A Federalist Fiscal Stimulus

Many economists are calling for another fiscal stimulus package. For example, Martin Feldstein, who once wrote an article called "The Retreat from Keynesian Economics," recently pulled a full Keynesian in an article in the Washington Post:

The only way to prevent a deepening recession will be a temporary program of increased government spending.

Marty thinks the tax rebates earlier this year did not do much to stimulate consumer spending. I think Marty is too quick in reaching this conclusion: Other scholars who have seriously analyzed the data disagree.

If there is going to be another fiscal stimulus, there will likely be a division between those who want tax rebates to households and those who want to help states pay for extra infrastructure spending. I have a compromise, based on the grand U.S. tradition of federalism: Let each state decide.

Congress could pass a fiscal stimulus of a certain amount per person but offer two ways to have it paid out. Each state governor could be allowed to determine whether to take the money as state aid or have it paid directly to his or her state's citizens. Those governors who think they have valuable infrastructure projects ready to go would take the money. Those who do not would let their citizens take the extra cash. When designing a fiscal stimulus, there is no compelling reason for one size fits all. Let each governor make a choice and answer to his or her state voters.

Happy Halloween!

The Pigou Club: Canadian Division

Check out this open letter from 255 Canadian economics professors in support of a carbon tax.

Get Ready for Deflation

Says NYU economist Nouriel Roubini.

How to Rework Bad Mortgages

Yale economist John Geanakoplos and lawyer Susan Koniak propose a way to deal with troubled mortgages:

we propose legislation that moves the reworking function from the paralyzed master servicers and transfers it to community-based, government-appointed trustees. These trustees would be given no information about which securities are derived from which mortgages, or how those securities would be affected by the reworking and foreclosure decisions they make. Instead of worrying about which securities might be harmed, the blind trustees would consider, loan by loan, whether a reworking would bring in more money than a foreclosure.

The government expense would be limited to paying for the trustees — no small amount of money, but much cheaper than first paying off the security holders by buying out the loans, which would then have to be reworked anyway. Our plan would also be far more efficient than having judges attempt this role. The trustees would be hired from the ranks of community bankers, and thus have the expertise the judiciary lacks.

Cutler & Mankiw

A Panel Discussion of the Presidential Candidates' Economic Policies.

** Today **

Wednesday, Oct 29, 4 to 5:30 pm.
Science Center Hall A.

All are welcome.

Addendum: This event is free, which is a bargain compared to other venues:

A reception, policy discussion and lunch was offered in Newark, N.J., with David Cutler, Obama for America’s senior health-care adviser, for $500 for a guest or $2,300 for a V.I.P.

And you don't even have to travel to Newark!

Update: The Crimson reports on the event.

Two Questions for SAM

Andrew Caplin et al. propose a way to stop home foreclosures:

The way to do so is through the shared appreciation mortgage, or SAM. The concept is simple: Homeowners are offered the chance to write down a portion of their mortgage debt, but at the same time, they are required to share future appreciation gains with those who helped them out....

For example, a homeowner unable to support payments on a house purchased for $200,000 that today is worth only $150,000 might be offered a write-down of up to $50,000. But this would not be a free lunch.

With the SAM, once the value began appreciating above $150,000, the mortgage holders would be due their share. The details of the write down and the appreciation sharing could be tailored to different circumstances. But one way to give lenders a share of the upside would be to pay back some of the write down if the house is later sold.

This is like Zingales's Plan B.

I can see the attraction of these ideas, but I have two questions:

1. Would a law giving homeowners the right to write down their mortgages in exchange for equity attract so many homeowners that financial institutions would suffer even bigger hits than they already have? As these authors note, foreclosure is unpleasant for everyone. But because it is so unpleasant, some homeowners who are underwater on their mortgages keep paying them anyway. If we give them a better alternative, why would they?
2. If Congress were to pass a law allowing homeowners to rewrite their mortgage contracts, and lenders suffered losses as a result, what would the constitutional implications be? The fifth amendment says "nor shall private property be taken for public use, without just compensation." Could lenders get "just compensation" for losses that resulted because Congress crammed down an equity-for-debt swap? If so, would this be the best use of taxpayer funds?

Update: Andrew brings to my attention his longer, earlier treatment of the issue. He also responds to my questions. In response to the first question, he writes:

The offer would come from the lender (not borrower) in cases in which there is a stop in payment on the mortgage. Offering this on top of a standard write-down is an option that is currently not in their arsenal, a fact that many of them are not aware of (essentially ruled out by the tax code). One offers incentives for the writedown e.g. by exempting the shared appreciation strip from capital gains taxes. This is then part of the workout routine that would be far more attractive than a pure write-down, and often superior to enforcing default.

Suppose someone stops payment on their mortgage without needing to just because this offer is potentially open. They can be offered some powerful discouragement: (a) Increasing share of appreciation with increasing write down; (b) Give lenders ability to check income. There would then be a high % dedicated to the loan (you won't want this if you are doing fine or expect to recover income); potentially, have payments on the mortgage rise with income if one needs to work this angle harder.

The complete incentive system could be designed in a dynamic manner, adjusting as evidence of excessive use came to light.

In response to the second question:

This would be voluntary negotiation. The idea would be to set up the incentives for it in the tax code. It simply dominates current options in most circumstances.

Thanks, Andrew.

A View from India

In The Times of India, Swaminathan S Anklesaria Aiyar writes about the U.S. presidential candidates:

McCain is one of the few American politicians in either party with the courage and conviction to stand up to protectionist populism. By contrast, Obama embodies protectionism....

McCain has voted 88% of the time against bills creating trade barriers, and 90% of the time against export subsidies for US producers. Few other senators have such a splendid record.

Obama has served a much shorter time in the Senate, and avoided voting on many key issues. He has voted against trade barriers only 36% of the time. He supported export subsidies on the two occasions on which he voted, a 100% protectionist record in this regard.

In 2007, he voted to reduce visas issued to foreign workers (such as Indian software engineers), and to ban Mexican trucks on US roads. He sometimes voted for free trade - he supported the Oman Free Trade Act and a bill on miscellaneous tariff reductions and trade preference extensions. More often he voted for protectionist measures including 100% scanning of imported containers (which would make imports slower and costlier), and emergency farm spending.

In 2005 he voted to impose sanctions on China for currency manipulation, and against the Central American Free Trade Agreement (CAFTA). He voted for the Byrd amendment, a disgraceful bill (later struck down by the WTO) that gifted anti-dumping duties to US producers who complained, thus making complaining more profitable than competitive production.

Obama says the North American Free Trade agreement is a bad one, and must be renegotiated. He has opposed the US-Colombia Free Trade Agreement on the bogus ground that Colombia is not protecting its trade union leaders from the drug mafia. In fact, such assassinations have fallen steadily from 205 in 2001 to just 25 last year. Obama is cynically twisting facts to woo the most protectionist US trade unions. This cannot but worry India, which may also be subjected to bogus slander and trade disadvantages.

By contrast, McCain has consistently voted for open trade. He has opposed federal curbs as well as private curbs on outsourcing to countries like India. He opposed the disgraceful Byrd amendment on anti-dumping duties. He voted against farm subsidies and labour standards for imports (which are not necessarily bad but could become a disguised form of protectionism).

Unlike Obama, McCain voted against imposing trade sanctions on China for supposedly undervaluing its currency to keep exports booming and accumulate large forex reserves. India has followed a similar policy, though with less export success than China. But if indeed India achieves big success in the future, it could be similarly targeted by US legislators and, will need people like McCain to resist.

Obama favours extensive subsidies for US farmers, hitting Third World exporters like India. This has been one of the issues on which the Doha Round of WTO is gridlocked. McCain could open the gridlock, Obama will strengthen it.

Obama also favours subsidies for converting maize to ethanol. The massive diversion of maize from food to ethanol has sent global food and fertiliser prices skyrocketing, hitting countries like India. But McCain has always opposed subsidies for both US agriculture and ethanol. While campaigning, he had the courage to oppose such subsidies even in Iowa, an agricultural state he badly needs to win if he is to become president.

If any of my economist friends who are working for Obama wants to defend his positions on ethanol subsidies, tariffs on Chinese goods, the Byrd amendment, etc., shoot me an email, and I will gladly post it for my blog readers. But I am not holding my breath.

A Tax Calculator

In a previous post, I compared the incentives offered to someone like me by the McCain and Obama tax plans. If you don't like the numbers I plugged in, Political Calculations provides an easy-to-use program that lets you pick your own and check the robustness of my conclusions.

The McCain Health Plan

From an analysis by economist Bob Carroll.

The Best Book Promo of All Time

I am pretty good at promoting my books. (You're reading this blog, aren't you?) But I can't hold a candle to my old friend Ben Bernanke. This email from his publisher, received yesterday, sheds light on his secret plan:

Dear Professor Mankiw,

I wanted to alert you to our paperback edition of Ben Bernanke's ESSAYS ON THE GREAT DEPRESSION.

As the subprime mortgage and credit disasters continue to wreak havoc on world economies and pocketbooks, many are looking to Federal Reserve Chair Ben Bernanke for guidance and leadership in this tumultuous time. Fortunately, our Fed chief is one of the pre-eminent scholars of the Great Depression. Because of the market turmoil, Bernanke's treatment of the Great Depression has been finding a new audience of readers as media, policymakers, businessmen, professionals, and others--both in the US and abroad--seek to understand our present economic situation.

Best wishes,

Andrew

I wonder how the economy would be doing if the Fed chairman were author of Dow 36,000.

The Latest from Larry

Summers, that is. An excerpt:

The crisis has also reminded us of the lessons of the technology bubble, Japan’s experience in the 1990s and of the US Great Depression – that finance-led growth is problematic. The wealth and income gains from the easy availability of credit were highly concentrated in the hands of a fortunate few. The benefits also proved temporary. In retrospect, the fact that 40 per cent of American corporate profits in 2006 went to the financial sector, and the closely related outcome – a doubling of the share of income going to the top 1 per cent of the population – should have been signs something was amiss.

A corollary: Remember that "problem" of an increasing share of income going to the superrich? Most likely, it has been solved.

My Personal Work Incentives

Here is a question that you may have been thinking about: How do the different candidates' tax plans affect Greg Mankiw's incentive to work?

Okay, you probably haven't been thinking about this. But I have, because, after all, I am Greg Mankiw. And if you are here reading my blog, maybe you have some interest in the random thoughts running through my brain. So bear with me.

Let me start with my personal situation: I am a pretty lucky guy. I have a comfortable, upper middle class life style that includes one house, two cars, three kids, a wife, and a dog. I am fortunate enough that I don't have trouble keeping that going. I am also fortunate enough that I don't crave much more than I already have. I don't particularly want to own multiple houses or drive a Ferrari or wear Armani suits. You might say that I am close to being sated.

On a regular basis, I am offered opportunities to make some extra money. It could be giving a talk, writing an article, editing a journal, and so on. What incentive is there to put forward that extra work effort?

To a large extent, the beneficiaries of that extra effort are my kids. My lifestyle is, as a first approximation, invariant to my income. But if I make an extra few dollars today, I will leave more to my kids when I move on. I won't leave them enough so they can lead lives of leisure, but perhaps I will leave them enough so they won't have to struggle too much to afford a downpayment on their houses or to send their own kids to college.

Now back to the McCain and Obama tax plans. Here is a neat summary from the Wall Street Journal:


Let me try to put each tax plan into a single number. Let's suppose Greg Mankiw takes on an incremental job today and earns a dollar. How much, as a result, will he leave his kids in T years?

The answer depends on four tax rates. First, I pay the combined income and payroll tax on the dollar earned. Second, I pay the corporate tax rate while the money is invested in a firm. Third, I pay the dividend and capital gains rate as I receive that return. And fourth, I pay the estate tax when I leave what has accumulated to my kids.

Let t1 be the combined income and payroll tax rate, t2 be the corporate tax rate, t3 be the dividend and capital gains tax rate, and t4 be the estate tax rate. And let r be the before-tax rate of return on corporate capital. Then one dollar I earn today will yield my kids:

(1-t1){[1+r(1-t2)(1-t3)]^T}(1-t4).

For my illustrative calculations, let me take r to be 10 percent and my remaining life expectancy T to be 35 years.

If there were no taxes, so t1=t2=t3=t4=0, then $1 earned today would yield my kids $28. That is simply the miracle of compounding.

Under the McCain plan, t1=.35, t2=.25, t3=.15, and t4=.15. In this case, a dollar earned today yields my kids $4.81. That is, even under the low-tax McCain plan, my incentive to work is cut by 83 percent compared to the situation without taxes.

Under the Obama plan, t1=.43, t2=.35, t3=.2, and t4=.45. In this case, a dollar earned today yields my kids $1.85. That is, Obama's proposed tax hikes reduce my incentive to work by 62 percent compared to the McCain plan and by 93 percent compared to the no-tax scenario. In a sense, putting the various pieces of the tax system together, I would be facing a marginal tax rate of 93 percent.

The bottom line: If you are one of those people out there trying to induce me to do some work for you, there is a good chance I will turn you down. And the likelihood will go up after President Obama puts his tax plan in place. I expect to spend more time playing with my kids. They will be poorer when they grow up, but perhaps they will have a few more happy memories.

Depression Redux?

My article in tomorrow's NY Times.

Obama vs His Advisers

Re Health Care.

Finally Revealed: The Source of the Crisis

Forgive me, Father, for I have sinned

My fellow economists, have you ever engaged in one of these activities?

• Building models one does not really believe to be useful or relevant.
• Making simplifications that obscure or omit important things.
• Using data one does not really believe in.
• Focusing on the statistical significance of one’s findings while quietly doubting economic significance.
• Engaging in data mining.
• Drawing “policy implications” that one knows are inappropriate or misleading.
• Keeping the discourse “between the 40 yard lines” so as to avoid being outspoken; knowingly eliding fundamental issues.
• Tilting the flavor of policy judgments to make a paper more acceptable to referees, editors, publishers, or funders.
• Disguising one’s methodological or ideological views, such as by omitting revealing activities or publications from one’s vitae.
• For government, institute, or corporate economists: Having to significantly play along with things one does not believe in.

If so, you now have an opportunity to make a full confession.

May you live in interesting times

Monetary Policy to the Rescue

In Pictures.

More Commentary on the Financial Mess

1. Peter Wallison and Charles Calomiris
2. V.V. Chari, Larry Christiano, and Pat Kehoe
3. Michael Boskin
4. Jeff Miron

Rawls vs Nozick: A Tie

In a previous post, I suggested that this presidential election was in part about competing views concerning "redistributive justice." Here are some relevant polling results on the matter:

In a conversation with "Joe the plumber" about his tax plan, Obama said "when you spread the wealth around it's good for everybody."

Americans are evenly divided on the idea: 45 percent think it is a good idea and 46 percent a bad idea to use some of the money government collects in taxes to "spread the wealth" to others who are less well off. Most Democrats think spreading the wealth is a good idea (66 percent) and most Republicans think it is a bad idea (72 percent).

Young Voters, Get Mad

Says Robert Samuelson.

Wage = Value of the Marginal Product

Thanks to Craig Newmark for the pointer.

McCain's Last Chance

Political advice from The Economist.

Found on Facebook

Above, the newest decorating fad, and a fan club for this blog.

"More Santa Claus than Vito Corleone"

My Harvard colleagues David Scharfstein and Jeremy Stein opine on Secretary Paulson's latest move.

Who pays the income tax?

Answer: Fewer and fewer people.

From the Tax Foundation via Economix.

Flashback: Middle-Class Tax Cuts

From January 1993:

Clinton now Says: The 'Big Things' Never Included his Tax-cut Vow

Seeking to explain why he is backtracking on a campaign promise to cut taxes for the middle class, President-elect Bill Clinton said Thursday that the plan was never a major theme in his race for the White House.

Mr. Clinton, speaking at a news conference a day after saying he would have to "revisit" his tax-cut plan, said Americans voted for him because of the "big things" he wanted to do.

The middle-class tax cut, he said, was not among them.

He said he was "absolutely mystified" that the news media had perceived it as a major pledge. In interviews Wednesday, Mr. Clinton said that, because of worsening deficit projections, "I have to put everything back on the table."

Mr. Clinton spoke throughout the campaign of the need to redress declining middle-class incomes during the 1980s. He proposed a tax cut for the middle class nearly a year ago, in New Hampshire, and repeated the pledge frequently.

But in the weeks since his election, two things have changed. The government's estimate of growth of the federal budget deficit over the next five years has grown about $60 billion. Also, the new team of Clinton economic advisers has apparently made new calculations and concluded that the tax cut idea is not tenable if Mr. Clinton wants to reduce the deficit and also move ahead with an "investment" program to revive the economy.

The Changing Meaning of "Subprime"

Simon Winchester reports:

when first applied to financial matters in 1976, “subprime” meant a loan offered below the prime rate and typically was offered only to the most desirable borrowers.

In was not until 1993 that it took on a much less enticing guise, with Business Wire referring to a company that “buys subprime loans made ... to creditworthy buyers unable to qualify for loans from banks.” And an O.E.D. editor was moved to write a new definition: “Of or designating a loan, typically having relatively unfavorable terms, made to a borrower who does not qualify for other loans because of a poor credit history.”

The Best Political Event of the Season

Part I


Part II


Part III


Part IV

The Pigou Club's Next Target

Taxing the Uninsured

Most economists agree on these two propositions about tax incidence (covered in Chapter 6 of my favorite textbook):

1. It does not matter which side of a market you tax. A tax on buyers is the same as a tax on sellers. In particular, a tax on employers is equivalent to a tax on employees.
2. Because labor demand tends to be more elastic than labor supply, a payroll tax falls largely on employees.

Now consider the Obama health plan. A major element of the plan is an extra payroll tax on firms that do not give their workers health insurance. By the basic theory of tax incidence, this is equivalent to a tax on workers without insurance.

In other words, the Obama plan is much the same as imposing a health insurance mandate, backed up by the penalty of a tax surcharge on your earnings if you fail to have coverage.

One difference: If an individual buys his own health policy, rather than getting it through his employer, he still pays the tax. That is, the Obama policy continues, even reinforces, a strong policy-induced preference for employer-provided over individually-purchased health insurance.

Update: Some readers interpreted the above description as a criticism. Not so! Note that the above post is entirely positive, not normative. I was merely explaining what the Obama plan does.

Is there a good rationale for taxing the uninsured? Perhaps. If an uninsured person can get free health care at an emergency room, passing the cost to others, then lack of insurance entails a negative externality. One can therefore make a Pigovian case for taxing the uninsured.

This Pigovian argument, however, would not point toward an earnings-based corrective tax, as Obama proposes. A high-earnings uninsured person does not impose more externalities than a low-earnings uninsured person. Indeed, if the former is more likely to pay his own medical bills, just the opposite is the case.

Moreover, I don't see a good argument for favoring health insurance bought through an employer over health insurance bought as an individual. A level playing field makes more sense. David Cutler notes in his book Your Money or Your Life,

Health insurance is not something that is made better by tying it to employment. As a result, essentially all economists believe that universal coverage should be done outside of employment.

I agree with David. Note that the Furman-McCain plan moves toward a level playing field.

Update 2: Jeff Jacoby weighs in.

An Interview with Anna

Wisdom from Anna Schwartz, the great monetary historian. Click through to read her view of recent policy from the Fed and Treasury.

What's so great about small business?

Wisdom from Michael Kinsley.

More Commentary on the Financial Mess

1. Ken Arrow
2. Richard Sylla
3. Bill Poole
4. Warren Buffett
5. Charlie Calomiris

The Obama Social Security Plan

Via Jason Furman, director of economic policy for the Obama campaign:

Obama is confident that we can come together to find a workable solution. He believes that one strong option to improve Social Security's long-term solvency is asking people who earn more than $250,000 to pay a little more into the system. But Obama will not raise the retirement age or reduce Social Security benefits.

That is, it sounds like Senator Obama wants to close the projected gap between taxes and spending entirely by raising taxes.

N.B.: Most economists favor raising the retirement age.

Update: A reader notes a rhetorical correction:

you might ask Jason Furman if Obama is really going to "ask" people who earn more than $250,000 to pay a little more into the system, or is he going to "tell" them to pay?

Update 2: Andrew Biggs, an expert on this issue, emails me a more substantive problem:

There's a big mathematical hole in Sen. Obama's plans for Social Security. While Obama is vague about the exact tax rate he would apply to people earning over $250,000 and whether they would receive extra benefits in exchange for the new taxes, a best-case scenario is that Obama's plan would fix around 15% of the long-term deficit, adding 3-5 years to the life of the trust fund. He's ruled out cutting benefits or increasing the retirement age, which could otherwise fill the rest of the gap, so it's not clear where the other 85% of the fix comes from. Sen. Obama has put himself in a bit of a box, which is perhaps the best rationale for a post-election commission -- it lets both sides forget about their previous campaign promises.

For Wellesley Residents Only

My article in the Wellesley Townsman about the new high school.

Two Bull Markets

(Click on the graphs to enlarge.)

In the midst of all the extraordinary asset price movements we have seen of late, here are two that particularly stand out. The VIX index, which measures expected stock market volatility, remains near all-time highs. So does the probability at Intrade that Obama will be the next president, which now stands at 85 percent.

Is the apparent comovement in these two series a coincidence? Probably not. All the recent bad news about the economy has been good news for investors who are long volatility or long Obama.

Jeff Frieden on the Current Crisis

Who wins the rich vote?

A split decision:

More than three quarters of those worth $1 million to $10 million plan to vote for Sen. McCain. Only 15% plan to vote for Sen. Obama (the rest are undecided). Of those worth more than $30 million, two-thirds support Sen. Obama, while one third support Sen. McCain.

Fact Checking the Presidential Debate

From the Tax Policy Blog:

the theme of this campaign: if it sounds good, say it regardless if it's misleading (or not true).

Click through the above link for details.

Who has the better health plan?

The Obama health plan:

Sen. Obama's plan would require large employers to either offer insurance or contribute a percentage of the company's payroll toward the cost of taxpayer subsidies....Sen. Obama also plans tax credits to encourage small businesses to offer insurance....Sen. Obama hasn't said where he would mark the line between the large employers who would be punished for not offering insurance and the small ones who would be rewarded if they do.

Is there a good rationale for this strongly asymmetric treatment of small and large firms? I cannot see it.

From my perspective, the Furman-McCain plan makes a lot more sense.

Technological Advance

A Rorschach Test

How do you react to this news story?

"Your new tax plan is going to tax me more, isn't it?" the plumber asked [Senator Obama], complaining that he was being taxed "more and more for fulfilling the American dream."

"It's not that I want to punish your success. I just want to make sure that everybody who is behind you, that they've got a chance for success too," Obama responded. "My attitude is that if the economy's good for folks from the bottom up, it's gonna be good for everybody ... I think when you spread the wealth around, it's good for everybody."

This exchange with "Joe the plumber" was discussed in last night's presidential debate.

My sense is that most liberals will instinctively agree with Senator Obama here. The last sentence, which I put in bold, is as good a summary of the Rawlsian notion of distributive justice as you are likely to find from a major political candidate.

Senator McCain took exception to Obama's statement, but he did not fully explained why. My guess is that McCain would agree with this passage from Robert Nozick's Anarchy, State, and Utopia:

The term "distributive justice" is not a neutral one. Hearing the term "distribution," most people presume that some thing or mechanism uses some principle or criterion to give out a supply of things. Into this process of distributing shares some error may have crept. So it is an open question, at least, whether redistribution should take place; whether we should do again what has already been done once, though poorly.

However, we are not in the position of children who have been given portions of pie by someone who now makes last minute adjustments to rectify careless cutting. There is no central distribution, no person or group entitled to control all the resources, jointly deciding how they are to be doled out. What each person gets, he gets from others who give to him in exchange for something, or as a gift. In a free society, diverse persons control different resources, and new holdings arise out of the voluntary exchanges and actions of persons. There is no more a distributing or distribution of shares than there is a distributing of mates in a society in which persons choose whom they shall marry. The total result is the product of many individual decisions which the different individuals involved are entitled to make.

The current election is in part a referendum on Rawls versus Nozick.

More Commentary on the Financial Mess

1. Alan Blinder and Glenn Hubbard
2. Charles Calomiris
3. Kevin Hassett
4. Doug Diamond and Anil Kashyap

Colbert interviews Stiglitz

Republicans, Democrats, and Stock Returns

A reader asks me what I think about this graphic from the NY Times, which purports to show that the stock market does better when a Democrat is in the White House.

My interpretation: It is meaningless.

I can imagine good reasons for being a Democrat (see this link), but stock market returns are not one of them. First of all, the stock market is hardly a barometer of economic well-being. Second, as David Backus wisely points out, the President's policies are only a small part of what drives the economy. Third, it is nearly impossible to get the timing right to do this kind of comparison.

Let me explain this last point.

According to the efficient markets hypothesis, financial markets are forward-looking. If so, you would expect the entire impact of a candidate's election on the market to occur on election day, or maybe even during the days leading up to the election, as the market learns about the party of the next administration. By the time the new President takes office, the news has been fully priced in, and it will not show up in returns during his term.

But suppose you thought that stock investors were not forward-looking, or did not understand the differences between the parties. If so, the stock market would respond to economic events only as they unfold. In that case, you would have to wonder whether the timing is off in the other direction. Does the President influence the direction of the economy from the first day he takes office? Do the effects of his policies disappear the day after he leaves office? Of course not. Policy influences the economy with long and variable lags.

The bottom line: Trying to isolate the differences between the parties using this kind of stock market data is silly at best.

Addendum: Related readings here and here. Meanwhile, a PhD candidate in economics suggests this explanation:

Suppose what New York Times finds is econometrically correct. They might have just found another risk factor for abnormal returns. Democrats sitting in the White House do bring about more risks in stock holdings. Therefore, investors demand higher return to compensate for extra risks they are bearing.

Shiller on Stock Market Valuation

Written after last Friday's close:

Robert Shiller, professor of finance at Yale University and chief economist for MacroMarkets LLC, tracks what he calls the "Graham P/E," a measure of market valuation he adapted from an observation Graham made many years ago. The Graham P/E divides the price of major U.S. stocks by their net earnings averaged over the past 10 years, adjusted for inflation. After this week's bloodbath, the Standard & Poor's 500-stock index is priced at 15 times earnings by the Graham-Shiller measure. That is a 25% decline since Sept. 30 alone.

The Graham P/E has not been this low since January 1989; the long-term average in Prof. Shiller's database, which goes back to 1881, is 16.3 times earnings.

But when the stock market moves away from historical norms, it tends to overshoot. The modern low on the Graham P/E was 6.6 in July and August of 1982, and it has sunk below 10 for several long stretches since World War II -- most recently, from 1977 through 1984. It would take a bottom of about 600 on the S&P 500 to take the current Graham P/E down to 10. That's roughly a 30% drop from last week's levels; an equivalent drop would take the Dow below 6000.

Currency Demand

Actually, somewhat to my surprise in light of all the financial turmoil, we are not seeing a large spike in currency holdings. (Click here to see the data.) There was a large spike at the end of 1999, when many people feared that banks might be paralyzed by the Y2K problem, but nothing like that more recently.

Update: A reader alerts me to this news story from the U.K.: "Sales of household safes have surged as wealthy savers concerned about the health of banks opt to keep cash at home. "

The envelope, please

This year's Nobel Prize in economics goes to Paul Krugman.

Here is a description of the contributions for which he is justly lauded today.

Congratulations, Paul!

To learn more about the newest laureate, you can read an analysis of Paul's research contributions and an analysis of his op-ed pieces.

Update: Justin Fox of Time Magazine says I predicted this prize back in 1999. I don't recall that precise conversation with Justin, but I am sure he is right. It was not a hard forecast to make. No one knowledgable about developments in the theory of international trade could have doubted that Paul was on the short list. The timing, of course, was impossible to predict, and I am a bit surprised that the Nobel committee did not award the prize jointly with some other economists who worked along similar lines. But the prize itself was an easy call.

Update 2: The prize induces Businessweek's Michael Mandel to reflect that Paul is not, as Mike once accused him, an "enemy of growth."

More Commentary on the Financial Mess

1. Alan Blinder
2. Burt Malkiel
3. Dani Rodrik

Economists Against Obama

A list recently released by the McCain campaign. It includes five Harvard professors.

Some blog readers may ask, why didn't I sign? I am not particularly fond of Obama's proposed tax hikes or his apparent retreat from free trade. (See this article of mine.) But I thought the statement in the group letter that "his proposals run a high risk of throwing the economy into a deep recession" was a tad too hyperbolic for my tastes.

Update: A reader alerts me to a longer list of pro-McCain, anti-Obama economists here.

Using Auctions to Inject Bank Capital

A proposal by University of Maryland econ profs Lawrence M. Ausubel and Peter Cramton. (Here is their earlier piece on using auctions to buy troubled assets.)

Trivia fact: Larry and I are old friends. We are both from the Princeton class of 1980, along with Danny Quah (now econ prof at LSE), Jim Rauch (now econ prof at UCSD), and David Romer (now econ prof at UC Berkeley). A bumper crop, if I say so myself.

The new edition is here!

The fifth edition of my principles text is now rolling off the presses, ready for spring-term classes.

Why a new edition? The fundamentals of economics are much the same: Supply curves still slope up, and demand curves still slope down. But a lot has changed over the past three years, and the new edition covers recent developments in economic research, events, and policy. In particular, it includes over 40 new applications, including Case Studies and In the News boxes, to remind students that economics is about the world in which they live.

If you are interested in learning more about the book, check out the publisher's website. Or you can buy it at Amazon.com.

If you are a professor eligible for a free examination copy to consider for your classes, or if you have any other questions, the person at the publisher to contact is Brian Joyner. His email is Brian.Joyner@cengage.com.

Score One for the Ivory Tower

Says Justin Lahart of the Wall Street Journal.

Plan B

From Chicago econ prof Luigi Zingales. Luigi has some creative ideas about how to facilitate mortgage renegotiation and the bankruptcy of financial institutions. In particular:

Congress should pass a law that makes a re-contracting option available to all homeowners living in a zip code where house prices dropped by more than 20% since the time they bought their property....

How do we implement this? Thanks to two brilliant economists, Chip Case and Robert Shiller, we have reliable measures of house price changes at the zip code level. Thus, by using this real estate index, the re-contracting option will reduce the face value of the mortgage (and the corresponding interest payments) by the same percentage by which house prices have declined since the homeowner bought (or refinanced) his property....

In exchange, however, the mortgage holder will receive some of the equity value of the house at the time it is sold. Until then, the homeowners will behave as if they own 100% of it. It is only at the time of sale that 50% of the difference between the selling price and the new value of the mortgage will be paid back to the mortgage holder....

The reason for this sharing of the benefits is twofold. On the one hand, it makes the renegotiation less appealing to the homeowners, making it unattractive to those not in need of it. For example, homeowners with a very large equity in their house (who do not need any restructuring because they are not at risk of default) will find it very costly to use this option because they will have to give up 50% of the value of their equity. Second, it reduces the cost of renegotiation for the lending institutions, which minimizes the problems in the financial system.

Nobel Pool Update

One of organizers of the Nobel Prize pool provides this update on the betting:

Robert Barro has emerged in the Harvard Nobel Pool with 16.2% of all bets. However, the triumvirate of Hansen, Sargent and Sims, who many believe would be chosen together, has garnered nearly 23% of the vote and is the most likely prize, especially when one controls for home bias. Top vote getters as of now are below, although entries can be submitted until Sunday.

Barro 16.2%

Hansen 12.2%

Sargent 6.8%

Fama 6.8%

Hart 5.4%

Diamond 4.1%

Feldstein 4.1%

Sims 4.1%

Thaler 4.1%

Jefferson had the Louisiana Purchase

A student alerts me to this story:

Iceland for sale on eBay

LONDON (Reuters) - Great scenery and wildlife but financial situation in need of repair -- collect in person. Iceland, which is going cap in hand to Russia for a 4 billion euro loan to bail out its failed banks, was offered for sale as a wholesale lot on eBay on Friday.

Bidding started at 99 pence but had reached 10 million pounds by mid-morning on Friday.

Globally renowned singer Bjork was "not included" in the sale, according to the notice.

Rumor has it there is a bidder waiting in the wings with $700 billion in his wallet.

Recession or Depression?

A student asks,

What makes a recession officially turn into a depression?

There is no official designation of depression. The NBER business cycle dating committee, of which I was once a member, picks the business cycle turning points. That is, with the benefit of hindsight, the committee says when the economy switches between expansion and contraction. Traditionally, milder contractions are called recessions and more severe contractions are called depressions, but there is no official word on which is which. Perhaps the clearest definition is this:

A recession is when your neighbor loses his job. A depression is when you lose yours.

Never say never

The VOA reports:

Blanchard and his IMF colleagues say there is no chance of a repeat of the global depression of the 1930s, because the lessons of that painful decade have been learned.

Is Olivier really this confident? I, too, would bet against another Great Depression. In fact, in my personal portfolio, I am. But "no chance" seems a bit of an overstatement, especially since there is not a consensus among economists about why the Great Depression was as bad as it was. In other words, the economics profession has not confidently established what the lessons from that painful decade were. If we are not sure what we have learned from history, how can we be sure not to repeat it?

More Commentary on the Financial Mess

1. Laurence Kotlikoff and Perry Mehrling
2. Vernon Smith
3. David Leonhardt
4. Nouriel Roubini
5. Robert Shiller
6. Nicholas Bloom
7. Casey Mulligan
8. Paul Volcker

How to Recapitalize the Financial System

There is broad agreement among economists that what the financial system needs right now is not only an injection of liquidity but also a recapitalization. The essence of the current financial crisis is that many firms bet that housing prices would not fall; the prices fell nonetheless; and now these firms have too little capital to perform the crucial function of financial intermediation.

(As an aside, one might ask, why did these firms make such bad bets? Essentially, it was a result of poor judgment among various private decisionmakers, encouraged by equally poor judgment of various public policymakers, many of whom were more interested in promoting homeownership among questionable borrowers than in the preserving the safety and soundness of the financial system. But this is not the time for recriminations. We have to face up to the problem sitting in our laps.)

The question for the moment is, How can we get capital back into the financial system? Ideally, it would be great if more Warren Buffetts would step up to the plate and recapitalize financial firms with private money. Unfortunately, that might not happen fast enough to prevent a major economic downturn.

Some economists have proposed forcing these firms to go raise more capital from private sources. But how exactly can the government do that? It is not entirely clear how, as a legal matter, that can be accomplished. Perhaps regulators can twist the arms of the financial institutions. Call it the Tony Soprano approach. “Nice bank you have here. I wouldn’t want anything bad to happen to it.”

Other economists have suggested that the government inject capital itself. That raises several questions. First, which firms? The government does not want to put taxpayer money into “zombie” firms that are in fact deeply insolvent but have not yet recognized it. Second, at what price should the government buy in? Third, isn’t this, kind of, like socialism? That is, do we really want the government to start playing a large, continuing role running Wall Street and allocating capital resources? I certainly don't.

Here is an idea that might deal with these problems: The government can stand ready to be a silent partner to future Warren Buffetts.

It could work as follows. Whenever any financial institution attracts new private capital in an arms-length transaction, it can access an equal amount of public capital. The taxpayer would get the same terms as the private investor. The only difference is that government’s shares would be nonvoting until the government sold the shares at a later date.

This plan would solve the three problems. The private sector rather than the government would weed out the zombie firms. The private sector rather than the government would set the price. And the private sector rather than the government would exercise corporate control.

Why would an undercapitalized financial firm take advantage of this offer? Because it would need to raise only half as much capital from private sources, that financing should be easier to come by. With Warren Buffetts in scarce supply, the government can in effect replicate them, by pigging backing on what they do.

I believe that Treasury has the discretion to use some of the $700 billion recently approved by Congress to make these equity injections. I would recommend that the Treasury announce an upper limit, say, $300 billion, allocated on a first-come, first-served basis. The limit would encourage financial institutions to act quickly to get in before the door closed. Given how fast matters are deteriorating, the sooner capital gets back into the financial system, the better.

Lessons from the Past

UCLA econ prof Lee Ohanian:

There are many historical precedents of bad policies following crises. The worst case was after the stock-market crash in October 1929, which produced a truly perfect storm of bad policies. Tax rates rose, tariffs rose (reflecting special interest groups attempting to insulate domestic producers from foreign competition), and both Presidents Herbert Hoover and Franklin Roosevelt strongly promoted industry-labor cartels that were designed to stifle domestic competition.

In the absence of these policies, the Great Depression would almost certainly have been like every other U.S. recession -- short-lived and relatively mild. Normal recovery didn't begin until the most onerous of these policies were reversed, a process that didn't begin until the end of the 1930s when antitrust activity was resumed, and during World War II when the National War Labor Board reduced union bargaining power by limiting negotiated wage increases to cost-of-living adjustments only....

I am particularly concerned about bad policies because significantly higher taxes have been proposed by Barack Obama. His plan would raise the marginal tax rate on the most productive workers more than 10 percentage points -- an increase that would bring us near Western European levels. His plan would also raise capital income taxes, taxing capital gains and dividends at 20%, compared to a 15% rate under Sen. John McCain's plan. A five percentage-point difference might strike you as small, but it is not. I have calculated that a five percentage-point difference in overall capital income taxation over the long haul is equal to a difference in the nation's capital stock of about 18%. This means a 6% difference in GDP and a 6% difference in the average wage rate. This means that real GDP and the average wage would fall, gradually but persistently declining about 6% after 25 years. That's not quite a Great Depression, but a significant step towards one.

What should be done? We should encourage the immigration of prime-age individuals. Beginning in 2007, net immigration fell to half of its level over the previous five years. Increasing immigration would increase the demand for housing and raise home prices. And note that the benefit would be immediate. Home prices -- and the value of subprime obligations -- would rise in anticipation of a higher population base. The U.S. particularly needs highly skilled workers. These workers not only would purchase homes, but would generate higher living standards for all Americans.

Explaining the Financial Crisis

Sort of.



If you enjoyed this explanation, you will appreciate previous attempts to make sense of recent developments here and here.

Fed 101

For teachers of basic economics: a good resource about the Federal Reserve.

Nobel Odds

PinnacleSports gives the current odds on some possible winners of the Nobel Prize in economics. Among the economists they have listed, Martin Feldstein is the favorite.

Update: You can also find odds at Ladbrokes, where Eugene Fama is the favorite.

A Few Good Reads

1. Andrew Biggs and Kent Smetters discuss tax fairness.
2. David Cutler et al. and David Gratzer debate health care reform. (See also Ruth Marcus.)
3. Joe Stiglitz, Glenn Hubbard, and Myron Scholes propose questions for tonight's presidential debate.
4. Gary Becker considers whether we're about to have another Great Depression.

Do you take models (too) seriously?

The very wise Paul Romer suggests that the key divide among economists today is between fundamentalists and realists.

The financial crisis provoked three open letters to policy makers. Fundamentalists opposed the plan (here.) Realists supported the plan (here) or supported more discretionary powers for dealing with the crisis without endorsing any specific plan (here.)

A quick look through the lists of economists who signed the various letters shows that the camps do not separate cleanly along the familiar lines of left-versus-right or active-versus-limited government. The key difference lies in the relative weight each side gives to formal models as opposed to judgment.

Fundamentalists have an unswerving faith in models. Policies should always be derived from the best available model. Data should be filtered through a model. If an observation does not fit within the context of a model, it should be excluded from consideration.

Realists are more conscious of the limits of models and more comfortable with a division of labor between the researcher who improves the models and the clinician who makes policy decisions. They recognize that the power of models comes precisely from a commitment to abstraction that filters out potentially important complexity. They believe that useful evidence can accumulate with direct experience as well as through the research process of testing and refining models. They believe that researchers should consider the possibility that the fault lies with the model when its predictions diverge from clinical judgment and that policies should draw on both sources of evidence.

Many times, the confidence fundamentalists have had in abstract models turned out to be well founded and the objections raised by realists who were more focused on details were misplaced. The fundamentalists were right that an airline industry could still function even if airlines could set their own fares; that people could still talk to each other even if they purchased phone service from different companies. The realists pointed to all the complicated details that arise in such markets, details that simple models could not capture. Fundamentalists, correctly, ignored the detail and pushed prescriptions based on the textbook model of competition.

Other times, the models are missing something that is too important. In the study of macroeconomic fluctuations, real business cycle theorists and their descendants, the dynamic stochastic general equilibrium modelers, are the quintessential fundamentalists. Their models are a useful way to make research progress, but in macroeconomic policy making, the great depression, which these models cannot explain, is a decisive data point warning us that the models are incomplete and have to be supplemented by clinical judgment.

Thanks to Mark Thoma for the pointer.

Another Sign of the Times

A reader writes in:

Last weekend at the Dupont Circle farmers' market here in DC, I saw a strain of heirloom tomato named "Mortgage Lifter".

Here is some background on it:

The Mortgage Lifter tomato was developed in the early 1930's in Logan, West Virginia by a radiator repairman, M.C. "Radiator Charlie" Byles. Without any experience in breeding, he made a successful cross of four of the largest tomatoes he could find - German Johnson, Beefsteak, an Italian variety, and an English variety. Radiator Charlie sold the first seedlings of his new tomato in the 1940's for one dollar each to customers who drove up to 200 miles for his famous plants that bore tasty tomatoes averaging two and a half pounds. With these sales, Charlie managed to pay off his $6,000 mortgage in only six years, and so the tomato was named Mortgage Lifter.

Is deregulation to blame?

No, says Sebastian Mallaby.

How careers begin

Advice from Down Under

Re Homeownership.

SNL on the Financial Rescue

Update: NBC has edited the skit from the original broadcast. There may be a good story about why it disappeared from the NBC website for a while before reappearing in edited form. But you can see the original here.

Predicting Election Outcomes

David Backus, a prominent macroeconomist at NYU, emails me some wise words he sent to his students:

There's a curious but robust feature of US presidential elections: when the economy isn't doing well, the incumbent party usually loses.It doesn't matter which party is in power, they usually lose. You can see that now in the online odds for McCain, which have dropped a lot as bad news comes out about the economy. You can talk all you want about other things, but the economy is likely the primary driver here.

The reason I say "curious" is that there's very little evidence that presidents (or the government more generally) have much impact on the current state of the economy. They can influence long-term performance, but in the short term, the US economy, and others, go through periodic ups and downs that we call business cycles. That was true 200 years ago and remains true today. There's some debate about where business cycles come from, but the president's actions are rarely on the list. Nevertheless, it's become good strategy to claim credit for good news and blame the other guys for bad news -- even though neither is likely.

Related link: the idea comes from a series of papers by Yale economist Ray Fair. A nice summary is his 1996 piece.

The Race Between Education and Technology

The NY Times reads the new book by my Harvard colleagues Claudia Goldin and Larry Katz.

More Commentary on the Financial Mess

1. Thomas Sowell
2. Arnold Kling (Kling 2)
3. Martin Feldstein
4. Michael Spence
5. Chris Carroll
6. Jeremy Siegel

Deflation?

In a previous post, I expressed surprise that yields on inflation-indexed Treasury notes are rising. Readers have emailed me a variety of hypotheses, the most common of which is deflation. As one smart economist put it:

Here's one possible answer -- the credit crunch has precipitated a massive expansion of money demand -- a scramble for cash. Despite its best efforts, the Fed has not matched this with a sufficient expansion of money supply. As simple IS-LM would predict, this surge in money demand has raised real interest rates (indicating that monetary policy is perhaps still too tight).

Rising real rates on inflation-indexed bonds and falling rates on nominal bonds also tell us that markets expect this surge in money demand to result in near-zero inflation or even deflation in the years ahead. It's starting to look more and more like 1990s Japan, though hopefully for not as long.

Maybe. But let me point out two things. First, the survey of professional forecasters has not seen much change in expected inflation over the next 10 years (although I can think of several reasons to be skeptical of this fact). Second, note this unusual feature of Treasury Inflation-Protected Securities (TIPS):

What happens to TIPS if deflation occurs?

The principal is adjusted downward, and your interest payments are less than they would be if inflation occurred or if the Consumer Price Index remained the same. You have this safeguard: at maturity, if the adjusted principal is less than the security's original principal, you are paid the original principal.

That is, in a period of substantial inflation uncertainty (e.g., now), TIPS are an attractive bet. You get inflation protection if prices rise, but you get your full nominal principal back at maturity if prices fall.

My guess is that Tyler Cowen is on the right track when he suggests that the answer to the puzzle involves credit market segmentation of some sort.

Charity and the Would-be Veeps

Mark Perry reports:

Even though the Palins ($294,000) earned only about half the income of the Bidens ($569,000) in 2006 and 2007 combined, the Palins gave almost 6 times as much to charity ($8,205) in those two years as the Bidens ($1,375).

Wanted: A Good Bernanke Speech

My sense is that the Washington economics establishment (that is, Paulson and Bernanke and the teams they lead) is losing the intellectual debate. Many, perhaps most, serious thinkers about financial matters are opposed to, or at least skeptical of, the plans the Treasury and Fed are pursuing.

One reason they are losing the debate is that they are not fully engaged in it. There appears to be a sense in Treasury and the Fed that they needed to convince Congress, which could be done behind closed doors, and that there was no need to address the legions of economics professors out there. Maybe they were right as a short-term political tactic. But as a longer-term strategy, the case for this new Washington consensus needs to be made. The general public is largely opposed to recent moves to rescue the financial system. If Washington crowd cannot bring along the intellectual elite as a first step toward convincing a broader audience, they will end up pretty much alone, which does not seem sustainable. As of now, it seems as if they have not even bothered to try.

To get a sense of this problem, I went back to the Fed website and asked this question: How many speeches were given by Federal Reserve officials in September? The answer is three. Only one by Chairman Bernanke. The topic: "Remarks on historically black colleges and universities." Ben did address the current financial crisis in his Congressional testimony, but that testimony did not offer the kind of meaty analysis that could start to sway serious skeptics.

Ben Bernanke has tremendous credibility among economists of all political stripes. He may be a conservative Republican appointed by President Bush, but even left-leaning, Bush-hating Democrats like Paul Krugman respect him. If the case for the new Washington consensus is going to be made in an intellectually serious way, Ben is the person who has to do it. In the past, Ben has given some terrific speeches that were both deep and lucid. It is time to do it again. I hope somewhere in the Federal Reserve System, the best staffers are drafting a speech for him that eschews the platitudes common in Washington speechifying and makes a serious, academic case for the path the Washington establishment has taken us down.

If Ben is looking for a forum to give it, I am sure I can arrange something at his alma mater. Maybe a guest lecture in ec 10.

---

Update: I reader alerts me to the fact that Ben is scheduled to talk to the National Association of Business Economists on Tuesday. We will have to wait and see if the speech provides the intellectual support for the Treasury/Fed rescue plan.

Elasticity

We have been learning about elasticity in ec 10. One of the students emails me this clip from The Wire (a great TV show, by the way) on the concept. For those who have not seen the show, the main character in the clip, Stringer Bell, runs a drug operation but wants to go legit and has an apparent interest in economics. The person spying on Bell is Jimmy McNulty, a police officer who in a later episode finds a copy of Adam Smith's Wealth of Nations in Stringer's apartment.

Why are real interest rates rising?

One might have thought that widespread fear in financial markets would cause a flight to quality, driving the price of safe assets up and their yields down. That certainly has been happening with short-term Treasury bills. But look above to see what's been happening to the yield on 5-year inflation-adjusted government bonds. (Click on the graph to enlarge.) If one wants to flee risky assets and invest safely, for many investors these securities are a pretty good place to be. But their yields, rather than falling, have been rising sharply of late. It's a puzzle.

Update: Here.