A Very Discount Christmas: Mises and Hayek are Dead part deaux

So what is wrong with the Austrian theory of the business cycle?

For one thing, the entire theory is predicated on the assumption that economic agents not only don't possess perfect information and foresight about the future, but cannot and do not react to events occuring around them in real time. To believe that real interest rates will be suppressed by inflation for a prolonged period of time comprising the "boom" you have to believe lenders don't notice rising prices around them and readjust nominal interest rates upward to keep the real rate constant.

For another, in the theory the mechanism by which the "boom" ends and the "bust" begins is a rise in real interest rates as they return to their equilibrium, making low-returning investment projects suddenly unprofitable on margin. This represents a misunderstanding of how finace works and what forms of liabilities are used to do what. Short-term debt like commercial paper is used to meet payroll and fund daily operations and basically allows for firms to consumption-smooth, because operating revenue flucuates more than operating costs. But no self-respecting firm would dream of building a factory or any large, long term project and financing it with short-term money. The market for long-term bonds exists to prevent exactly the thing Austrians say causes the business cycle.

Inflation drives nominal interest rates because bond markets
are forward looking;the monetary authority has
little to no ability to peg a real magnitude

A world that operated on the lines of the Austrian theory would be chaos. It is a great irony that the school of economic thought that claims to place the most faith in the market is predicated on the assumption that market paricipants are myopic to a fatal extent. A form of capitalism where lenders don't respond to expected inflation, firms make long-term investments with short-term variable rate debt, and the governmnet can fool everyone time and time again would be a hellish nightmare; indeed state-run communism would be preferable! Thankfully, its the not world we live in. Long-term bonds do exists, as does the Fisher effect. Lenders and businessmen are more savy and less easily outsmarted by government bureaucrats than Hayek of Mises gave them credit for.

A Very Discount Christmas Special: Mises and Hayek are Dead

Austrian economics dominates online amateur economics blogging and commentary. Their views go largely unchallenged because most people who read their stuff agree with it or have better things to do than worry about it. Yes, I have nothing better to do on Christmas Eve than try to start a war with libertarians.

This is actually a rather charming picture and makes the
headline seem morbid and untactful.

The Austrian business cycle theory posits that the business cylce is caused by the monetary authority. So far, so good. As I understand it, the theory is based around the analysis of the so called "boom and bust cycle," with booms preceding and causing the inevitable bust. The monetary authority increases the money supply which in short-order causes an increase in prices (inflation) and a fall in real interest rates. These artificially low interest rates are below the equilibrium real interest rate that would prevail in an "unmanipulated" market, and remain so for an extended period. Firms borrow funds at these interest rates and use the loans to invest in capital projects, which because they are financed at low interest rates are low-quality projects. Later, at some unspecified point in time, real interest rates are revised upward to their equilibrium value and the investment projects, which were undertaken to the point where their rates of return equalled the previous, low, interest rate, are now unprofitable. A recession ensues as firms cancel their "malinvestments," banks write off bad loans made with the initial increased money stock, and workers and capital are reallocated away from investment, which was made excessive, and toward consumption or other sectors. 

To Review:

1. Money Supply Increases 2. Interest Rates Fall 3. Firms Borrow and Make "Malinvestments" 4. Rates Rise Again 4. Malinvestments are liquidated 5. A Reallocative Recession Ensues 6. Rinse Repeat

This all sounds reasonable enough; but as we'll see in part 2, there are fatal flaws that need to be addressed.

The Fed Takes Another Step in the Right Direction

How I love printing money.

But seriously, the Fed just announced a new set of actual RULES it intends to use as guidelines to set monetary policy for the next several years. Basically, its a committment to keep the Fed funds rate at zero and continue the $40 billion a month in asset purchases until unemployment falls below 6.5% or inflation rises above 2.5%. Its not targeting the TIPs spread, or NGDP, but its something- and a sign of good things to come. Check it.

"To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored. The Committee views these thresholds as consistent with its earlier date-based guidance. In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments."

From here: http://www.federalreserve.gov/newsevents/press/monetary/20121212a.htm

I've Performed and Invaluable Public Service

Behold, a time series illustrating one of the more elusive economic indicators, the real interest rate. The blue line is the real rate on corporate AAA bonds, the red on 10 year Treasuries. Useful stuff. FRED data transformations are the miracle of the age.

Texas, Secession, and My Hubris

Awhile back I made a post about Eurzone integration where I voiced the concern that Europe was probably not a good candidate for fiscal and political unification. I said the disparate cultural attitudes and preferences of the Periphery vs. the Core would prevent peaceful integration, with common policies accepted across regional lines.

And I was probably right. But what I didn't see was this: 

http://abcnews.go.com/Politics/texas-petition-secede-reaches-threshold-obama-comment/story?id=17701519#.UKGq_Bwui4A

"A petition for Texas to secede from the union, submitted to the White House, reached the number of signatures needed to draw comment from the Obama administration today.

The petition appeared on a section of the White House website called "We the People" that invites users with a U.S. zip code to submit or sign petitions about policy changes they would like to see. A petition must reach 25,000 signatures within 30 days for the administration to comment on it."

You can bet we'll be following this for the duration of its relevance. Or I might lose interest. 

Where We're Going, and Where We Won't

Now that the election is over, lets take stock of where we go from here. For starters, Obama won (incase you missed it.) That is to imply that Romney lost, so we'll start there.

On the positive side, it looks like we'll be able to avoid a trade war with China. It never did make sense to "get tough with China" for doing nothing in particular. They exported us goods they can produce in the least-cost way? They pegged their nominal exchange rate to the dollar (like most countries did prior to 1971, and many others still do). They save a large portion of their national income, and invest a portion of that in US Treasury Securities? Someone stop me from swooning.

His tax policy never was coherent, but there were elements of it I liked. I loved the idea of eliminating capital gains and capital income taxes for families earning less than $200,000. Also, lowering tax rates for corporations and other firms while eliminating some deductions is a good idea, albeit one Romney never specified definitively.

Now to the victor. Obama's victory means, most importantly, that we will be spared any risk of the Paul Ryan spending-cut slaughterhouse I dreaded so severley. Obama will keep steady, if not increase, spending on medical and science research, alternative energy, and education and preventative medicine for the extremely poor. These are things that will make us all richer in the long-run, even the subsidies for the poor- Medicaid for poor kids now means less chronic heart disease ect. when those kids hit middle age.

I wish Obama would move to overhaul the tax system in a way he probabily will not. He has expressed interest in cutting corporate tax rates down to 28% from 35% presently. If we did that, and raised top income rates to 39.% from 33%, I would be pleased- businesses would face lower taxes with total revenue taking less of a hit. But I doubt either will be enacted.
There's more to say, but that's all for now.

The Big Election Winner: Puerto Rico

"SAN JUAN, Puerto Rico — A majority of Puerto Ricans have opted for the first time to become the 51st U.S. state in what jubilant members of the pro-statehood party call a resounding sign that the island territory is on the road to losing its second-class status."

http://www.washingtonpost.com/politics/puerto-rico-votes-on-whether-to-change-relationship-with-us-elects-governor-and-legislators/2012/11/06/d87278ae-288b-11e2-aaa5-ac786110c486_story.html

ELECTION DAY! (In Horrible Quality)

I've Found a New Toy...

Here's an interesting application from the committee for a Responsible Federal Budget that lets you simulate different corporate tax rates by eliminating/ keeping various corporate tax deductions and setting a revenue target. It's pretty fun, and illustrates the insane difficulty of getting the corporate tax system right.

http://crfb.org/corporate/

Private/Public Salaries, A Visual for a Trend (or, Another Boring Data Transformation)

I thought I'd get another post with political implications in before the election. Its not really timely or relevent, but its something I've been curious about for a while and just realized a way to investigate it.
Below is a chart showing the ratio of private employee labor compensation / public employee labor compensation. Unfortunately, the data doesn't go back as far as would be cool. But its something, and does seem to suggest that public pay has gotten slightly out of line with private pay in recent years, but the trend seems to be rapidly reversing itself.

What else can this graph tell us? Notice how the ratio of private/public compensation declines at a faster pace in the recession of 2008-2009. This could be an indicator that private wages are less sticky than public wages; and the rise in the ratio since then does seem to mirror the recovery rather well. As an aside, recall that in equilibrium we would want this index to be at 1.000. 

Bond Markets Predicting Inflation, Round Deaux

Can Bond Markets Predict Inflation?

One of the key pieces of evidence marshalled by inflation doves is that the bond market expected extremely low inflation for foreseeable future. We know this because the spread between non-indexed and indexed Treasury yields has collapsed since the financial crisis of 2009, as nominal income growth has slowed to a crawl and excess capacity is plentiful. But just because bond investors in the aggregate expect low inflation, does that mean inflation won't happen anyway?

First off, lets take a look at the relationship between nominal interest rates and inflation:

So far so good. It appears the old monetarist notion that inflation expectations drive nominal interest rates holds. In addition, heres the relationship between inflation expectations and actual inflation:

So it appears that the bond market is not a perfect predictor of inflation, but not in the direction inflation hawks might think. The bond market consistently OVERESTIMATES the rate of future inflation. Nominal bond investors are peevish when it comes to the value of their investments. And if they're not afraid of inflation, neither should you be.

The IMF's Unhelpful Retreat on Capital Controls

 Something I've been meaning to get to, that was brought to my attention the other day via Scott Sumner. It seems the IMF has "rethought" its position on capital controls in the wake of the financial crisis and lackluster global recovery. So what's this about? Here's a link to an article that lauds the decision, but nevertheless provides some good background http://www.guardian.co.uk/commentisfree/cifamerica/2011/apr/06/imf-capital-controls

My understanding is that the IMF is working off two justificaitons for capital controls: 

1. The financial crisis was contagious via the international mobility of financial assets. American mortgage securities were bought and sold by institutions and funds around the world, some of which are located in developing nations. The revaluation of these assets therefore caused disruption to economies beyond those that originated them. 

2. Many advanced economies remain depressed, with the result that both real and nominal interest rates remain low. With domestic returns to capital low, savings are increasingly flowing out of advanced economies and into develping economies where the marginal product of capital is higher. The IMF sees these new capital flows as potentially destabilizing, an argument they used to dismiss until the capital flows of the 2000's proved destabilizing. 

These justifications seem reasonable on their face. Why shouldn't policy makers in developing markets have tools available to protect their economies from the demonstrated volatility of financial asset prices in global capital markets? Here's the caveat: CAPITAL THEN WAS FLOWING IN THE OPPOSITE DIRECTION! Savings from China and Russia were being routed into American and European finanical assets. Now American savings are being routed into financial assets and FDI projects in developing markets, a shift that standard economic theory would predict. Effectively, the global imbalances in merchandise trade and financial assets are beginning to reverse themselves. And the IMF wants to reverse that reversal. 

Who's Afraid of Foreign Trade?

Both Presidential candidates seem to have their apprehensions. I'm sure the upcoming foreign policy debate will feature the familiar boogie monster of cheap overseas workers, malicious central banks "manipulating" their currencies to boost exports, yadda yadda. I'm going to wait for the debate to debunk the specific claims made. But as a prelude, keep the below graph in mind. Its economic openness (Import+Exports)/GDP run against the total manufacturing index for the United States.

John Taylor, Pariah Amongst Piranhas

Lots of heat directed at John Taylor for a recent blogpost about financial crisis and recoveries. Check it out:  http://johnbtaylorsblog.blogspot.com/2012/10/simple-proof-that-strong-growth-has.html
Here's an older, better post on the same thing:
http://johnbtaylorsblog.blogspot.com/2012/08/its-still-recovery-in-name-only-real.html
And here's some of the reactions, many of which raise some valid points: http://krugman.blogs.nytimes.com/2012/10/17/financial-crisis-denialism/
http://misleadingguidetocurrentaffairs.blogspot.com/2012/10/the-muss-method-and-john-taylor.html

Taylor's argument is that that financial crises needen't cause a prolonged slump in output below its potential. Its true that his methodology in the second post was sloppy. The 1973 oil price shock and the 1981 disinflation were not financial crises. Maybe he is guilty of intellectual malpractice, or of trying to manipulate evidence to make his case stronger. But I find his premise that a prolonged slump in the wake of a financial crisis is unnecessary if policy responds appropriately convincing. Por ejemplo, take these three examples: 1893, 1907, and 2008. These three crises WERE financial crises that did result in economic slumps!                                                                 

We currently have unemployment at about 7.8%, or several points above anyone's best guess of the NAIRU. Consensus opinion is that the labor market is still in disequilbirum, with desired quantity demanded less than desired quantity supplied. What is the mechanism that is supposed to bring the market for work into equilibrium? It's the real wage, or the nominal wage / price level. A coherent story about the slump is that the financial crisis caused credit markets to contract and firms to lower expectations of future earnings. This caused a decline in the demand for labor, but because nominal wages are sticky and the price level did not rise, real wages failed to adjust, so more workers are seeking employment than firms want to use as inputs to production. If real wages were perfectly flexible, they would fall in the wake of the crisis, making workers more attractive to employers and causing the remaining jobless to remain so as a result of their leisure/consumption preferences. We had a demand shock. Prices didn't adjust, so we still have a slump. Monetary and fiscal policy (both changes in taxes and targeted spending) can boost aggregate demand. If they haven't, policy makers should be made to answer why. 

The financial crises and recoveries above demonstrate that it IS possible to have a rapid recovery. Maybe prices and wages were more flexible in the past, so demand shocks were not so disequilibrating. But bold movements on taxes, spending and monetary policy can and should go a long way toward mitigating a slump, whatever its origins. Just because poor past policy in other crises may have lead to slow recoveries doesn't mean current policymakers should get a pass. And those who want to throw up their hands and say "It's just how it is after a crisis" are giving a blank check to those in power. A check drawn on the empty account of the unemployed.

Update: John Cochrane weighs in with what I think is the best commentary yet. Here's my favorite excerpt

"If you conclude "recessions are always long and deep after financial crises" then you're saying policy doesn't really matter...so you shouldn't be advocating different policies! If policies matter a lot to the length and severity of recessions, then "recessions are always deep and long after financial crisis" is a meaningless statistic, and a poor fig leaf of an excuse."

Things You Won't See on Either Platform...

But probably should. If I were Tsar  running for President, some policies I'd advocate.

1. Re-finance the Federal debt to greatly extend its maturity. This would mean higher interest payments in the immeidate aftermath, but would mean we could lock in extremely low rates for decades, even after interest rates return to "normal." We could save hundreds of billions without changing/doing a thing.

2. Expand free trade and lower/ eliminate tariffs across the board. I was struck in the debate tonight when Obama said "we prevented China from exporting us cheap tires." I ran over two nails in one week and paid out the $%&# for two new tires. Obama directly lowered my real income with that tariff. Tariffs are taxes on American consumers, not foreign producers. Run for Premier of China if you want to get tough on the Chinese.

3. Eliminate farm subsidies. We pay billions of dollars a year in direct payments to agri-business so that they will produce less food. That's right, we collect a round of taxes literally for the privledge of constraining food output and raising prices. That's the intent not just the consequence of the policy. And when food (shock) is expensive, we collect another round of taxes (with the associated dead weight loss) to give people food stamps to buy the food we paid to make more expensive. Lets stop paying taxes to reduce our real incomes.

4. I've saved my favorite and most oft repeated mania policy for last. Yes, change the Federal Reserve Board's mandate from a dual mandate of price stability and low unemployment to a single mandate of a nominal GDP growth rate target. For explanation, click on nearly any prior post.

Rates Are Low in Spain and Italy...

By historical standards.

I finally managed to paint the picture I wanted to see  illustrate the absurdity of the claim that fiscal profligacy is causing rates in Italy and Spain to "spike." Here's rates for both in historical context.

I'll admitt I was taken aback when I saw this. I knew rates weren't incredibly high in historical context, but I had no idea how relatively low rates still were. So Spain and Italy had no trouble financing their debts at rates twice as high fifteen years ago. What's changed recently?

Notice the plung in nominal income growth right after 2009. The recession of the early 2000s doesn't even show up (Europe went into recession then too, right?) These "high" rates are unsustainable in a tight-money environment; if the ECB would play ball and stabilize nominal GDP in the Eurozone, it'd be smooth sailing.

Krugman, Low Rates, and Growth Expectations

One assertion frequently made by Paul Krugman is that low long-term interest rates in advanced economies reflect the expectation of continued economic weakness. Apparently, there's to be a debate in Britain's House of Commons featuring Krugman et. al. on the subject.

I figured I'd investigate this hypothesis with regard to the United States. If low rates imply weak expectations and rising rates rising expectation, I expect rates and the S&P to rise and fall together.

Krugman, as usual, is proved correct by the evidence.                  

Interest Rate Spreads (Again)

See how the U.S. Germany, and United Kingdom have all seen borrowing costs decline, roughly in the same proportion, despite vastly different public finance regimes, budget deficits, and stocks of debt, because they all have their own currencies (the euro being effectively Germany's currency.)

Here's the borrowing costs of Spain and Italy divering from the original three. No real point to this, but its sometimes helpful to have a picture to illustrate a phenomenon. 

The Agony and the Ecstasy, And the Government Debt

Whoow boy. A big hubub in the blogosphere about whether government debt imposes a burden on "future generations." Lots of input from high places. Check it:
http://krugman.blogs.nytimes.com/2012/10/12/on-the-non-burden-of-debt/
http://delong.typepad.com/sdj/2012/10/the-intergenerational-burden-of-the-debt-nick-rowe-tempts-fate-weblogging.html
http://worthwhile.typepad.com/worthwhile_canadian_initi/2012/10/the-burden-of-the-bad-monetary-policy-on-future-generations.html 
http://noahpinionblog.blogspot.com/

And now for some input from a low place, featuring my hat in the ring.
I've basically made this argument before, in my post about the stance of fiscal policy. Noah Smith spells it out well by framing the situation in terms of the effect on the capital stock, or the K term in the Cobb Douglas Production function.

Y = A(t) Ka Nb

The budget deficit affects the economy by absorbing funds that would otherwise have been invested in private capital. To the extent that the budget deficit "crowds out" this private investment, it does it by raising the real interest rate faced by borrowers. It makes sense that a larger budget deficit would raise the interest rate more than a small one, so that as the deficit grows, it increases the "burden" of future generations. Here's an ad hoc rule of thumb I just invented. It's basically an interest rate elasticitiy of the budget deficit:

(% change interest rate / % change in budget deficit)  < 1 no net "burden" on future generations

(% change interest rate / % change in budget deficit) > 1 net "burden" on future generations

Maybe I'll develop this further later. Perhaps something about future taxes.

More Russian Dutch Disease...

Featuring the world's ugliest regression. As Russia has increased its economic "openness" (Imports+Exports)/(GDP) in recent years,  it has not correlated with rising income.

Russia needs a development plan to harness foreign direct investment in new capital and technology, and end the reliance on oil and gas exports and capital flight. Here's an article about the Duma trying to ban officials from moving funds overseas. 

Dutch Disease in Russia

As an aside, I've been investigating some trends with regard to Russia's balance of payments, and noticed two startling strong correlations. Both the value of Russia's exports and its growth in real GDP seem to be determined by the price of crude oil, to an extent greater than I had expected. Enjoy. 

* Dutch Disease is a term originating in the 70s or 80s or something when the Netherlands starting exporting lots of natural gas. These exports drove up their real exchange rate, stunting exports of and investments in other manufacturing industries.

New Obama Ad: Sesame Street vs. Wall Street

Here's a former PBS corresondent commenting on Romney's proposed de-funding of PBS:

http://www.huffingtonpost.com/lee-banville/mitt-romney-big-bird_b_1948460.html

"And so the reaction to this stylistic turn has been a frothy one from many sectors and it is obvious why. When discussing the elimination of the federal support for public broadcasting, Gov. Romney did not mention the liberal-leaning Bill Moyers or the sparsely viewed classical music performances, he went after the biggest star the network has and one that holds special power over generations -- Big Bird.

PBS itself put out a tersely worded statement on the whole thing, pointing out:

In fact, our service is watched by 81 percent of all children between the ages of 2-8. Each day, the American public receives an enduring and daily return on investment that is heard, seen, read and experienced in public media broadcasts, apps, podcasts and online -- all for the cost of about $1.35 per person per year.

If you wanted to take on PBS there are lots of ways to do it. If you want to pick a fight you will probably lose in the court of public opinion, pick on a muppet -- or whatever Big Bird is."

Joseph Stiglitz, Nobel Luddite

Evil, thy name is automation. 

Joseph Stiglitz, a Nobel Laureate, is undoubtedly one of the most brilliant economists alive today. From his work on asymetric information and its effects on microeconomic and macroeconomic decisions to his work at the World Bank and the Clinton White House he has proved himself to be a giant in the field. So I was mightly suprised to read this boneheaded quote, with regard to why the Fed's low interest rate "policy" is bad. 

http://www.washingtonpost.com/opinions/how-policy-has-contributed-to-the-great-economic-divide/2012/06/22/gJQAXTX2vV_story.html

"Today, persistent low interest rates encourage firms that do invest to use capital-intensive technologies, such as replacing low-skilled checkout clerks with machines. In this way, the Fed may still be contributing to a jobless recovery, when we finally do recover."

So additions to physical capital by firms displace workers and kills jobs. If we want to create jobs and end the jobless recovery, we should, I supose, ban purchases of capital equipment by firms and force them to use more labor to produce the same output. Dear God. Actually, I've got a Milton Friedman anecdote right here that's better than my unqualified snark.

"He was shocked to see that, instead of modern tractors and earth movers, the workers had shovels. He asked why there were so few machines. The government bureaucrat explained: “You don’t understand. This is a jobs program.” To which Milton replied: “Oh, I thought you were trying to build a canal. If it’s jobs you want, then you should give these workers spoons, not shovels."

P.S. By the way, I think I know the premise Stiglitz was working with here. Its a micro equilibrium condition that determines how much capital and how much labor a firm will use to hold output constant and minimize costs (hence maximizing profits). It goes like this: 

MPl/w = MPk/r 

Where MPl and MPk are the marginal products of labor and capital and w and r are wages and interest, or the cost of labor and cost of capital. Arithmetically, if you lower r relative to w and hold the marginal products and total output constant, you find it behooves the firm to use less labor and more capital to produce the output. I think Stiglitz extrapolated this single-firm condition into a fallacy of composition to the entire economy, ignoring that increases in investment leads not to displaced labor but to an increase in the marginal product of labor, increased, not decreased, labor demand, and RISING, not constant, output. 

The First Obama-Romney Debate: Watch It Here Live (as far as you know)

They Needed Someone to Blame. They Found the Fed.

Scott Sumner on the obtuse claim that the Fed's "inflationary" policy stance is responsible for the continued slump in income:

The WSJ Says the Lowest Inflation in 50 Years is Killing the Middle Class

Lets take a look: (I've included both the PCE and the CPI)

David Beckworth lends an assist, but about the claim that the Fed is responsible for low real interest rates. 

PSA: Brief but Substantial Inflation is Expected in a Recovery

I
I've been thinking on the Kocherlakota turn-around and the recent hubbub over the increased TIPS spread, and I'd like to say a piece on inflation in recoveries.

My outlook on inflation in recoveries is informed mostly by John Maynard Keynes in his General Theory of Employment Interest and Money. In one of the final chapters Keynes lays out dynamics of the price level in a slump and in a recovery with regard to the price-output split. Basically, as aggregate demand increases, some of that demand manifests itself as more real output and some as inflation; the amount of each is determined by the slope of the short-run aggregate supply curve. If all workers and capital goods were perfectly fungible, no factors of production would be in a position to demand higher nominal compensation while some resources were still idle. So any increase in nominal demand would be met purely with an increase in real GDP while real GDP was below its potential. Once real GDP was at its potential, however, any increase in demand would merely add more inflation with no increase in output. No inflation while the economy is depressed, soley inflation once the economy is recovered.

In reality, however, workers and capital goods are far from perfectly fungible. This means that as aggregate demand increases, some factors of production find themselves fully employed before others and before real GDP is at its potential, so that they can demand higher rates of remuneration while the economy recovers but before it has fully. So in a normal recovery, we should expect to see a spurt of increased inflation as employment and prodction recovers, and for this inflation to tapper off once recovery has been achieved. There is no long-tradeoff between inflation and unemployment; but the two should reverse correlate during a healthy recovery.

Note how inflation rises and falls with the utilization rate of manufacturing capacity; the price level is determined by aggregate demand AND supply. 

Teams with Plans, not Men with Cred

As with any presidential election, the decision between President Obama and Mitt Romney ultimately comes down not to which man is more suited to the office but to what team they will bring in to conduct policy. And the spoils of the general election go to the candidate who convinces the American electorate that their team will deliver them the goods. Obama's message in 2008 that he would make Americans richer with infastructure spending, education support and more progressive taxation trumped John McCain's attempt to run on his military and service credentials. In 2000, Bush's calls to redistribute the budget surplus in the form of tax cuts overcame Gore's message of... okay, bad example.

Americans in 2012 must evaluate the different promises made by the Obama and Romney team, not just the personal gravitas or experience each man may or may not have. We have a rather clear idea of what Obama's plan will entail; thats the benefit of being the incumbant. We can expect continued investments in public infrastructure, an open but cautious stance toward international trade, and perhaps increased spending on scientific research and subsidies for new engery industries. If Obama moves on taxes at all, we can expect him to allow the Bush tax cuts to expire, which would boost top marginal rates slightly. As far as the Federal Reserve, Bernanke and Co. are likely to stay in place, and that crowd seems to be moving in the direction of NGDP targeting, or at least likely to remain sympathetic to accomodative monetary policy as labor and capital markets stay slack. 

We have to distill Team Romney's plan from what he has claimed on the campaign trail, the history of his running mate's plans, and the opinions of his closest economic advisors. From that, we can predict reduced spending on infrastructure, reduced spending on scientific research and alternative energy subsidies, and a combative stance on international trade. In tandem, Romney would slash taxes by reducing capital taxes and marginal tax rates across the spectrum. As far as monetary policy, its widley expected that Romney would replace Bernanke with advisor John Taylor at the first chance. This would mean a change in the stance of monetary policy away from NGDP targeting and expansion and toward a tightening intended to raise the Fed funds rate to the level determined by Taylor's own Taylor Rule. 

As a caveat applied to both teams, I highly doubt either approach will be successful in closing the long-term budget deficit. I say that because despite the posturing, neither side has given a comprehensive or coherent plan for dealing with the driver of those deficits, Medicare.

Has Obama Made Us Better Off?

Not according to Mitt Romney. But the facts claim other wise. Let's take a look at some charts of key indicators to distill the President's real economic record: In order of appearence, we have unemployment, real GDP, capacity utilization in manufacturing, and the S & P index.

So we have lower unemployment, more national income, less idle manufacturing capacity, and a substantially healither stock market. And that doesn't count as being better off? I suppose the facts really are stubborn things; but who needs the facts when you've already got the answers?

Kocherlakota may be a Dove, But he Needs to Read his Milton Friedman

So Narayana Kocherlakota, one of the perennial hawks on the FOMC, has revealed himself to be a dove. 

"The new “liftoff plan,” Kocherlakota said, was an alternative to the proposal from Charles Evans, president of the Chicago Fed Bank, in which the central bank would commit to keeping rates exceptionally low until unemployment falls below 7%, only stopping if inflation rises to 3%."

I would add one large adjustment. Basically, it comes down to a question of derivatives. Kocherlakota is advocating using the derivative of the price level as an indicator. He needs to monitor the second derivative of the price level. 

What this means is that instead of an increase in prices, the Fed should watch for an acceleration in prices. This harkens back to the original work on the Philips Curve by Milton Friedman in his 1967 speech to the AEA. Friedman dissproved that there is a long-run tradeoff between inflation and unemployment, despite the statistical appearance of a short-run trade-off.

His reasoning went as follows: as inflation rises, final product prices rise faster than nominal wages which take longer to adjust due to labor contracts. This rise in P relative to W (the nominal wage) leads to a lower real wage or (W/P). The structure of real wages is now lower than the equilbirum value that clears the labor market, creating an excess demand for labor. This leads to faster job growth as employers try to soak up "cheap" labor, and this creates the short-run Philips Curve illusion.

The buck does not stop there, however; workers find that their nominal wages do not command the purchasing power they did now that inflation has caused the price level to rise. So nominal wage contracts are renegotiated upward, so as to return real wages to their equilibrium value. 

Central banks, therefore, can only lower unemployment below the "full employment" level of unemployment if they continually increase the rate of money growth, not merely create a high rate of growth. Final product prices need to rise faster than workers can anticipate, so as to keep real wages below equilibrium and create the excess demand for labor. 

What this means for Kocherlakota is that a high rate of inflation, if it stabilizes, does not indicate that labor markets are in equilibrium. Accelerating inflation, however, is the inicator that labor markets have cleared, and further additions to aggregate employment will only persist as long as the Fed can fool workers.

In short, here's my prediction: Kocherlakota's 5.5% unemployment target will only be met if inflation is permitted to rise above 3%. 

Video Time: A Very European Break Up

Interest Rates and Monetary Policy (part 1, of many)

With the Fed's resumption of the task of trying to do it's job, I figured I'd get around to a piece on interest rates and monetary policy I've been putting off for a while. Here goes.

The interest rate is a price like any other; it is the price of present consumption in terms of future consumption.  Say you start out with $200. You have the option of consuming the entire $200 today, or delaying consumption until a later date in order to consume more. The tradeoff is given by the equation:

Future Value of consumption  = Present Value of consumption * (1 + r) ^ t  where r is the real interest rate and t is the amount of time consumption is delayed. So $200 delayed at a real interest rate of 5% for 10 years would be: $200 * (1+0.05) ^ 10 = $325.78. The higher the interest rate and the longer the time defered, the greater the consumption to be had in the future. 

The point of this is that the real interest rate is an actual price, the kind settled by good ol' fashion supply-and demand, where supply and demand are the supply of deferred consumption and the demand for purchasing power immediately, as illuistrated by the following diagram to the right. 

The tradeoff  between consumption today and consumption tomorrow can be illustrated by the indifference curve to the left. Any point on the curve represents a combination of present and future consumption that maximizes utility for the individual, with the actual combination being point where the curve intersects the budget line.

Who Owns the Income Now?

Something I've been curious about for awhile; you here a lot about income inequality, but rarely about where the income is located geographically; here's the answer.

On the subject of economic geography, check out this old paper by Paul Krugman on the subject.

and the same map, for 2008

Also, here's unemployment by county.