Make the case, and trust the public

There is an interesting topic raised in Krugman's latest column, responding to the Eric Cantor primary defeat: "movement" conservatives.  Krugman defines this as the "fix" by which the 1 percent "buys" the conservative base by accepting their priority on social conservatism in order to pursue their objectives of reduced taxes and smaller government.  Krugman gives credit to Thomas Frank, whose book "What's the Matter with Kansas?" (titled lifted from the essay that brought William Allen White to the public eye) first put this thesis on the map.

I expect Krugman would be willing to admit there is much oversimplification in this analysis, but as a starting point it clearly captures an important truth.  This alliance has existed almost from the time Nixon forged the "Southern Strategy" to take advantage of the wedge issue of busing for school integration, and when fundamentalists emerged from their religious near isolation as Roe v Wade gave them a handle at about the time the end of segregation took away the resistance by the Southern clergy to engaging public issues.  However, the "anti-government" movement has never been monolithic, or spoken with one voice, and tracing its evolution (in broad strokes) gives some idea of the complexity at work.

First, I would note that the movement began with real intellectual chops.  Milton Friedman, in particular, not only said things no one else dared to say, but unlike the disconnected sound bites that emerged from early neo-con thought, his theme was considered, had deep roots, and held together as a generality even when individual applications sounded crazy.  That made it persuasive to a broad swath of the intelligentsia.  Some supporting material such as Buchanan and Tullock's "government failure" analysis and the Law and Economics movement similarly made valid points with the contrarian appeal of flying in the face of platitudinous bilge which dominated reporting on the left.

Second, up until the Right faced the task of actually legislating in 1994 (the Reagan Administration was far from a triumph, and Bush I had competence without crowd appeal, the opposite of the Reagan combo), they still put a premium on effectiveness rather than ideological litmus tests.  It is hard  to remember that in 2000 when George Bush slipped into office with a theme of "compassionate conservatism" they still looked something less than legitimate, because "big ideas" like privatizing Social Security (and repealing Glass-Steagall and cutting capital gains taxes) smelled suspiciously like cordite.

So how did we get from there to the Tea Party?

Gail Collins' column on Cantor gives a strong clue.  She notes that Cantor's upset may have been as simple as his attack on his opponent for being a "liberal college professor", relying on the notion that college professors would seem worse to conservative voters than professional politicians.  Movement conservatism has long had anti-intellectualism deeply embedded, and the conservative reaction to intellectual elites may have fooled some exploiters working for the 1 percent into thinking that the faultline between liberals and conservatives could be painted successfully as a split between arrogant intellectuals bent on social engineering, on one side, and solid citizens relying on common sense, on the other.  Krugman falls into the liberal version of that oversimplification himself (and some posts of mine may have sounded similar), portraying anti-intellectualism as a fig leaf for racism and religious zeal. 

There is certainly an element of racisim in the Tea Party and the world of Talk Radio and Fox News ranters that have puffed up the wounded egos of the provincial voters for decades, undoubtedly manipulating them as cynically as a televangelist.  But watch out when anyone reduces a strong movement to such stark antagonism.   Their anti-intellectualism is part of an anti-elitism and anti-cosmopolitanism that is not owned by plutocrats wielding attack ads.

The truth of the "counterculture of ignorance" shibboleths, such as Intelligent Design and school prayer, is that they stand for a kind of solidity of values in traditional society that has a genuine and powerful appeal, not through cynicism but exactly the opposite, through knowing what life really takes.  David Brooks taps into this regularly by promoting attention to the values of community that sometimes seem under assault by an unrestrained Federal Government and the infamous "activist courts".  When we liberals say, "It takes a village" all too often we mean "it takes a court order."

We have stood by while defense  of a kind of absolutistic freedom of speech has turned into social chaos, when a suggestion of standards is jeered as censorship.  The attack on Sistah Souljah was portrayed as a success for distancing Clinton from the loony left of interest group trough-feeding, and no doubt it did that, but it also distanced him from the "anything goes" ideology that makes the ACLU set of issues dominate the social agenda on the left.  The Clintons "get" that social chaos is a real phenomenon, observable in high schools but also on into the 20s of kids who have no sense that they know how gender relations is supposed to work in the age of female empowerment.

If it sounds like I am arguing that we should take the values of social conservatives seriously, then I am making my point.  But not because I am a social conservative.   I think what "movement liberals" refuse to see is that the arrogance of the thin slice of leftist intellectuals mirrors the arrogance of the Koch Brothers and Mitt Romneys.  We did think we could do social engineering, and we still do.  But somewhere along the line we lost the belief that we could persuade the public rather than just seizing control with our superior intellectual credentials as justification.

Liberals quite literally hold social conservatives in contempt.  They do not believe it is possible to persuade them, being convinced that they have discerned the true nature of the trap these sorry people are caught in, and how nothing short of a total reform of society will make them see the light.  We have lost the belief that our solutions can be demonstrated and their success will be persuasive, rather than having to be imposed.

If we pay attention to the sea change in views of gay marriage, we will see quite a different dynamic at work.  Social conservatives want their values respected.  When they see that happening, they are willing to listen, and can, by and large, be persuaded by simple humanity.  When instead they feel top-down imposition, the pushback is likely to be visceral.

Had the economy not melted down in 2008, Obama would have had a very different career. He might not have been elected, but I think he would have anyway, if only because of socially conservative African-American voters in the swing states of Ohio and Florida.  He probably would not have brought in the Affordable Care Act, which would have been too bad, but his persuasive side would have gone on display instead.  Frankly, I think Obama understands the middle of the road voter as well as the Clintons do.  Most importantly he is able to articulate vision, including a vision of healing society that resonates very well with solid middle Americans.

It is not too late for the Democrats to put that message together for 2014.  Instead of coming across as those who know better, they can be the party of 1996 that believes both public and private sectors have their strengths and it is possible to put the two together properly.  Perhaps because he is black, Obama gets that values are not anti-intellectual.  He believes rhetoric matters because he has seen great changes - he is, after all, America's first president of color.  Only Obama has really shown that we can make the case and trust the public, if we are willing to be patient. The party needs to follow its leader.

Soft power

Watching Russians' teary-eyed support for Mr. Putin over Crimea, you couldn't help but see a different side of Russia.  It isn't all about spheres of influence and nostalgia for empire - there is also a feeling among the Russians that they have been blocked and hemmed in from legitimate aspirations such as international trade.  The mistrustful treatment by the West is reminiscent of the Cold War in ways less obvious than the rhetoric of toughness brings to mind.

Russians are all too conscious that their country was traumatized by the collapse of Central Planning, with Russian standard of living falling by one-fourth (imagine that your job was replaced by one paying only 75% as much.).  If it resembles the massive invasion and sacrifice of WWII to some, surely they can be forgiven.  And this translates into an achievement of those Russophobes who would humiliate Russia every chance they get, (and then gambol about, chortling with glee), at least in the minds of many Russians.

I would make two points about this chasm of perceptions.  The first is that we missed a golden opportunity for soft power when we did so little to help after the transition.  For a country who recognized the opportunities to win hearts and minds in post-War Marshall Plan spending, and then again in cementing the Camp David accords with a stream of assistance, this must rank as a major failure.  I hope historians will analyze it carefully.

(My boss at OMB at the time looked me straight in the eye over this, and said "No one wants their fingerprints on it." Put that on the tombstones of Bush I and of Clinton, I say).

The second is that  Putin will live to regret choosing hard power over soft, one day.  It is frequently argued that we in North America cannot fathom the patchwork of ancient animosities that is the old world, and that Russia still has to fight for territory just as Israel or Turkey does.  My response is that the soft power of mutual economic cooperation overcomes that need, and that Russia's need to cling to Stans in the Caucasus is as manufactured as its encirclement by a hostile West.  Only by persisting in acting as though they are under threat can they make such a paranoid worldview seem reasonable, in a kind of self-fulfilling prophecy.

Which brings us back to the tearful backers who see Crimea as the bastion of Russian civilization.  Soft power comes from within, as surely as hard power does, and Russia's pathetic need to continue lording it over someone is the source of their lack of actual persuasiveness.

Are we losing long run output?

Does failure to restore demand lead to lower output in the long run?

By now it must be clear, at least to most economists, that the stimulus was too small, as Krugman claimed, that the GOP opposition to all things Obama undercut further stimulus, and that there is still room for demand-led expansion.  Predictions of inflation have failed, and failed, and failed.  Why?  Because in a demand-constrained economy, added demand translates into added output, not into higher prices.

This is good old Keynesian old-time religion. One might make arguments as to other possible interpretations (a subject for another post) but at this point the presumption is that a Keynesian model makes sense when the economy is well short of long run equilibrium, and every indication is that we are in such a time.  Until unemployment drops at least another two percent, and housing is close to demographically sound levels of new home sales, that interpretation will keep looking good.

So it raises the question: what about the long run?  Are we just increasing the recessionary gap, so that the recovery will have considerable "spring" back in its step?  Or has the long-run equilibrium output level suffered from all this slump, so that it can in some sense never be made up?

There are some reasons to think prolonged slump damages supply.  First is the obvious lack of investment.  People learn to get used to old storefronts and to hang on to their cars longer.  The investment hasn't been there to depreciate less advanced capital, and lack of investment has led to a lower base to add further investment to, so that the standard notions of investment being a percentage of the capital stock translate into lower investment because the capital stock is less than it would have been.

If you focus on education, some of this effect materializes, but mixed with forces working the other way.  First, if people can't afford college and its debts, there will be less investment in human capital, and so less human capital to use in creating further human capital investment.   However, as is well known, the opportunity cost of studying is lower in a recession, so education formation will not fall by as much as overall output does.

The lag in investment is more likely to show up in lack of critical skill-formation among new employees who would have been hired in a real recovery, but were not.  Speculation focuses on these young people becoming "structurally unemployed" with a stigma of "slacker" on them, but I think they have just delayed the entry-level skill acquisition.

The tougher and more interesting question is whether students have avoided investing in specialist degrees out of concern for demand growth - specialists are more vulnerable to shifts in demand than generalists are, and it is impossible to diversify your investment in a degree.  There is no obvious reason why a prolonged recession should increase the likelihood of demand shifts, but it may increase the downside risk of what happens to you if your specialty loses its luster.  Instead of having a decent chance of retreating to generalist jobs, the specialist may find all those are taken by better prospects, who trained as generalists in the first place.

A standard neo-classical analysis would suggest that all the opportunities accumulating from advancement in technology remain waiting out there, and the economy will make up for lost time when demand does return.  This is the "closing of the recessionary gap" by long-run equilibration.  I am deeply skeptical of it, and believe that concern about "pushing on a string" is a sensible analysis, but in 1992 the economy did snap back from the recession that began with the end of the cold war.   On the other hand, interest rates did not fall to zero and stay there for years, in 1992.

I am inclined to think that opportunities are generated by local capital stock, not just by technology.  Allthough the impact is not as great as the impact of changing technology, we know that there are "interaction" effects in capital investment, so that within a region, investment by one industry helps to make investment by other industries more profitable.  This is an amorphous conglomeration of spillover effects due to production linkages, added profitability of infrastructure investments, consumption linkages (valuable homes make other homes nearby more valuable), and enhanced specialization.  Roughly speaking, these are the famous "agglomeration" external economies of scale.

Furthermore, I suspect that the most recent vintage of capital has the most significant spillover effects on related industries, stimulating problem-solving and idea exploration that carries over into upstream, downstream and cross-stream industries.  So if you pass up some of that investment, you pass up some stimulus to further investment, and some portion of the opportunities are permanently delayed, rather than accumulating. 

In theory this is partially offset by cheaper factors of production for the opportunities that do get exploited.  The question of long run effects might be boiled down to whether these "price adjustment" stimuli can overcome the "spillover" sources of drag.  But my reading of the Philips Curve evidence is that it isn't close - that price adjustment simply cannot create much stimulus, and in a serious slump, with interest rates all the way down to zero for more than six months, it may never catch up with continuing negative demand spillovers as people adjust to having less savings to dip into, less prospect of finding jobs that actually use their skills, and generally, an assumption that the long term will be bleak becomes a self-fulfilling prophecy.

In the face of all of those pressures, whether they seem ephemeral, like loss of optimism, or might actually be measurable, like loss of reinforcing productivity spillovers from new investment, I think you have to be a true believer to hold with zero effect on long-term prospects.

Dynamic Divide

   The glaring gap between rich and emerging economies has some interesting issues to present.  First is the high savings rate in China.  Second is the gap between opportunity and investment rates in emerging economies.  Third is the requirement for new paths to social development to match the challenges of trailing economies by contrast with the path-breaking Western economies and the immediate followers in East Asia.  These are related.

   The savings rate in China is known to be extraordinarily high - on the order of 40 percent.  This might not seem to be a dynamic issue, since the investment rate is also high (30 percent?).  But much of the investment in China is replacing productive capacity in MEDCs,or pre-empting the creation of such capacity.  Estimating conservatively, then, every dollar of gain for China at the expense of Western producers is increasing net savings in the world by about ten cents.  Fortunately this is probably less than a quarter of their growth.  Nevertheless adding to the world savings rate by a quarter of a tenth of a tenth of world GDP every year has a significant cumulative effect - the net world savings rate may be two percentage points higher than 10 years ago due to the shift in relative savings.

   Trying to do the same math with gross shares of world GDP gives me only half as big an effect.  It may be that replacement of MEDC production has been substantially offset by new Chinese demand for capital and business services from the MEDCs. That is more or less what would be expected from trade theory.  Nevertheless one percentage point impact on world savings in a decade is substantial drag on aggregate demand.

   One question it raises is whether the high rate will be sustained.  It would seem to be temporarily high, due to rapid advance in affluence and slow growth of expectations about consumption. Furthermore their retirement wave is more imminent than Europe's and more drastic than Japan's,
creating temporarily high crash savings for retirement.  It may be that we can expect a decline in the
rate of savings as more and more of the population moves from high pre-retirement savings to living off investments.

   But this raises yet more questions -- about returns on investments and where they will come from. We know that LEDC returns have not dropped down to incredibly low MEDC levels (approximately zero), suggesting that opportunities for productive investments continue to be high, as would be expected.  Yet if risks of financial investment were low, the flows of finance from rich to poor would be large enough to roughly equalize returns.  Substantial barriers must be deterring the flows, perhaps as simple as fear of confiscation and lack of in-depth knowledge of the opportunities, by rich country intermediaries.

   Note the implication that there are extensive untapped opportunities in the LEDCs.  So if the barriers could be overcome, growth in developing countries could be considerably faster, while retirements of the MEDC elderly could be considerably better financed.  Next question: is there some intervention in world institutions that would smooth those financial flows?

   The background picture is that there is a coordination problem.  If investors knew others would invest more, for example in housing, each would have more incentive to invest.  (Perhaps more important, if they knew what kinds of investments were most likely to benefit from the latent growth, the overall amount would receive a further boost.)

   There are at least two ways to intervene to reduce the coordination problem.  One is a sort of growth insurance, in which the whole (i.e. the government) offers some interventions such as higher education at a cost that will be reduced for areas with growth below expectations, and above average costs for those with excessively high unexpected returns.  Call it "progressive public service".  By reducing ex ante system risks it encourages banks and other knowledgeable intermediaries to lend.

   And of course assessing the expectations is an interesting problem.  One could argue that MITI was assessing expected returns by industry, and this might be a valuable role worldwide for the Development Banks such as the ADB.  Broadly, a geographical approach to assessing prospects, and providing growth insurance on that basis, might also benefit from international institutions pooling risks between regions.

  A second type of intervention could be greater use of equity positions.  Consider the motivation of confiscation risk.  If we ask ourselves how governments get to the point of finding foreign investments to be tempting targets, it surely derives somewhat from "zero sum" foreign investments such as resource extraction, in which confiscation loses very little on-going input from the investor.  But these do not seem to be the only kinds of investments subject to confiscation.  In general, a high ratio of foreign proftis to local input would be a flag for danger investment. 

   Equity positions make such imbalances less likely.  If it was routine, for example, to begin with at least 40 percent of equity from the host country (or a region, in the case of very small or very poor regions) or to build to it with employee share ownership plans, then the shared success would create mutuality, and encourage a mutual approach in upcoming waves of investment. 

   Which leads to the last issue - how to approach social development differently.  In the West, this was created by the dramatic increase in productivity as the industrial era moved into mass production after WWI.  It inevitably increased workers' wages and living standards.  But as technology and the globalization of labor-intensive production halted the gains to labor starting in the late 70s, we have been given reasons to doubt whether labor would continue to progress.  East Asia has adopted the Western model, by and large, and rapidly appropriated the same gains of industrialization for  their workers.

   But as countries such as Argentina and the Philippines have lagged, it is worth asking whether their social development can be created by the same dynamic of wage advancement due to industrialization.  Further advancements in production of goods seems to be shifting toward capital intensive sources, and advancement in services seems to be a slow-growth process of gradually adapting to high-service approaches due to advancing incomes.  The danger is that no sufficiently powerful source of advancing productivity will spread across enough sectors to turn technologcial gains into income gains for the masses of LEDCs.

    Simply put, the advancement of productivity in goods may be diluted by too large a population of potential workers, so that the gains do not diffuse to the wage level and remain within too small a population of owners, unable to support the real mass-production economy that made the MEDCs what they are today.  It seems more and more possible that productivity will continue to grow but without distributing the results broadly, so that "absorptive capacity" (i.e. demand) does not keep up. The result is low-level equilibrium, with extractive control of production and stunted actual growth.

    My answer would be equity capital.  Like "pension fund socialism" that seemed possible in the 70s but never materialized, this would involve a broad base of ownership, so that the surplus value created by industrialization is not held in foreign hands, or in the hands of a small group of "entrepreneurs" who are benefitting from increasingly concentrated production of goods and and increasingly large returns to positionality of marketing.

     Like the introduction of credit in South Korea in the 90s, equity capital for equity would actually switch important sources of negative feedback into positive feedback for growth.  But it may require governmental management of the process, either using external debt to create equity positions internally, or using mandates for foreign investors to include substantial local equity, with a large portion of this distributed broadly in the population.  It may be necessary for education, or social institutions for managing the process, to link ordinary people to the accumulation and management of equity capital.  But I think the role of such "social intermediation" is already visible and likely to grow more discernable quickly.

Flat-earth society opposes stimulus package

Wow, what a wild 7 months it has been. The recession did finally arrive with a vengeance, and rounds of bailouts have kicked up tons of fuss. Somehow controversy manages to continue, though to his credit Bernanke has truly turned out to be a "two-handed economist" with the ability to recognize the nature and magnitude of the threat.

Business Week publicized a meeting sponsored by the Cato Institute, showcasing the "long run equilibrium" perspective with Nobel laureate Ed Prescott as headline speaker. These folks are actually arguing that the stimulus plan is a mistake, will make no difference to output and will add significantly to inflation over the next few years. "All that is needed" they argue, is for wages and prices to fall far enough to capture people's spending, and then things will pick up again at the same "real" level of output that would have prevailed without the intervention.

I will try to avoid going apopleptic at the notion that they can get away with arguing that kind of drivel. Because Prescott can do well with a research paradigm that assumes that sort of thing to be true, and can solve technical problems within it that would be intractable in a more realistic setting, he gets to pocket fat fees for spouting the Cato line. But when I say, "do well" with this paradigm, I don't mean finding evidence that anyone believes to be persuasive. Rather I mean setting and solving problems that are technically interesting enough to sustain lots of Ph.D. dissertations and articles leading to tenure. In some ways the profession is as corrupt as the politicians.

The main problem, of course, is that much of the profession is still interested in fighting the last war, meaning the war against inflation that was so painfully won in the 80s. They haven't spent much time thinking about the possibility of a demand-constrained economy or about what needs to be done in that case. The fact that the obvious answers are Keynesian (the Keynesian approach arose from the last really seriously demand-constrained economy, namely the 30s) sounds to these people like going back to the over-confident Keynesian approach of the 60s and early 70s, when supply constraints were deliberately, consciously ignored. Fortunately Bernanke made a study of the Great Depression, and with an open mind rather than an ax to grind (or a paymaster to please).

In fact, there is no evidence that the "equilibrium" approach is of any value at all once a serious downward spiral begins. The talk of long run adjustment to the economy producing at capacity (sorry at "equilibrium" determined by capacity) is completely baseless, imposed by a certain symmetry in the models that do well in a supply-constrained economy and have therefore been at least competitive for professional backing. Chris Sims, 25 years ago when I was at Minnesota, said that he was not interested in any model that didn't have rational expectations, but also said that he had never seen any results from econometric modeling that didn't come out favoring the Keynesian view. That was after the St. Louis model (that falls apart even in the 80s) and I would venture to guess that his views haven't changed. On either point.

I cannot confidently predict that today's stimulus will add nothing to inflation in a few years. I can say with a high degree of confidence that 6 percent inflation would be much better than the situation if there was no stimulus. And in fact, the most likely inflation rate in the next 3 years will be below 2 percent all 3 years.

Just one other note. I think the press should be obligated, whenever they give time to any of the conservative crew as a way of being "even-handed", to ask them what they think about privatizing Social Security now, and to print their answers. They don't have to let themselves be spun by a bunch of hacks, or to pretend that they are allowing a fair hearing for a legitimate alternative point of view. It has no more empirical backing than creationism.

Tax the beasts

An interesting piece in the Economist this week (on "rebalancing") took note of Chinese retail sales growing faster than exports.  This is big news, folks.  If there is anything to my notion that the world as a whole is in a Keynesian configuration (demand-constrained, not supply-constrained) it will only show up if China and India can go on growing based on demand in their rapidly developing internal market, while the rest of the world goes through at least a slowdown or "growth recession."  A friend passed on reports from McKinsey types that China has vast excess capacity (but then, people have been reporting that since 98 or so, at least), but nearly every observer believes there is a vast unmet need for infrastructure, despite China pouring 50% of the world's concrete last year.  (The last time any country had 50% of the world's anything was 1948 when America had half the world's output.)

Now if we could just get them to try credit cards . . .  Hmm.  Maybe not the year to suggest it.

More interesting stats from the article:  the US would have been in a recession since last Fall if not for export growth.  US exports to China grew 20% year on year.  And China's trade surplus fell from 11% of its GDP to 9% last year.  Also BRIC demand (Brazil, Russia, India, China) is forecast to rise 9% next year.

Since I often dump on the Economist, I am happy to praise them now and then for getting the real facts together like no one else.  

Speaking of the credit crisis, fascinating to follow the debate over it.  I'm not optimistic for a real change in the regulatory regime until after the election, but if you look at what happened in the Microsoft case, you have to wonder if even the combination of Demo pres and Demo Congress could pass legislation that would hold up to capital market innovations.   Since what is really needed is discretion by bureaucrats to slap down any repackaged version of excessively risky behavior, you know the process would end up in the courts, and they have been taken over by Scalia types.  Lord, save us from another Republican administration.  We can't afford the bills.

Since I have argued that Demos need to look for actual solutions, and not settle for being mirror images of the Republican knee-jerk anti-governmentalists, let's try one.   Obviously the solution to the kind of slick exploitation that brought on the crisis doesn't have to be government saying "No."  Instead of an FDA-type supervisor that fines for bad behavior, we could just use extensive inspection and "truth in labelling" to give experience rating on the accuracy of mortgage originators, for example.   Now that has real difficulties: originators in Las Vegas would look a lot worse than originators in Chicago right now.  But the ratings can be corrected for regional performance, and those who lent to disproportionately many turkeys from a given area could be exposed for what they are to the markets.    My guess is that would shape people up a lot, without facing innovative packaging or court challenges.

But it has to go even deeper.  Basel II has put risk assessment in the hands of banks themselves. The flagship of sophistication was supposed to be Citibank, the best modelers outside of investment banking.  But like the ratings agencies, they proved to be systematically biased so that their spectacular failure in the light of hindsight turns out to represent an unspectacular but much more dangerous failure in pricing "expected outcomes."  Apparently counting next to nothing for liquidity risk was a big part of that - replicated throughout the financial system, that creates the potential for the systemic equivalent of a run on the bank that Bernanke has been doing such a good job of fending off.

I suggest, with all due humility, that the problem is externalities and the solution is a version of Polluter Pays.  Nobody worries about the fact that their excess leverage (lets call it what it is) imposes risk on the whole system.  So let's tax them.  Literally.  For overuse of Fannie Mae and Freddie Mac, for underuse of capital and reserves, and for failure to diversify their portfolio of assets. Make them pay for sampling to determine accuracy and completeness of the information they provide when they sell assets, and use SQL to charge them whenever they burden the system with asymmetries in their omissions: if, as one study found, the ones they sell do worse than the ones they keep, for any given Moody's rating, charge them (heavily) for it.  Charge them when too high a percentage of their assets are in the form of derivatives. Charge them when they have conflicts of interest, even if they haven't created any disasters yet. The flavor of the decade in the 90s was "Moral Hazard".  With all due respect, the problem wasn't the government standing ready to save the system when someone too big to fail looks like failing, it is the government's failure to charge for the risk those people impose on the system.  

Come to think of it, we need a "too big to fail" tax.

I like it so well, I think I will email it to Krugman.  If he uses it, you will hear from me.

But other than that, you probably won't hear from me.  School starts this week.  I doubt if I will find anything urgent enough to say before the election.

Oh, just one little note.  I heard about a great website: www.gapminders.org.  You can watch China and India catching up with the West before your eyes.

Ignoring the Yield Curve sign.

Just checking in

Work has eased up a touch, at the end of a teaching year. So I am checking in to see how things stand in my narrow little blogworld.

First, the astonishing news that the yield curve continues inverted after a year now, with no recession in sight. There was a time six months ago when markets had priced in a pretty significant chance of a downturn, but it just hasn’t happened. True, it has been only a quarter of a percent inverted for many months, but that has between 30 and 40 percent chance of bringing on a recession, according to Estrella and Mishkin (96). This must be the longest inversion ever without a recession following it.

The Fed has apparently inquired into this oddity, and believes that the story is the amount of credit flowing in for long term lending, presumably mainly from East Asia. Makes sense, but it turns our standard interpretation on its head. Instead of the inversion representing tightness in the short-run relative to “the markets”, it is telling us about excess liquidity that is hitting in the long run part of the yield curve. We live in interesting times.

I think the story should be combined with the obvious Keynesian facts that the world is helping to support the US economy in a time when it would otherwise have stumbled from the housing slump. Continued export of everything, helped by a falling dollar, keeps an even course for the economy and for investment. We have finally become an open economy, in the export sense and not only as importers. Capital pouring in while export orders continue – it is a different picture from the standard textbook macro and financial world.

I will claim another accurate prediction to offset my overeager jeering that the Fed had engineered a recession. Looks like the analysis that Asia would have to let the dollar down gradually has proved accurate. It may help that Middle Eastern oil money is sophisticated enough to diversify early. May they find plenty of Third World opportunities. Yet China still has a large trade surplus, presumably indicating the country is accumulating foreign exchange. Their overhang is growing faster than they are easing the adjustment by letting the dollar fall. Perhaps outward investment in Africa, Latin America and Australia will help to relieve their predicament. And of course the US still has a large trade deficit, indicating we have a long way to go to get adjusted.

Keep an eye on the “dollar adjusted” price of oil. Oil prices are down 9% from last year in dollars, but in euros you need to add 6% to that.

Keep an eye on the Republican implosion as well. It is not just Iraq – or the “Mayberry Machiavellis” (I got the phrase from Frank Rich) who are running the show. It is still fundamentally that they lack a vision to cohere around. They run better in opposition, obviously, but their opposition is based on an obsolete anti-Government position (“starve the beast”) that will not be trusted with governing for any length of time. Until they put together a philosophy of governance capable of resisting pressures for cronyism, they will continue to look like Mugabe because they act like Mugabe. There is some hope for them in the pragmatism of a Mitt Romney (Mormons always were better at making the trains run on time than on thinking abstractly about principles), but in his case, at least, it just looks opportunistic.

How will they sort themselves out? Since they are more ready to opt for pragmatism than the Democrats, it may be that in their next opportunity they actually invent some interventions that have a chance to work. I still think school vouchers had, and has, some potential, but they need to throw out the knee-jerk anti-government stance to get it into shape to perform and persuade.

Four mega-policies of the last 30 years are theirs, at least in spirit, and are essentially successful. 1. Free trade (with structural adjustment) has paid off handsomely for the world economy and for the ideology of capitalism relative to socialism. 2. Welfare reform was a good idea, though painful in execution. We can be thankful that it was essentially pragmatic Democrats who implemented it, and for the economic recovery that smoothed the adjustment. 3. The Earned Income Tax Credit, essentially Milton Friedman’s Negative Income Tax, (originating in the years when we were all Keynesians) was brilliant and has made all the difference to the budget pictures in the US and in Blair’s Britain. 4. Cap and trade systems for CO2 have helped move business into seriously engaging global warming, which is what they were designed to do. Ironic that Bush resisted the latter. All of these are pre-NeoCon. There was a time when the Republican critique of Socialism brought forth actual solutions, and not just rip-offs and Bad Cop role playing. The big question is how long it will take for that side of the party to reassert itself.

And the answer, I suspect, depends heavily on how willing Democrats are to commit to communitarian-based problem solving, rather than just pandering to interest groups. The ideologies of socialism and then of civil rights made real progress. Interesting to note the difference in response: socialism brought forth reasoned, pragmatic analysis. Civil rights opened up the opportunistic Wedge Issue politics that Nixon started, and that has essentially run its course with the current collapse. If the Democrats engage as thoughtfully this time, then they will push the Republicans out of their rut and we may get some more dialectical progress. Read that as an endorsement of any of the big 3 Democratic candidates: Edwards, Clinton and Obama are all taking a thoughtful approach to fundamentals, and I say Bravo. Forget Iraq. Get on with governing.

* Estrella, Arturo and Frederic Mishkin, “The Yield Curve as a Predictor of U.S. Recessions,” Current Issues (by the NY Fed), June 1996.