Z: **Inactive:** Brad DeLong--Economics Only

The Small Place of Economists in a President's Mind

From Douglas Brinkley, ed. (2007), The Reagan Diaries (New York: Harper Collins: 9780060876005).

It is interesting--but depressing--to recognize that Ronald Reagan did not know the difference between a group of prominent outside economists brought in to the White House compound for a day or so--an economic advisory council--and the economists on his personal staff who worked for him--the Council of Economic Advisers, a group of three who were headed during the Reagan administration by Murray Weidenbaum, Marty Feldstein, Bill Niskanen, and Beryl Sprinkel:

Thur Dec 10 1981: Met with Council of Ec. advisors. While one or two spoke of possible tax increases after 1982 the others (majority) said no. Tax increases don't eliminate deficits they increase govt. spending. The general consensus was that our plan is the proper medicine for the recession and we should stick to it. That's what I intended to do all the time.

Justin Fox on the Washington Post's take on Cheneynomics

Compared to the rest, this is boring--but important:

The Curious Capitalist: Today brings us the economic-policy chapter of the big Washington Post series on how Dick Cheney runs America. It's not nearly as dramatic or sinister.... Economic policy is like that, I guess.

One big takeaway is that economic policy in the Bush administration is run not by the Treasury Secretary... but by the Vice President.... [P]olitical considerations, combined with a very facile supply-side view of how the economy works, that drove Cheney's thinking on the subject.... Cheney leaves behind on the economic front... persistent budget deficits (albeit, I always feel obliged to point out, much smaller deficits relative to GDP than those of the 1980s and early 1990s), an economy that's still growing and dynamic but has clearly seen better days, and a bunch of huge, as-yet unresolved problems, from the U.S. trade relationship with China to the future funding of Social Security and especially Medicare. Apparently Cheney was against the expensive new Medicare drug benefit, but he was accommodating enough to let the President have his way on that.

Oh, and one other interesting moment in the article. Ed Lazear apparently needed Cheney to tell him that the mortgage-interest tax deduction is popular:

When Edward P. Lazear, chairman of the White House Council of Economic Advisers, broached the idea of limiting the popular mortgage tax deduction, he said he quickly dropped it after Cheney told him it would never fly with Congress. "He's a big timesaver for us in that he takes off the table a lot of things he knows aren't going to go anywhere," Lazear said...

This is really too bad. One role of the CEA is to keep chipping away at issues that are not politically possible now, but may become so in ten years. Curbing the mortgage interest deduction is one of these.

The Social Impact of Microsoft Once Again

Here's a comment http://delong.typepad.com/pdf/20070626-thoma-barro-microsoft.pdf on Robert Barro's claim that the social value contributed by Bill Gates is roughly equal to Microsoft's total revenue:

Bill Gates's Charitable Vistas - WSJ.com: In 2006, [Microsoft's] revenue was $44 billion, with earnings of $13 billion. This money was generated by creating something consumers value. Only Microsoft's competitors could believe that this much market value, revenue and earnings would have been created by delivering products that have little value to society. Suppose that a copy of a new version of Windows sells for $50 (and is typically charged as part of the price of a personal computer). Microsoft's revenue from Windows would then equal $50 multiplied by the number of copies consumers snap up. Microsoft's earnings are the revenue less production and development expenses. But that's not the social value. That comes from the increase in productivity created when businesses and households use the software. The social benefit equals the value of the extra product, less the total paid for the software. Almost by definition, the benefit has to be positive. Otherwise, why would consumers willingly pay for Windows? A conservative estimate, in a model where software serves as a new variety of productive input, is that the social benefit of Microsoft's software is at least the $44 billion Microsoft pulls in each year.... Mr. Gates is free to do what he wishes with his $90 billion. But I think he is kidding himself if he believes that the efforts of the Gates Foundation are likely to provide society anything like the past and future accomplishments of Microsoft. And, frankly, I would have preferred to get the $300 per person "Gates Grants."

Barro's defense of this claim is at http://economistsview.typepad.com/economistsview/2007/06/robert-barro-sk.html#comment-73987582.

I don't buy it. Barro's model doesn't address the major issues that have to be dealt with in assessing the social utility of Microsoft:

http://delong.typepad.com/sdj/2007/06/mark_thoma_is_i.html: Whether the net social value of Bill Gates is positive or negative depends on his impact in creating and shaping Microsoft: relative to its competitors and to its alternative paths of development, did he make it more of a lockin-breaking innovator or a death zone-creating predator? Did he do more to make Microsoft a company that takes advantage of economies of scale or more to make Microsoft a company that raises profit margins? I'm on the side that thinks that Microsoft has been a considerable net plus. But others I respect see it is a net minus...

And I don't think Barro uses his own model correctly. He gets to the conclusions that the ratio of the social value of Microsoft to its total revenue is (a) roughly one, (b) does not depend on how substitutable Microsoft's products are with those of other intellectual-property holders, and (c) depends primarily on the share of "idea factors" relative to "standard factors" in the economy's production function. These seem to be wrong: artifacts of an extra term Barro adds to the production function in order to get a balanced-growth path out of the model.

Proper use of Barro's model leads, I think, to the conclusions that:

• The ratio of the social value of Microsoft to its revenue could be very big--much more than one--or very small--much less than one--and there is certainly no reason to think that it is about one.
• The ratio will be large to the extent that Microsoft's goods are radically different from those of others, and small to the extent that Microsoft's goods have close substitutes made by others.
• As long as Microsoft's goods are not radically different from those of its competitors, the share of "ideas" in the economy's overall production function has relatively little to do with this ratio.

But, as I said, the big issues with Microsoft have to do with its effect on the pace of innovation. Was it a lockin-breaking innovator that provided a platform--shoulders on which others can stand? Or was it a death zone-creating predator that discouraged innovation and experimentation in broad market segments? My reading is that it was more of the first. But I am happy to be educated.

Ezra Klein: Every Man A Doctor, Purchaser, and HMO

Oh, this is funny--in a sick sort of way:

Ezra Klein: Every Man A Doctor, Purchaser, and HMO: It's pretty funny to watch Michael Cannon explain how, if you didn't hurt yourself too badly, and you happen to be a professional health care expert deeply steeped in theories of consumer cost control, you can use an HSA to bring down costs on your torn ACL. So we get lines like "I heard a tear, not a crack — which suggested soft tissue damage, but no broken bones. The only reason I used that information to rule out an X–ray was because I had a financial incentive to avoid unnecessary spending." That's all for the good, when it's all for the good. On the other hand, that's just a hop, skip, and a jump away from "She had shortness of breath, but no radiating arm pain, so she decided to wait through the weekend because she couldn't afford the ambulance ride. She died."

That's not my collectivist impulses spinning some implausibly hellish scenario, by the way. A recent study looked into what happens if you increase cost sharing on pharmaceuticals in Medicare. In other words, what happens when the patients have what Cannon calls a "financial incentive to avoid unnecessary spending." The answer? "[S]ubjects whose benefits were capped had higher rates of nonelective hospitalizations, visits to the emergency department, and death. In addition, subjects whose benefits were capped had lower pharmacy costs but higher hospital and emergency department costs, with no significant difference in total medical costs between the two groups."

They did try and bargain down care, and even skip some pharmaceuticals. But their choices led to neither better outcomes nor lower spending. Instead, they died more often, and we paid for their ambulance rides more frequently. Everyone's a loser!

What is the true social marginal cost of an x-ray, given that Michael Cannon is already using the doctor's time for a diagnosis? $50? Is there a chance an x-ray might pick up something bad that an MRI wouldn't? Does Michael Cannon really want to gamble on his ability to distinguish a "tear" from a "crack" in the middle of a soccer game? Apparently he does.

Poor John Updike. Poor New Yorker. The Great Depression Once Again

Oh, this is sad. Really sad. Depressing. And pathetic. It is really too bad that the New Yorker gave Amity Shlaes's book about the Depression, The Forgotten Man to John Updike to review. A competent editor would have chosen a reviewer who knew economics and history. But Updike is lost from the start:

Laissez-faire Is More: [Shlaes tells us that the 1929] crash preceded an underlying problem, deflation, caused by not enough money in circulation as banks failed and shut their doors; a number of dollar-starved communities—Salt Lake City; Ventura, California; Yellow Springs, Ohio—issued their own scrip, while Presidents Hoover and then Roosevelt supported policies, like the gold standard, aimed at a nonexistent inflation...

We need to stop right there. Roosevelt abandoned the gold standard. That Updike thinks that Roosevelt spent the 1930s clinging to the gold standard to control "a nonexistent inflation" is the first sign that he has lost the game of intellectual three-card monte Amity Shlaes is playing with her readers. If Milton Friedman were here, he would blow the whistle at that point.

Updike goes on:

[T]he gravest problem, as Shlaes sees it, was government “intervention, the lack of faith in the marketplace.” Both Presidents tried to lift wages, when letting them sink would have liberated businesses to start hiring and resume business as usual. Business knows best...

Once again, Milton Friedman would blow the whistle if he were here. The main thing reducing the stock of money was bank failures. The main thing causing bank failures was falling prices of all kinds--of real estate, of consumer goods, and of labor. More of what Milton Friedman's teacher Jacob Viner called "unbalanced deflation" would have produced an even deeper depression.

If only Updike knew this. If only Updike knew that nearly all economists--from Milton Friedman to Ben Bernanke to John Maynard Keynes to John Kenneth Galbraith on left--believed that further and faster deflation would have made the Great Depression worse! Here's John Maynard Keynes's argument: "Changes in Money Wages" http://www.marxists.org/reference/subject/economics/keynes/general-theory/ch19.htm. It was written in 1936, and still reads very well today. But nobody told Updike.

Hoove... was a dynamo... he favored government intervention, as long as it didn’t violate his sense of the Constitution, and sought control over economic events that would, according to Shlaes, have gone better if left alone.... Shlaes pursues her thesis through the thirties, few heroes emerge, and the most highly placed two are not apt to figure in many liberal pantheons: Calvin Coolidge and Andrew Mellon. Coolidge... is presented as a kind of Zen saint, a pillar of inaction.... [Shlaes] underlines Mellon’s honorableness, private generosity, and public spirit...

But she doesn't tell Updike that at the bottom of Mellon's personality was a pronounced social-darwinist streak, a belief that you had to be cruel to be kind. And Updike, of course, doesn't know. So he cannot quote Herbert Hoover's retrospective judgment of Mellon, that the policies Mellon had convinced him to follow made the Great Depression much worse:

[T]he “leave it alone liquidationists” headed by [my] Secretary of the Treasury Mellon... felt that government must keep its hands off and let the slump liquidate itself. Mr. Mellon had only one formula: “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate.” He insisted that, when the people get an inflation brainstorm, the only way to get it out of their blood is to let it collapse. He held that even a panic was not altogether a bad thing. He said: “It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people”...

Updike forges on, lost in the swamp, so lost that he is unable to protest Shlaes's libel that that Roosevelt was practically a fascist and her argument--argument--a very serious argument that has never been made in such detail or such care--that Roosevelt wanted to make the government boss people around because he couldn't use his legs:

Shlaes, in a bold stroke of psychologizing, lays the hyperactivity to “the restlessness of the invalid.” She goes on, “Like an invalid, the country took pleasure in the very thought of motion.” More ominous was Roosevelt’s totalitarian tendency: “His remedies were on a greater scale and often inspired by socialist or fascist models abroad.”

Updike watches Shlaes make the claim that that communist Roosevelt hired other commies as New Dealers:

One of Shlaes’s chapter-length detours deals with a junket... to investigate and report on conditions in the Soviet Union.... [T]he economic commentator Stuart Chase.... Stuart Chase upon his return wrote, “Laissez-faire rides well on covered wagons, not so well on conveyor belts and cement roads.” Collectivism was the inevitable direction. After all, Chase wrote, “why should Russians have all the fun remaking a world?” The poisoned chalice was passed around...

But then she doesn't:

But “few New Dealers were spies or even communists,” she reassures the reader....

At the end of his review, Updike tries to fight back:

[T]he Depression slogged on, ending only in 1940, as the government decisively hiked defense spending.... My father had been reared a Republican, but he switched parties to vote for Roosevelt.... The impression of recovery-—the impression that a President was bending the old rules and, drawing upon his own courage and flamboyance in adversity and illness, stirring things up on behalf of the down-and-out—mattered more than any miscalculations in the moot mathematics of economics. Business, of which Shlaes is so solicitous, is basically merciless.... Government is ultimately a human transaction, and Roosevelt put a cheerful, defiant, caring face on government at a time when faith in democracy was ebbing throughout the Western world. For this inspirational feat he is the twentieth century’s greatest President, to rank with Lincoln and Washington as symbolic figures for a nation to live by.

A better New Yorker editor would have chosen a reviewer who at least knew what an aggregate demand curve was. Here's my take:

http://delong.typepad.com/sdj/2007/02/arnold_kling_vs.html: I, at least, think that as far as recovery was concerned the macroeconomic good done by the New Deal vastly outweighed the structural bad. Any reasonable counterfactual involving no New Deal that I can see has things a good deal worse in the middle and late 1930s than they were in our reality.

But there is an argument to be made that an even better New Deal would have been possible, and ought to have been attainable.

Had Milton Friedman been special assistant to and whispering in the ear of Fed Chair Marriner Eccles in 1936-1938, he would have successfully headed off Eccles's boneheaded idea of raising reserve requirements on banks. Then the late 1930s would have been a much happier time. Had FDR given his baton in 1933 to trustbuster Thurman Arnold rather than to cartelizer Hugh Johnson and had the initial round of the New Deal increased rather than decreased the degree of competition in the American economy, then... well, the neoclassical part of my brain thinks that 1934 and 1935 would have been somewhat happier--but the Fundie Keynesian part of my brain thinks that Hugh Johnson's NRA was irrelevant because aggregate demand was a much bigger problem then than aggregate supply....

The New Deal essentially dusted off and implemented the unsuccessful Progressive Era program for the reform of American finance that had been pushed by the likes of Louis Brandeis during the 1900s and the 1910s. And Louis Brandeis was definitely on the side of the upwardly-mobile and the smart and technically competent, as opposed to the side of old wealth and new thrift.... Financial markets function well for the economy only when they do a good job of seeking out and transmitting information.... This requires that people be incentivized to seek out and uncover important pieces of information by being able to profit handsomely from doing so--which requires that there be a bright visible line between what you can do and what you can't, between legitimate research and illegitimate insider trading. The SEC as born in the New Deal has always found it relatively difficult to draw such a bright visible line....

[On the other hand] financial markets also function well only when they mobilize great masses of savings from scattered individuals by giving them confidence that their investments are liquid in that they can be bought and sold at a fair price.... Smart financial regulation attains a point of balance. There is... a general worry that the system the New Deal has left us pays too much attention to the desirability of a level playing field for buyers and sellers, and not enough to the desirability of having truly informed buyers and sellers....

[L]et's not lose sight of the fact that even badly-handled as it was, really-existing deposit insurance [implemented during the New Deal] was a mammoth improvement over no deposit insurance at all. I think that that is a good thumbnail summary of the entire New Deal: badly-handled, but a vast improvement over the preceding system and over the politically-viable alternatives--with the exception, I would argue, of Agriculture Support and the NRA, which did little if any good at immense long-run cost...

Links: I like J. Bradford DeLong's Journal of Economic Perspectives article http://econ161.berkeley.edu/pdf_files/Keynesianism_Pennsylvania.pdf and his still unpublished attempt to get at the guts of the economic advice Joseph Schumpeter and others were giving in 1933 http://econ161.berkeley.edu/pdf_files/Liquidation_Cycles.pdf--what John Maynard Keynes called "extraordinary imbecility." An online for-pay version of Joseph Schumpeter et al. (1934), The Economics of the Recovery Program is at< http://www.questia.com/library/book/the-economics-of-the-recovery-program-by-douglass-v-brown-edward-chamberlin-seymour-e-harris.jsp>. Schumpeter and company were fiercely critical of the New Deal. A contemporary review of their book by Princeton's Otto Nathan is here http://links.jstor.org/sici?sici=0022-3808%28193408%2942%3A4%3C537%3ATEOTRP%3E2.0.CO%3B2-D.

Wikipedia has good background entries on Huey Long http://en.wikipedia.org/wiki/Huey_Long, the Bonus March http://en.wikipedia.org/wiki/Bonus_march, and Father Coughlin http://en.wikipedia.org/wiki/Charles_Coughlin.

For Eichengreen and Sachs on abandonment of the gold standard--which Roosevelt did in 1933--as the key to even partial recovery from the Great Depression: "Exchange Rates and Economic Recovery in the 1930s" http://scholar.google.com/scholar?num=100&hl=en&lr=&safe=off&c2coff=1&client=safari&q=Eichengreen+and+Sachs&btnG=Search

Ben Bernanke's analysis of the role played by unstemmed financial panics, industrial bankruptcies, and bank closings is Ben Bernanke (1983), "Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression," American Economic Review, 73, (June) pp. 257-76 at google scholar >http://scholar.google.com/scholar?num=100&hl=en&lr=&safe=off&c2coff=1&client=safari&q=Nonmonetary+Effects+of+the+Financial+Crisis+in+the+Propagation+of+the+Great+Depression&btnG=Search>. Ben has a nice speech about money, gold, and the Great Depression http://www.federalreserve.gov/boarddocs/speeches/2004/200403022/default.htm.

Milton Friedman and Anna Schwartz's account of the role played in the Great Depression by gold-standard and other policies that contributed to the sharp decline in the money supply is in the "Great Contraction" chapter of their Monetary History of the United States http://scholar.google.com/scholar?num=100&hl=en&lr=&safe=off&c2coff=1&client=safari&q=Monetary+History+of+the+United+States&btnG=Search.

Poverty Traps: The High Price of Investment Goods in Poor Countries

Tyler Cowen notes the "relative prices and relative prosperities" literature. It is an updating of Prebisch-Singer: that poor countries have really lousy terms of trade that grow worse over time, and this greatly hinders their development by making it extremely expensive for them to import the high-quality technology-carrying capital goods that they need.

See Caselli and Feyrer (2007), Klenow and Hsieh (2006), DeLong (1997), Jones (1994), DeLong and Summers (1991), and problems 4, 5, and 6 from Problem Set 3 of the DeLong-Rosenberg fall 2006 version of Economics 101b.

Tyler quotes from Caselli and Feyrer:

Marginal Revolution: The marginal product of capital, and policy irrelevance: The May 2007 Quarterly Journal of Economics offers up a fun piece on the marginal product of capital, earlier version here.  The bottom line is startling, though it requires only a simple model:

Francesco Caselli and James Feyrer (2007), "The Marginal Product of Capital" http://www.aeaweb.org/annual_mtg_papers/2006/0106_1430_0703.pdf: Whether or not the marginal product of capital (MPK) differs across countries is a question that keeps coming up in discussions of comparative economic development and patterns of capital flows.  Attempts to provide an empirical answer to this question have so far been mostly indirect and based on heroic assumptions.  The first contribution of this paper is to present new estimates of the cross-country dispersion of marginal products.  We find that the MPK is much higher on average in poor countries.  However, the financial rate of return from investing in physical capital is not much higher in poor countries, so heterogeneity in MPKs is not principally due to financial market frictions.  Instead, the main culprit is the relatively high cost of investment goods in developing countries.  One implication of our findings is that increased aid flows to developing countries will not significantly increase these countries’ incomes.

Tyler concludes

The rough equality of financial rates of return means that [financial] capital [does] flow to where it is most productive.  That means if a country receives some aid, and converts that aid into useful capital goods, less capital flows into your country.  A version of neutrality holds.  Of course there is no reason to focus on aid in this argument.  Most one-off improvements (or destructions) wash out in the longer run, due to subsequent adjustments in the capital stock.  The one-off improvements matter only if liquidity and credit imperfections hinder the international mobility of capital; such imperfections would mean that transfers could bring about a permanently higher level of capital...

This claim that policies to boost capital investment in poor countrise will not help (much) is, of course, true only if the rich who save and invest have time preferences corresponding to those of society as a whole, and only if the private profits earned by investors are in line with the social benefits produced by investment.

Here is how Larry Summers and I formulated it back in the early 1990s, and I believe that we were correct:

Begin with the large divergence between purchasing power parity and current exchange rate measures of relative GDP per capita levels. The spread between the highest and lowest GDP per capita levels today, using current exchange rate-based measures, is a factor of 400; the spread between the highest and lowest GDP per capita levels today using purchasing power parity-based measures is a factor of 50. If the purchasing power parity-based measures are correct, real exchange rates vary by a factor of eight between relatively rich and relatively poor economies. And the log GDP per capita level accounts for 80 percent of the cross-country variation in this measure of the real exchange rate, with each one percent rise in GDP per capita associated with an 0.34 percent rise in the real exchange rate.

Why? Because real exchange rates are such as to make the prices of traded manufactured goods roughly the same in the different nation-states of the world, putting to one side over- or undervaluations produced by macroeconomic conditions, tariffs and other trade barriers, and desired international investment flows. Thus the eight-fold difference in real exchange rates between relatively rich and relatively poor economies is a reflection of an approximately eight-fold difference in the price of easily-traded manufactured goods: relative to the average basket of goods and prices on which the "international dollar" measure is based, the real price of traded manufactures in relatively rich countries is only one-eighth the real price in relatively poor countries.

This should come as no surprise. The world's most industrialized and prosperous economies are the most industrialized and prosperous because they have attained very high levels of manufacturing productivity: their productivity advantage in unskilled service industries is much lower than in capital- and technology-intensive manufactured goods.

And a low relative price of technologically-sophisticated manufactured goods has important consequences for nation-states' relative investment rates. In the United States today machinery and equipment account for half of all investment spending; in developing economies--where machinery and equipment, especially imported machinery and equipment is much more expensive--it typically accounts for a much greater share of total investment spending (see Jones, 1994; DeLong and Summers, 1991).

Consider the implications of a higher relative price of capital goods for a developing economy attempting to invest in a balanced mix of machinery and structures. There is no consistent trend in the relative price of structures across economies: rich economies can use bulldozers to dig foundations, but poor economies can use large numbers of low-paid unskilled workers to dig foundations. But the higher relative price of machinery capital in developing countries makes it more and more expensive to maintain a balanced mix: the poorer a country, the lower is the real investment share of GDP that corresponds to any given fixed nominal savings share of GDP.

The gap between nominal savings and real investment shares of GDP that follows from the high relative price of machinery and equipment in poor countries that wish to maintain a balanced mix of investment in structures and equipment is immense. For a country at the level of the world's poorest today--with a real exchange rate-based GDP per capita level of some $95 a year--saving 20% of national product produces a real investment share (measured using the "international dollar" measure) of only some 5% of national product.

In actual fact poor economies do not maintain balanced mixes of structures and equipment capital: they cannot afford to do so, and so economize substantially on machinery and equipment. Thus here are three additional channels by which relative poverty is a cause slow growth:

First, the fact that investment in general--taking equipment and structures together--is expensive relative to consumption goods and services in poor countries provides them with an incentive to diminish their nominal savings effort: to reduce the share of nominal incomes saved.

Second, the fact that relative poverty is the source of a high real price of capital means that poor countries will have a low rate of real investment corresponding to any given nominal savings effort, and thus a low steady-state aggregate capital-output ratio corresponding to any given nominal savings effort.

Third, to the extent that machinery and equipment are investments with social products that significantly exceed the profits earned by investors (see DeLong and Summers, 1991), the price structures in relatively poor developing economies lead them to economize on exactly the wrong kinds of capital investment...

---

References:

"The Singer-Prebisch Thesis," Wikipedia http://en.wikipedia.org/wiki/Singer-Prebisch_thesis (accessed June 25, 2007).

J. Bradford DeLong (1997), "Cross-Country Variations in National Economic Growth Rates: The Role of 'Technology'", in Jeffrey Fuhrer and Jane Sneddon Little, eds., Technology and Growth (Boston: Federal Reserve Bank of Boston) http://www.j-bradford-delong.net/Econ_Articles/Growth_and_Technology/Role_of_Technology_.pdf (accessed June 25, 2007).

J. Bradford DeLong and Lawrence H. Summers (1991), "Equipment Investment and Economic Growth," Quarterly Journal of Economics 106: 2 (May), pp. 445-502 http://www.j-bradford-delong.net/movable_type/archives/000606.html (accessed June 25, 2007).

J. Bradford DeLong and Joseph Rosenberg (2006), "Problem Set 3: Economic Growth: Further Explorations," U.C. Berkeley Economics 101b, Fall 2006 Version http://delong.typepad.com/print/20060911_101b_f06_ps3.pdf (accessed June 25, 2007).

Francesco Caselli and James Feyrer (2007), "The Marginal Product of Capital" http://www.aeaweb.org/annual_mtg_papers/2006/0106_1430_0703.pdf (accessed June 25, 2007).

Chang-Tai Hsieh and Pete Klenow (2006), "Relative Prices and Relative Prosperity" http://www.klenow.com/RPandRP.pdf (accessed June 25, 2007).

Charles Jones (1994), "Economic Growth and the Relative Price of Capital," Journal of Monetary Economics 34, pp. 359-82 http://elsa.berkeley.edu/~chad/JonesJME1994.pdf (accessed June 25, 2007).

Richard Thaler: Slippery Slope Arguments Should Be Avoided Unless There Is Proof that the Slope Is Greased

Via Pinky and the Brain: Richard Thaler:

Pinky and the Brain: Richard Thaler: Libertarian Paternalism: Let's recapitulate. People make mistakes, so sometimes they can be helped. It is possible to help without coercion. That is libertarian paternalism. The concept can be and is used in both the public and private sectors. For example, in London, pedestrians from abroad are reminded by signs on the pavement to "look right" because their instincts from back home are to expect traffic to approach from the left. No one is forced to look right, but fewer pedestrians are hit by trucks.

Another example comes from Sweden, which launched a partial privatization of their social security system in 2000. The plan was open to any fund, which meant that participants faced 456 options. There was also a very well-designed default fund -- using private managers selected by the government -- that offered global diversification at very low fees (16 basis points). By any standard, both ex ante and ex post, the participants who selected their own portfolio of funds did worse than those who took the default plan. The main mistake the government made in designing this plan was to discourage participants from choosing the default fund, perhaps thinking, as Mario does, that choosing for oneself is always the best approach.

Mario thinks we are naïve about government. We think he is naïve about firms. Does he think that the companies that offered stock options to student loan officers to induce them to feature their loans had the "actual preferences" of the students at heart? Maximizing profits does not always mean maximizing the welfare of the customers.

Finally Mario seems to have a phobia about slippery slopes. I guess he thinks that if governments start with signs that say "look right," the next thing you know we will have Prohibition coming back. By the same logic, we should worry that if libertarians succeed in eliminating rent control that we will be soon down the slippery slope toward anarchy. Slippery slope arguments should be avoided unless there is proof that the slope is greased. In our case, by insisting, as we do, on only libertarian paternalism, the slope runs into a brick wall before it even gets started. And besides, what is the alternative? Inept neglect?

John Succo on Pricing CDO Mortgages

John Succo:

Minyanville : Actual prices where traders can really buy and sell is substantially lower than where investors are marking their positions. I asked a large broker firm to send over its smartest math person on Collateralized Debt Obligations (CDO) structuring.  I wanted to know what I am missing: why is the market so sanguine in the face of deteriorating collateral values in the mortgage market?  One of my firm's theses has been that, as the mortgage market deteriorates, investors holding CDO as an investment would realize losses and this would feed into other risky asset classes.  Why aren’t losses being seen when the market is clearly deteriorating?

The team that came over was headed by a very smart gentleman. He was very good at math and very straightforward. Working for a broker I was prepared for some sugar coating. I didn’t get any. The answer is simple and scary: conflict of interest. He explained that due to the many layers of today's complicated credit products, the assumptions used to dictate the pricing and outcome of CDO are extremely subjective. The process is so subjective in fact that in order to make the market work an “impartial” pricing mechanism must exist that the entire market relies upon.

Enter the credit agencies. They use their models, which are not sensitive to current or expected economic activity, but are based almost entirely on past and current default rates and cash flow to price the risk. This of course raises two issues.

First, it is questionable whether "recent" experienced losses over the last few years really represent the worst of the credit market (conservative). But even more importantly, it raises a huge conflict of interest: the credit agency's customers are the very issuers of the tranches they rate. The credit agencies, therefore, need to compete for business based at least in part on the ratings they are willing to give these tranches. As a result, they will only downgrade when forced to by experienced losses; not rising default rates, not a worsening economy, but only actual, experienced losses. Even more disturbing, they will be most reluctant to downgrade the riskiest tranches (the equity tranches) since those continue to be owned by the issuers even after the deal is sold. So even though the mortgage market has deteriorated substantially, mark-to-market losses by those holding the CDO paper have generally not been realized simply because the rating agencies have not changed their ratings for all the above reasons.

Accounting rules only require holders of the paper to mark prices according to the accepted model, not actual prices. For example, below is a chart of the actual BBB minus tranch of the mortgage-backed securities pool from November '06 to present. Actual prices where traders can really buy and sell is substantially lower than where investors are marking their positions.

The levels at which investors are carrying the paper is not reflecting underlying reality as the holders simply hold their collective breath and the rating agencies ignore a worsening environment.

I asked them what would force the rating agencies to change their ratings and the response was “it's just a matter of time if the market continues to deteriorate, for the agencies at some point will be forced by the cumulative losses to acquiesce." Because these losses have been compressed, any re-adjusting of ratings by these agencies are likely to result in a massive repricing of risk.

Michael Clemens on the Real Immigrant Underclass: "The People Who Wanted To Come, But Could Not"

Michael Clemens of the Center for Global Development, with a good rant, including bonus New Republic bashing:

Global Development: Views from the Center: The Real Immigrant Underclass: The People Who Wanted To Come, But Could Not: The New Republic's lead editorial (free registration required) blasts the now-moribund Immigration Reform Act for including a provision to admit hundreds of thousands of temporary workers each year. It bitterly condemns America's "unsavory tradition" of "importing non-Europeans to do the difficult tasks that our own citizens shun" as part of a "shadowy underclass". To the editors, this is "the tradition of the African slave ship, the Chinese coolie, and the Mexican bracero" and is "one of the worst ... instincts in American democracy".

I take a breath and count to ten. First, and emphatically, we must set the brutal, coercive slave trade completely and irrevocably apart from Chinese and Mexican immigration, which has been almost universally voluntary. Forcing Africans to come to this country and work for nothing was indeed far beyond unsavory and it did reflect, in its time, the worst instincts of this country. A colossal difference lies between this and the braceros' decision to come here and work for pay. Slaves were indeed "imported" as subhuman commodities. Mexicans and Chinese chose to come. And allowing people to voluntarily pursue their dreams is not something for which we should hang our heads in shame.

Now: What is the alternative to admitting Chinese and Mexicans to do "difficult" work here in a "shadowy" underclass? The alternative was not mass admission of unskilled labor with full citizenship, which would have been politically impossible and continues to be. For most of them, the alternative was not to come at all, and the temporary worker provision of the Immigration Act embodies a sophisticated understanding of this fact. If the US had not admitted Chinese and Mexicans in the past, those people would have remained where they were: doing far more difficult work in a sub-sub-underclass in the places they came from --- not just shadowy, but completely invisible to Americans. How do we know it was that bad where they were before? Because despite the enormous hardships of coming here, both groups kept on choosing to come, for many decades. Immigrants, bluntly, are not stupid; they know what makes them better off, and they act on it.

The failure of the Immigration Reform Act means no temporary worker program, so fewer people will have that chance for a better life. The way the editors of the New Republic excoriate that provision of the bill, you'd think the bill's collapse is a victory in the fight against poverty.

Those editors would appear to prefer that the non-Europeans who have been afforded tremendous opportunities to improve their lives here had stayed home and kept their desperation out of sight, out of mind -- as the bill's failure ensures many more will. If the New Republic didn't prefer this, it might point out that admitting Chinese and Mexican laborers is precisely the act of setting them free from the very, very "shadowy underclass" in which they lived prior to coming here, when most did much more "difficult" work for a lesser reward. It might note that giving those enterprising people a chance is one of the best "instincts in American democracy", one that is not emulated by other rich democracies like Japan.

It might also point out that it was the precisely the halting of Chinese immigration, via the unapologetically racist Chinese Exclusion Act of 1882, that indeed reflects our "worst instincts". Was that law any less repugnant because building railroads is "difficult" work?

This doesn't mean that there are no problems with immigration and assimilation here; those need to be solved. But let us not patronize the migrants. "Saving" them from the conditions they face here, if that means sending them home or not admitting them, means "saving" them from something they have told us loudly that they prefer --- by voting with their feet. Full and immediate citizenship for hundreds of thousands of unskilled Mexican laborers a year is politically infeasible, and the temporary worker program was a great shot at an outcome that still would have made a lot of people better off. Now we face the alternative, which is that those people will never have the chance to come, or will try to come through very dangerous and harmful illegal channels. The New Republic might like the sound of that, but I don't.

Whatever you think of how America has handled the people it did let in, the fact is that it did let them in, and many other countries simply have not and do not allow as many people to better their lives in this fashion as we do. That is a distinction of which we can be proud. It is light years away from the slave trade. The death of the Immigration Bill and its temporary worker program means more people will be "saved" from the chance to pursue their dreams and see their hard work better rewarded. Now there's something to be ashamed of.

Jim Hamilton and Mark Zandi on Interest Rates

In the Wall Street Journal:

Econbrowser: Econoblog on interest rates: I was pleased to participate in the latest Wall Street Journal Econoblog with Mark Zandi, Chief Economist and co-founder of Moody's Economy.com. Here's a brief preview of what you can find over at the WSJ. Our topic was the following question:

Treasury-bond yields, a benchmark for market interest rates, scared investors earlier this month with a sharp rise, and pull back. What was behind the uptick? And what does it mean?

And here is part of what we said.

Hamilton: Long-term bond yields are generally procyclical, falling with the decreased spending and borrowing that accompanies an economic slowdown. Indeed, a lot of us look at the spread between long-term and short-term yields as a predictor of what is going to happen to economic growth. When the 10-year yield fell below the overnight fed funds rate from 2006:Q2 to 2007:Q1, that was followed by slower than average real GDP growth. But if investors are now expecting stronger growth, that could explain why nominal rates, TIPS yields, the dollar, and stocks have all risen together...

Zandi: Behind the higher rates is slowly evaporating global liquidity. This is most evident in tighter monetary policies across much of the globe. Central banks ranging from the European Central Bank to the Chinese Central Bank are in the midst of a series of tightening moves. Indeed, the Federal Reserve is the only major central bank not expected to tighten policy again before the year is over....

Given that 80% of mortgage loans are fixed rate loans, this will be another significant hurdle for the housing market to overcome. The spring selling season was already a bust prior to the run-up in long-term rates. Home sales are being hit hard by the tightening in lending standards in response to the stunning erosion in mortgage credit quality. It will be very difficult to make any progress in reducing the bulging inventories of new and existing homes without further substantial cuts in housing construction and house prices.

Hamilton: Unfortunately, Mark is exactly right about housing. I had been among those who incorrectly predicted that lower mortgage rates would arrest the housing downturn last fall. I think we did see some evidence of a rebound, but then the sector was hit badly by the tightening lending standards Mark mentioned. Now with mortgage rates back up and, as Mark also noted, the inventory of unsold homes, it's hard to find any reason for optimism in this sector. But the housing bust has been subtracting 1% from annual GDP growth for a year now. What we've clearly seen is that, unless some other part of the economy follows it down, a recession in housing need not mean falling overall GDP.

There's much more over at the WSJ...