notes that future inequality will likely be tolerated without Occupy-esque discontent as an aging country likes stability and calm. It may similarly be the case that older workers are less likely to quit their job as that implies an abrupt shift and uncertainty. Job changes may also require intrastate relocations, something else that has declined over the last few decades (though there’s a bit of chicken and egg, here).

All are pretty harrowing tales for American workers, though in the long-run the former is preferable. The growing unwillingness of workers to quit places strong disinflationary headwinds in the economy as the ability to hit a wage-price spiral becomes much more difficult. Edward Lazear and James Spletzer also estimated that low churn (of which quits are a big component) cost the US economy $208 billion dollars this recovery. More generally – and in this arena I have no expertise; I turn to leftists like Matt Bruenig – this has social consequences by placing a subservience of labor to capital. I’m generally wary of such distinctions, and it’s unclear that any of the proposed solutions like higher minimum wages and stronger unions would make much of a difference – but the possibility exists and it is important.

The powerless recovery is freaky. We are possibly seeing a greater dependence on employment when tight labor markets are a thing of the past.

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