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Simon Nixon suggests that the ECB is ready to step up to the plate

The second task is to stabilize sovereign debt markets to ease solvency concerns, cut interest costs and shore up confidence. The ECB is considering a big increase in its Securities Markets Program including targeting explicit government bond yields. The hope is that, by setting a credible target in conjunction with a long-term bank liquidity facility, it can ensure governments retain access to bond markets; banks will borrow to buy bonds at attractive yields knowing any losses are capped.

Obviously I have long advocated this as the only way to stem the crisis.

At this point, however, I am not sure it will work. The ECB may have a larger problem if the marginal cost of cash is diverging across countries.

The irony is that assuming basic market theory and fully integrated and liquid markets, this program can’t work as advertised. Targeting rates on bonds should cause the bonds – at least at the very short end – to collapse towards the same yield.

If not, then that tells us something about the integration of the money markets which in turn tells us something about the ECB’s ability to stem the crisis with this type of action alone.

To be sure, a credible cap can keep the Eurozone from flying apart but if short yields maintain their spread that is evidence of different effective monetary policy in different countries and possibly cripplingly tight monetary policy in the periphery.

I say that with the full recognition that it is not even clear what it means to say that there is different monetary policy under the same currency. What I mean is that there are differing marginal costs of funding. Some questions

  1. Does this extend up into the commercial paper markets?
  2. How many firms have access to credit from outside their country?
  3. How many households have access to credit from outside their country?

Of these questions I would usually consider (1) the most important but the prevalence of small and medium sized business in the periphery may mean that (2) is the most important.

More when I get the chance.


From Reuters

China’s central bank said it lowered the reserve ratio by 50 basis points. That reduces the ratio for the biggest banks to 21 percent from a record high 21.5 percent, freeing up funds that could be used for lending to cash-strapped small firms.

"It’s a surprising move — the market was not expecting the central bank to (cut RRR) so fast," said Shi Chenyu, an economist with the investment banking unit of Industrial and Commercial Bank ofChina.

"The move sends a clear message that the central bank is ready to relax its policy stance."

The central bank, which has already loosened credit curbs to help cash-starved small firms, has pledged to "fine-tune" policy if needed. The new level becomes effective on December 5, the central bank said in a short statement on its website.

How long ago was China’s primary focus curbing inflation and rebalancing the export driven economy. Was that two months? At the time its seemed clear that China was prepared to do that on the backs of Small and Medium Sized Enterprises (SME) in an effort to maintain stability for State Owned Enterprises (SOE).

Being a bloodless technocrat that was a move I could understand. It was no very “free markety” or progressive. However, China could ill afford instability in the SOE and Municipalities at the same time if the central government was to maintain legitimacy.

Now, it looks like they are reversing course and signaling more reverse. My sense is that they are hunkering down for the worst out of Europe.

From Izabella at Alphaville

Fresh off the wire on Wednesday:




An interesting announcement by the Italian Treasury indeed.

For two reasons.

First, it reveals that the Italian Treasury is prepared to intervene in the money markets directly — presumably to ease tensions, a job usually reserved for the central bank.

Second, the facility sounds awfully like the Supplemental Financing Program which was introduced by the US Treasury in cooperation with Fed in the fall of 2008. The move could therefore be designed to give the Italian central bank a little more fighting power and control of money market rates.

What’s key to note here is that this operation is being done in by the Italian Treasury in conjunction with the Bank of Italy. Which is to say it is not just illiquidity in the money markets, but idiosyncratic illiquidity.

Within a single currency zone money should wash across borders so that if the ECB injected liquidity anywhere it would show up everywhere. That is not what is happening. This implies that the ECB is effectively not managing monetary policy in the Eurozone.

The marginal cost of funds – the key instrument in monetary policy – is diverging between countries and local central banks and governments are having to step in to attempt to solve the mess.

Izabella is cautious in her wording and that is a good thing. However, because I was cautious last time this happened – and roundly ignored – I will be loud this time.

The Eurozone is now a single currency area in name only. Worse, the national central banks do not have the power to control monetary policy. Which means by American or British standards there is no monetary policy in Europe right now. There is regimented chaos.

I haven’t completely sorted this out yet but for a number of reasons I believe that the ECB has lost control of monetary policy in the Eurozone.

By that I mean the ECB is no longer controlling the marginal cost of funding and that indeed the cost of such funding is rising much higher than the official 1.25% rate, at least up to 2.25% and perhaps as high as 6 – 7%.

This incredibly contractionary monetary “policy” began sometime earlier this year and is continuing to accelerate. I put policy in scare quotes because there is no policy as such there is simply contraction.

Paul Krugman and Joe Weisenthal look at the growing spread between Sweden and Finland and conclude that failure of the ECB to act as Lender of Last Resort explains the difference. This is a position I would have endorsed as recently as yesterday, but now I am not so sure.

Based on entirely different indicators this looks to be the point where the ECB’s control over Eurozone monetary policy began to come unmoored.

At the crux of the problem seems to be the inability to arbitrage away differences in funding costs between institutions and countries because of malfunctioning in the European Repo market.

This malfunctioning appears to be down right mechanical with trades regularly not settling on time, collateral not being delivered, awkward interventions by local regulatory agencies and a host of other deep, deep problems.

I don’t have it all sorted out but its not clear that there is a fully functioning money market in Europe right now. Well informed opinion suggests that there is literally a shortage of know-how on the ground. That is to say, some large banks or brokers cannot trade in certain types of paper because they don’t have anyone on staff who knows all of the relevant institutional details.

Its really maddening and quite disconcerting.

Had a very interesting call with a correspondent this morning about the European Repo Market.

Most writing on bond markets treats bonds as if they are a savings vehicle and that the pricing is determined by how risky savers think the loan the bond represents is.

I have struggled over the past 4 years or so to determine whether this model of the world was only partially wrong or completely wrong. The reason is that the marginal bond does not serve primarily as an investment vehicle but as collateral for repurchase agreements or Repos.

What really matters is not the probability of default but the time path of the probability of default and the correlation of the probability of default to other instruments. If I have a bond A whose default probability is concentrated in the out years and is inversely correlated to the default probability of other assets then A is quite valuable as a liquidity hedge because when *stuff* hits the fan I know I will still be able to Repo my bond for short term cash, which can have very high value.

If I have a bond B that has a more uniform default probability and that probability is correlated with other bonds, then bond A can be more valuable than bond B even if the hold-to-maturity value of bond B is greater under all possible states of nature.

This is because in a crisis bond A can be repo-ed for short term cash with very little haircut, while bond B will have to be sold. Thus at the very point in time where money is expensive, bond A gets me money more cheaply than bond B. This is potentially more important than the hold-to-maturity value of the bond – under all state of nature.

I emphasize the later point because I am not merely suggesting that Bond A pays off in a world where my marginal utility of income is higher. I am suggesting that because Bond A is unlikely to default during the crisis event – even if it will in this world line – means that it retains its collateral status during the crisis and therefore allows me to extract cash when cash is expensive.

All of this is to say that the Repo market is key to understanding the bond market.

Here is the problem though – Bond A’s are floating out there in the world trading at extremely high yields. They are Sovereign Debt from Eurozone members.

This lead me to believe that something is wrong with the European Repo market. I called a student of this issue, who can identify herself if she wishes, on this only to find out that not only was she confused but so seemingly is everyone else. This includes the Eurosystem expert – apparently there is only one – on the state of the entire Eurosystem Repo market.

So no one knows exactly what’s going on here.

Some odd key facts though:

  • German Bunds trade below the deposit facility rate at the ECB and well below the Overnight Rate. I tell my students that this can’t happen. But, it is happening.
  • Auctions for Sovereign debt are not only over-subscribed but more over-subscribed as the yields rise. Implying that the appetite for debt increases as the yield does. This makes sense if you are planning to Repo the bond. What doesn’t make sense is why this doesn’t drive down the actual yield
  • Generally speaking there is enormous divergence in at the short end of Sovereign Debt curve and its not clear what theory of the world supports this.

To emphasize, I do not actually believe that assortative mating is the cause of the obesity epidemic.

A major challenge to any theory, however, is that it has to operate as a multiplier. The heritability of obesity is seemingly constant. That is, what we mean when we say “Whatever is happening, its seems to be happening to all of us”

If that were not true then presumably some people would be protected not only by their genes but by their environment. In which case heritability would fall.

For example, suppose that it is fast food. Well some people may be adopted into families which don’t eat fast food. This person should have a large degree of protection that is not genetic. Yet, the data don’t bear that out. Environment has not become more important.

Suppose it was watching TV, or drinking Soda, or any of those things. Then some sort of environmental protection should show up in the data but it doesn’t seem to.

This is why I have argued before that I suspect it is a ubiquitous small molecule. Its something that’s in everything. Maybe a universal preservative. Or, a legally mandated fire retardant. Something like that.

Some of the people I am fans of suggest that it is sweeteners like High Fructose Corn Syrup. This is not nutty as there is a clear mechanism and HFCS is more universal than you might think. However, its still a big hurdle. Surely some parents restrict their kids exposure to HFCS. Why don’t we see that?

Further my point is that a wholly genetic theory of the obesity epidemic can be constructed and to my knowledge no one has laid down solid evidence that it is in fact wrong.

That’s different from thinking its right, but it does highlight the state of our ignorance.

Also, for there are a couple of go-to studies on Obesity and Heredity. I’ll pull a chart from one of my favorite hereditary studies, the Sacerdote’s “What Happens When We Randomly Assign Children to Families” because this is the type of study we are typically tying to emulate statistically.


This shows the relationship between the child’s outcome and that of their adoptive parents and their biological parents. The children are on average about 30 or so I think.

Some outcomes are of course going to be influenced by neither. However, you can get a sense of the relative contribution of “role model” vs “genetic” effects by looking at the ratio.

On this measure BMI and Height are about the same. Studies usually find height is about 90% genetic and BMI is between 70% and 90% genetic. Usually measures of obesity as a binary variable find lower genetic effects but because “unexplained” variation is categorized as environmental this is at least partially and possibly entirely due to binary cut-off.

That is, if you have a BMI of 29.9 and your twin has a BMI of 30.1 then you are obese and he is not. However, this would look like unexplained variation when really the variation is an artifact of the cut-off.

Lastly, you can build a model that says its just self-control. One’s self-control is genetic and what has changed is the opportunities for indulgence. Maybe, but its hard to square that with childhood obesity which is under control of the parents and thus we should see a strong affect of strict adoptive parents.

There are also some other issues with self-control being the mechanism that I’ll just mention. One, self-control seems to be rising by almost all other measures yet obesity is rising. Not a killer problem for the theory but perplexing.

More importantly its hard to square with the stability of weight, which is probably the biggest or second biggest next to heritability, stylized fact about obesity. That is, if you always over eat you don’t get fat, you get fatter. Presumably, you will get fatter and fatter over time.

However, non-dieting obese folks have a weight stability that is roughly the same as thin people. Its as if they tried to go exactly to a particular too heavy weight and then stop and act like a thin person with 50 extra lbs.

Why does it stop like that?

That’s a puzzle.

It also *suggests* that there is some regulating mechanism that is set to the wrong parameter. We can also measure regulating hormones and they are systematically off in obese people, but this is enough for one post.

Felix Salmon discusses some of the reasons Apple’s stock price is so low.

What’s certain here is that the market simply isn’t rewarding Apple for its astonishing level of earnings growth of late. Which is weird, since that kind of earnings growth really wasn’t priced in a couple of years ago. Zaky’s convinced we’re seeing a market failure here, and I’m not convinced he’s wrong. But I’d be happier if someone could persuade me that there’s actually a good reason why Apple earnings seem to be worth so much less than so many of Apple’s less-successful peers

I have a theory.

On the one hand you can buy Apple stock for $375 a share and pay $7 to ScottTrade. On the other hand I also have a trash can in which you can deposit your $375, pay me $5 and I will set it on fire for you.

Clearly, I am offering the better deal as in both cases you have approximately zero probability of getting your money back and I am willing to burn it for $5 whereas you have to pay ScottTrade $7.

Now that’s not quite true. Apple’s stock price is sustained by the fact that if it goes low enough someone will buy the whole company and liquidate it. However, current investors shouldn’t be under any delusions that Apple has any plans whatsoever to provide them with a return on their investment.

As Arnold Kling might say: Thank You for your donation to the Steve Jobs Consumer Product Enrichment Fund, have a nice day.

Sarah Kliff writes

But more recent research, particularly a highly cited study in the American Journal of Clinical Nutrition, suggested that was more a question of genes than habits. The study, which followed 5,092 pairs of British twins ages 8 to 11, found that the most influence parents have on obesity is actually genetic, a factor of inheritance, rather than the environment. “Contrary to widespread assumptions about the influence of the family environment, living in the same home in childhood appears to confer little similarity in adult BMI [body mass index],” authors Jane Wardle, Susan Carnell, Claire Haworth and Robert Plomin write.

The research raises one key question: If obesity is genetic, why has it increased so much in recent years? The researchers explain that, some of the genetic predispositions for obesity have existed for awhile. But changes to our food environment, like the proliferation of fast food, have enabled those predispositions to become more powerful.

Although contemporary environments have made today’s children fatter than were children 20 years ago, the primary explanation for variations within the population, then and now, is genetic differences between individual children,” they write.

One thing, just as a comment on how public health is done in America, is that “everyone” knows this.

That is to say, its nearly impossible to spend more than 6 hours on Google Scholar researching obesity and not come away knowing that obesity is high heritable. You might question whether the heritability has declined over time, but looking this up will point you to immediately to studies which suggest, no.

You’ll hear offhanded references to this fact when you read certain obesity researchers who write phrases like: “whatever is happening is happening to us all”

However, few people come out and say it. The fear I think is that if people believe that obesity is genetic they will stop trying to do anything about it. The problem is that the implicit lying to people causes all types of immediate human suffering.

Those who have been reading me for a while know that this is also the case with exercise. Its well known that exercise as an intervention is unlikely to cause a reduction in body fat percentage. Yet, this fact is shoved under the rug seemingly because exercise has extensive health benefits and the public health authorities know that lots of people would stop exercising if they were aware it was unlikely to cause them to loose weight.

On many counts the way public health is treated in America borders on intentional deception.

Secondly, no one knows for sure why obesity has exploded. Indeed, though I doubt this is the answer, I have not seen anyone convincingly show that it is not genetic.

That is, that it is not assortative mating. Under this theory fat genes are synergistic. If you have fat gene 1 you are 20 lbs overweight. If you have fat gene 2 you are 10 lbs overweight. If you have fat genes 1 and 2 you are 50 lbs overweight.

When overweight people marry overweight people they then have morbidly obese children. This would help explain the bimodality of obesity but off the cuff you would expect the thin peak to expand not contract, if this was the case.

Still, differential reproduction rates might get you around this.

In any case I don’t think that’s the likely answer, but the point is that no one actually knows for sure what the answer is and whatever it is it has to amenable to the fact that not only is obesity highly heritable but its heritability has not changed – up or down – since the onset of the epidemic.

Regular readers now this but from the traffic it seems like some new folks are tuning in for the Euro-Crisis debate.

On video I have a tendency to smile and laugh a lot. I am also a generally happy-go-lucky type of person. This combined with my sloughing off of long term issues has people often mistake me for a Pollyanna. That is someone who thinks everything will be ok.

Ironically – or not – I believe the exact opposite. Everything will definitely not be ok. I often tell my students: if you ever find yourself worried sick about whether or not things are going to turn work out, don’t worry, things are definitely not going to work. Everything is going to go horribly, horribly badly.

This is the essence of life. We are not forever. Our institutions are not forever.

Indeed, in a relatively short time, we and all the things that matter deeply to us will be annihilated. They will not exist at all and they will never come back. Not at least as we would think of such. There will be no faint hint of them in the background of the universe or spirit occupying another plane.

All things we care about are at their heart information – particular arrangements of the building blocks of reality – and entropy eats information.  Everything we care about will be gone.

Indeed, what we mean by the passage of time is ultimately the direction in which we and the things we care about die. The two are fundamentally inseparable because they are defined in terms of each other. Why we perceive death and time the way we do is a separate question, but there can be little doubt about the basic story here.

This is part but not the entire reason why I am so focused on making sure that policy addresses immediate suffering and is less concerned about the long-run.

The other is that I think we have far, far less control even over the “near long run”  say the next 50 years or so, than we think. Its highly unlikely that we as policy makers are going to do something right now that radically alters the course of even the next 25 years.

As economists we can see that institutions matter, but if development economics has taught us anything it is that we cannot simply write down a set of institutions hand it to policy makers and walk away. There are fundamental reasons why institutions rise and fall and they do not appear to be due to the wisdom of the institution makers.

Yet, as impotent as we are in the long run, we are very powerful in the short run. This is because we have discovered a few levers that have profound impacts on short term human experience. One of them is the printing of money.

It didn’t have to be the case that money was so powerful. We can imagine a world where it is not. But, in this world money and its management are a very big deal. This extends, though somewhat less so, to credit systems in general. Credit matters a lot. We also have the power to influence credit. Again, we can imagine a world where we didn’t but this is not the world we live in.

In this world, runs do happen. In this world credit markets have multiple equilbria and in this world we can influence which equilbria comes to pass. This has profound short run consequences and should not be ignored.

Trying to avoid causing people undue pain should be our major goal. This is why I focus like a lase beam on a strategy of preventing the world possible shorterm outcome – a global financial meltdown – from stemming out of Europe.

Kantoos and Tyler Cowen have subtlety different critiques of my way forward on Europe.

Tyler seems to suggest that what we are seeing is an acknowledgement by the bond markets that the fundamentals in Europe are deeply off.

Kantoos – it seems – recognizes that what we are likely seeing is a run. However, the primary tool for stopping a run – lend freely against good credit – would only be applicable if Italy’s long term prospects were better. Otherwise, there are significant risks to the ECB and in turn to Germany from lending freely.

Up front, I should be fair to the readers and note that my stance on handling runs is a bit heterodox. In part, because I think what counts as good credit is incredibly nuanced and situation dependent, something the Central Bank in fact has a lot of control over. In part, because I think runs have what others might call a strong psychological component. I actually think its just profit maximizing under uncertainty, but nonetheless if you believe that the Central Bank can and will ruin you then you are not going to run. So, what the Central Bank makes you believe about its immediate response function is a big deal.

That having been said let me address the two issues.

First, for Cowen, I see a lot of evidence that the periphery in general and Italy in particular have extensive institutional and demographic problems and will suffer from sluggish growth from here forward. The extent to which this makes it impossible for Italy to service its debts is not clear. After all Italy has been stagnating for at least a decade and over most of that time its debt-to-GDP ratio was falling.

FRED Graph

More generally the overnight rate in a currency area generally does not exceed the nominal GDP of the currency area over the long term. That would imply that as long as Italy’s growth rate was not too far below that of the Eurozone it could service this debt indefinitely.

Worse case scenario Italy needs to run something on the order of a 2% primary budget surplus.

The real issue for Italy and the periphery and why things are so difficult is that Italy as a nation – not a government –  borrowed a lot of money. Now it needs to pay it back. However, the way you do that is by running a current account surplus. The way you do that is by letting your currency fall. However, the ECB will not let the Euro fall and so Italy simply cannot pay back the money it owes.

Not in the sense that it doesn’t have the money or the real resources. It doesn’t have the mechanism.

Kantoos’s point is well taken. However, there are clear mechanisms for dealing with this. He thinks my plan is too much for Europe to handle. Ok. fine.

Let the ECB stand as Lender of Last Resort for T-Bills on an issuance by issuance basis. Every time Italy comes to the well, the ECB will announce that this issuance of T-Bills will ALWAYS stand as collateral for Repurchase Agreements at Par, no matter what.

This will bring Italian or anyone else’s actual borrowing cost down. The ECB will not actually have to take any of these bonds on to its balance sheet permanently, liquidity vehicles will be provided for European banks, the Secondary market in old debt will continue to send price signals about the long term viability of the periphery and the ECB has the ability to stop guaranteeing new issues at any time.

This solves most of our immediate problems and leaves all the cards in EC and ECB hands.

We don’t need to drag the IMF into this and we don’t need to take this outside the banking sector. Anytime you start involving non-bank agencies into these matters I get nervous. I know I hate on the ECB but my wish is for them to reform and act like an activist Central Bank, not to start pulling in politicians to do work that bankers should do.

You just can’t have but so much confidence once you start turning over the operation of credit markets to politicians. This is not a jab. They have different incentives, training, views of the world. They do not value stability in the same way. And, quite frankly they are answerable to democratic processes in ways that bankers are not.

Settle it inside the Eurosystem. Settle it fast. Let markets calm. If you are worried about handing away to many cards we can always structure some type of facility that leaves the Central Bank with all the cards.

But, for God’s sake don’t let the future of the world depend on the EU member states coming to some lasting and mutually beneficial agreement. Everyone is aware that they have managed to screw-up on a colossal scale in the past. You should no confidence that they will do the right thing even after they have exhausted all other possibilities, today.

Very bad things do happen.

They very well might be happening right now.

Casey Mulligan says

One interpretation of these results is that the safety net did a great job: For every seven people who would have fallen into poverty, the social safety net caught six. Perhaps if the 2009 stimulus law had been a little bigger or a little more oriented to safety-net programs, all seven would have been caught.

Another interpretation is that the safety net has taken away incentives and serves as a penalty for earning incomes above the poverty line. For every seven persons who let their market income fall below the poverty line, only one of them will have to bear the consequence of a poverty living standard. The other six will have a living standard above poverty

. . .

Of course, most people work hard despite a generous safety net, and 140 million people are still working today. But in a labor force as big as ours, it takes only a small fraction of people who react to a generous safety net by working less to create millions of unemployed. I suspect that employment cannot return to pre-recession levels until safety-net generosity does, too.

I assume – based on Casey’s general thesis – that his point here is that the expansion of the safety net is a major cause of the decline in employment.

A core problem with this interpretation is that it models the decline as resulting from an expansion in individual budget constraints; now you can work less and avoid poverty were as before you couldn’t.

Yet, an expansion of your budget constraint is an unambiguously good thing. If that’s the case the people are not not working because “the economy is bad”, they are not working because the economy is awesome.

Yet, they don’t talk and act like that. They talk and act as if something bad has happened; as if they are more afraid of their economic future than they were before; as if they are afraid to spend; as if they are afraid to quit their jobs.

Indeed, the quit data shows a sharp decline in quits associated with the recession. One would expect an expansion of the budget constraint to be associated with an increase in quits.

It also knits in with an important point that can help economists stay grounded and not get lost on unproductive tangents: The economy is not bad because some statistics show anomalous patterns. The economy is bad because if you ask Joe on the street, how’s the economy, he will say, “it sucks.”

That is the alpha and the omega of a bad economy. A bad economy is an economy that makes people feel bad.

We could go on a long discussion about how badness is fundamentally a property of human minds and not of external real world phenomena. That a thing unto itself – including the entire global economy – is nothing more or less than a particular arrangement of sub-atomic particles.

But, even without that I think we should all be able to get why human emotion is the ultimate arbiter here and why it’s a key piece of evidence in trying to understand what’s going on.

If people are telling you that their current situation sucks that’s a strong clue that you should be looking for something reminiscent of a contraction of the choice space.

I had decided not to say anything because I thought there were few people who understand where I was coming from. However, since I took the time to scold Scott Sumner I should be fair and give my take on the Keynes-Hayek debates.

I saw two of them. I don’t know if there were more. I saw the one at LSE and the one hosted by Reuter’s I think.

These were two of the most grotesque spectacles I have ever seen in my life. I teared-up watching the first one. I apologized to my son – on behalf of the intellectual community – after watching the second.

There are some serious ideas at stake here but the speed at which these things descended in gutter-wallowing and thinly veiled political sophistry was both depressing and embarrassing for everyone involved.

This is not the way intellectuals should behave. Not on stage. Not in front of the world.

That the issue at hand affects the lives of hundreds of millions of people made the whole thing more all the more nauseating. That we who live relative lives of comfort should treat the question of how to prevent mass suffering as a game – a game – in which we no rhetorical trick is too low and the truth is merely an inconvenience to arriving at predetermined answers – well, I don’t know what to say about that.

If you say that well, its ok that we should be allowed to have a little fun. Fine I have no problem with that. But, not on stage, in front of the world, wearing the badges of intellectualism.

If this is the community of thoughtful men and women then who is the world supposed to turn to for answers? Society does not invest valuable resources in us so that we can engage in public displays of pettiness.

It does it so that we can move the ball forward in making their lives better.

Scott Sumner says

Keynes was fully aware of the fiscal tightening by this time.  And he was fully aware that a steep recession would cause a sharp sell-off on Wall Street.

So which is it?  Is the Keynesian theory wrong?  Or did Keynes not believe his own theory?

I say the Keynesian theory is wrong.  There was no reason for Keynes not to own stocks in 1937.  The events that caused the severe recession also caused the stock market crash–and those occurred in the last half of 1937.  EMH + market monetarism >>>>>> Keynesian theory.

The differences between my view of the world and Scott’s view are pretty technical. Yet, I consider myself a card-carrying New Keynesian.

I think I view the banking sector, collateral and the time path of capital demand as more fundamental than many New Keynesians, but these are add-on features. It helps explain why financial panics are such a big deal and why investment in structures is such a big deal, but it doesn’t change the basic dynamics.

When we write posts like Scott’s it gives the impression that there is more fundamental disagreement than there really is. This is great for sport and perhaps fun for the readers but I don’t think its healthy overall.

There is some fact-of-the-matter about how markets will respond to policy. This is going to make a big difference in the lives of actual human beings. I think it would be nice if we focused on coming to consensus about those facts and what should be done.

Getting the wrong answer means that real people will suffer and manufacturing disagreement pushes into camps where it is more difficult to see our biases and more difficult to come to a common understanding that is likely to be correct.

This is not good.

My tendency towards policy nihilism should lead me to underestimate the value of elections generally. So, it is natural that I am missing the value of this one. Nonetheless, I offer for consideration that this is turning out to be an election in which not much is on the table and that is – as almost always – a good thing.


There is some chance that this will be rolled back if there is a GOP sweep. I thought the whole thing was much ado about nothing in large part because I didn’t think that expanding health care would do much to improve health and I don’t think that the cost controls embedded in ObamaCare will work.

The major benefit I saw was that folks would not necessarily be driven to declare medical bankruptcy if they got really ill. This is an emotionally traumatic event for folks even if I am not sure the change in real resource distribution is that different.

In any case, during the GOP Google debate there was a poll that asked GOP voters if someone should be denied medical treatment because they could not afford it. 80% said no. This is the end of the major question in my mind. If you answer no then you have de facto signed on to socialized medicine through some means.

You could formally socialize through universal insurance or you could force hospitals to treat the sick regardless of ability to pay which just informally socializes it.

If you want to get into the weeds of public policy efficiency there is an argument here, but nothing like the national debate that people seemed to want to have.

Taxes on the Rich

At least in the near term highly punitive taxes on the rich are not likely to be passed by a Democratic majority. Over the long term if something is not done to raise the living standards of the bottom half of Americans more rapidly then there will be punitive taxes on the rich regardless. The GOP will shift on the issue and when it happens it will be fast and furious.


The anti-trade constituency is multi-party and at this point unlikely to wield any serious power.


I am not actually sure how this even cuts. Though increases in Latin American immigration are more likely with Democrats in power. Increases in high skilled immigration may be more likely with the GOP in power, as I see a desire among the GOP to quiet the pro-immigration crowd without expanding Latin American immigration.

This means that some movement is actually more likely under the GOP, though the ideal is more likely under the Dems. I am just not sure which is better.


I think the actual policy moves here are limited. A reversal of Roe vs. Wade, in my estimation, would destroy the pro-life movement. The chipping away strategy can work, but will happen regardless of who is in office.


Human Biological Research

This can matter but, neither Mitt Romney nor Newt Gingrich will stand in the way of cloning or other techs if they gather mainstream support. Right now I think both the right and the left intelligentsia is pushing this far more than the bulk of the population. If popular sentiment changes then neither intellectualist leaders from both parties will support more human biological research



I think it should be clear by now that the Democrats are no less hawkish than the GOP. I think the Bush administration was particularly wide-eyed and naïve about the costs of war, but my bet – maybe I am wrong – is that the broad swath of elite opinion on both sides has learned from Iraq.


The Welfare State

I just don’t take efforts to dismantle most of the welfare state seriously. People have been trying for 75 years and no one has made any progress. No Western Nation has instituted a Welfare State and then repealed it. I suggest this is because it can’t be done. Old people are a really popular, not just powerful, constituency. No one wants to see starving Grannies.

No one.

If you want to be policy wonkish about it you would say that what is really going on here is that people are paying for the positive externality of knowing that there grandparents are taking care of without actually having to take care of their grandparents themselves.

This is because people feel extremely guilty about not taking care of their grandparents but there is also an enormous amount of inter-family strife that imposes very heavy costs on the grandchildren.

Thus support for the state to take on this burden is huge. Even if it means very high taxes. What would you pay to know that your Nana was well fed but not have to listen to her constantly criticize your lifestyle choices? Probably well over half your income.

The only large welfare state program I can environ being cut is Medicaid. Here again I don’t think the provision of health insurance is that big of a deal and where it is – children and the elderly – I think you will see a backlash in favor of healthy doses of public support for these two groups.


Crime and Gun Control

Crime is falling and will likely continue to fall, irrespective of what the government does. I think its falling because there is less lead in the air and more estrogen in the water. This isn’t going to change anytime soon.

This also kills support for gun control. I don’t think anything is likely to change the status quo of a slow move towards less and less state control over guns.


The Deficit

See Atrios: No one cares about the deficit


Civil Rights and the Power of the State

This will continue to evolve in a direction that civil libertarians find unpleasant. I don’t think there is any popular support for stopping it and the elite is not interested in standing shoulder-to-shoulder in support of civil liberties. There may be a point where we hit an elite backlash, though I doubt there is any foreseeable point where we hit a popular backlash.


Gay Marriage

Gay marriage will be legal in almost all states and practically legal everywhere within 10 years. Political parties are irrelevant here.



Marijuana will be almost completely decrimalized within 10 years. It will not be made legal. By the time my son is a teenager, smoking pot will be looked upon like speeding or underage drinking. Everyone will do it. Everyone will know you are just not supposed to get caught. Political parties are irrelevant here.


Those are the long term issues and I don’t see much difference there. I see some difference on short term issues but it cuts opposite ways.

Near Term Demand Stimulation

Here is where I think there is some difference and I actually think your best hope here is that Mitt Romney gets elected president and the Republicans sweep the congress. If the economy is not in full rebound Romney will propose Keynesian tax cuts.

My hunch is that this time we will see more action around the payroll tax or other broad based taxes as this can win support from Republicans without risking raising the ire of the public.

Of course, the Bush tax cuts would be made “permanent” but I don’t think this in itself really means much because the path of taxes is always determined by what Congress at the moment is willing to tolerate. You’ll notice that the sunset on the Bush tax cuts did not actually make it really easy for them to go away.

If Obama is re-elected I see it as much more difficult for him to push any kind of demand side stimulus including tax cuts.

I know it upsets progressives because they are on the “correct side” of this issue, but the organizational discipline of the GOP means that in fact they are more likely to deliver here.  Its not “fair” but neither is life.



If additional bailouts are needed I think we have a better chance getting them through a Democratic Congress and a Democratic president. I get the impression that enough Congressional Republicans really are willing to tank the economy to stand on principle here. The likelihood of needing this seems relatively low at this point as I think a crisis could be handled by an aggressive use of Federal Reserve facilities, but nonetheless this is a big Damocles to hang over the economy.



So all-in-all it looks to me like practically speaking very little is at stake in this election. Yes, the absence of bailouts could be extremely bad for humanity but it is a low probability event balanced by the more high probability of tax cuts.

Since, its impossible to actually know what state of nature we will be in its impossible to say that at this point in time that one is more consequential than the other.


Technical Note:

I am horribly irregular about reading the comments. It depends on my mood and my willingness to take the abuse that sometimes appears in the comments. I am not proud of this fact, but it is true. If you have an important point that you want to make sure I see, email me.

Europe continues to hang over our heads as does the potential failure of Congress to extend the payroll tax cuts. Nonetheless, the near term trajectory of the economy is meeting or exceeding my expectations.


Sales rose an estimated 6.6 percent to a record $11.4 billion on Black Friday, typically the busiest shopping day of the year for Americans, while the traffic at stores rose 5.1 percent, according to ShopperTrak.

The day’s sales growth was the strongest percentage gain since 2007, when sales rose 8.3 percent on the day after Thanksgiving, said Ed Marcheselli, chief marketing officer at ShopperTrak, which monitors retail traffic.

The fundamentals for a US recovery are in place. Without trip-ups we should be looking at accelerating growth through 2012 and the potential for an enormous boom.

There will also be inflation. Pay no attention to those saying that inflation cannot pick up unless wages pick-up. It can and it will. What they miss is that labor’s share of national income will fall and probably at a slightly faster pace than before the recession. Just my baseline guess.

Nonetheless, the point is that the inflation will be generated by greater corporate profits and much higher returns to natural resource extraction.

Eventually the natural resource extraction returns will fall as capital and technology flood into that sector but I expect that the increase in corporate profits as a fraction of national income will continue for the foreseeable future.

FRED Graph

Megan has an elegant review in the Wall Street Journal of Shinny Objects and Against Thrift, two new books on Consumer Culture and Inequality

A couple of notes. First, its perhaps the highest praise to Robin Hanson that these few lines shocked me

One of the running themes of the economist Robin Hanson’s excellent blog is that arguments like the ones found in these books are actually an elite-status proxy war. They denigrate the one measure of high-visibility achievement—income—that public intellectuals don’t do very well on. Reading "Shiny Objects," you get the feeling that he is onto something.

As I read those lines I had two reactions, the first was “oh yeah I got that from Robin” and the second was, “wait a minute there is some alternative belief system about these things.”

The more substantive comment I want to make though is to note that I have such trouble getting these discussions. It really seems like something is being talked about and its virtually indisputable that the participants are attached to the conclusions that are drawn but I can quite make out what its all about.

For example Megan writes

Like their forebears in this robust polemical genre, neither Mr. Livingston nor Mr. Roberts gets us much closer to answering the essential questions: What makes American consumers spend as they do—and is it a bad thing? For some thoughts on these matters, I’d suggest turning to James B. Twitchell’s "Living It Up" (2002), a wry account of the author’s own complicated relationship with luxury brands that explores the moral and psychological aspects of our free-spending ways without seeming to be a paternalist rant against the folly of BMWs. "The pleasure of spending is the dirty little secret of affluence," says Mr. Twitchell, a professor of English literature and advertising at the University of Florida. "The rich used to do it; now the rest of us are having a go." He is keenly alive to the risks—and occasional risibility—of American-style consumerism. But he never pretends not to understand its undeniable appeal.

What is all this supposed to mean?

First, that a relationship with luxury brands can be complicated – I get this because I see people having strong emotional reactions about these things.

But, what moral and psychological aspects of our free-spending ways? Is there really something to be explained here? We marshal resources with the intent that they should be enjoyed. What would be the point to people constraining their enjoyment of them. Why are we doing any of this then?

And, why should the pleasure of spending be a dirty secret and of affluence, no less? The poor don’t want to buy things? Are we to suggest that people should not shop in public? Is the act somehow obscene?

And, what are the risks of American-style consumerism? Is there a safer form?

I know that people mean something by these things because they keep talking about them and act as if they understand one and even disagree with one another. However, this whole matter is just deeply, deeply bewildering to me.

I was going to do a long post explaining why Scott Sumner’s attempt to nihilate the concept of inflation was going too far.

However, Scott has accepted the crux of my argument making the whole thing a lot easier. He says

I said “almost every use” because there is one valid use of inflation.  Take the rate of NGDP growth per capita and subtract out your subjective estimate of how much NGDP growth would have left us equally happy as before.  The difference is inflation.  But inflation still doesn’t have practical value, it’s merely your personal estimate of how much of the increase in NGDP is not “real.”

So we can do the same thing, but take all people in society and allow side payments so as to determine which NGDP growth path is Kaldor-Hicks preferable.

We then have a relation defined over all possible NGDP growth paths such that Growth Path A is equal to or superior to Growth Path B if and only if there exists some set of side payments that would make all parties at least as well satisfied with path A as Path B.

This is then a partial ordering over the possible NGDP growth paths. There then exists some F mapping NGDP paths into the real numbers such that F(NGDP Path A) is greater less than or equal to F(NGDP Path B) if and only if NGDP Path A is equal to or superior to NGDP Path B.

This mapping F is what we call the inflation function and it is well defined.

What is not immediately clear is if we can meaningfully pass lotteries through F such that the partial ordering is maintained. Though it seems to me that you could.

If you can then you have a cardinal mapping. That is, a price index, and it is fundamental and well defined.

Even if we can’t we have a meaningful measure of ordinal inflation.

A lot of my progressive friends are besides themselves over the fact that lots  conservatives and centrists don’t get the Paradox of Thrift. This is an interesting result in itself because I think it helps support the notion that there are deep biological difference between schools of thought. However, that’s a point for another day.

Today I want to at least outline why conservative and centrist intuition is wrong on this issue. As usual I think the misunderstanding is grounded in basic near meta-physical assumptions and so I will speak in that language.

The fundamental question comes down to this, how does one transport goods and services through time. This is what a “prudent” person wants to do. You want to accumulate goods and services when times are good, when you are young, and strong and then consume those goods and services when times are bad or you are old.

This is the message underlying the Fable of Ant and the Grasshopper. In this fable the Ant stores actual grain that he collects during the summer, while the grasshopper plays. When the winter comes the Ant has plenty of food and in the more strict versions of the tale the Grasshopper dies of starvation.

Now, fast forward to a modern economy. Is this tale still  a useful guide for us.

In most cases the answer is yes. However, not in all. The reason is that the Ant is actually experiencing negative real rates of return. This is because grain in the winter is the same as grain in the summer. The grain has not delivered a return.

However, the grain does have a “carrying cost” that is it is not free to store grain. So, collecting grain in the summer in order to eat in the winter means that you face negative real rates of return.

The rates of return are actually worse than that from the Ant’s perspective because he has a very high marginal value of leisure in the summer and very low in the winter. So he is effectively collecting grain when it is expensive, holding it at a positive carrying cost and then eating it when it is cheap.

However, we don’t really need to go deep into that. We just have to recognize that there is a negative real rate of return here.

Now, in a monetary economy this can become problematic. The reason is that the rate of return on cash money is always minus the inflation rate. If the inflation rate is lower than the carrying cost of real goods and services then it will never be profitable to stockpile them the way the Ant did.

Its always be a better idea to attempt to hold lots of cash, which you can then use later to buy things. Indeed, you see both banks and tech companies doing this.

This problem is made worse by the fact that in our modern economy lots of things have a really really high spoilage rate and so the carrying costs are enormous and sometimes infinite.

For example, how do you stockpile medical services. To some extent you can get a lot of tests done today, but if you don’t actually need a procedure today, then getting it today usually won’t help you out tomorrow. You have to actually wait until tomorrow comes. That makes it hard to stockpile medical services.

The same is true for accounting services, legal services, lawncare services etc. These things are darn near impossible to store. However, they are things you might want in the future and so the only way to save for a rainy day is to accumulate either cash or assets you hope to sell for cash later.

Not to beat a dead horse but I want to point out this is also true for lots of industrial goods as well. Cars depreciate and so does industrial machinery. Indeed, in an environment where technology is moving fast, these things actually depreciate faster, meaning that high tech growth makes it even harder to hoard physical goods because they will become obsolete soon.

This further encourages you to hoard cash. The problem of course is that not everyone can hoard cash at the same time. Moreover, the attempt to do this causes a perverse effect. The way you get cash is by selling things.

However, the way you horde cash is by not buying things. So when people are trying to hoard cash you get into a peculiar situation where everyone wants to sell but few people want to buy. This drives the entire economy down.

Now, you may still feel uncomfortable with this. There should be some way to make productive investments in the future. Indeed, there is a way that is almost always open to us.

That is, to build more buildings. The reason this usually works is that well built buildings depreciate really slowly and the cost to carry them is usually pretty low because the sit on the ground and are by definitions protected from the elements. You could just build the building and let it sit empty until it was ready to be used.

You can also usually feel pretty confident that people will want to use buildings because the population has been for most of the industrial age, growing. Thus there will always be some person in the future to live and work in this structure and so it’s a good idea to build it.

This is why property bubbles are particularly painful. They cause a run-up in the price of land. If you look its really the land not the structures that are most rapidly increasing in value. Indeed, the structures only increase in value in weird circumstances where there are legal impediments to modifying or tearing down old structures to build new ones.

It’s the land that becomes expensive in a bubble. Then the bubble pops and the value of land falls. Now, if you have a sudden increase in the desire to push consumption into the future you are going to have a big problem.

The type of negative real rates of return the Ant is willing to endure cannot be realized because people can just start hoarding money. Our go to outlet for pushing resources into the future – building structures – is closed because structures are by definition attached to land. The price of land is falling, which means that the value of the “structure-land” unit will be falling and so its not profitable to buy land in order to build a structure on it.

Thus we are stuck in a trap that where we can’t do what we as a market society want to do – transfer more resources from today, into the future. Its not that savings has somehow become “bad” its that savings in the quantity that people want to do is impossible.

That’s because the essence of savings is not refraining from consumption today. Its refraining from consumption today, so as to push real resources into the future. Since, the second part can’t be done at the rate people wish to do it, saving is impossible.

Just to make the point very clear, the market would be able to solve this if it the interest rate could go negative. All the time we run into the problem of people wanting to do things which are impossible for them simultaneously do. This problem is solved by a shift in prices that discourages people from doing it.

If lots of people want to save at once then the return to savings should fall to arbitrarily low levels until markets balance. However, since this cannot happen we wind up with a perverse affect from savings.

This is the source of our problems today.

Robert Frank thinks so

The costs to store owners and their employees and families are enormous: millions must now spend time away from home on the one occasion that all Americans, regardless of religion or cultural background, share as a family holiday.

These costs might be worth bearing if they led to even larger gains. But when all outlets open earlier, no one benefits. Few people actually want to shop in the wee hours, and the purchases that do occur then are presumably offset, dollar for dollar, by reduced sales during normal business hours. Even the shoppers who turn out for early openings seem motivated primarily by a fear that others might snap up bargains before they get there. But if all stores opened later, there would be no fewer bargains than before. In short, we have a classic collective action problem, an arms race.

I can’t see how this could possibly work out.

For example, I offer to potential employees that I will be closed on Black Friday, guaranteeing them as much time with their family as they like. This allows me to attract better workers at lower costs.

Then, instead I hold a sale on the Saturday after black Friday. I hold back my inventory for this day and am offering sales to shoppers who didn’t want to stand in line on Friday to be sure they got the best merchandise, or who did stand in line on Friday but still lost out.

This gives me an advantage in attracting both customers and workers that allows me to increase profits.

If this strategy fails then it would need to be because people prefer standing in line on Black Friday morning to finding the exact same sales at my store on Saturday.

Indeed, I suspect this is the case and the Holiday and shared experience that is Black Friday brings enjoyment to Americans greatly in excess of the costs of the experience.

HT: Cowen

I pick on Tyler because he is probably one the sharpest voices for what I see as a deep misunderstanding of the issue. Though, I think this misunderstanding is incredibly widespread – as holiday gatherings make clear.

Tyler says

Maybe these markets simply will shut down soon.  There is so much talk about what the Germans should do, but I don’t see the viable options.  With Germany’s own credit status now in doubt, eighty percent debt to gdp ratio, massive welfare state, and unfavorable demographics, are they supposed to endorse — going to endorse — ten or fifteen percent price inflation for a few years’ time, all with no guarantee of reforms in the economically weaker countries?  And is that inflation then followed by a subsequent deflation?  Or does it continue forever?  And would Germany have to move to a regime of wage flexibility for the professions too?  How politically feasible is that?  I don’t see how the Germans benefit from going down this road, even if you think, as I do, that the alternatives are quite dire.

Germany doesn’t need to experience any of these things. Germany only needs to agree to letting the ECB stand as Lender of Last Resort.

I haven’t spoken with Tyler personally on this but from my conversations over the holidays I can see that the difficult thing to understand is that what is at issue here is the distribution of private claims over private resources.

On one level you can see this by noting that part of the reforms which Mario Monti is putting in place are to decrease tax evasion. Yet, taxes are simply the forcible extraction of private resources by the government. Its not as if taxes represent the government producing something or even government officials or government pensioners consuming less.

Taxes represent the transfer of resources under the threat of imprisonment. Now, if this could possibly solve your problem then you know that at root the problem has to be about who holds private claims over resources.

You can attack the problem in another way by seeing that Italy is roughly in primary budget balance. This means current borrowing exists only to repay past lenders. Again, this is an issue over the distribution of private claims.

To make the point more clear – this is explicitly not the case for Greece. From a budget standpoint Greece faces a more fundamental issue. It is currently in primary deficit. It would have shift resources from private control to public control in order to balance the budget given the current economic environment.

It is true that Greece’s economic environment is primarily the result of a fundamental mismatch in monetary policy between it and the core countries and so could be solved if Germany were to endure more inflation. However, Greece does face an immediate adding up constraint that Italy does not face.

A third way to see this is to imagine what would happen if Italy repudiated its debt vs. Greece. Italy would then be able to support itself on tax revenue. Greece would not. Greece would have to go back into the bond markets somehow and get more money.

Why is all of this important?

Its important because it means Italy doesn’t actually need anyone to transfer real resources to it. It simply needs someone to manage resource distribution among bondholders. The ECB can do this at virtually no direct cost.

Again that is because nothing actually has to be produced or transferred. Debt just has to be managed.

Perhaps, a fourth way to see this is by noting that you only need new savers to agree to step in where old savers were. This is ultimately a co-ordination issue between groups of savers. Its breaking down because there is a musical chairs issue. No one wants to be the last saver who can’t find someone to whom to transfer his savings.

The ECB can assure this doesn’t happen because the ECB controls the total amount of borrowing from European banks. It can constrict the amount of borrowing to make sure that someone steps up to take the transfer of Italian debt.

All of this is to say that Germany doesn’t have to suffer any near term economic bad effects. What Germany loses in supporting a move like this is the ability to pressure peripheral governments into changing their ways.

In theory one could agree to a new system, along the lines I have proposed, in order to keep the pressure on. The problem, of course, is that if you are even considering offering Lender of Last Resort status then you have signaled that you do not have a complete commitment to irrationality, in which case it immediately becomes in the interest of the peripheral countries to dig in and refuse to change unless Lender of Last Resort status is offered up front.

Paul Krugman has elevated his “job creators don’t matter” blog post to an op-ed with some changes that I think strengthen his argument and also implicitly acknowledge the correctness of the criticisms I made.

First, he substantially narrows the focus of his point from the top 1% to the top .1%:

If anything, however, the 99 percent slogan aims too low. A large fraction of the top 1 percent’s gains have actually gone to an even smaller group, the top 0.1 percent — the richest one-thousandth of the population.

Having narrowed his focus, he makes the “job creators don’t matter argument from his blog post:

Well, aside from shouts of “class warfare!” whenever such questions are raised, the usual answer is that the super-elite are “job creators” — that is, that they make a special contribution to the economy. So what you need to know is that this is bad economics. In fact, it would be bad economics even if America had the idealized, perfect market economy of conservative fantasies.

After all, in an idealized market economy each worker would be paid exactly what he or she contributes to the economy by choosing to work, no more and no less. And this would be equally true for workers making $30,000 a year and executives making $30 million a year. There would be no reason to consider the contributions of the $30 million folks as deserving of special treatment.

Then acknowledges and agrees with the argument I made that marginal product is likely to be higher than compensation for many top earners:

Still, don’t some of the very rich get that way by producing innovations that are worth far more to the world than the income they receive? Sure, but if you look at who really makes up the 0.1 percent, it’s hard to avoid the conclusion that, by and large, the members of the super-elite are overpaid, not underpaid, for what they do.

But, having narrowed his focus to the top .1% rather than the top 1%, he argues that the contributions here are largely CEOs and financiers who do not create more value than they are paid.

So it fair to read what Krugman has and hasn’t written as an acknowledgement that the bottom 90% of the top 1% (i.e. those above 99% but below 99.9%) are indeed job creators, many of whom create more value than they are paid, and that therefore we should worry about taxing them at 70%? It seems so to me.

To turn things around, is my above non-criticism of Krugman’s narrower and substantially more modest argument an implicit acknowledgement that he is correct? I think people in the segments of finance and CEOs that Krugman focuses on are less likely to be creating value high paid individuals overall. But what percent of the financiers are venture capitalists? What percent of the CEOs are like those running Google, Apple, and Netflix? The value created by some of these people is massive, and I think the burden of proof that they are on average getting paid more than the value they create is pretty high. I have not seen anyone convincingly overcome that burden of proof. You’re certainly not going to find it in the Diamond and Saez paper Krugman cites, despite the fact that it is of first order importance to the question they’re seeking to answer.

Halt the Crisis: The ECB should announce that it will become Lender of Last Resort for all Eurozone Countries. If I were running the show I would lead this off with a particular show of force. A short term bond issue for which there is heavy short interest I would have the ECB buy into specifically and dramatically to drag bond yields to 1.25%, in an effort to cause the shorts to miss their margin calls and take heavy losses on the issue.

This is not because I have anything against shorts, think they are acting irresponsibly or even initiating some type of implicit attack. Instead, its because I don’t need to waste the rest of the afternoon or god-forbid the better part of a week with markets wondering whether or not I am serious. It will become abundantly clear within the first 10 mins of trading that I am quite serious and prices need to adjust, lest there be more losses of this type.

Replace Individual Sovereign Debt with Eurobonds: The ECB will pull on to its balance sheet all Sovereign Debt of Eurozone Nations are replace that debt with Eurobonds. This process can proceed over the course of weeks or months. With prices stabilized it need not be done fast.

Independent Issues of Sovereign Debt are Banned: Any Sovereign requesting additional funding must come through the ECB and be sterilized with Eurobonds. Rollover issues may be funded at the overnight rate. New issues will be initially funded at the overnight rate plus 2%.

Sliding Scale on New Issues: New Issues of debt, that expand the total stock of debt held by a member country will be funded on a sliding scale voted on by the European Commission. The sliding scale will provide for a penalty rate based on the Primary Balance of the nation in question.

Issue Holds For Violation of EC Rules: A violation of European Commission rules can result in a increase in the penalty rate for new issues or a hold on the funding on new issues.

The Single List is Replaced By Eurobonds: The ECB will accept only Eurobonds as collateral for primary funding operations.

Super-Sovereignty for Eurosystem Banks: Banks which participate in the Eurosystem and receive liquidity under primary funding operations, are no longer under the jurisdiction of member states. They are under direct jurisdiction of the European Commission, with the ECB as their regulator.


Right now, the EC is attempting to use “market discipline” to impose reforms on peripheral countries. As I pointed out from the beginning this is a dangerous game.

It only works if you are actually willing to drive the bond markets over a cliff and if you are actually willing to do this and the markets believe you then you go over the cliff automatically.

It is theoretically possible to thread the needle if you know that the peripheral countries are willing and importantly able to offer unconditional surrender. Then you can creditably halt the train from going over the cliff and everyone knows that you can and so you are safe.

Yet again, as we pointed out earlier, for this to fail all you need is incompetence, not intransigence, on the part of your counterparties. This is the problem with doomsday devices or credible commitments to be irrational, generally.

To solve this the EC should just abandon attempts at market discipline – which are unserious or in any case should not be used by serious people – and replace that with administrative discipline.

Simply require that member states come to the EC or the ECB for financing and that the financing may face a penalty or be outright refused. This means that the EC or the ECB can force a government shutdown without having to force a bond market crisis.

This is the power it really wants. It wants the power to say that Greek retirees will not get their pension checks unless Greece shapes up. It does not want the power to say Greek bondholders will not get paid. You see where that leads.

With this set up the only way a government can get out from underneath the EC’s thumb is by running a cash surplus (not simply a primary surplus) which is what the EC wants anyway.

The concern that people will raise is that this puts “tax payers on the hook” for debts in other countries. I don’t think this is in fact true, though one would have to sit down and look at the numbers.

What it does is puts Eurozone economic growth on the hook for the total debt in all member countries. Remember that now that refinancing operations are conducted only in Eurobonds they are “first at the table” in soaking up savings in the country.

Thus an excess of bonds over desired savings would imply inflation if the ECB took no action and higher interest rates generally if the ECB took action. The outstanding quantity of debt is not so high that I think you would ever need to raise taxes to finance it. The total debt is small enough that it can always be financed through crowding out.

And, since the EC effectively now has the means to force a cash surplus on member nations it can push the outstanding stock of debt down over time.

Martin Wolf has a better grasp on the Eurozone crisis than most nonetheless he still writes.

So what is to be done? Last week, I moderated a discussion of this topic at a conference in honour of Paul de Grauwe of Leuven University in Belgium. I concluded that the eurozone confronts three interwoven challenges. The first is to manage the illiquidity in markets for public debt markets. The second is to reverse the divergence in competitiveness since its launch. The third is to create a regime capable of ensuring less unstable economic relationships among its members. Behind this list is a simple point: people have to believe that members will fare better in than out if they are to trust in the euro’s future.

No, they do not.

They need to believe two things

1) If they short Eurozone member bonds they will lose money

2) If they hold Eurozone bonds to maturity they will receive the principle and interest that are listed on the bond.

This is the alpha and the omega, the beginning and the end of this issue. Nothing else matters, because as long as these conditions hold it is always profitable for Euro holders to buy bonds at the prevailing risk free yield.

And, importantly someone must hold as many Euros as the ECB decides to print.

Now, the Euro itself could crash in value. That is, while the desire of Euro holders to themselves hold bonds is determined only by those two factors. Some folks could decide they would rather not hold Euros at all. This would put downward pressure on the exchange rate of the Euro in international markets. You would have a currency crash, not a bond crash.

However, given that the Eurozone is in current account balance, European debt is denominated in Euros, European foreign assets are denominated in dollars and the sheer size of the Euro area a massive crash seems unlikely and a small crash would be a clear net positive for Europe.

No one needs to be convinced of the general desirability of the European project or the long run prospects of the members. They need to be convinced that selling European Sovereign debt is not a way to earn profit.

“We’ve seen six straight months of year over year gains for new vehicle sales, which shows positive momentum for the auto industry, ” said Jesse Toprak, Vice President of Industry Trends and Insights for  “There is a strong possibility that we could reach a 14 million SAAR next month.

Link. HT Calculated Risk

Kevin Drum posts a nice summary of the concerns about European Pull back in the shadow banking system.

Translated, this means that as sovereign debt woes get worse, bank woes get worse too. And as bank woes get worse, sovereign debt woes get worse. The result is a vicious circle that produces a big credit contraction, and since European banks have become so important as funding sources to the U.S., it means a big credit contraction in the U.S as well.

Its still not clear to me that this poses a major threat to the United States. At least, through this channel. This is especially true because, unless I am mistaken here, the way European banks are providing additional credit is by raising funds in the money markets and then purchasing Asset Back Securities.

However, these are not markets in which European banks have unique advantages. As they retreat American banks can step in to provide liquidity. Further American banks currently have about $1.6 Trillion in excess reserves, so that shouldn’t be an issue, so liquidity strains shouldn’t be an issue.

In short, I see no particular reason why this action short spark some sort of generalized run in the shadow banking system. The US banks can pick up the slack and have more than enough reserves to quell fears of illiquidity.

The issue, I see, comes from losses that might occur from exposure to Europe.

Justin Wolfers continues to remind everyone that we have two measures of the size of the US economy, Gross Domestic Production and Gross Domestic Income.

It turns out that GDI is more accurate in real time that GDP.

That’s true.

However, a couple of things

1) My understanding is that were we get most of the movement is on inventories and imports. If we look at Final Sales of Domestic Product its much more stable under revision that GDP.

2) I, at least, can’t get much out of the GDI report. It breaks things up into where people got their income from: wages, profits, interest and rent.

However, with exception of rent that doesn’t tell me a lot about what’s going on in the economy. Especially, when we think we are dealing with demand constrained output, what we are interested in is the proximate sources of demand. We get that out of GDP, not GDI.

So while GDI is something of a guide to revisions, I think we should be careful about discounting the GDP tabulation too much. Its still our most comprehensive source on the real time movements in the economy.

Adam pushes back on Paul’s assertion that we lose nothing if we lose the “job creators”

Here is Paul

Yet textbook economics says that in a competitive economy, the contribution any individual (or for that matter any factor of production) makes to the economy at the margin is what that individual earns — period. What a worker contributes to GDP with an additional hour of work is that worker’s hourly wage, whether that hourly wage is $6 or $60,000 an hour. This in turn means that the effect on everyone else’s income if a worker chooses to work one hour less is precisely zero.

Adam responds

I think that many high skilled, high paid workers, and job creators in the U.S. can be an important deviation from this general rule. Many of these people work at moving the productivity frontier forward, and thus increasing the marginal productivity of other workers. After all, one of the important things that entrepreneurs do is find ways to increase the productivity of other workers so they can underprice their competitors.

Yet we don’t actually need any deviation from standard neo-classical general equilibrium analysis.

The problem was with Paul’s period. He stopped with one person, one hour. However, most people suspect that we are dealing with more than a single man-hour here.

Let’s review.

The underlying assumption here is that the economy is an optimizing machine. And, we know that a the optimum, the marginal products of any factor are equal to the factor price and that the cross marginal products are equal to zero.

However, this holds only at the optimum. Any deviation away from the optimum will cause the condition to fail and prices and quantities will need to readjust to bring the economy back into line.

If that sounds to abstract imagine the following claim: Every factor of production is paid its marginal product, including crude oil. So, if crude oil imports to America are restricted the impact on real wages and income for everyone in America would be precisely zero.

That doesn’t sound right.

Well, it would be right if we were talking about 1 barrel. The effect of 1 barrel of crude oil on the US economy is about the price of the barrel. Restrict the barrel and we lose that positive affect but we also lose having to give up what we paid for it.

However, as you continue to increase the number of barrels you restrict the marginal product of each barrel rises and the marginal product of most everything else in the economy falls.

The way we experience this is that when there is a sharp restriction on imports of oil – because of a war or something – we see the price of crude oil rise and the real incomes of most Americans fall.

The same thing would happen with the “job creators.”

If we discouraged them from showing up to work, the price of job creators would rise and the real incomes of most Americans would fall.

A side point that I often see missing in this story is also the following:

Most measures of income inequality in the United States and elsewhere look at pretax income inequality or the income share earned by the top 1%. However, raising taxes on high income earners should cause both of these things to rise.

That is, it should increase our measures of income inequality.


Well, contracting the supply of high income earners will cause the pre-tax incomes of those who remain to go up. It will also cause the pre-tax income of the rest of the economy to go down.

If you tracked the total incomes of the folks who were in the top 1% before and after the tax increase you might find that this quantity went down. However, that’s not what you are tracking. You are tracking the incomes of the folks who explicitly remained.

That is, you are removing those who were pushed out by higher taxes from the sample. The remaining tax payers should then have even higher incomes.

The underlying assumption here is that the extensive margin dominates the intensive margin, but I think we all believe that.

Conversely, however, if you lower taxes and you see income inequality rise, as a result, your first guess should be that your labor supply curve is backward bending and that lower taxes actually caused some high skilled folks to stop working. Thus raising the incomes of the remaining high skilled workers.

Tyler Cowen looks at the massive scale of ECB bond buying and asks

There is a longer discussion here.  One way to read this is: “That’s not yet a lot.”  Another is: “Oh my goodness, they’ve already been doing quite a bit.”  Another is: “Lots of buying without a credible signal of future intent isn’t worth a whole lot.” I would stress the point that credible long-run signals don’t exist for Europe right now.  No one knows what “the game” will be like a year now, or less.  That makes all possible solutions harder to pull off, since announcements can be shrugged off as idle chatter.

My obvious position is that you can buy all the bonds you want and it means less than a promise to buy bonds.

More importantly, such a promise cannot be dismissed as idle chatter.

The thing many economists are missing in this whole discussion of Europe, bond prices and the like is an understanding of the motives of bond traders.

Ultimately bond traders are looking to make money. In the short term you might be looking to support a liquidity position or something, but at the end of the day everyone is looking to increase profitability.

If the ECB stands ready to buy bonds at par for example, then how can it possibly be profit maximizing to sell bonds at below par? It doesn’t matter what the fundamentals are or what the long run is or any of that. So long as you are fully confident that tomorrow you can sell your bond to the ECB at par, it is not sensible to sell it below par today.

This means interest rates on Sovereign Debt collapse if the ECB stands ready to trade.

Now, someone could come in and attempt to break the ECB. That is you could say to yourself: I don’t think the ECB really means it. They will fold if they are required to buy more than X bonds.

Then you attempt to short sell them X+1 bonds so that they will break, the price of the bonds will collapse and you can rake in a ton of money. This is a fairly high stakes game and the ECB is very large, so its not clear who will play it.

More importantly, while I definitely see the ECB as the type of institution that would dither while Europe burned and don’t at all see them as the type of institution that would give in to a speculative attack.

I feel pretty confident that they would double down against the speculator and ruin him or her as a matter of principle. Moreover, anyone who is going to loan you the bonds for this attack has got to be worried that the ECB is going to ruin you.

So, I find it unlikely that an attack will be successful.

Lots of the latest numbers are coming in well. New Claims for Unemployment insurance are moving in the right direction and at the right pace.

Importantly, the factors are aligning for the economy to “kick” that is enter a self-sustaining period of more rapid expansion. Looking at the labor market, the commodities markets and until recently the capital markets, there are no major impediments to the kick which means it could reach a pretty high speed. We could be talking about up to 5% or 6% growth by the end of 2012.

Now, I say a caveat because the obvious problem is Europe. If Europe goes very bad, well so does the Global Capitalist System. However, even Europe going marginally bad can put a major crimp on US growth.

If Europe goes even marginally bad then that is going to send money flooding towards the United States. That in turn will raise the dollar and crimp US exports. This is a bigger deal than the reduction in pure European demand from a recession because it will affect US industrial imports and exports around the world, not just high margin tech exports.

The money also doesn’t do the US any good unless it increases bank lending. And, with banks already sitting on an extra trillion in reserves its likely that a title wave of cash from Europe will simply join that pile.

Even worse disruptions in the European banking system could cause a contraction in bank lending here as banks are worried about their exposure.

Some people have mentioned concern that Europe’s pull back from the Shadow Banking system could cause problems. A pullback causing problems seems unlikely to me at this point: again because there are so many reserves sitting on the sideline.

There is plenty of cash to flood into the repo and commercial paper markets, so long as no one is worried about exposure to Europe. However, I am sure that people will be worried about exposure to Europe.

In any case right now everything hinges on the other side of the Atlantic. The ECB could make this problem go away for everyone, including the US. However, I am not holding my breath.

Paul Krugman has some words for job creators and other high skilled people: we don’t need you.

…textbook economics says that in a competitive economy, the contribution any individual (or for that matter any factor of production) makes to the economy at the margin is what that individual earns — period. What a worker contributes to GDP with an additional hour of work is that worker’s hourly wage, whether that hourly wage is $6 or $60,000 an hour. This in turn means that the effect on everyone else’s income if a worker chooses to work one hour less is precisely zero. If a hedge fund manager gets $60,000 an hour, and he works one hour less, he reduces GDP by $60,000 — but he also reduces his pay by $60,000, so the net effect on other peoples’ incomes is zip.

First let me just say that the extent to which what people earn is equal to their marginal product is greatly unappreciated, so before I disagree with Krugman I just want to pause and point out that this is truer than most people think. But it’s not true everywhere and always. Note that Krugman does not go so far to say that marginal product *does* in fact equal income, but that “textbook economics says that in a competitive economy…”, and that job creator praise is not “something that comes out of the free-market economic principles these people claim to believe in”, and that “Even if you believe that the top 1% or better yet the top 0.1% are actually earning the money they make…”.

He doesn’t actually say “people earn what they make”, nor does he say how good of an approximation to reality marginal product theory is. But in his economics textbook with Robin Wells, they are a bit more explicit, and do call the marginal product theory a pretty good approximation:

The main conclusion you should raw from this discussion is that marginal productivity theory is not a perfect description of how factor incomes are determined, but that it works pretty well. The deviations are important. But, by and large, in a modern economy with well-functioning labor markets, factors of production are paid the equilibrium value of the marginal product -the value of the marginal product of the last unit employed in the market as a whole.

This is a really important point, and I don’t disagree. But I think that many high skilled, high paid workers, and job creators in the U.S. can be an important deviation from this general rule. Many of these people work at moving the productivity frontier forward, and thus increasing the marginal productivity of other workers. After all, one of the important things that entrepreneurs do is find ways to increase the productivity of other workers so they can underprice their competitors. The process of creative destruction is not manna from heaven. I won’t pretend to know have all the answers about what drives this process, but entrepreneurs, job creators, and high skilled people are an important part of it.

Consider, for instance, that if we suddenly kicked out the top 10% of high IQ people (or 10% most productive people, or 10% most creative people, or whatever) in the U.S.. It strikes me as fairly likely that the total output of the remaining 90% would go down. Krugman seems to argue that this would not be the case. But even if you disagree with me in the short run, in the long-run the productivity increasing innovations these people would have made won’t show up, and the rest of us would have lower productivity as a result.

Now, instead of kicking out the top 10% of workers, just make them work less as a result of high income taxes.  See my concern?

Lowered incentives of job creators and other innovators should be considered as one of the likely downsides to higher taxes.

Note that if you don’t think this is true, then what business do we have subsidizing higher education? If workers capture the entirety of their higher productivity, then I don’t see who gains by giving young people money to go to college rather than just cash.

The group tasked with finding a plan to cut the debt by $1.5 trillion or more has failed to come to an agreement. If you’ll recall, two of the the ratings agencies, Moody’s and Fitch, recently reaffirmed the AAA status of U.S. debt, while S&P downgraded them one notch to AA+. Will the Super Committee’s failure lead to more downgrades? Well nobody is downgrading immediately, but this certainly doesn’t help the odds of preserving AAA status.

S&P has already announced that they will not downgrade as a result of the Super Committee failure, which is not a surprise. In their original downgrade statement S&P cited the debt panel failure part oftheir down-side scenario that they would regard as “consistent with a possible further downgrade to a ‘AA’ long-term rating”. However, that down-side scenario also included other bad things occurring, like higher nominal interest rates for U.S. Treasuries, which have not surfaced.

However, it’s hard not to see the failure of this committee as reaffirming one of S&P’s chief concerns, which is essentially that politicians can’t come to agreement. As they said in their downgrade statement:

Our opinion is that elected officials remain wary of tackling the structural issues required to effectively address the rising U.S. public debt  burden in a manner consistent with a ‘AAA’ rating and with ‘AAA’ rated  sovereign peers (see Sovereign Government Rating Methodology and Assumptions,”  June 30, 2011, especially Paragraphs 36-41). In our view, the difficulty in framing a consensus on fiscal policy weakens the government’s ability to manage public finances and diverts attention from the debate over how to achieve more balanced and dynamic economic growth in an era of fiscal stringency and private-sector deleveraging…

If you’re concern is that the government is unable to work together and come up with the right solutions to long-term debt problems, it’s my position that the super committee failure should make you more worried. But it’s not necessarily the case that S&P sees it that way. And I see nothing in their August downgrade statement that commits them to further downgrades now that the super committee has failed. If some or all of the automatic cuts end up being nullified, then S&P’s previous statements certainly indicate the risk of a downgrade will go up. How much remains to be seen.

How about Fitch? I’ve read some commenters saying that the failure to come to agreement is actually good news, but Fitch does not see it this way. In their previous statement affirming AAA status they committed themselves more explicitly than S&P:

An upward revision to Fitch’s medium to long-term projections for public debt either as a result of weaker than expected economic recovery or the failure of the Joint Select Committee to reach agreement on at least USD 1.2trn of deficit-reduction measures would likely result in negative rating action….

Agreement and passage into law of a credible set of deficit-reduction measures of at least USD1.2trn by end-2011 would be consistent with Fitch’s own fiscal projections and demonstrate that a sufficiently broad-based political consensus can be forged on how to reduce the budget deficit and provide a platform for the additional measures that will be required over the medium to long term. In the event that the Joint Select Committee is unable to reach an agreement that can secure support from Congress and the Administration, Fitch would be less confident that credible and timely deficit-reduction strategy necessary to underpin the US ‘AAA’ sovereign rating and Stable Outlook will be forthcoming despite the USD1.2trn of automatic cuts that would follow.

So even if the automatic cuts go through as planned, Fitch has previously committed to being “less confident” in the maintenance of the AAA rating. While one can read S&P’s downgrade statement as being concerned about the kind of inability to agree that the Super Committee failure represents, Fitch has come right out and said that they would regard it negatively. Their statement that the failure of the committee would “likely result in negative rating action” is certainly suggests to me that a downgrade will be forthcoming.

All I’m seeing from Moody’s right now is a statement that this news is “informative but not decisive” in it’s decision whether or not to downgrade. This seems to approximately sum up the position of the other two agencies as well, although Fitch’s previous statements look to me to be the most hawkish in terms of how they will view this. I’m in agreement with the ratings agencies, I don’t think this failure is good news.

Android app + machine that mixes drinks. As Paul Krugman notes in his “futurism article“, most things that symbolic analysts do can and will be automated. Add to that category (unsurprisingly) repetitive remedial tasks. This, of course, reduces the marginal product of bartenders to zero for people who eschew witty banter and simply want a drink. On the plus side, you would never have to ask a bartender if he knows how to make a particular drink (I’m not creative with drinks…).

However here is a developing point; In any society, people should be able to dream up jobs for other people to do (for example, at one point in history, ironing newspapers was someone’s job). In reality, that may require some changing mores about what is considered paid work. The second part of this point is that I think as specific human interactions become more rare, they become more premium, that is, the marginal product of simply being human and having a particular skill rises (and if economics is any guide, extremely rapidly). That doesn’t bode well for the quantity of jobs, but it does for the quality of reproduction.

Keep in mind, however, that up to this point society has seen it fit to heavily subsidize areas of the economy which have already suffered from this phenomenon (arts, music, farming).

P.S. I think that the future will see the rise of complementary currencies — money with different mechanics than legal tender — which will facilitate this type of human interaction. I think a lot of economists overlook this possibility in their futurist extrapolations. Many try and shoehorn the current rules into their interpretations…but I think that kind of brushes aside fundamental concept in economics: incentives.

Via David Wessel, I see that the University of Chicago has a new website with a panel of elite economists answering weekly questions. Tyler is skeptical, but I am already finding it interesting. Here, for instance, is one of the first questions posed:

Federal mandates that government purchases should be “buy American” unless there are exceptional circumstances, such as in the American Recovery and Reinvestment Act of 2009, have a significant positive impact on U.S. manufacturing employment.

The results are overwhelmingly against the statement. Of the 41 respondents, only 4 agree. One of them is Daron Acemoglu who, cites the work of David Autor:

4 years ago I would have disagreed. Recent evidence (Autor Dorn Hanson) suggests yes.Caveat: costs from higher prices & other inefficiencies -see background information here

Yet a few positions down in the experts panel, Autor himself disagrees, and seems to disagree that his study is useful analysis here:

Hard to believe this does much at all. But I’m speaking based on my prior. I’ve not seen any rigorous analysis.

I would like to see more from this website. A great follow-up to this would be a conversation between Autor and Acemoglu about the extent to which Aturos’ work is applicable to the question.

Steven Landsburg has an Op-Ed on the super-committee that is more or less right as it goes but, I think leaves the wrong impression. He says

Here’s another way to say essentially the same thing: The government’s chief asset—in fact, pretty much its only asset—is its ability to tax people, now and in the future. The taxpayers are the government’s ATM. Make a withdrawal today, and there’s less available tomorrow.

Now the ability to tax is a pretty huge asset and the government has not (yet!) come close to depleting it. In that sense, there’s a lot of money in the bank. But no matter how much you’ve got in the bank, a policy of ever-increasing withdrawals is nothing at all like a decision to earn more income. It’s important to get the analogy right. And it’s clear from the blogs and the op-ed pages that not everybody gets this.

Instead, the notion persists that an extra trillion in federal spending can be converted from "irresponsible” to "responsible” as long as it’s accompanied by an extra trillion in tax hikes. That’s like saying a $500 haircut can be converted from "irresponsible” to "responsible” as long as you withdraw the $500 from your bank account. If the super committee loses sight of this fundamental truth, it is doomed to fail.

This is correct. However, seeing this I think should help people understand why its not really sensible to say that current or even project federal spending is irresponsible or unsustainable.

It may be undesirable, in that you wish the government was smaller but there is nothing irresponsible about it in the sense that it is exhausting the government’s ability to either forcibly take command of or direct the allocation of real goods and services.

As is often the case this deserves a more detailed response than I am going to give it but I wanted to address these observations by Tyler Cowen before they went cold.

Tyler says

The population of Germany is about 81 million, if you wish round that up to about 100 million, if you include some of the smaller Triple A countries.  In other words, that is a guarantee of $30,000 per German, or $120,000 for a household of four.  Note in passing that an ECB guarantee either requires recapitalization of the central bank or a higher rate of inflation, unless you think the whole thing is a self-sustaining free lunch and all the liquidity problems would vanish (unlikely, at this point).  In any case a guarantee has to at least put resources on the table.

The core issue is that there are no lunches on the table. Italy for example currently runs a primary surplus. The central government is not extracting any resources beyond its ability to tax. What is at issue is competing private claims on private sector resources.

To get to the heart quickly imagine this: The Italian government looks at the bond market and says, “Oh screw us? No, no, no my friend, screw you.” Default. Boom. We’re outa here. [Mario Monti drops microphone, exits stage right]

What’s the stage one effect for the Italian central government? They move from a budget deficit to a budget surplus. That is, currently they are running a primary surplus. They don’t need the bond market to fund their operations. They need the bond market to fund the claims of bondholders.

The problem comes from the fact that the financial system is not indifferent to the distribution of private claims. This is why Europe faces a crisis. I remember William Buiter arguing in the middle of the subprime collapse that the US could not go into recession because housing wealth was not wealth.

The mistake he made then and the issue now is that total wealth or productivity is not what matters. Vastly more important for the functioning of the financial system is that there are no sudden unexpected changes in the distribution of wealth.

That is, to say its not a matter of some how getting a free lunch. It’s a matter of making sure that the lunches we do have are distributed in the manner in which people expected them to be distributed.

A couple of Market Monetarists seem to be suggesting that the ECB should forget about standing as Lender of Last Resort and instead simply focus on a Nominal GDP level target of perhaps 4% or so.

There is a part of me that is twisted enough to want them to do this just to see what would happen.

Off the cuff I can see a couple of possibilities

Scenario One: The market believes the target and concludes that this means the periphery countries will be able to self-finance. Spreads collapse, the money supply expands rapidly and Europe emerges from its current double-dip in six to nine months.

Scenario Two: The market believes the target, but concludes that the result will be extremely rapid near term real growth and inflation in Germany, with matching stagnation in the periphery. Spreads on sovereign debt continue to expand, there is wide spread default and we enter Post-Apocalyptic Nominalism.

Scenario Three: The market doesn’t believe the target, spreads continue to rise, there is default and we enter Post-Apocalyptic Nominalism.


Now what does this Post-Apocalyptic world of NGDP targeting look like? Its not immediately clear because we could have complete collapse of the banking system. At that point we have to ask how the ECB is going to go about injecting money into the economy.

One way, however, would be via bond purchases. This is interesting because it we have a world were the supply of money is rapidly collapsing as the banking system descends into oblivion. Real output is collapsing and deflation is setting in.

Yet, in order to hit its target the ECB has to be devoted to increasing the money supply. Presumably this then means very aggressive bond buying from any institution that can issue bonds that the ECB determines to have low default risk.

That opens the door for the ECB to wind up funding bond purchases at highly negative nominal rates. This would allow a small set of player to build up massive economic empires in the wreckage, possibly large enough to draw Europe out of depression but into a world in which European wealth was concentrated into very few hands.

Now why do I see highly negative nominal rates. Isn’t there a Zero Lower Bound on nominal rates.

There is a ZLB if you have a place to safely stockpile cash or reserves. However, you don’t because the banking system has been annihilated.  There is also a ZLB – or something close – if you have a competitive market for borrowers. However, you don’t because in post-Apocalyptic Europe the number of institutions eligible to have their bonds purchased would be tiny.

You also have a ZLB if lenders are attempting maximize profits but the lender is the ECB and it is committed to expanding the money supply in order to hit its NGDP target.

So, you have removed the constraints that create the ZLB opening the door for negative nominal rates for a few key players who will then become massive wealthy.

Non Residential Fixed Investment in Equipment and Software – what most people are thinking of when they use the word investment – has been surging over this recovery.

Here is levels

FRED Graph

Here is growth rate

FRED Graph

I’ve seen some private analysts reports that have this slowing down over the coming year, presumably because we will return to trend. They are looking at this as a bounce back.

Right now, I don’t see any reason to think that’s true. As absolutely insane as it sounds, my baseline has to be for the growth here to accelerate in 2012.

That’s because we you decompose this you see that its not really the case that “Business Investment has returned to trend”

What happened is that the non-tech parts of business investment – transportation equipment largely – got hammered right along with the rest of the economy and was slow to come back.

However, investment in Information and Communication Technology took an ever so slight dip and then turned back northward at a slightly higher rate than it was moving before the recession.

Thus the recovery in business investment is the fact that tech has been blowing it out of the water and everything else is just now starting to come back online.

Well everything else has a ways to go before it returns to trend and everything else usually lags construction. Thus, if anything you would expect an uptick in construction to drag up non-tech business investment at an even faster rate.

Now Information and Communication Tech could slowdown but its not clear why that would be the case. Its not really clear what’s going on in that space aside from the possibility of

(A) Measurement error. This is a real issue here.

(B) Paradigm shift.

Indeed, assuming the measurements are right, it looks like a paradigm shift began in the 1990s stalled out for a bit in the early 2000s, started to kick back in gear in the late 2000s and hasn’t stopped since.

Sorry I didn’t produce charts on all of this but the detailed data comes from the BEA and they make it a bit of a pain to get the charts out.

Via Calculated Risk, JD Power is calling for 13.4 SAAR.

That looks a little low to me. I would expect a bit stronger contribution from fleet sales. However, I wouldn’t seriously dispute it. Looking for 13.4/13.5 in November and if anything – right now – I would expect a December bump.

Nice contribution from autos for Q4 GDP.

First just a note on Brad’ chart about the BBB spread. IIRC the ML BBB effective yield does not map directly on to the 10-year. However, ML does produce its own spread analysis over spot Treasuries.

FRED Graph

Same general effect but the relative magnitude of recent movements is a bit less.

More substantively Brad says

Suppose we tried monetary policy to move the IS curve:

Announce that we will buy bonds for cash all along the yield and risk curve when the 10-Year nominal Treasury rate was less than 4%/year and keep doing so until it hit 4%/year; announce that we will sell bonds for cash all along the yield and risk curve when the 10-Year nominal Treasury rate was more than 4%/year and keep doing so until it hit 4%/year.

Why wouldn’t that be an absolutely fine monetary policy? Wouldn’t that be a much better than the one we are following now, wouldn’t it?

My guess is that you are likely to get some sort of knife-edge instability here if you are standing ready to trade in unlimited quantities.

So, if people expect the yield to 4% and it is we are fine. Now, suppose some shock hits the US economy and drops the expected yield. The Fed then buys Treasuries to expand the money supply. This will raise expectations of future growth and in principle, raise the yield on the 10 year back to where it was.

However, how is the 10 year going to actually get there when as long as its below trend level the Fed keeps applying downward pressure on the yield by buying? You in effect have the problem that: the Fed can stay irrational longer than you can stay solvent.

You want to sell the 10 on expectations of future growth but you can’t profitably do this because you know the Fed is committed to unlimited buying so long as you are not selling more than they are buying. Thus, the stability condition is something the private market can never satisfy.

The way this could work is that the Fed promises to buy X amount every Tuesday unless the close on Monday was 4%. Thus the market has time to rationalize without being offset by Fed action.

I think that could work.

One thing I have noticed over the past couple of months is that a number of libertarian thinkers have a deep disdain for the “insights” of the man on the street.

From what I can tell one of the reasons Bastiat is so popular is because of his ability to use reason to dismantle the prejudices of the common man.

A current point that I am making at here at Modeled Behavior and in private correspondence is that Bastiat was actually “wrong” about a lot of stuff, and wrong precisely in that he did not acknowledge the effects the “man of the street” was talking about.

Now, when I say “wrong” here, I don’t mean that is logic was flawed. In most cases it appears to me that his logic is pristine. What was wrong were his maintained assumptions about the actual properties of the world. In particular, he has a bunch of maintained assumptions about money that are not actually accurate.

Money doesn’t behave the way he assumes it does. And, importantly he doesn’t take devote a lot of time to the discussion of money itself, he just basically assumes the core properties of an economy that would make money non-neutral and then works from there.

Unfortunately those properties do not hold in real life.

Now, this connects to one of my long theses this way. If you find that you are ridiculing common sense, in a way that makes it seem as if common sense is baseless then you are probably missing something.

This is because common sense lies – as Hayek might have said – between instinct and reason. It has evolved over generations of folks dealing with each other.

And, importantly it does not depend on reason itself. People don’t have to have any understanding of why they believe what they believe for what they believe to be usefully true. That is, operating as if the world was this way informs you about the world.

A reasoned theory of the world should acknowledge this anchor. In some way our reasoning should accommodate common sense. Either as a special case, or as an approximation, or as a local maximum or something.

Otherwise, you have a hard time explaining why common sense has stood the test of time and cultural selection.

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