Sunday, January 30, 2011

Cowen on Innovation

I think Tyler Cowen is one of those people who Shiller thinks is out of touch with the "real world." Cohen thinks that advances we have seen since 1962 are small potatoes compared to what happened between 1905 and 1962.

Let's go back to 1959, which is when I started to notice technology in a serious way. My father bought a new car that year - a 1959 Oldsmobile. My father wanted a radio in the car, and seatbelts, and those had to be installed by the dealer. The car came with an automatic transmission, but for us that was a novelty. This car required attention. It quickly developed oil leaks, its tires had to be replaced frequently, and it did not always want to start in the cold weather. Compared to this, the car that is within reach of the average person in the US today is a marvel. It is enormously safer, more efficient, easier to maintain, and with many devices that did not exist in 1959.

How did we communicate in 1959? We had telephones, but they were clunky devices that did not record messages, and required dialing. Long distance calling was something of a luxury, and calling overseas was virtually unheard-of for the average person. We received our news from the television (two broadcast channels) and via newspapers delivered to the door. The post office was very important. Everything was billed my mail, and transactions technologies were primitive. Transactions were all made with cash and checks, and withdrawing cash from the bank or depositing a check required waiting in a line, sometimes for a long time.

For entertainment, we had movies. We had one movie theater in town. If you did not like what was showing, you could stay at home and watch Ed Sullivan. The event of the year was an annual showing of "The Wizard of Oz" on TV. We had records. Of course you had to purchase the physical vinyl and bring it home to play it. Stereo was relatively new. My father bought one, and all the neighbors came over to hear it. Radio was primarily AM.

Was father was an engineer, and the tools he had were quite primitive. He did most of his calculations with a slide rule (three significant digits, four if you had good eyes), but he also had a machine that could do basic arithmetic. The transistor had been invented, but most of my father's electronic equipment used vacuum tubes.

In the town where I lived, we had a couple of department stores in the downtown: a Woolworths and a Five-and-Dime store. Some things we could buy locally, typically in specialty stores, but there was much that we could not find in town. For those things, there was the Eaton's catalog, i.e. mail order.

It's quite possible that Tyler Cowen lives like his grandmother. I know that I don't. While the technological change we have seen since 1959 is sometimes less obvious than the changes wrought by the automobile and electrification, it is no less phenomenal. Particularly notable are advances in information technology, communication, retailing, and biotechnology. I don't have my fingertips on the latest measurements of secular technological change and change in the quality of goods and services, but maybe some readers could provide us with references. However, standard national income accounting tells us that average growth in real per capita GDP in the US was about the same, pre-1962 and post-1962. What is Cowen on about?

Tuesday, January 25, 2011

The Keynesian Cross Crusade

After complaining about Shiller in my last post, I might as well continue while I'm in the mood. I just read this Krugman blog post. This reminds me of the annual Fox News stories about the War on Christmas. The Keynesian Cross is as shrouded in myth as Christmas, and about as likely to go away, unfortunately.

According to Krugman, here's the problem:
Basically, in the face of what I would have said is obviously a massive shortfall of aggregate demand, we’re seeing on all-out attack on the very notion that the demand side matters.
As I've said before, on more than one occasion, "shortfall in aggregate demand" has no meaning, either in fully-articulated New Keynesian models, or any other modern models of macroeconomic activity. If the statement has no meaning in terms of the theory, we can't observe the shortfall empirically either. Of course, Krugman is thinking about a Keynesian Cross model, which is not what modern macroeconomists (of any stripe) work with. If you buy into the Keynesian Cross, what recession would not be a shortfall in aggregate demand?

Then, we get:
This isn’t entirely new, of course. Real business cycle theory has been a powerful force within academic economics for three decades. But my sense is that the RBC guys had very little impact on public or policy discussion, simply because what they said seemed (and was) so disconnected from actual experience.
You could actually say more than this. Real business cycle theory is based on work on economic growth by Solow, Cass and Koopmans, which stretches the "powerful force" back more than five decades. Real business cycle theory, in its original form was hardly "disconnected from actual experience," indeed part of the influence and strength of the approach came from its quantitative nature and the attempt to confront models with the data. Now, you won't find many practitioners today who actually use the RBC framework in its original form. However, what it became was New Keynesian theory (and applications), with the addition of sticky wages and prices with monopolistic competition; and any number of branches of the macroeconomic literature (asset pricing, credit markets and bankruptcy, for example) that use competitive heterogeneous agent constructs. To say that the "RBC guys" had no influence on policy is false. People who I might think of as RBC guys are now running Federal Reserve Banks, for example, and the ideas permeate policy discussion.

Krugman seems to think that people are out to attack the Keynesian Cross, but that certainly is not anyone I know. Most of them don't think much about it. Apparently the attacks are coming from the commenters on Krugman's blog posts. Well, good for them! Krugman's defense is that the Keynesian Cross has been in the Econ 101 textbooks for 62 years. I have also heard that a majority of Americans believe that angels exist.

Krugman goes on by resurrecting his babysitting co-op story. To me, the lesson from this story is that the designers of this co-op did not do a good job. About 25 years ago, my wife and I participated in a babysitting co-op in Minneapolis that seemed to work fine, without anything that looked like Keynesian intervention. I don't get it.

Anyway, we know how this will finish off. Krugman will be alarmed - but sad.
Seriously, though, this is truly sad — and dangerous. Demand-side understanding, in my view, played a big role in helping us avoid a full replay of the Great Depression; if enough people had shared that understanding, we might have avoided even the minor-league Depression we’re going through. But willful ignorance is on the march — and the odds are that we’ll handle the next crisis very badly.
I think Krugman and I have different ideas about where the ignorance resides.

1. People who think that Old Keynesian (or more accurately, the Hicksian interpretation of Keynes) economics has something to say typically argue that the "demand deficiency" is obvious by looking out the window. But the fundamental source of inefficiency in their framework comes from sticky wages and prices. To make a good case that Old Keynesian forces matter for recent history, the Old Keynesians should be showing us direct evidence of the sticky wages and prices, as they relate to the current state of the economy.
2. What I think Krugman is worried about is that, if the non-Keynesians are correct then somehow we no longer have a role for the government. Nothing could be further from the truth. Not accepting Keynes as your savior does not mean that you think the government's role should be very narrowly defined, that you don't care about the poor, or that you are a Republican.

Shiller and Economic Science

I ran across this piece in Slate by Robert Shiller, which ponders the state of economic thought.

The financial crisis was certainly unanticipated, and there are features of it that are complicated, with various anomalies relative to historical experience. We have already learned a lot. At the minimum, your average economist and layperson now understand a lot more about the nature of financial derivatives, the mortgage market, and financial intermediation in the United States than they did in the Spring of 2008. But there is much that remains to be sorted out. As economists, we now have fertile ground for future research, and the problems are fascinating.

One particularly interesting feature of the financial crisis and the recent recession has been how it has affected the struggle among economists over basic ideas and methodology. Generally, economists seem to see this as an opportunity for a shakeup. You can't blame people for trying. Why not use the financial crisis as an opportunity to make peddlers of ideas I disagree with look stupid, and to make my ideas look good? I have done this from time-to-time myself. I like to argue that New Keynesians, who had a lot of influence over central bankers and monetary policy pre-crisis (and still do), missed the boat on financial factors and their role, and left us with models that could not tell us what to do in the crisis. I think that real business cycle types (if there are any pure RBC types still around) missed the boat as well - the RBC approach typically downplays monetary and financial factors as being nothing more than a sideshow. Like everyone else, I'm trying to push my ideas, which are that financial intermediation, monetary exchange, liquidity, and credit markets are important. Other people are pushing in other directions. This one wants us to throw out modern macroeconomics and go back to 1937. Some others want to push behavioral economics. Some New Keynesians want to argue that they can retain most of their existing framework and fix things with modest extensions.

What is Shiller up to? Well, like everyone else, he is using the crisis to peddle his ideas. He first argues that the general public has "lost faith" in the economics profession for its lack of foresight with respect to the financial crisis. I would characterize the situation in a different way. For the most part, economists are ignored. We are not like the doctors, used car dealers, lawyers, etc. Most people do not consult economists on any regular basis, and we are not the subject of many television programs or films. There are no economics-profession-counterparts of "House," or "Wall Street." Economists are just not that exciting. I felt sorry for Paul Giamatti, who will have to portray Ben Bernanke in "Too Big to Fail," an HBO movie. What's next? "The Economists," with Dustin Hoffman as Mike Woodford, Jeff Bridges as Larry Jones, Rick Moranis as Randy Wright, and Gwyneth Paltrow as Deirdre McCloskey? What idiot would finance that film and risk losing his/her shirt?

To the extent that anyone now pays attention to us, it's either because they actually want to learn about the financial crisis, or because they enjoy a good fight; i.e. economics is like a hockey game. In contrast to the medical profession, we don't close ranks, but instead prefer to pummel each other in public. That has to be entertaining on some level. Even when the controversy isn't there on the surface, journalists will go looking for it, and they can always find some fringe economists willing to criticize the rest of the profession. Now, speaking of the medical profession, what have they done for us lately? Most of us die in hospitals, where the concentration of doctors is highest. Explain that to me.

Anyway, Shiller's point seems to be that economists should think outside the box. Of course that is hard to argue with. Research is about thinking outside the box and coming up with novel and useful ideas. I think that, in general we are rewarded for doing that. However, Shiller does not seem to think so. Indeed, he appears to be questioning the whole formal structure of academic peer review, and suggests that we don't properly reward grass-roots thinking. According to him, economists are divorced from reality, and they need to do more popular writing that is accessible by the lay person. I could not disagree more. Popular writing may not be rewarded by the tenure review committee, but it has its own reward. Just ask Steven Levitt, who is rolling in cash. To be treated seriously as a science, which I think is important, we have to do proper peer review and go through the formal publication process. That's the only way to properly sift ideas and somehow certify the good ones as such.

Part of Shiller's bottom line is:
The financial crisis delivered a fatal blow to that overconfidence in scientific economics. It is not just that the profession didn't forecast the crisis. Its models, taken literally, sometimes suggested that a crisis of this magnitude couldn't happen.
This is nonsense, and it is vague. (i) The inability to predict everything need not mean we should throw out current scientific methods, or that the science is bad. (ii) Which models is he talking about? There are plenty of excellent economists, working with off-the-shelf economic theory and empirical methods, who are making plenty of sense out of what we have seen in the last few years. Who is Shiller talking to? What conferences is he going to? Actually, Shiller does not even have to leave town to learn something. He could talk to his colleague Gary Gorton, who knows a lot about derivatives, securitization, and shadow banking, among other things.

The rest of the piece is an appeal to the "human element," "personal judgement," intuition, morality, looking the general public in the eye, etc. How unhelpful. I think I'll stick to science.

Saturday, January 22, 2011

Obama and Competitiveness

If I heard only that President Obama had created a "Council on Jobs and Competitiveness," this would seem fine. This is politically marketable (who could be against jobs or competitiveness?) and it's possible to actually use this as a vehicle to accomplish something useful. If Barack were to, in a foolish moment, appoint me to such a Council, what would I want to do? Competitiveness is about productivity, and all good economists know that our standard of living flows from total factor productivity (TFP). In turn, TFP is determined by our technological capabilities, educational attainment and skill at organizing production in individual firms, and the efficiency with which available resources (labor and capital) are allocated across those firms. Thus, a first job for the Council would be to study whether there is anything the government could do to promote growth in TFP. Are there new initiatives that the government could be taking in the educational field? Are there things the government could do to promote research and development? Are there existing policies that misallocate resources and should be changed? Are there new policies that could lead to a more efficient allocation of resources? With regard to any of these policies, of course we have to analyze the costs and benefits; we need to know that the government is somehow stepping in to do something the private sector cannot do but should.

Now, many of the important issues related to productivity - education and government regulation for example - are ones we have been discussing for years. In some cases the government has acted, for example with No Child Left Behind, with questionable results. One issue that is somewhat new, and which has been pushed into relief by the financial crisis, relates to the allocation of resources - labor specifically. Some of the ideas are stated nicely in this book review by Robert Solow. Toward the end of this piece, he states:
We would be much poorer without a functioning financial system, and the flow of credit and equity purchases that it permits. If anyone who wanted to start a business--a software company, a biotechnology laboratory, a retail store--had to do so with his or her already saved-up wealth and the help of relatives, many good ideas would go unrealized, and some wealth would lie idle or be wasted. If every time you chose to invest in an existing company it was forever, because there was no way to sell your share and invest somewhere else, it would be much harder for promising enterprises to attract capital and grow.

But those needs were being taken care of a quarter-century ago, and well before that. The real question, to which Greenspan gave such a confident and grandiose answer, is whether anything much was added to the system’s ability to allocate capital efficiently by the advent of naked CDSs and CDOs and the rest of the alphabet. No blanket answer is possible. The securitization of mortgages and college loans is not intrinsically a foolish or useless idea--it enlarges the pool of capital available to finance home purchases and college educations; but the opportunity for you and me to bet a large sum of money on the outcome of somebody else’s bond issue is not nearly the same sort of thing.

Take an extreme example. I have read that a firm such as Goldman Sachs has made very large profits from having devised ways to spot and carry out favorable transactions minutes or even seconds before the next most clever competitor can make a move. Deep pockets in a large market can make a lot of money out of tiny advantages. (Of course, if you have any such advantage the temptation is irresistible to borrow a lot of money to enlarge your bets and your profits. Leverage is good for you, until it isn’t. It is not so good for the system.) A lot of high-class intellectual effort naturally goes into trying to invent ways to find those tiny advantages a few seconds before anyone else.

Now ask yourself: can it make any serious difference to the real economy whether one of those profitable anomalies is discovered now or a half-minute from now? It can be enormously profitable to the financial services industry, but that may represent just a transfer of wealth from one person or group to another. It remains hard to believe that it all adds anything much to the efficiency with which the real economy generates and improves our standard of living.
As is all-too-obvious now, how our financial industry is regulated is important for the allocation of resources. A poorly-regulated system can create profit opportunities in activities that have no social value and which cause us to sacrifice highly-skilled people that might have otherwise been engaged in science, engineering, and research. Further, when the system fails, the skills of an army of lawyers are required to sort out the losses - another misallocation. But maybe that's not what is going on. Maybe all this financial innovation is indeed socially useful and we're better off for all of it, in spite of suffering the odd financial crisis. In any event, this is something the Council might study and sort out.

What is the Council on Jobs and Competitiveness actually up to? Well, judging from this WP piece by Jeffrey Immelt, who is to chair the Council, apparently not much that is useful. In particular, here is one of Immelt's points:
We need a coordinated commitment among business, labor and government to expand our manufacturing base and increase exports. The assumption made by many that the United States could transition from a technology-based, export-oriented economic powerhouse to a services-led, consumption-based economy without any serious loss of jobs, prosperity or prestige was fundamentally wrong. But there is nothing inevitable about America's declining manufacturing competitiveness if we work together to reverse it. For example, we have returned many GE appliance manufacturing jobs to the States by collaborating with our unions and making our operations more efficient.
Seems like what he has in mind is subsidizing the production of refrigerators in the US. Here is an instance where I can actually agree with Krugman, who calls this "hackneyed." That being successful as producers of tangibles rather than intangibles is a good thing, and that we need government intervention to reverse the long-run shift from manufacturing to services is quite wrongheaded. Hopefully Obama will use this Council only to cozy up to the business community, and no legislation will result.

Friday, January 21, 2011

Fannie and Freddie Rise Again

Apparently Fannie and Freddie are like the zombie who won't die. This piece in today's NYT tells us that some of the large banks would like to take over Fannie's and Freddie's activities, complete with government guarantees (explicit this time). Apparently the large banks would like to convince us that 30-year mortgage contracts and mortgage subsidies are essential for the pursuit of happiness. So long as Fannie and Freddie are going the way of the dinosaurs, they would be happy to take over for them. This is of course to be expected, and you can't blame them for trying, but what a bad idea.

Checking the Fed's Balance Sheet

Here is the latest update to information on what is on the Fed's balance sheet. There are some words at the beginning of the release about the unwinding of the relationship between AIG and the New York Fed, and that shows up in several places on the balance sheet. On the asset side, the QE2 asset purchases continue, with an increase in long-maturity Treasuries of about $27 billion during the past week. Mortgage-backed securities (MBS) are now running off at a slower rate than previously, presumably because of the increases in mortgage interest rates. The reduction in MBS was about $3 billion, so the net increase in securities held outright is $23 billion from the previous week - a rate higher than the monthly target of $75 billion in net purchases. In spite of that, with all the AIG action, total assets actually went down in the week by $16 billion.

Then, on the liabilities side, the balance in the Treasury's general account (which I have discussed here and in other posts) fell by $30 billion, which would increase the stock of outside money in private hands. However, on net, particularly given the transactions with AIG, the result is that the net increase in outside money is small: $280 million in currency and $5 billion in reserves.

As has been the case since the beginning of the QE2 program, the effects of the program have only been to lower the average duration of the consolidated government liabilities held by the private sector. Other factors - movements of reserves to Treasury accounts, and the unwinding of Fed credit programs - have acted to hold down the growth in outside money. When Bernanke said in his 60 Minutes interview that QE2 was not about printing money, that sounded out of context, or misleading, but apparently he was (perhaps unintentionally) correct (so far).

Thursday, January 20, 2011

Inequality and the Macro Literature

Here's a useful survey by Heathcote, Storesletten, and Violante of the literature on heterogeneous-agent models and applications to inequality, among other things. This relates to what I was writing about here and here.

Acemoglu, Income Distribution, and the Financial Crisis

By way of Mark Thoma and Simon Johnson I was led to this set of slides by Daron Acemoglu, from a presentation at the ASSA meetings in Denver.

The slides are titled "Thoughts on Inequality and the Financial Crisis." There is some hard evidence in there, but Acemoglu is mainly throwing out some ideas for discussion. A key aim of his is to debunk some ideas that you can find in Rajan's book, and in this "pre-report" from the apparently-dissenting Republican members of the Financial Crisis Inquiry Commission (FCIC). Those people think that an important cause of the financial crisis was the proclivity of the government to do things for the poor by way of credit market intervention, in particular through the Community Reinvestment Act of 1977 (CRA), and the GSEs (Fannie Mae and Freddie Mac). I discussed some of these issues here (learned some things too - see some of the exchange in the comments section and a later post on CMHC).

As Acemoglu points out, it's hard to find evidence that the US government has been particularly favorably disposed to poor people during the last few decades. As most economists are well aware, the dispersion in income in the US population has increased, and Acemoglu summarizes the research results as telling us that this is mainly due to "supply, technology, and trade." Here, I think he means scarcity of particular skills, technological change that has increased the skill premium, and import competition in goods that are low-skill intensive. Changes in some government policies may indeed have favored rich people, particularly 1990s welfare reform and changes in income tax rates in the second Bush administration, but for the most part the changes in the income distribution appear to be driven by the effects Acemoglu mentions.

Now, what bothers Acemoglu are some ideas he has about what is going on at the very top (i.e. above the 99th percentile) of the income distribution. Essentially the idea is that, even in a democracy, money is power, as money buys politicians. Too much wealth at the very top only perpetuates itself, as the very wealthy have too much power to relax regulatory constraints in ways that allow them to prosper at the expense of everyone else. The hypothesis here is that what is going on at the very top of the income distribution is related to deregulation (in particular of the financial industry). This deregulation is seen as essentially issuing licenses to steal. For example, the regulatory loophole that permitted mortgage originators to make loans to low-income people who were incapable of ultimately meeting the loan payments, with those originators then selling the loans and making off with the profits was, in this view, essentially a social waste. Income was transferred from poor to rich, more houses were built than should have been, and the borrowers and the ultimate holders of the mortgages were left to sort out the losses and pay the legal fees.

Acemoglu certainly has a point. While Rajan has some interesting things to say about Fannie Mae, Freddie Mac, and the CRA, for example, it seems his political economy story is wrongheaded. However, Acemoglu seems to want to claim that the thrust of federal government policy was to "marginalize" the GSEs, and I don't think that is correct. Indeed, Fannie and Freddie are part of the phenomenon he is discussing. Fannie and Freddie were granted tax advantages and implicit (now explicit) government guarantees that gave them a cost advantage over private sector competitors. In fact, one could argue that it was the Fannie/Freddie cost advantage that drove the private sector to the only profitable game in town - risky mortgage lending. Further, the huge growth in Fannie and Freddie, given their implicit subsidy, created institutions with a huge amount of power, and they used that power to lobby Congress for favors. We can think of Fannie and Freddie as being run by another set of rich people at the top of the income distribution.

Tuesday, January 18, 2011

Average Labor Productivity

Here is an issue that is currently floating around the blogosphere. If we look at post-World War II aggregate data, a standard business cycle regularity is that deviations of average labor productivity from trend are procyclical. For example, suppose we focus only on the period from late 1950s to the late 1980s, and use the ratio of real GDP to employment (household survey) as a crude measure of aggregate labor productivity. In the first chart, we see that average labor productivity is typically lower at the end of NBER recessions than at the beginning.

Now, in terms of the macro models that people were working with in 1990, this regularity might be seen as being consistent with the predictions of real business cycle (RBC) models, and inconsistent with Keynesian models. Indeed, unless total factor productivity (TFP) is falling in a recession, average labor productivity has to increase. One response to this is (was?) that labor hoarding is an important phenomenon. In a recession, if a particular firm has previously invested a lot in the firm-specific human capital of its work force, it will be reluctant to lay off those workers. In the interest of the long-run profitability of the firm, the firm might choose to keep workers on its payroll and not ask them to do much, rather than lay those workers off and potentially lose them forever. With labor hoarding, actual labor input can fall without measured labor input falling. Indeed, if we measure TFP using the Solow residual, we may observe the Solow residual falling when actual TFP is not falling. I'm not sure how these issues sorted themselves out in the literature (if at all), but certainly Keynesians and non-Keynesians were writing about it.

Next, if we look at more recent recessions, focusing on the period from 1990 until now, the pattern changes (see the second chart). In the three most recent recessions, average labor productivity is higher at the end of NBER recessions than at the beginning. This is particularly pronounced in the most recent recession. Indeed, in the last quarter of 2010, average labor productivity is about 6% higher than at its lowest point during the recession.

What is going on here? In the blogosphere, Brad DeLong shows us some plots of unemployment and productivity that tell essentially the same story, and Krugman offers up some explanations. Some other people are talking about "zero marginal productivity" workers, and that makes little sense to me.

Let's try to understand this. Here are some possibilities:

1. As one blogger pointed out, the productivity of workers on the job could have risen, as these workers might increase effort on the job in response to the fact that unemployment is now potentially a worse state (expected duration of unemployment has increased), i.e. the cost of separation for a worker is higher. This is the kind of mechanism at work in an efficiency wage model. I'm going to dismiss this, as I don't think it's quantitatively important, but I'm willing to be convinced if someone has evidence to offer.

2. Krugman mentions unionization (and makes a reference to Nick Rowe's stuff), which may have something going for it as an explanation. The degree of unionization in the US has certainly fallen in the post-1990 period relative to the pre-1990 period. However, maybe the effect goes the wrong way. Likely the key effect of unions on how a firm adjusts total hours of work is that a union puts more constraints on how time is used at work, and on the specific tasks a worker can be assigned to. In principle, it seems that if you put constraints on how the firm can adjust the intensive margins of its work force, the firm will adjust more on the extensive margin, and you might then expect a unionized firm to have more variance in employment over the cycle, not less.

3. What could be going on is Schumpeterian creative destruction. Within an industry, the low-productivity firms fail during a recession, raising average productivity in the industry. But what makes the post-1990 period, and particularly this recession, different then? Maybe the financial factors driving the recession give the Schumpeterian mechanism more kick.

4. Maybe we can explain this by looking at the sectoral composition of output. An important difference in this recession is that residential construction declined by a very large amount compared to the typical post-WWII recession, and residential construction presumably is a low-productivity sector of the economy. Further, residential construction has remained in the toilet while the other components of GDP are growing. Typically, investment in residential construction recovers before other components of GDP - it leads the cycle. Possibly this can account for the large increase in productivity from mid-recession on. However, the decline in residential construction began long before the recession started, and we did not see an increase in productivity then.

Looks like this is a problem that isn't going to be solved in a blog piece, unless someone can shed some light on this for us. In any case, uncovering what is causing the recent productivity increase is very important. For example, if this is Schumpeterian creative destruction at work, then that is cause for optimism, as that would tell us that the increase in aggregate productivity is permanent, and this sets the stage for future growth in GDP and employment. However, if the recent productivity increase reflects only a temporary change in the sectoral composition of output, the effect is only temporary, and we should be less optimistic.

Friday, January 14, 2011


Paul Krugman sees our current political/economic predicamentcurrent political/economic predicament as a battle of alternative moralities. In Krugman's world, there are good guys and bad guys; your policy prescriptions are driven by who you label good and bad. What I see is a lot of confusion. People are confused about alternative economic policies and their effects, and some of the people who are making decisions about those policies, or advocating for them, deliberately sow that confusion.

Here's an example. I'm running for political office, and I offer you a free lunch. The free lunch is that I am going to cut your taxes. I don't mention the fact that this means that you, or somebody else, is going to have to give up something. Maybe I make some vague promises about cutting spending, and make it sound like this spending will cost you nothing. Maybe I make you believe that it will be some set of nameless poor people who will bear the brunt. You don't fancy yourself a poor person, so this looks great. Maybe you don't even understand the connection between government spending and taxes, or the idea that a government deficit represents deferred taxation. Certainly I'm not going to help you understand that. Maybe you don't understand that it's not even feasible to balance the federal budget by reducing services to poor people, or that the places to look for waste in the federal government are in the Pentagon and the Department of Homeland Security.

Here's another example. Suppose that I am convinced the government needs to be larger. I think the government should provide more goods and services, and I would like the rich to be poorer and the poor richer. This is a going to be a tough sell, as it's clear I have to make someone worse off, and we can't create goods and services out of thin air. But maybe I can market this as a free lunch. Vast numbers of college graduates have been educated in the free lunch of Keynesian economics. This is great. I can easily argue that we are currently in very dire straits, and that Keynes justified an expansion of government in such circumstances. I may or may not actually believe this, but so what? I can harness the wide belief in Keynesian economics to get where I want.

You know who is peddling each of these ideas. I don't think either approach enlightens anyone about the effects of government fiscal policies, or the tradeoffs we face.

Wednesday, January 12, 2011

Income Distribution Part II

Here's another thought relating to this post. Our basic notion of social insurance is that each of us is placed, at birth, in a set of circumstances beyond our control. Before birth, we're not able to write insurance contracts that will compensate us for being born poor, for being born with a serious disease or birth defect, or for other possible bad events. There is then some role for the government in stepping in to provide the insurance that the private market cannot provide, by redistributing income from the rich to the poor, providing health care, or other interventions.

The problem we have to deal with is that, as we teach students in Econ 101, prices help to allocate resources efficiently. To a degree, people are rich by virtue of the fact that society puts a high value on their services, and society puts a high value on their services because these are the services society wants. To provide the services that society wants, people have to be motivated to provide them. Becoming a skilled brain surgeon requires time and effort, and people won't do it if there is no payoff.

Thus, what we have here is a very standard economic problem. We are trading off insurance with incentives. The same problem occurs in employment contracts, and in designing unemployment insurance; it's what canonical principal-agent problems are about.

Now, I don't think this is the way a lot of people, particularly non-economists, think about the problem of income distribution. For them, it seems to be all about theft. On the one hand, some people look at CEOs and bankers, for example, and think that these people are rich because, effectively, they have been stealing from the rest of us. As economists, we know that theft is a serious problem. At best, the time and effort of thieves is a pure social loss. This time and effort simply moves wealth around and the time and effort could be put to productive use. At worst, theft provides a disincentive to the productive people. Why work if others are going to steal your wealth? On the other hand, hard core libertarians, for example, are worried about another kind of theft. For them, the government is simply a mechanism for theft. Whoever runs the government can use its power to steal wealth from the people who have it. From a libertarian's point of view, the government is a parasite, and a good parasite can in fact extract resources from its host without killing it.

What are the lessons here? Theft exists, but we should not be too quick to ascribe bad motives to the rich, or to the government. That said, it is certainly legitimate to ask whether some kinds of financial activities, the creation of complex derivatives for example, are more about obfuscation - theft, effectively - than socially desirable innovation. As well, we have to watch our government carefully. Dictators with armies are well-known for their confiscatory exploits, but democratic governments can go overboard too.

What's the Treasury Up To, Part II

Here is an update on this post, this one, and this one. Apparently, before fall 2008, standard Treasury procedure was to target the balance in the Treasury's balance in its General Account with the Fed at about $5 billion each day. The Treasury would then allow its balances in Treasury Tax and Loan Program (TTLP) accounts to fluctuate as funds flowed into and out of the Treasury. The idea was to both make life easier for the Fed, which in normal times targets the daily quantity of reserves to hit its fed funds target rate, and to earn interest on its cash balances. Targeting the fed funds rate would be more difficult if the Fed had to account for a fluctuating Treasury reserve balance, and interest on TTLP accounts with private depository institutions was significantly higher, pre-crisis, than the zero interest the Treasury would receive on the balance in its General Account with the Fed.

After fall 2008, however, Treasury procedures changed. You can find information on TTLP account balances here. The data is a bit awkward to look up, as there is a file for each date, but what this indicates is that the Treasury's TTLP balances are now fixed at a token $2 billion. The flip side of this is that it is the balance in the Treasury's General Account with the Fed that fluctuates. Why the change? First, of course, the Fed is not currently in the business of trying to hit a fed funds target. With more than $1 trillion in reserves in the system overnight and the interest rate on reserves pinning down overnight interest rates, the Fed appears to be unconcerned about the very large variance in the quantity of reserve balances held privately. Second, TTLP balances are essentially earning zero now, so there is no interest rate advantage for the Treasury in holding cash balances with the private sector.

Now, a key question is whether the fluctuations in private reserve balances matter. Clearly the Fed does not think so, and presumably banks would be kicking up a stink if this were actually disruptive. What this suggests is that dumping $600 billion in reserves into the system may not have any effect. The effects of QE2, if there are any, would then have to come solely from an effect on the term structure of interest rates from changing the relative supplies of long and short-maturity Treasury securities.

Tuesday, January 11, 2011

What the Fed Thinks It's Doing

Janet Yellen gave a speech at the ASSA meetings in Denver, which appears to be the best the Fed can do in terms of justifying its QE2 asset-purchase program. I was in Denver, but (perhaps fortunately) I was stuck in a hotel room interviewing recruits for junior faculty positions. The recruits were quite interesting, and there is really not much new in Yellen's speech if you have been listening to what Fed officials have been saying for the last few months. However, what Yellen had to say is a helpful review, and I have some other things to say about QE2 as well, so here goes.

What is the theory behind QE2?
The underlying theory, in which asset prices are directly linked to the outstanding quantity of assets, dates back to the early 1950s.4 For example, in preferred-habitat models, short- and long-term assets are imperfect substitutes in investors' portfolios, and the effect of arbitrageurs is limited by their risk aversion or by market frictions such as capital constraints. Consequently, the term structure of interest rates can be influenced by exogenous shocks in supply and demand at specific maturities. Purchases of longer-term securities by the central bank can be viewed as a shift in supply that tends to push up the prices and drive down the yields on those securities.
So, as we have been hearing for a long time, the basic idea is based on 1950s "preferred-habitat" ideas. Financial markets are segmented by maturity, and so if monetary policy alters the relative supplies of securities of different maturities, then this can move the yield curve. In this instance, the short end of the nominal yield curve is pegged by the interest rate on reserves, so if the Fed swaps reserves (overnight maturity) for Treasury securities with an average duration of about 7 years (which is what the Fed is doing), then nominal bond yields on long-maturity assets should fall. One might hope that we could do better than 1950s-era modeling and, indeed, there are some modern preferred-habitat models. For example, Yellen cites a paper I have seen which is this one, by Vayanos and Vila. This is much more sophisticated than the 1950s stuff, but it's basically a theory where we explain the term structure of interest rates by putting assets in the utility function. Thus, we can safely say that we are still waiting for a good theory of preferred habitat.

Is there empirical work suggesting that QE2 could be quantitatively significant, or that would tell us how large a program is needed to give us the effects we want - inflation rate about 1% higher, and less unemployment? Yellen cites two pieces of evidence. The first consists of event studies and regression analysis, conducted by economists in the Federal Reserve System and at the Bank of England. Of course, without a theory, these studies are pretty meaningless. We need sound structural evidence to say anything about the effects of policy. Second, Yellen argues that we can use large-scale macroeconometric models to look at the effects:
Turning now to the macroeconomic effects of the Federal Reserve's securities purchases, there are several distinct channels through which these purchases tend to influence aggregate demand, including a reduced cost of credit to consumers and businesses, a rise in asset prices that boosts household wealth and spending, and a moderate change in the foreign exchange value of the dollar that provides support to net exports. The quantitative magnitude of these effects can be gauged using a macroeconometric model such as FRB/US--one of the models developed and maintained by Board staff and used routinely in simulations of alternative economic scenarios.
Now, we know what the FRB/US model is for. In instances where no one at the Board has a clue what the effects of a policy will be, the policy (as best this can be represented in the model) is run in the FRB/US model, the computer spits out some numbers, these numbers are delivered to Janet Yellen, and she puts them in her speech. Hopefully the public buys it. Unfortunately there is no way to check whether the numbers make any sense. There are some sources like this one, that tell us a bit about what is going on in FRB/US, but we can't see the whole model, and we certainly can't run it for ourselves to see how it behaves. The best guess is that FRB/US is essentially a dressed-up version of the FRB/MIT/Penn model, developed in the 1960s. The economists at the Board who run the FRB/US model may pay some lip service to rational expectations, the Lucas Critique, and other developments in modern macroeconomics, but we would be surprised if the FRB/US model were anything more than an elaborate quantitative IS/LM model. As such, it would be ill-equipped to predict the effects of the QE2 program. Janet Yellen may tell us, as she does in her speech, that the FRB/US model predicts a 25 basis-point reduction in the 10-year Treasury yield and an increase of 700,000 in aggregate employment, but we would be foolish to attach any more significance to those numbers than we would to predictions that Janet thought up while walking her dog.

What have the effects of QE2 been thus far? Here, Yellen is quite selective. According to her, since late last summer, when Treasury yields have fallen it was because of QE2, and when yields have been rising, it is because of other factors. In other words, we have no idea whether this is working according to plan or not. In any case, it appears that the Fed cannot control long-term Treasury yields, unless they are just not intervening enough. Ultimately, of course, if the Fed were to purchase the entire stock of Treasury debt, it could certainly control long Treasury yields.

What might be a useful approach to understanding the effects of QE2? We might start by thinking of the Fed as a "shadow bank," of the type so well-described by Gary Gorton here and in his published work. Currently, the Fed is holding as assets mainly long-maturity securities - Treasury bonds, agency debt, and mortgage-backed securities, and it finances this asset portfolio by issuing currency and reserves. It is the transformation of long-maturity marketable assets into overnight reserves that looks like the asset transformation done by a shadow bank, which typically borrows overnight using repurchase agreements (repos) with the securities in its portfolio used as collateral. The Fed does not post collateral against its overnight borrowing in the form of reserves, as everyone has confidence that the Fed will not default. Now, in shadow banking, as Gorton points out, the shadow banks perform a useful service. Large institutional investors need a place to park cash overnight, and asset-backed securities are what helps support credit markets in the US. The shadow banking system is critical to how the banking system works as a whole.

Now, how useful is the shadow banking that the Fed is doing? On the asset side, the Fed's long-maturity assets are not information-sensitive (as Gorton would say). The stuff is Treasury debt, agency debt, or mortgage backed securities issued by the GSEs - nothing there of questionable quality. Presumably a private shadow bank is not going to have trouble in using any of these assets as collateral. On the liability side, the issue of reserves as liabilities is not accomplishing much. Many large institutional investors do not hold reserve accounts, and therefore cannot park their overnight liquidity with the Fed. The inconvenience of reserves (as Andy Harless points out) is reflected in the fact that reserves pay 0.25% overnight while the 3-month T-bill rate is currently 0.14%. Indeed, the Fed could potentially get more bang for the buck with QE2 if it could issue a marketable security - i.e. Fed bills, which could be used as collateral in repo transactions.

The only potential advantage the Fed has as a shadow bank is that it can issue currency (by virtue of the monopoly granted to it). But the stock of currency is determined by the willingness of people to hold it, and the unwillingness of banks to hold reserves. It's not clear whether, or how much, currency holdings will increase as a result of QE2.

Conclusions? We actually know little about what QE does. The theory has not been developed, and we can't have useful empirical evidence without a theory. It seems to me that intermediation has to be at the heart of the theory. To understand the effects of QE, we need to understand what the Fed can do as a financial intermediary that the private sector cannot, and this has a lot to do with the functioning of the so-called shadow banking system. Once we have the theory, we need to be able to measure the extent of private intermediation activity, particularly in the shadow banking sector. Unfortunately, as Gary Gorton points out, the measurement of shadow banking activity is close to non-existent. All the more reason to bring this activity under the regulatory umbrella.

Saturday, January 8, 2011

What is the Treasury Up To?

As I pointed out here, the QE2 Treasury security purchases by the Fed have actually had little effect on the stock of outside money, principally because there have been large inflows into the Treasury's General Account at the Fed. That continues to be the case. The first chart shows securities held outright by the Fed. According to plan, the Fed's stock of securities has increased about $122 billion since the QE2 program began in November 2010. However, in the next chart, we see modest increases in currency and reserves. Since early November, the increase in currency is about $18 billion, and in reserves only about $10 billion. The next chart, however, shows that the Treasury accumulated $81 billion in its General Account over the same period.

In its General Account and Supplementary Financing Account with the Fed, the Treasury now holds a total of about $315 billion. As one commenter suggested, perhaps what is going on is that the Treasury is hoarding cash in anticipation of a showdown over the federal debt limit, which seems as plausible as anything. In any event, if you thought that some of the effects of QE2 might come through effects on the stock of outside money (e.g. increases in the currency stock as banks dump the extra reserves), there is not that much of that happening.

Wednesday, January 5, 2011

Banking Regulation

The report of the Financial Crisis Inquiry Commission will be out soon (though delayed) so it is useful to start thinking about what types of additional regulatory reforms might be proposed in the current Congress. Gary Gorton and Andrew Metrick have a paper with some proposals for regulating the shadow banking system. This is among the set of ideas floating around that people seem to be taking seriously.

Gorton and Metrick basically have two proposals here. The first is to regulate money market mutual funds (MMMFs) as "narrow savings banks," and the second is a framework for "narrow funding banks" to intermediate asset-backed securities. As Gorton and Metrick see it, the problem with MMMFs is that they guarantee one dollar return per unit deposited, with the implicit backing of the government, but have an advantage over commercial banks in that, for example, they do not pay deposit insurance premia. To solve this problem, Gorton and Metrick adopt the proposal of the Group of Thirty, which is:
a. Money market mutual funds wishing to continue to offer bank-like services, such as transaction account services, withdrawals on demand at par, and assurances of maintaining a stable net asset value (NAV) at par should be required to reorganize as special purpose banks, with appropriate prudential regulation and supervision, government insurance, and access to central bank lender-of-last-resort facilities.

b. Those institutions remaining as money market mutual funds should only offer a conservative investment option with modest upside potential at relatively low risk. The vehicles should be clearly differentiated from federally insured instruments offered by banks, such as money market deposit funds, with no explicit or implicit assurances to investors that funds can be withdrawn on demand at a stable NAV. Money market mutual funds should not be permitted to use amortized cost pricing, with the implication that they carry a fluctuating NAV rather than one that is pegged at US$1.00 per share.
In regulating the shadow banking industry, Gorton and Metrick propose a regulatory framework for "narrow funding banks," which would be the only financial institutions permitted to hold asset-backed securities.
Narrow Funding Banks would be genuine banks with charters, capital requirements, periodic examinations, and discount-window access. All securitized product must be sold to NFBs; no other entity is allowed to buy ABS. (NFBs could also buy other high-grade assets, e.g., U.S. Treasuries.) NFBs would be new entities located between securitizations and final investors. Instead of buying asset-backed securities, final investors would buy the liabilities of NFBs.
Gorton and Metrick's idea is that narrow funding banks will guarantee a safe supply of collateral for repo transactions, which is required for the financial system to work efficiently.

Gorton and Metrick's thinking is encapsulated in their opening two sentences:
After the Great Depression, by some combination of luck and genius, the United States created a bank regulatory system that was followed by a panic-free period of 75 years – considerably longer than any such period since the founding of our republic. When this quiet period finally ended in 2007, the ensuing panic did not begin in the traditional system of banks and depositors, but instead was centered in a new “shadow” banking system.
Their view seems to be that, historically, US financial regulation has had many elements of success. Their aim is to take what we have learned from the successes of the past, and apply those lessons to our current predicament. Gorton and Metrick argue that their were three key features of historical banking regulation that provided safe "money." (i) During the free banking era (1837-1863), state-chartered banks issued circulating currency. In this instance, safety was provided by the requirement that these notes be backed by state government bonds. (ii) In the National Banking era (1863-1913), currency was issued by National Banks that were required to back the notes with federal government bonds. (iii) Checks were made safe through the provision of deposit insurance in the 1930s. Gorton and Metrick then argue that the process of intermediating asset-backed securities in the shadow banking system is much like the creation of "money." Shadow banks finance a portfolio of long-maturity asset-backed securities with short-maturity liabilities. Much of these liabilities are overnight repurchase agreements (repo), with the asset-backed securities pledged as collateral. These shadow banks, much like banks during the National Banking era or prior to the establishment of the FDIC, are subject to runs. Thus, as the argument goes, the kinds of government interventions that "worked" to make currency and transactions deposits safe will also work to make shadow banking safe.

Gorton and Metrick's narrow-funding-banking proposal is very much in the spirit of traditional narrow banking ideas, for example as outlined by Milton Friedman in A Program for Monetary Stability. Friedman argued that all private liabilities used in transactions should be backed 100% by the liabilities of the Federal Reserve System. This is of course not exactly what Gorton and Metrick have in mind. What they are proposing is that there be sufficient regulation and supervision of shadow banking that participants in repo transactions can think of the collateral as essentially riskless.

Now, one could view the history of US banking regulation as evidence of "genius" at work, or we could view it as series of attempts to fix a fundamentally flawed system. Indeed, if our only criterion were safety, we do not have to look very far to find a banking system that "works" better. The Canadian system of private note issue was wildly successful relative to either the Free Banking or the National Banking system in the United States. Deposit insurance did not come into force until 1967, yet Canada has never experienced a banking panic episode, and bank failures are very rare events (since 1920: one in 1923, a couple of small ones in the 1980s, none in the Great Depression or during the recent financial crisis). This is basically broad banking at work. Entry into banking is difficult, there is little effort to restrict size (though some mergers have been prevented), and there are no Glass-Steagall restrictions. But banks are tightly regulated; in particular there are stringent capital requirements. Perhaps we could learn as much from this as from US banking history. Maybe the Canadian system is so safe that it stifles innovation, and perhaps we are better off with more innovation and periodic crises. However, it pays to think carefully about this before we implement another fix.

My worry is that we could set up a regulatory structure that permits a "narrow savings bank" for this, a "narrow funding bank" for that, a narrow whatever bank for the other thing, and then wait for the next problem to arise, due to a clever innovator who can find a way to circumvent the new regulatory structure. Maybe a better approach is to embrace big banks, broaden our definition of what we call a bank (part of what Gorton and Metrick have in mind), insure retail transactions deposits at all institutions that choose to offer such deposits, and leave it at that.

The Income Distribution

This piece by Mark Thoma is a strange one, but it at least got me thinking. Mark starts with:
There is an equivalent of a Laffer curve for inequality, but the variable of interest is economic growth rather than tax revenue. We know that a society with perfect equality does not grow at the fastest possible rate. When everyone gets an equal share of income, people lose the incentive to try and get ahead of others. We also know that a society where one person has almost everything while everyone else struggles to survive – the most unequal distribution of income imaginable – will not grow at the fastest possible rate either. Thus, the growth-maximizing level of inequality must lie somewhere between these two extremes.
The "Laffer curve for inequality" is new to me, so I was hoping for a little more in terms of theory, but I guess the rest of the paragraph will have to do. Here's what Mark might have in mind here, though it's hard to tell. From standard neoclassical growth theory, we know that growth in our standard of living is driven by growth an aggregate TFP (total factor productivity), which in turn depends on technological innovation, and the efficiency with which factor inputs are allocated across productive units. Suppose we focus only on technological innovation. Innovators of course need incentives. Innovation is costly, and the reward needs to be sufficient to make it worthwhile. Now, imagine a population of identical people who have two choices: they can engage in risky innovation, or they can engage in subsistence farming. Also, suppose that there is one person - call him Kim Jong-Il - in this society, who has the power to redistribute income at will.

Suppose, on the one hand, that Kim Jong-Il is an egalitarian, and chooses to equalize income across the population. Then, there is no innovation, and this economy will be stuck in subsistence farming forever. On the other hand, suppose that Kim Jong-Il is, well, Kim Jong-Il. He starves the population, actually keeping them below what we would think of as subsistence, but still healthy enough to produce some extra stuff for the dear leader. There is no innovation in this society either, and it remains stuck.

So, now we have two points on the Laffer curve for inequality. What happens in between? Well, there are many ways in which we can redistribute income. We can provide some minimum quantity of a particular service - e.g. health care - for everyone; we can provide insurance against bad events - e.g. unemployment; we can tax some people and use the proceeds to provide public education for anyone who wants it. The effects on innovation will of course have a lot to do with how we do the redistribution. For example, unemployment insurance and welfare could have the effect of deterring innovation through poor incentives, but if the risk of innovation is difficult or impossible to insure through private financial markets, social insurance might actually increase innovation.

This certainly seems interesting. Now, where is Mark going with this? He drops this one:
We may be near or even past the level of inequality where growth begins falling.
So, Mark's concern is that we are entering Kim Jong-Il territory, which would certainly be distressing. What's the evidence for this?
The evidence on this is highly uncertain, so it’s difficult to say.
So Mark admits to not knowing what is going on, but he's quite willing to bull ahead with a policy recommendation:
But increasingly I am of the view that even if we could level the domestic playing field, it still won’t solve our wage stagnation and inequality problems. Redistribution of income appears to be the only answer.
Basically, Mark wants to throw in the towel on education and embark on an income redistribution project. Though the details of the redistribution are critical, Mark avoids specifics.

What do I think? What anyone can see with their own eyes in American cities is appalling. Many of our graduate students come from countries where people are much less well-off than is the average American, and they find it appalling. In many cases, for example here in St. Louis, the first world lives comfortably a short distance from the third world. The dispersion in income across the population in the US is large relative to what it is in other wealthy countries, and that dispersion has increased over the last few decades. Maybe we would not be too bothered by that if we thought that there was high mobility among income classes over time, but we know that there is a significant fraction of the population that is stuck near the bottom.

What's to be done? I'm certain that dumping cash in the inner cities will not promote economic growth in the United States, just as dumping cash in sub-Saharan Africa will not increase world economic growth. The answer has to be education. Here's an example of a sharp economist who has not thrown in the towel. Art Rolnick, recently retired from the Federal Reserve Bank of Minneapolis, has been an advocate of early childhood education. He uses economic evidence, including work by Heckman, to argue that the benefit/cost ratio for funds spent on early childhood education is very large. Further, he puts his time and effort where his mouth is. Indeed, Art embodies what is best in the economics profession: productive work toward a better society using a solid foundation of theory and empirical evidence.

Monday, January 3, 2011

Mankiw and Krugman

Mankiw's piece in the Sunday NYT and Krugman's column from this morning's NYT provide an interesting contrast.

Mankiw does a nice job of making the case for the conservative cause, though I'm not sure if there are any powerful people in the Republican party who actually embody this cool and rational approach. In any event, Mankiw's piece is a plea to the President to understand economic conservatives as standing for the following principles:

1. Focus on long-run issues: Milton Friedman was a strong proponent of this approach. When pressed for his views on short-run macroeconomics, Friedman's framework looked like an IS-LM model, but he was firmly against the use of short-run stabilization policy. According to Friedman, given policy lags and our lack of knowledge about how policy works, we would be better off not intervening to smooth business cycle fluctuations.

2. Incentives are important: The tax system and social insurance have to be designed with incentives in mind. For example, high marginal income tax rates discourage work. Note that this applies to the rich as well as the poor, if not more so.

3. Forget about income redistribution: Essentially all changes in fiscal policy have implications for the distribution of income and wealth. What I think Mankiw means here is that fiscal policy should not be designed specifically to redistribute income. For example, some objections to the recent tax bill from Democrats were related solely to the fact that the bill would retain the top marginal tax rate where it has been since the Bush tax cuts, instead of increasing it.

4. But inequality is a serious problem. We need to improve our educational system: Mankiw is not specific here. It's not clear if what he has in mind is an expansion of public education, or incentives for private education.

5. The demonization of conservatives won't get anything done.

Now, Krugman's column from today is not about these conservative principles, of course.

1. Focus on the short run: Mankiw, who certainly appears to be very much a short-run Keynesian (he of the Sticky Price Manifesto) seems to think that we have done enough stimulus, and it is time to move on. However, Krugman is very concerned, most of all about what he thinks is unwarranted optimism.

2. Don't worry about incentives.

3. Income redistribution is the main goal: Krugman states:
Jobs, not G.D.P. numbers, are what matter to American families.
Krugman focuses almost exclusively on the unemployment rate as a welfare measure. What he seems to have in mind is that, in any recession the dispersion in income across the population increases, and this effect is even larger in this recession. In the aggregate, we of course care about GDP numbers, but Krugman cares a lot about the distribution of income, and he wants to change it through the tax system and government expenditures on goods and services.

4. Public education? I think if you asked Krugman, he would come out in support of more resources for public education. In line with his focus on the short run, he does not mention that here.

5. Demonization: Krugman is of course well-known for this. You know that eventually he'll get around to "this Republican is a jerk," or "that Republican is a dope." This time out, he's a little milder than usual, but comes up with:
Realistically, the best we can hope for from fiscal policy is that Washington doesn’t actively undermine the recovery. Beware, in particular, the Ides of March: by then, the federal government will probably have hit its debt limit and the G.O.P. will try to force President Obama into economically harmful spending cuts.
Before we see it, we know that nothing good can come from Republican economic policy.

What are we to make of this? To me, Mankiw is making some sense, but I don't see any long-run vision coming from either political party, and Krugman isn't helping.