One of the reasons I started this blog almost was to try to correct the distortion of economic ideas by people masquerading as economists in pursuit of political goals. Ideas were presented in a misleading, distorted, or incomplete way in an attempt to sway the broader public toward a particular political agenda (tax cuts paying for themselves and Social Security were particular sore spots).

Economics is not the only discipline with this problem as the debates over issues such as global warming illustrate well, but I didn't realize some people think the answer to this problem is to shield research from the public. This is from a discussion of the way in which ideas about quantum physics are used to mislead the public:

For some scientists, the unfortunate distortion and misappropriation of scientific ideas that often accompanies their integration into popular culture is an unacceptable price to pay.

But I think this is the right response:

I share their irritation, but my strongly held view is that science is too important not to be part of popular culture. Our civilization was built on the foundations of reason and rational thinking embodied in the scientific method, and our future depends on the widespread acceptance of science as THE ONLY WAY WE HAVE to meet many, if not all, of the great challenges we face. Is the climate warming and, if so, what is the cause? Is it safe to vaccinate children against disease? These are scientific questions, in that they can be answered by the analysis of data, and therefore the answers are independent of the opinion, faith or political persuasion of the individual. ... The key words in the above paragraph are “widespread acceptance”. In democratic societies, progress is made through persuasion, and science has a most persuasive story to tell. ...

The problem that economists have, particularly macroeconomists, is that data rarely settle the issue. This is something I wrote on this about a year ago:

Why can’t economists tell us what happens when government spending goes up or down, taxes change, or the Fed changes monetary policy? The stumbling block is that economics is fundamentally a non-experimental science, particularly in the realm of macroeconomics. Unlike disciplines such as physics, we can't go into the laboratory and rerun the economy again and again under different conditions to measure, say, the average effect of monetary and fiscal policy. We only have one realization of the macroeconomy to use to answer important policy questions, and that limits the precision of the answers we can give. In addition, because the data are historical rather than experimental, we cannot look at the relationships among a set of variables in isolation while holding all the other variables constant as you might do in a lab and this also reduces the precision of our estimates. Because we only have a single realization of history rather than laboratory data to investigate economic issues, macroeconomic theorists have full knowledge of past data as they build their models. It would be a waste of time to build a model that doesn't fit this one realization of the macroeconomy, and fit it well, and that is precisely what has been done. Unfortunately, there are two models that fit the data, and the two models have vastly different implications for monetary and fiscal policy. ... [This leads to passionate debates about which model is best.]
But even if we had perfect models and perfect data, there would still be uncertainties and disagreements over the proper course of policy. Economists are hindered by the fact that people and institutions change over time in a way that the laws of physics do not. Thus, even if we had the ability to do controlled and careful experiments, there is no guarantee that what we learn would remain valid in the future. Suppose that we somehow overcome every one of these problems. Even then, disagreements about economic policy would persist in the political arena. Even with full knowledge about how, say, a change in government spending financed by a tax increase will affect the economy now and in the future, ideological differences across individuals will lead to different views on the net social value of these policies. Those on the left tend to value the benefits higher, and place less weight on the costs than those on the right and this leads to fundamental, insoluble differences over the course of economic policy. Paul Ryan will never see eye to eye with Obama. Progress in economics may someday narrow the partisan divide over economic policy, but even perfect knowledge about the economy won’t eliminate the ideological differences that are the source of so much passion in our political discourse.

So it is not at all clear to me that the strong divides in economics can be settled with the data. It is certainly problematic with the data we have -- it's just not able to discriminate well between competing models, and as noted above even perfect data wouldn't settle all the isues. It's not completely hopeless:

...the ability to choose one model over the other is not quite as hopeless as I’ve implied. New data and recent events like the Great Recession push these models into unchartered territory and provide a way to assess which model provides better predictions. However, because of our reliance on historical data this is a slow process – we have to wait for data to accumulate – and there’s no guarantee that once we are finally able to pit one model against the other we will be able to crown a winner. Both models could fail...

I think the Great recession has, for example, provided evidence that the NK model provides a better explanation of events than its competitors, but it is far from a satisfactory construction and it would be hard to call its forecasting and explanatory abilities a success.

I have a few comments on the president's proposal for corporate tax reform (which relies, in part, upon Jared Bernstein's post):

Obama's Proposed Corporate Tax Cut Won't Do Much to Stimulate the Economy

The bottom line is that it is mainly a redistribution of the tax burden rather than a net cut in taxes, and I don't think it will have a large impact on the economy.

 

More on the evolution of the stimulus package:

The Memo that Larry Summers Didn’t Want Obama to See, by Noam Scheiber: ...Last month,... Ryan Lizza wrote a much-discussed piece in The New Yorker... The piece ... described the stimulus options that Obama’s team—including Larry Summers ... and Christy Romer ... sent him. The options ranged from about $550 billion to just under $900 billion. Intriguingly, Lizza also noted that Romer “was frustrated that she wasn’t allowed to present an even larger option,” suggesting that ... the memo he obtained ... was far from the whole story. ... I can fill in ... the narrative—an earlier version of the same memo that includes Romer’s larger option. (A source provided the memo...) In this version of the memo, Romer calculated that it would take an eye-popping $1.7-to-$1.8 trillion to fill the entire hole in the economy... By clicking on the graphic..., you can examine ... Romer’s version of the memo alongside the final version... What’s striking is that ... the paragraph in which Romer makes the case for $1.7-to-$1.8 trillion has simply vanished. What happened? When Romer showed Summers her $1.7-to-$1.8 trillion figure..., he dismissed it as impractical. So Romer spent the next day or two coming up with a reasonable compromise: $1.2 trillion..., along with two more limited options: about $600 billion and about $850 billion. At first, Summers gave her every indication that all three figures would appear in the memo... But less than twenty-four hours before the memo needed to be in Obama’s hands, Summers informed her that he was inclined to strike the $1.2 trillion figure. Though Summers ... believed more stimulus was ... better, he also felt that a $1.2 trillion proposal, to say nothing of $1.8 trillion, would be dead on arrival in Congress. Moreover,... Summers worried that urging more than this amount would stamp him and Romer as oblivious... “People will think we don’t get it.” Romer was uneasy with this. She felt that $1.2 trillion was itself a pragmatic middle ground. She also believed the president-elect should deeply grasp all the trade-offs he faced... She protested, but ... Summers held firm. ... The final version of the memo ... framed the debate around two basic choices—roughly $600 billion and roughly $850 billion... Neither the memo nor the meeting would have given Obama reason to suspect this amount was arguably $1 trillion too small. ... Though Obama was never going to propose a $1.8 trillion stimulus, and Congress certainly wasn’t going to pass one, the president may well have felt a greater sense of urgency had he better understood how far he was from the ideal.

With respect to Summer's "People will think we don’t get it" excuse for not even presenting the higher figure, it seems to me their job was to make people get it -- to make them understand why the larger figure was on the list of options.

Does the way in which the language we speak describes the future have an impact our intertemporal choices? Apparently so:

Whorfian Economics, by Keith Chen: Mark and Geoffrey were kind enough not only to write thoughtful columns on a recent working paper of mine here and here, but to invite me to write a guest post explaining the work. In the spirit of a non-linguist who’s pleased to be discovering this blog, I wanted to use Mark and Geoffrey’s insightful posts as a springboard to explain my work. In a nutshell: I find a strong correlation between how a language treats future-time reference (FTR), and the choices that speakers of those languages make when thinking about the future. Specifically, in large data sets that survey families across hundreds of countries, I find a strong and robust negative correlation between the obligatory marking of FTR in the language a family speaks, and a whole host of forward-looking behaviors, like saving, exercising, and refraining from smoking. [...For those readers unfamiliar with this typological distinction, English is considered a strong-FTR language because of observation that unlike most Germanic languages, English generally requires speakers to grammatically mark future events, primarily with either the de-andative construction “be going to” or the de-volative construction “will”. It is this generally tendency toward obligatory grammatical marking of future time that characterizes the strong vs. weak FTR distinction. ...] These correlations hold both across countries and within countries, even when comparing effectively identical families born and living in the same country. While the data I analyze don’t allow me to completely understand what role language plays in these relationships, they suggest that there is something really remarkable to be explained about the interaction of language and economic decision making. These correlations are so strong and survive such an aggressive set of controls, that the chances they arise by random lies somewhere between one in 10,000 and one in 10^32. Starting with Mark’s post: Mark illustrates beautifully an idea that is really the central concern of all work done in modern econometrics: it can often be difficult to tell the difference between strong correlations produced by causal relationships, and correlations which arise through non-causal factors. Since questions of the connection between language and behavior have historically generated considerable controversy, it seems important to think hard about what exactly these correlations actually suggest. Towards this, I’ll discuss briefly why my analysis suggests that a non-causal story is unlikely, and that a language’s structure is causing its speakers to behave differently. ... In short, I believe the data suggest a strong and robust relationship between linguistic and economic data, a relationship that bears explaining. Where this leaves us is what I think is an exciting place: one where Economists have a lot to learn from Linguists.

Much, much more here, including a discussion of potential weak points in the results.

• Assistant Secretary Eberly Responds to the Economist - Treasury Notes
• Google to Sell Heads-Up Display Glasses by Year's End - NYTimes.com
• Romer: We Need A Regime Change at the Fed - David Beckworth
• FHFA releases plan for Freddie, Fannie exit - The Washington Post
• Precautionary savings in the Great Recession - Vox EU
• Minutes of Board discount rate meeting - FRB
• The GOP's Big Investors - Robert Reich
• Work experience: does it work? - Jonathan Portes
• Does Latvia Give Us Any Clues? - The Wilder View
• Partying Like It's 1934 - Paul Krugman
• Grit is Good - Howard Davies

Teaching day, so a quick one on Greece -- the reviews are in:

Greece, by Paul Krugman:

We must do something. This is something. Therefore we must do it.

Yes, Minister.

What can I say? As Felix Salmon says, this really isn’t credible. The problem with all previous rounds here has been that austerity policies depress the economy to such an extent that it wipes out most of the topline fiscal gains: revenue fall, so does GDP, so the projected debt/GDP ratio gets, if anything, worse.

Now we have another round of austerity — which is assumed not to do too much damage to growth. The triumph of hope over experience.

OK, nobody here is an idiot (although see my next post). What’s happening is that nobody is prepared to take the plunge into either of the paths that might eventually lead out of this: sustained aid (not loans) to Greece, or departure from the euro, leading eventually to higher competitiveness and faster growth. Both options would be politically catastrophic, which means that they can’t be taken until there is literally no alternative.

So Greece will be strung along some more.

Political constraints limit the options for rescuing the financial sector after a meltdown:

Political constraints in the aftermath of financial crises, by Atif Mian, Amir Sufi, and Francesco Trebbi, Vox EU: Financial crises of all colors (banking, currency, inflation, or debt crises) leave deep marks on an economy. ... What exactly occurs in the aftermath of financial crises that makes recovering from such shocks so hard? This column argues that the answer may lie mostly with the politics, not the economics.

Let us start with some stylized facts. One thing that happens with some regularity, but seems not to have been systematically documented, is an association of financial crises with ...  increases in income inequality...

Although the relationship between higher inequality and persistent contractions is not conceptually straightforward, the evidence is consistent with the view of a financial crisis damaging certain constituencies in society more than others.

As an example we can look at ... the disparity of how the value of real estate assets, mostly held by middle- and low-income indebted households, is still far from having recovered to pre-crisis levels, while financial assets, mostly held by the wealthy, have already bounced back. Some may be hit harder than others in a financial crisis, and this is a consequential phenomenon. ...

Individuals differentially affected will probably support different policy responses to the crisis. Agreement on unified reactions to the negative financial shock may become harder to achieve or nonexistent. This may stall potentially beneficial macro-financial reform, which could speed up the recovery. ...

A systematic analysis of ‘politics after the crisis’ fits this logic. ... Voters become more ideologically polarized... Government coalitions become weaker... Opposition coalitions become larger. Party fragmentation increases across the board. ...

As one would expect,... after the crisis hits, the moderate middle sinks and the extremes rise. This is reminiscent of the rise of the Tea Party on the right and of Occupy Wall Street on the left in the post-Great Recession US. ...

Political gridlock and lack of reform are natural outcomes of polarization. Gridlock delays reform and possibly makes recovery slower (explaining the long recessions and sluggish recoveries). ... Crises are occasionally thought of as critical junctures where macroeconomic reform unlocks by shattering entrenched conditions (Drazen and Easterly 2001). The opposite seems true.

The list of potential negative implication does not stop here though.

1. Gridlock brings selective intervention. In the aftermath of a financial crisis, any type of reform, including bailouts, faces a higher bar for passage. Unfortunately, if a reform overcomes political gridlock, it may well be not because of efficiency or merit, but because of strong political organization by its constituency... Is it surprising that concentrated special interests (such as large US banks...) got a sizeable bailout through TARP, while diffused special interests (such as mortgage debtors) did not? This selective intervention may then feed back into further increasing economic and political polarization.
2. Gridlock brings political uncertainty. Markets for sovereign debt do not seem particularly appreciative of governments engaging in stalemate or political bickering at the time a country needs decisive intervention the most. Recent credit rating downgrades of US or European debt fit this interpretation. ...
3. In the same way that financial crises appear to polarize constituencies at the national level, it is not hard to envision polarization at the international level playing an important role. ...

In conclusion, to those of us interested in efficient policy response in the aftermath of financial crises, understanding the logic of political constraints may be useful. The chances are that a country will not achieve reform precisely when it needs it the most. Any model of post-crisis macro intervention that leaves this political feature aside forgoes an important dimension. ...

We didn't have until after the fact to learn this lesson. At the time, many of us were urging the administration to consider the distributional consequences of the financial bailout -- who was helped and who wasn't -- and to adjust policy accordingly (e.g. the banks could have been saved without rewarding financial executives who had a hand in creating the problems). But the administration was afraid that if it took the steps required to do this, i.e. if it nationalized the banks temporarily, removed the management, put the good assets in one pile, the junk in another, and then sold the good assets back to the private sector, Republicans would have been upset. They might have called the administration socialists, criticized the bailout, something like that, you know --like they did anyway.

The administration argues it had little choice about how to conduct the bailout due to legal restrictions that prevented it from taking over shadow banks in the same way it could traditional banks, and there was an urgent need of an intervention of some sort. Nevertheless, there were other options it could have pursued even within the structure the administration adopted, e.g. more aggressive clawback on profits resulting from the bailout through warrants and other means. In any case, I just wish more had been done for the households that were struggling every bit as much as the banks. A lot more.

Menzie Chinn says "there is substantial space for rising wages":

Competitiveness, and the Bush Tax Cuts and Deficits, by Menzie Chinn: The Administration released the annual Economic Report of the President on Friday. Many topics were covered, but here I’ll remark upon a few issues, motivated by several graphs. First is price markup over unit labor cost. The interesting trend since 2001 has been the rise in this variable.

Source: Economic Report of the President, 2012.

From this graph, one would be hard pressed to find American business in terrible shape. Productivity has increased, labor compensation growth has been modest, so that it’s obvious where profits have come from. This also means (to me) that there is substantial space for rising wages to be absorbed without a commensurate wage-price spiral. ...

[Menzie also discusses several other aspects of the report.]

Update: Karl Smith comments on the same graph.

• How to Get the Rich to Share the Marbles - NYTimes.com
• Are macroeconomic methods politically biased? - Noahpinion
• The Moving of the Overton Window on Fiscal Policy - David Dayen
• Political constraints AND financial crises - Mian, Sufi, and Trebbi
• Straight Talk and Shifting Windows - Paul Krugman
• 2010 and Monetary Policy in the UK - mainly macro
• Did Obama Turn Around the Economy? - Jeff Frankel
• 'Germany Has Been the Winner...' - Kenneth Rogoff
• America needs its own infrastructure bank - FT.com
• Playing With Fire With Oil And Iran - Barkley Rosser
• Why Inequality Matters - Bruce Judson
• Mr Shirakawa’s open ‘goal’ - Money Supply

I want to follow up on Paul Krugman's post about the shifting Overton window in the UK toward the political right (think of the Overton window as a view into the center of a debate). As Krugman would be the first to tell you, it's not just in the UK. For example, consider the current discussion over the president's proposed budget, a budget that is touted as "broadly consistent with the bipartisan deficit reduction proposals put forward by the Bowles-Simpson Commission."

I thought the recommendations for balancing the budget that came out of the Bowles-Simpson committee gave far too much to the GOP - the solutions that were proposed were much further to the right of the political spectrum than I would have preferred. My recollection is that people such as Paul Krugman and Dean Baker were critical as well (and recall that there was no official report because four Democrats and three Republicans on the seventeen member committee could not agree to the recommendations on the table -- instead we got an unofficial report from the committee chairs, Bowles and Simpson).

However, Republicans have shifted the debate so far to the right that Bowles-Simpson is now being portrayed by the administration and others as a model of balance, reason, and compromise that both sides ought to embrace.

Now it is true that the administration is backing off on one proposal in Bowles Simpson that generated much of the opposition from the left, one to raise the Social Security retirement age and cut Social Security benefits in other ways:

Treasury Secretary Timothy Geithner on Thursday explained why President Obama never fully embraced the 2010 report of his fiscal commission, headed by former Sen. Alan Simpson (R-Wyo.) and Erskine Bowles.

Geithner, under heavy fire from the Senate Budget Committee, said the Obama administration “did not feel” it could embrace it because the cuts to defense were too deep and the reforms to Social Security relied too much on benefit cuts.

I don't like the position on defense cuts, at all, but at least the administration has committed to protecting Social Security. That's a step in the right direction (assuming it won't be put on the table as a bargaining chip for other policies -- I'm not ready to relax about the administration's plans for Social Security just yet).

But the point of this post is to note how far the debate -- the Overton window -- has shifted to the right. Suddenly, Bowles-Simpson is held up as the ideal, something to strive for -- as though achieving it would be a great success -- yet from my perspective it is, as noted above, far to the political right. With the Social Security and other changes, it is, perhaps, the minimum acceptable policy for progressives, but it is not an ideal to strive for as it is currently being portrayed.

This is Jenni LeCompte of Treasury:

Difference on Deficit Reduction is not about “How Much?” but “Who Pays?”, by Jenni LeCompte, Treasury Notes: The Budget released by the President this week uses a balanced approach to achieve more than $4 trillion in deficit reduction over the next 10 years. This level of savings and the manner in which they are accomplished are broadly consistent with the bipartisan deficit reduction proposals put forward by the Bowles-Simpson Commission and the Senate’s bipartisan “Gang of Six.” Using this balanced approach, the President’s Budget reduces deficits from about 9 percent of GDP in 2011 to below 3 percent by 2018, and stabilizes the debt as a share of the economy by the middle of the decade. In general, there is little disagreement on the magnitude of savings that are needed over the next decade to put us on a sustainable fiscal course. Rather, the main difference between the President and Republicans are related to the composition of these savings. As Secretary Geithner made clear in testimony on the Budget this week, the greatest impediment to bipartisan progress on reducing deficits is the unwillingness by Republicans in Congress to take a balanced approach. Instead, they have sought to achieve budget savings solely through cuts to critical programs like Medicare and Medicaid, without asking the most fortunate citizens to contribute anything more than they do today. This position is at odds with both of the bipartisan efforts cited above. Though often invoked by Republicans in Congress as a model for reform, the Bowles-Simpson Commission recommendations included about $2 trillion in additional revenues over 10 years, which is $2 trillion more than Republicans have been willing to support. ... Rather than address our fiscal challenges largely on the back of middle class families and seniors, the President’s plan calls on the richest two percent of Americans – those who have seen their incomes grow more than the rest – to make a contribution to our deficit reduction efforts. At the same time, the Budget carefully slows growth of spending in Medicaid and Medicare through both the Affordable Care Act and additional proposals in the Budget that save about $360 billion in mandatory health spending, while preserving these vital programs. It saves more than $270 billion in so-called “other mandatory” spending implementing a number of policies consistent with the Bowles-Simpson Commission’s recommendations. ... Notwithstanding the many misleading claims that were made about the President’s Budget over the past week, the fact is that if the President’s Budget were enacted today, it would boost growth and job creation in the short term, reduce our deficits and stabilize our debt by the middle of the decade, and put us in a strong position to pursue long-term reforms. As Secretary Geithner said this week, “This plan will not solve all the nation’s challenges, but it will put us in a much stronger position to deal with those challenges.”

When he chooses engage, the president is doing a bit better in battling Republicans. I wish he'd engage on more fronts, but lately there has been progress. However, it seems to me that all the president has done is stop the rightward drift in the center of the conversation. That's something, but it is not enough. What I want is a president who can begin pushing the Overton window back in the other direction, and it's not clear that Obama is up to this task (either politically or ideologically).

Reducing aggregate demand when spending is already falling makes things worse, not better:

Pain Without Gain, by Paul Krugman, Commentary, NY Times: Last week the European Commission confirmed what everyone suspected: the economies it surveys are shrinking... It’s not an official recession yet, but the only real question is how deep the downturn will be. And this downturn is hitting nations that have never recovered from the last recession. ... Worse yet, European leaders — and quite a few influential players here — are still wedded to the economic doctrine responsible for this disaster. ... Specifically, in early 2010 austerity economics ... became all the rage in European capitals. The doctrine asserted that the direct negative effects of spending cuts on employment would be offset by changes in “confidence,” that savage spending cuts would lead to a surge in consumer and business spending, while nations failing to make such cuts would see capital flight and soaring interest rates. ... Now the results are in... The confidence fairy has failed to show up: none of the countries slashing spending have seen the predicted private-sector surge. Instead, the depressing effects of fiscal austerity have been reinforced by falling private spending. Furthermore,... austerity’s star pupils, countries that, like Portugal and Ireland,... still face sky-high borrowing costs. Why? Because spending cuts have deeply depressed their economies, undermining their tax bases to such an extent that the ratio of debt to GDP ... is getting worse rather than better. Meanwhile, countries that didn’t jump on the austerity train — most notably, Japan and the United States — continue to have very low borrowing costs, defying the dire predictions of fiscal hawks. ... Yet as far as I can tell, austerity is still considered responsible and necessary despite its catastrophic failure in practice. The point is that we could actually do a lot to help our economies simply by reversing the destructive austerity of the last two years. That’s true even in America, which has avoided full-fledged austerity at the federal level but has seen big spending and employment cuts at the state and local level...: all the federal government needs to do to give the economy a big boost is provide aid to lower-level governments, allowing these governments to rehire the hundreds of thousands of schoolteachers they have laid off and restart the building and maintenance projects they have canceled. Look, I understand why influential people are reluctant to admit that policy ideas they thought reflected deep wisdom actually amounted to utter, destructive folly. But it’s time to put delusional beliefs about the virtues of austerity in a depressed economy behind us.

• Why aren’t there more women in top jobs? - Vox EU
• Work-arounds for the politics of Keystone - Econbrowser
• A Fan’s Notes (on L. Summers) - David Warsh
• Fiscal policy & the Overton window - Chris Dillow
• Is This the End of Market Democracy? - Thomas Edsall
• Wars and Growth - Paul Krugman
• Flexibility Credibility - Macro Matters
• Difference on Deficit Reduction is about Who Pays - Treasury Notes
• Liberal, leftist, Islamist economists talk post-Arab Spring - Ahram

Duncan Black:

What's To Be Done About The Lower Classes, by Duncan Black: I was thinking about BoBo's latest Charles Murray inspired claim that that what the lesser humans among us need is some "bourgeois paternalism." Apparently they're behaving badly, in ways which hurt BoBo's aesthetic sensibilities, and Upper Class Daddy is going to have to bring out the rod. Because what poor people - and their kids - need is leadership and discipline from the proper sort of people. Like BoBo.

Mostly these people need decent schools, affordable simple health care, and, yes, a bit more money without working 3 jobs. A stern lecture from Daddy BoBo probably won't do much for them.

Here's a description of recent academic work on offshoring and US workers:

Offshoring, International Trade, and American Workers, by Ann Harrison and Margaret McMillan, NBER Reporter 2011 Number 4: Research Summary: In 1982, only one out of four employees of U.S. multinationals was located offshore, and over 90 percent of those employees were in industrial countries. By 2007, the share of offshore employment had reached 44 percent, and the majority of those jobs were in low-income countries. These trends in offshoring are mirrored in the statistics on international trade: over the past two decades imports from low-wage countries have more than doubled.1 Over this same time period, U.S. employment in the manufacturing sector fell sharply and income inequality increased. ... Our research is motivated by these parallel developments and seeks to understand the implications for American workers. Are U.S. Based Multinationals Exporting Jobs? This question has always been of interest to policymakers and is arguably more important now than ever before. Accordingly, there is no shortage of academic research on this topic.2 The problem is that the answer to the question seems to change depending on the study. ... Our research examines this seemingly contradictory evidence in an attempt to bring closure to this debate. ... Interpreting the Results on Multinational Employment Abroad Our results indicate that whether the offshoring of jobs by U.S. multinationals leads to a decline in U.S. based employment depends on both the location of the investment abroad and the motive for the investment. In general, the expansion of employment in low-income countries has been associated with a contraction in employment in the United States... However, when American workers and workers in low-income countries perform different tasks, the expansion of multinational employment abroad can lead to increases in domestic employment. Taken together, these results go a long way toward explaining why previous researchers have found seemingly contradictory results. ... Economy-wide Trends in Employment, Wages and Inequality Using data from the CPS, we show that between 1982 and 2002, total manufacturing employment fell from 22 to 17 million, with rapid declines at the beginning of the 1980s and in recent years. However, the effects were uneven across different types of workers. For workers without a college degree, there were significant declines in manufacturing employment over the entire period. The opposite was true for workers with a college degree. Within manufacturing, the labor force has become increasingly well educated, as college graduates replace workers with high school degrees. Wage trends mirror the shifts in employment. While wages fell for the least educated workers, they increased for workers with at least some years of college. The biggest wage gains were for manufacturing workers with an advanced degree. The decline in wages for high school dropouts and the steep wage increases at the upper end of the income distribution indicate a sharp increase in wage inequality. Are Trade and Offshoring Responsible for Growing Wage Inequality? ... We focus on ... the movement of workers across sectors and occupations. To the extent that trade leads workers to switch industries (for example from manufacturing to services) or occupations (for example from machine tool operator to burger flipper), studies that focus on the impact of trade liberalization on within-sector inequality miss an important part of the story. ... We begin by showing that trade and offshoring are associated with a contraction in the manufacturing workforce. Then,... we demonstrate that workers who switch industries within manufacturing experience almost no decline in wages. However, when workers relocate to the service sector, they experience a significant wage loss. The negative wage impact is particularly large among displaced workers who also switch occupations. ... These effects are most pronounced for workers who perform routine tasks. This downward pressure on wages because of import competition and offshoring has been overlooked since it operates between and not within sectors. ... Implications for American Workers The trends in offshoring and international trade that we have described are likely to accelerate. China currently employs around 120 million people in the manufacturing sector and, although some reports indicate that wages are rising in China, those wages are still only a tiny fraction of wages in the United States. Moreover, China is expanding its manufacturing base to low-wage countries across the globe through a series of overseas economic zones11 . The implication for American workers is that in order to regain ground, they will need to find jobs outside of manufacturing where wages are comparable to those in manufacturing. This is a tall order. ... This state of affairs has led some economists, including one of us, to reconsider the role of industrial policy. ...

• Motor Vehicle Output and Sales, Three Years after the Deluge - Econbrowser
• China Takes New Step to Prime Its Slowing Economy - NYTimes.com
• How can European banks learn from the US? - Vox EU
• Keynes vs Modern Macroeconomics - Angry Bear
• Austerity and Growth - Paul Krugman
• Gay Marriage Debate Is About Money, Too - Richard Thaler
• More on the Output Gap - Modeled Behavior
• Policy errors like 2010 austerity – what can academics do? - mainly macro
• Early Contributions to Training in Econometrics at the USDA - Dave Giles
• Output gaps, inflation and totally awesome blogosphere debates - John Barrdear
• To: John Cochrane, Re: Positional Externalites - Richard H. Serlin
• Payroll tax cut undermines Social Security's security - latimes.com
• Does economic blogging matter?? Part one - Dan Crawford
• Surge in temp jobs reflects change in workplace - Washington Post

There's been quite a bit of discussion recently about the output gap. I want to make a simple point in this post, how the gap is measured can have a big impact on the estimate of the state of the economy, and hence on the need for policy. Below, three different gap measures are presented, one that measures a large gap and hence implies the need for a large stimulus, one that measures a "medium size" gap, and one where the gap is absent altogether. In fact, according to this model we have already exceeded the full employment level of output.

In the first model, the trend is assumed to be linear, i.e. Ytrend = b0 + b1*t. Recall that the gap is measured as (Y - Ytrend), i.e. as the distance between the red and blue lines in the following diagram showing the estimated trend for GDP (click on figures for larger versions):

Linear Trend

To highlight recent movements, here's the same picture for the last 10 years:

Linear Trend - Last 10 Years

Thus, this model of the trend calls for lots of stimulus.

In the second model, the trend is assumed to be quadratic, i.e. Ytrend = b0 + b1*t +b2*t2:

Quadratic Trend

Again, here's the last ten years:

Quadratic Trend - Last 10 Years

The value of the current output gap in this model, as is clear in the second diagram, is smaller than for a linear trend model. However, it is still quite large and stimulus would still be called for, particularly given that actual output (the blue line) is running parallel to trend rather than making up ground.

However, there's a problem with this method of measuring the gap. One way to think of these models is that variation in the red line arises from supply shocks, and variation around the red line -- shown by the blue line -- represents demand shocks. Thus, under this interpretation, the first two models assume that all variation in the economy is due to demand shocks. This is clearly incorrect -- certainly supply shocks matter too -- and therefore these models may not give a very good measure of the gap.

The last model uses the HP filter popularized in the Real Business Cycle literature to overcome this problem (lambda = 1600, the standard value for quarterly data). This model allows the trend to be variable (stochastic), i.e. it allows the trend to reflect supply shocks:

HP Trend

The last 10 years for the HP trend model:

HP Trend - Last 10 Years

The results for the HP model tell us that we are now above trend! That doesn't seem believable to me (but I've never liked the HP filter, so no surprise, but some people might buy into this).

There are other ways to measure the underlying trend for GDP, and hence there are other ways to measure the gap, but they will generally be near one of these three outcomes so I won't cover those in any detail. There are also questions such as which potential output level to target, today's or one in the future. If, say, policy takes a year to be fully realized, and in the meantime the trend in model three begins to recover, as it likely would, how large is the gap to be targeted?

Unfortunately, there is no perfect way to choose among the gap models (the problem is that you have one time-series, output, and you are trying to extract two things, a trend and a cycle, and that can't be done without an assumption of some sort -- and when assumptions are involved, there's room to argue about their validity). If I had to choose, it would be somewhere between the first and second models. That is, I think the long-run trend for GDP is lower than the pre-crisis track we were on, but not as low as the more dour among us believe (and, to be clear, I endorse the stochastic trend model, but from the accumulated econometric evidence I've seen, I think aggregate demand shocks are the more important source of variation in output over time -- e.g. the movement in the trend in model three is much too large). In any case, I think there's enough uncertainty about the size of the gap, and enough asymmetry in the errors -- assuming model three when model one is actually true is worse than the other way around -- to justify aggressive policy actions to help the economy.

Brad DeLong is heartened by the response of economists to the question "Because of the American Recovery and Reinvestment Act of 2009, the U.S. unemployment rate was lower at the end of 2010 than it would have been without the stimulus bill":

Effects of the 2009 Recovery Act: Heartening News About What Economists Think--Although Caroline Hoxby and Ed Lazear Do Go All-in for Team Republican..., by Brad DeLong: The University of Chicago's IGM Forum:

Poll Results | IGM Forum: Question A: Because of the American Recovery and Reinvestment Act of 2009, the U.S. unemployment rate was lower at the end of 2010 than it would have been without the stimulus bill.

At the time, back at the start of 2009, arguments that the Recovery Act would not push the unemployment rate down over the two years after its enactment took one of three lines:

1. Unemployment is really not cyclical but structural, so whatever boost to spending it might generate would show up in higher prices and wages as businesses trying to satisfy demand bid against each other for a fixed pool of non-zero-marginal-product workers.
2. Government purchases must be financed by issuing government debt, and debt issues would push up interest rates and so would discourage private investment spending.
3. Government purchases must be financed by issuing government debt, and the future taxes needed to amortize the extra debt would frighten businesses and investors, so we would see equity prices tank as this fear would discourage private investment.

None of those things happened. And that is why the Chicago panel agrees 80%-4% with the statement that the Recovery Act the unemployment rate in 2010 below what it would otherwise have been.

And in this context it is worth noting that the two members who want to go on record agreeing with the Republican Party line and disagreeing with the statement appear to do so very carefully... Caroline Hoxby and Ed Lazear, both of Stanford [disagree]. Note that Hoxby appears to be evaluating a different statement--that the ARRA was worth doing--rather than the question asked--that the ARRA reduced the unemployment rate in 2010 below what it would otherwise have been. ...

And note that Lazear's comments--"the estimates [of the Recovery Act's effects] are varied and the highest are based on ex-ante models, not experience-based data. The upper bound estimate is low"--appear to justify the position that he is uncertain about the truth of the statement, not that he disagrees with the statement.

From one perspective, this is quite heartening: 183 years after John Stuart Mill and Jean-Baptiste Say agreed that Say's Law applies in the long run but not in the short business-cycle run, 4 years after what John Quiggin calls its zombie-like rising from the grave, the claim that increases in government purchases must by the metaphysical necessity of the case--no matter what happens to asset or commodity prices--crowd out an equal and opposite amount of private spending appears to be dead.

And staked.

Again.

To Be Continued...

I don't know that we've learned one important lesson about the use of fiscal policy to attenuate the effects of a downturn. For the most part, even economists who supported fiscal policy as an option insisted that we try monetary policy first and give it a chance to work. Monetary policy alone, we were told, would likely get the job done. And in the unlikely case that it didn't, we could then turn to fiscal policy for help.

That was the wrong advice (and I get annoyed when people who insisted that we wait pat themselves on the back over their support of things like infrastructure spending). By the time we realized that monetary policy would help, but wouldn't be enough to turn things around by itself, it was very late in the game to be applying fiscal policy. Fiscal policy still had an impact, but had it been put in place much earlier -- before problems had a chance to worsen and gel making them harder to overcome -- it would have been much more successful.

When this happens again, we need to to use both monetary and fiscal policy tools to full effect instead of trying one policy, realizing it's not enough, and then turning to the other. But it's not at all clear we've learned this lesson (and, to refine it a bit, we need to get help to state and local governments immediately -- the failure to effectively backfill the budget problems at the state and local level was a big mistake).

Let me emphasize that I'm not saying fiscal policy did not work -- see the following from Jeff Frankel -- only that it could have been much more effective if we hadn't waited so long to put the policies into place:

... The full force of the fiscal stimulus package began to go into effect in the second quarter of 2009, with the NBER officially designating the end of the recession as having come in June of that year. Real GDP growth turned positive in the third quarter, but slowed again in late 2010 and early 2011, which coincides with the beginning of the withdrawal of the Obama administration’s fiscal stimulus. Other economic indicators, such as interest-rate spreads and the rate of job loss, also turned around in early 2009. ... Again, such data do not demonstrate that Obama’s policies yielded an immediate payoff. In addition to the lags in policies’ effects, many other factors influence the economy every month, making it difficult to disentangle the true causes underlying particular outcomes. Given that difficulty, the right way to assess whether the fiscal stimulus enacted in January 2009 had a positive impact is to start with common sense. When the government spends $800 billion on such things as highway construction, salaries for teachers and policemen who were about to be laid off, and so on, it has an effect. Workers who otherwise would not have a job now have one, and may spend some of their income on goods and services produced by other people, creating a multiplier effect. Those who claim that this spending does not boost income and employment (or that it causes harm) apparently believe that as soon as a teacher is laid off, a new job is created somewhere else in the economy, or even that the same teacher finds a new job right away. Neither can be true, not with unemployment so high and the average spell of unemployment much longer than usual. ... Economists’ more sophisticated forecasting models also show that the fiscal stimulus had an important positive effect... Allowing for a wide range of uncertainty, the CBO estimates that the stimulus added 1.5-3.5% to GDP by the fourth quarter, relative to where it otherwise would have been. The boost to 2010 GDP, when the peak effect of the stimulus kicked in, was roughly twice as great. Of course, econometric models do not much interest most of the public. A turnaround needs to be visible to the naked eye to impress voters. Given this, one can only wonder why basic charts, such as the 2008-2009 “V” shape in growth and employment, have not been used – and reused – to make the case.

This from a (much longer) Five Books interview with Christina Romer:

Let’s talk about the role of fiscal policy, from the perspective of Lester Chandler’s America’s Greatest Depression. Please tell us about the book. This book gives a great description of what went on during the Great Depression. It is especially strong in describing the policy response. It was published in 1970, but is still the book I go to when I want to know about the actions that were taken in the New Deal [economic programs]. It gives you a sense of all the things that were done in the 1930s. One of the things you learn from Chandler is that President Roosevelt was trying everything. Back in the 1930s policymakers didn't know as much about what monetary and fiscal policy could do. So they tried all sorts of things – housing policy, agricultural policy, various credit policies, even allowing industries to collude to raise prices. Now, many of these policies were not very successful. And the ones that were successful often were not pushed far enough. This is especially the case with fiscal policy. Chandler’s book reminds us of something that is often forgotten, that the fiscal response to the Great Depression just wasn’t very big. In fact, under President Hoover it actually went the wrong direction. When the deficit rose because tax revenues fell due to high unemployment, Hoover’s answer was a big tax increase – that was the Revenue Act of 1932. This misguided deliberate fiscal contraction was another reason why the economy kept going down and the Depression was as terrible as it was. Even under Roosevelt the fiscal expansion was modest. When we think about the New Deal, we tend to remember things like the WPA [Works Progress Administration relief program], which built dams and bridges, and the Civilian Conservation Corps, which constructed so many buildings in our national parks. These programs left enduring legacies, and so we often think of the fiscal policy response of the New Deal as being big and aggressive. But what Chandler points out, building on a classic paper by E Cary Brown, is that the fiscal response to the Great Depression was actually quite small – not nearly as large as the American Recovery and Reinvestment Act of 2009. Even when Roosevelt increased the Federal deficit in the mid-1930s, a move to budget surpluses by state and local governments meant that the net fiscal stimulus was much smaller. Brown’s famous conclusion, repeated in Chandler’s book, is: “Fiscal policy, then, seems to have been an unsuccessful recovery device in the ’thirties – not because it did not work, but because it was not tried.”

The same is true this time around. When declines at the state and local level are factored in, the net stimulus was near the breakeven point. That doesn't mean the stimulus did nothing -- the state and local declines would have happened in any case so offsetting the state and local declines with federal spending was important and preserved many job -- but maintaining rather than gaining ground is harder to sell as a policy success. [Update: I should have also noted Paul Krugman's Reversing Local Austerity.]

• Motor Vehicle Sales, Three Years after the Deluge - Econbrowser
• Heartening News About What Economists Think - Brad DeLong
• The Dodd-Frank act: Too big not to fail - The Economist
• Reversing Local Austerity - Paul Krugman
• Manufacturing Illusions - Robert Reich
• Obama’s Recovery? - Jeffrey Frankel
• Behind a White House Pivot on China - NYTimes.com
• Key Measures of Inflation in January - Calculated Risk
• Health-Care Costs and Climate Change - James Kwak
• The Options for Payment Reform in Health Care - Uwe Reinhardt
• The Countrywide Complaint and the Capitalization of Trust - Rajiv Sethi
• The fraying thread between pay and productivity - Resolution Foundation
• Rethinking industry policy: Size matters - Vox EU
• Charles Murray, a Libertarian... - Miles Corak
• Apple moves the Gatekeeper offsite - Digitopoly

Not too long ago, I sent the following email to several people I thought might have the answer:

Something that's been bugging me -- I don't know much about how they estimated future health care cost increases, but since that is largely behind the budget problems -- and hence the source of the ability to use the deficit for ideological purposes -- is there any reason to try and question these numbers? Do we really know what these will be 30 or 40 years from now?

I didn't get an answer.

We can't forecast very well beyond a 3 to 6 month horizon, yet we are relying upon projections for decades in the future as the basis for cutting social programs now. The CBO, for example, uses a 70 year projection for revenues and outlays, and that is the basis of a lot of the worry over the long-term budget picture. But, did we have any idea at all 70 years ago -- in 1942 -- what health care costs would be today?

Jeff Sachs takes up this issue:

Entitlements Hysteria, by Jeff Sachs: One of the unshakable myths of the punditariat is that the federal government is going bankrupt because of entitlements spending, especially spending on Medicare and Medicaid. Each day we hear the drumbeat saying that either we cut entitlements now or we are finished as a nation. This is a stampede of unreason, contradicted by the facts. ... So what is the source of the hysteria? Some of it is simply propaganda, by those with the political agenda to gut the country's social safety net. But there is something else. Confusion! The punditocracy is repeating the results of forecasts that indeed suggest calamity, but calamity in the late 21st century, not now. These long-term forecasts are arbitrary but have been repeated as an immutable fact by those who don't read the fine print. The most frequently quoted forecast is that of the Congressional Budget Office. The CBO's long-term forecast assumes that health care costs will continue to rise steeply during the next 70 years, though at a diminishing rate. If healthcare costs continue to soar for decades to come, then yes, lo-and-behold, the government would eventually go broke. ... Yet somehow I'm not ready to panic about the health care costs as of 2085. Mechanical extrapolations that assume that health care costs will rise much faster than GNP between 2011 and 2085 are utterly unconvincing. Why should healthcare costs continue to rise so far and fast when healthcare costs are already vastly over-priced now compared with what other countries pay for the same services? Why should we assume failure decade after decade to use the new information technologies to lower the costs of health-care delivery and administration? In fact, the recent trends are mildly favorable. As J. D. Keinke of the American Enterprise Institute writes today in the Wall Street Journal, the idea of runaway health spending is a "myth" because "new data show that health spending over the past several years has been normalizing toward the rate of general inflation, rather than growing higher and higher, as had been the case almost continuously since the 1970s." ... Even if we don't get all the way down to the lower costs that we should have, there is no reason to assume that health care costs will continue to soar year in and year out for another seven decades. Let's therefore fight the right-wing hysteria demanding immediate and harsh cuts in Medicaid and other health outlays. We do not need to cut off the lifeline of the poor and elderly. We simply need to keep up the pressure against the healthcare lobbies, and resist the panic of the punditariat.