fiscal stimulus

More Monetarism and the Great Depression.

The “spending hypothesis” attributes the Great Depression to a sudden collapse of spending which, in turn, is attributed to a collapse of consumer confidence resulting from the 1929 stock-market crash and a collapse of investment spending occasioned by a collapse of business confidence. The cause of the collapse in consumer and business confidence is not really specified, but somehow it has to do with the unstable economic and financial situation that characterized the developed world in the wake of World War I. In addition there was, at least according to some accounts, a perverse fiscal response, cuts in government spending and increases in taxes to keep the budget in balance. The latter notion that fiscal policy was contractionary evokes a contemptuous response from Scott, more or less justified, because nominal government spending actually rose in 1930 and 1931 and spending in real terms continued to rise in 1932. But the key point is that government spending in those days was too low to have made much difference; the spending hypothesis rises or falls on the notion that the trigger for the Great Depression was an autonomous collapse in private spending.

Glasner on market monetarism

Monetarism and the Great Depression by David Glasner

...
Scott is totally right, of course, to point out that the fall in interest rates and the increase in the real quantity of money do not contradict the “money hypothesis.” However, he is also being selective and unfair in making that criticism, because, in the three slides immediately following the one to which Scott takes such offense, Foote actually explains that the simple IS-LM analysis presented in the previous slide requires modification to take into account expected deflation, because the demand for money depends on the nominal rate of interest while the amount of investment spending depends on the real rate of interest. Here are the slides: 

Thus, expected deflation raises the real rate of interest and causes the IS curve to shift to the left but leaves the LM curve where it was. Thus, expected deflation explains a fall in both nominal and real income as well as in the nominal rate of interest; it also explains an increase in the real rate of interest. Scott seems to be emotionally committed to the notion that the IS-LM model must lead to a misunderstanding of the effects of monetary policy, but Foote actually shows that it can accommodate a correct understanding of the role of monetary policy in the Great Depression. 

The Great Depression was triggered by a deflationary scramble for gold associated with an uncoordinated restoration of the gold standard by the major European countries in the late 1920s, especially France and its insane central bank. On top of this, the Federal Reserve, succumbing to political pressure to stop stock market speculation, raised its discount rate to a near record 6.5%, adding to the pressure on gold reserves, thereby driving up the value of gold, and leading to expectations of further deflation. It was thus a rise in the value of gold, not a reduction in the money supply (and thus no shift in the LM curve), which was the source of the monetary shock that produced the Great Depression. IS-LM is not necessarily the best model with which to describe this monetary shock, but the basic story can be expressed in terms of the IS-LM model. 

So you may be asking yourself why, if I don’t think that Foote’s exposition of the IS-LM model seriously misrepresents what happened in the Great Depression, did I say at beginning of this post that Foote’s slides really annoy me? Well, the reason is simply that Foote seems to think that the only monetary explanation of the Great Depression is that of Milton Friedman: that the Great Depression was caused by an exogenous contraction in the US money supply. That is totally wrong. What caused the Great Depression was an international disturbance to the value of gold, caused by the independent actions of a number of central banks, most notably the insane Bank of France, which was maniacally trying to convert all its foreign exchange reserves into gold, and the Federal Reserve, which was obsessed with the suppression of a non-existent stock market bubble on Wall Street. It was a bubble only because the combined policies of the Bank of France and Fed wrecked the world economy and drove into Depression. The decline in the nominal quantity of money in the US, the great bugaboo of Milton Friedman, was truly an epiphenomenon. But as Ron Batchelder and I have shown, Gustav Cassel and Ralph Hawtrey had already diagnosed and explained the causes of the Great Depression fully a decade before it happened. Unfortunately whenever people think of a monetary explanation of the Great Depression, they think of Milton Friedman, not Hawtrey and Cassel. Scott Sumner understands all this, he’s even written a book – a wonderful book – about it. But he’s gets all worked up about IS-LM. I could not care less about IS-LM, it’s idea that monetary cause of the Great Depression was discovered by Milton Friedman that annoys the [redacted] out of me.

positive outlook: Kocherlakota

A Tale of Two Fed Presidents by Krugman

There’s an interesting contrast with one of the real intellectual heroes here, Narayana Kocherlakota of the Minneapolis Fed, who has actually reconsidered his views in the light of overwhelming evidence. In our political culture, this kind of switch is all too often made into an occasion for gotchas: you used to say that, now you say this. But learning from experience is a good thing, not a sign of weakness.

Eureka! Paul Krugman Discovers the Bank of France by David Glasner

I believe he has discussed it before.

Great Depression: Central Bank mismanagement

 Why Hawtrey and Cassel Trump Friedman and Schwartz by David Glasner

Not only did Friedman get both the theory and the history wrong, he made a bad move from his own ideological perspective, inasmuch as, according to his own narrative, the Great Depression was not triggered by a monetary disturbance; it was just that bad monetary-policy decisions exacerbated a serious, but not unusual, business-cycle downturn that had already started largely on its own. According to the Hawtrey-Cassel explanation, the source of the crisis was a deflation caused by the joint decisions of the various central banks — most importantly the Federal Reserve and the insane Bank of France — that were managing the restoration of the gold standard after World War I. The instability of the private sector played no part in this explanation. This is not to say that stability of the private sector is entailed by the Hawtrey-Cassel explanation, just that the explanation accounts for both the downturn and the subsequent prolonged deflation and high unemployment, with no need for an assumption, one way or the other, about the stability of the private sector.

Emphasis added.

books and bankers can alter history

What did FDR Write Inside His Copy of the Proto-Keynesian Road to Plenty? by Mike Konczal

...Though Roosevelt didn't buy it at first, he thankfully later evolved on the issue. One lucky reason is because a big fan of the book was a Utah banker who read it intensely starting in 1931, when the Depression seemed like it would never end, much less recover. That man's name was Marriner Stoddard Eccles. The rest, as they say, is history. (Except it's not, because we are currently fighting this all over again.) 

The book* itself is a series of conversations among strangers on a Pullman-car over what is going on in the economy.

So if not for a book and an influential fan, things may have turned out very differently.

Let it Bleed? by Brad DeLong

BERKELEY – In the 12 years of the Great Depression – between the stock-market crash of 1929 and America’s mobilization for World War II – production in the United States averaged roughly 15% below the pre-depression trend, implying a total output shortfall equal to 1.8 years of GDP. Today, even if US production returns to its stable-inflation output potential by 2017 – a huge “if” – the US will have incurred an output shortfall equivalent to 60% of a year’s GDP.

When I talk to my friends in the Obama administration, they defend themselves and the long-term macroeconomic outcome in the US by pointing out that the rest of the developed world is doing far worse. They are correct. Europe wishes desperately that it had America’s problems. 

Nevertheless, my conclusion is that I should stop calling the current episode the Lesser Depression. Yes, its shape is different from that of the Great Depression; but, so far at least, there is no reason to rank it any lower in the hierarchy of macroeconomic disasters.

 Another version.

Christina Romer on Learning from the Great Depression

What we learned from the Temin and Wigmore paper is that one way out of a recession at the zero lower bound is by changing expectations. To do that, often what is needed is a very strong change in policy – something economists call a “regime shift”. The most effective way to shake an economy out of a terrible downturn when we’re at the zero lower bound is an aggressive change in policy that makes people wake up, say “this is a new day” and change their expectations. What the Fed has done since early 2009 is much more of an incremental change.

I think that what the Fed needs instead is a regime shift. A number of economists have suggested that the Fed adopt a new framework for monetary policy, like targeting a path for nominal GDP. If the Fed adopted such a nominal GDP target, they would start in some normal year before the crisis and say nominal GDP should have grown at a steady rate since then. Compared with that baseline, nominal GDP is dramatically lower today. Pledging to get back to the pre-crisis path for nominal GDP would commit the Fed to much more aggressive policy – perhaps more quantitative easing and deliberate actions to talk down the dollar. Such a strong change in the policy framework could have a dramatic effect on expectations, and hence on the behavior of consumers and businesses.

(via Thoma)

Joe Stiglitz on the Great Depression by Yglesias

Blogging the Zombies: Expansionary Austerity - Life by John Quiggin

The Depression hit the government hard, and provoked a demand for austerity policies, most notably a cut in unemployment benefits. The finance minister, Rudolf Hilferding was a leading Marxist theoretician, but in matters of macroeconomic management Marxist orthodoxy coincided with the Treasury view. Hilferding argued that, while crises and depressions would inevitably bring about the downfall of capitalism in due course, in the meantime, there was nothing to do but to follow the dictates of capitalist sound money.

As in Britain, the government split and fell, and was replaced by a conservative government led by Heinrich Bruning. Bruning pushed austerity policies even harder, steadily losing public support and driving the growth of the extreme parties, most notably the Nazis. By the time he fell from office in 1932, Hitler was unstoppable.

Much the same story played out in Japan. As the Depression intensified, the civilian governments imposed austerity measures that produced a sharp deterioriation in living standards. After a period of chaos, with growing political violence and assassinations, the military took over government, using the time-honored policy of international aggression to cement domestic support. The invasion of Manchuria in 1931 was the first in a series leading up to the Pearl Harbor attacks of 1941, and Japan’s entry into World War II.

Commenting on Romer's article, Yglesias writes

But even though unemployment was still very high in 1938-39, it fell dramatically during the 1933-36 period thanks overwhelmingly to things that were done on the banking/monetary side. Fiscal policy during the early Roosevelt administration, somewhat like fiscal policy during the Obama years, largely served to offset ongoing fiscal contraction at the state and local levels. Today, additional aid to state and local governments to forestall the creation of new restructuring problems would be very welcome. But today, as in the 1930s, the monetary lever could be very powerful.

Well in the Eggertson paper Romer links to, he writes

By any measure, the increase in government spending was dramatic, but the spending spree clearly violated the prevailing policy dogma of small government. Table 1 records several measures of government spending. The federal government’s consumption and investment, for example, was 90 percent higher in 1934 (Roosevelt’s first full calendar year in office) than in 1932 (Hoover’s last).14 Other measures of federal spending also increased substantially. Table 1 also reports total government expenditures. This measure includes several transfer programs and the gold purchases of the Treasury that are not included in the consumption and investment statistic, but which had an important impact on the government budget.15 This spending campaign was financed not by new taxes but by running budget deficits, thus violating another important policy dogma of the time: the budget should be balanced. Deficit spending plays an important role in the model of the paper because it measures the change in the inflation incentive of the government, which is crucial to determining expectations about the future money supply. The deficit during Roosevelt’s first fiscal year is one of the highest in US history outside of wartime. This helped to make a permanent increase in the money supply credible, thus firming up inflation expectations, because it was a critical strategy to finance the government debt payments. The deficit is defined as the difference between the government’s expenditures and tax revenues. Table 1 shows three estimates of the deficit, further described in the Appendix C. The estimate that corresponds most closely to the deficit in the model is the third one.16 The deficit, according to this estimate, increased by 66 percent in the fiscal year June 1933 to June 1934 and stood at 9 percent of GDP in that fiscal year. The other estimates show a smaller, yet significant, increase. Leaving measurement issues aside, however, there is even stronger evidence for the regime change than reported in Table 1.

It is quite likely that fiscal policy played a key role in firming up inflation expectations, since it was well understood at the time that deficit financing could lead to future inflation. In fact, the belief that deficits caused inflation was a foundation of the balanced budget dogma. Many commentators at the time, especially in the conservative press, were worried that Roosevelt’s deficit spending would in fact be too inflationary.19 As proof, many “sound money men” pointed toward the deficits of several European countries after World War I and the resulting hyperinflation.20 

Right now the government is engaged in deficit spending so more actions by the Fed could change inflation expectations.  But it looks like the government did a lot of deficit spending during the Great Depression, but maybe Matt is right that it was offset by cuts at the state and local level.

With unemployment at 9.1 percent, government cutting back spending, and the mortgage market in the dumps, could it be that QE1 and 2 helped prevent deflation> Would we have 2.5 percent annualized growth in Q3 (granted it may be revised downwards later)?

Well the economy grew at 2.5 percent so there is demand. Maybe unorthodox monetary policy can help. It helped during the Great Depression.

Christina Romer Joins Team NGDP Level Targeting by Yglesias

I like how Yglesias remembered to put "Level" in there.

DeLong on the Great Crash, Great Slump and "Liquidationist" ideology

(via Krugman)

Cyclical and Secular Trends

After saying Ezra Klein's narrative and tour d'horizon of Obama's economic policy is ultimately a white wash, I feel compelled to quote the parts which I thought were excellent. Afterwards I'll coment on David Leonhardt's essay "The Depression: If Only Things Were That Good." Leonhardt is writing for the New York Times and Klein is writing for the Washington Post so perhaps both felt the necessity to add some "balanced" comments so that their worthwhile insights don't appear too controversial or partisan. This is probably why Klein's piece ends up feeling like a white wash. Leonhardt's piece starts off shaky but gets better at the end. I'd cut the two some slack given the state of newspapers these days, but that's just me.

Let me first say I'm sympathetic to Obama and I admire the advisers he picked like Romer, Bernstein, and Goolsbee and I'm less down on Orszag, Summers, Geithner, and Bernanke than others have been.

First off, Klein is right to report that other respected forecasters were in agreement with the administration's analysis of the downturn.

But Romer wasn’t trying to be alarmist. Her numbers were based, at least in part, on everybody else’s numbers: There were models from forecasting firms such as Macroeconomic Advisers and Moody’s Analytics. There were preliminary data pouring in from the Bureau of Labor Statistics, the Bureau of Economic Analysis and the Federal Reserve. Romer’s predictions were more pessimistic than the consensus, but not by much.

Granted the "consensus" was all wrong about the housing bubble, but still. Klein could have pointed this out, but it would have called into question the authority of the Washington Post. 

By that point, the shape of the crisis was clear: The housing bubble had burst, and it was taking the banks that held the loans, and the households that did the borrowing, down with it. Romer estimated that the damage would be about $2 trillion over the next two years and recommended a $1.2 trillion stimulus plan. The political team balked at that price tag, but with the support of Larry Summers, the former Treasury secretary who would soon lead the National Economic Council, she persuaded the administration to support an $800 billion plan.

So the damage was $2 trillion and they were going with 800 billion which was whittled down by the Senate to 700 billion with a large part being ineffective tax cuts? What if it was an "L-shaped" recovery as in the early 1990s and early 2000s, the last two recessions? What if recovery took longer because it followed a financial crisis as shown in Rogoff and Reinhart's book "This Time It's Different"? Klein writes that everyone underestimated the amount the economy shrank:

To understand how the administration got it so wrong, we need to look at the data it was looking at.

The Bureau of Economic Analysis, the agency charged with measuring the size and growth of the U.S. economy, initially projected that the economy shrank at an annual rate of 3.8 percent in the last quarter of 2008. Months later, the bureau almost doubled that estimate, saying the number was 6.2 percent. Then it was revised to 6.3 percent. But it wasn’t until this year that the actual number was revealed: 8.9 percent. That makes it one of the worst quarters in American history. Bernstein and Romer knew in 2008 that the economy had sustained a tough blow; t hey didn’t know that it had been run over by a truck.

So was Romer's $2 trillion estimate off the mark? What makes Klein's story better than most is the following:

There were certainly economists who argued that the recession was going to be worse than the forecasts. Nobel laureates Krugman and Joe Stiglitz were among the most vocal, but they were by no means alone. In December 2008, Bernstein, who had been named Biden’s chief economist, told the Times, “We’ll be lucky if the unemployment rate is below double digits by the end of next year.”

The Cassandras who look, in retrospect, the most prophetic are Carmen Reinhart and Ken Rogoff. In 2008, the two economists were about to publish “This Time Is Different,” their fantastically well-timed study of nine centuries of financial crises. In their view, the administration wasn’t being just a bit optimistic. It was being wildly, tragically optimistic.

He'll acknowledge the existence of "Cassandras" even if he doesn't highlight how the consensus - whose figures he's citing - had been wrong about the housing bubble and deregulation, etc. Klein quotes Orszag's mea culpa:

I don’t think it’s too much of an exaggeration to say that everything follows from missing the call on Reinhart-Rogoff, and I include myself in that category,” says Peter Orszag, who led the Office of Management and Budget before leaving the administration to work at Citigroup. "I didn’t realize we were in a Reinhart-Rogoff situation until 2010.

I like that Klein quotes critics who have been right about a lot like Stiglitz and Baker. Here they comment on Reinhart-Rogoff:

Yet even among economists who admire Reinhart and Rogoff’s work, there is skepticism.

One source comes in how Reinhart and Rogoff find the economic phenomena they’re trying to study. “There’s an identification problem,” Stiglitz says. “When you have underlying problems that are deep, they will cause a financial crisis, and the crisis itself is a symptom of underlying problems.”

Another is in their fatalism. “I don’t buy their critique in the sense that this was an inevitability,” says Dean Baker, director of the Center for Economic and Policy Research and one of the economists who spotted the housing crisis early.

Klein gets a gold star for that third paragraph. I remember very well when Bernanke was asked about Reinhart-Rogoff and he deadpanned in response "yes policy makers usually don't respond well to financial crises and their aftermath" which is why it takes a while for the economy to recover after they occur. He was probably thinking of Japan. I could be wrong but I don't believe Reinhart and Rogoff emphasized the failure of policy makers in their publicity for the book. They seemed fatalistic as Baker points out.

Klein reports that the stimulus was too small:

Critics and defenders on the left make the same point: The stimulus was too small. The administration underestimated the size of the recession, so it follows that any policy to combat it would be too small. On top of that, it had to get that policy through Congress. So it went with $800 billion — what Romer thought the economy could get away with — rather than $1.2 trillion — what she thought it needed. Then the Senate watered the policy down to about $700 billion. Compare that with the $2.5 trillion hole we now know we needed to fill.

Klein doesn't really emphasize the point, but the administration should have gone back for more or done more unilaterally or at least refrain from talking of green shoots and cutting government spending.

Some more good info Klein highlights is the Federal Reserve and inflation.

There was, however, one institution that some think could have reduced the debt overhang crushing the economy and that didn’t face such political obstacles: the Federal Reserve.

The central bank manages the nation’s money supply and credit and sits at the center of its financial system. Usually, it spends its time guarding against the threat of inflation. But in December 2008, Rogoff argued that the moment called for the reverse strategy.

“It is time for the world’s major central banks to acknowledge that a sudden burst of moderate inflation would be extremely helpful in unwinding today’s epic debt morass,” he wrote.

...
Rogoff scoffs at this. “Creating inflation is not rocket science,” he wrote. “All central banks need to do is to keep printing money to buy up government debt. The main risk is that inflation could overshoot, landing at 20 or 30 percent instead of 5 or 6 percent. Indeed, fear of overshooting paralyzed the Bank of Japan for a decade. But this problem is easily negotiated. With good communication policy, inflation expectations can be contained, and inflation can be brought down as quickly as necessary.”

Klein could have mentioned Volcker's success. In fact we need Bernanke to get some Volckerian resolve. But at least he discusses the Federal Reserve. Usually liberals and progressives neglect to mention it.

Another good idea Klein raises is Germany's work-sharing:

Germany’s response to the recession included a work-sharing program that subsidized salaries when employers trimmed the hours of individual workers to keep more people on the job. If workers attended job training, the government gave a more generous subsidy.

The program worked. Even though Germany’s economy was devastated by the recession — declining by almost 7 percent — the jobless rate fell slightly, from 7.9 percent at the start of the recession to 7 percent in May 2010.

There are reasons to question whether work-sharing programs would have been as effective here as they were in Germany. For one thing, they work best in sectors where jobs are bound to return after a recession — such as Germany’s export sector — rather than sectors that need to be downsized after being inflated by a credit boom.

Germany also has a different labor market. Employers, unions and the government work together with an unusual level of cooperation. The culture is much more hostile toward layoffs than the United States’ is, which has caused Germany problems in the past but has been a boon throughout this recession.

But paying the private sector to save jobs was not the administration’s only option. There was also the possibility of simply paying workers to work.

For one thing, the government could have refused to fire anyone. Says Baker, of the Center for Economic and Policy Research: “We’ve lost 500,000 state and local jobs, and before that, we were creating 160,000 a year. If we hadn’t had those losses and had done more to keep creation at that pace, we would have almost another million jobs.”

It also could have started hiring. Romer, for instance, proposed to add 100,000 teacher’s aides. Imagine similar proposals: Every park ranger could have had an assistant park ranger. Every firefighter station could have added three trainees. Every city could have expanded its police force by 5 percent. Everyone between ages 18 and 26 could have signed up for two years of paid national service.

Another idea Klein could have touched on is FDR's mistaken turn towards deficit cutting in 1937. Klein could have been clearer on the numbers, too. First Romer says a $2 trillion dollar hole. How does that relate to the shrinking economy in the last quarter of 2008? Then Klein says $2.5 trillion and finally he mentions the loss of $8 trillion in housing wealth.

However, if you read between the lines, it's quite a good article all in all, not perfect, but thorough.

------------------------------------------

Leonhardt's piece comparing the Great Depression with today is shorter but good also. Leonhardt starts off comparing the 1930s with today.

Economists often distinguish between cyclical trends and secular trends — which is to say, between short-term fluctuations and long-term changes in the basic structure of the economy. No decade points to the difference quite like the 1930s: cyclically, the worst decade of the 20th century, and yet, secularly, one of the best.

It would clearly be nice if we could take some comfort from this bit of history. If anything, though, the lesson of the 1930s may be the opposite one. The most worrisome aspect about our current slump is that it combines obvious short-term problems — from the financial crisis — with less obvious long-term problems. Those long-term problems include a decade-long slowdown in new-business formation, the stagnation of educational gains and the rapid growth of industries with mixed blessings, including finance and health care.

Together, these problems raise the possibility that the United States is not merely suffering through a normal, if severe, downturn. Instead, it may have entered a phase in which high unemployment is the norm.

I just don't agree with this. Christina Romer doesn't and I don't believe Leonhardt himself does either.

On Friday, the Labor Department reported that job growth was mediocre in September and that unemployment remained at 9.1 percent. In a recent survey by the Federal Reserve Bank of Philadelphia, forecasters said the rate was not likely to fall below 7 percent until at least 2015. After that, they predicted, it would rarely fall below 6 percent, even in good times.

Well they've been wrong before. Leonhardt discusses education:

Despite the media’s focus on those college graduates who are struggling, it’s not much of an exaggeration to say that people with a four-year degree — who have an unemployment rate of just 4.3 percent — are barely experiencing an economic downturn.

Maybe Obama is less concerned about unemployment than he ought to be because all of the states that voted for Obama in 2008 had high levels of college graduates, especially the new purple states like Virginia. (This is why they took out no insurance after passing the stimulus.) They are counting on these states to win in 2012. (Granted Obama is more concerned than Republicans. Plus median incomes have fallen 10 percent or so since the beginning of the recession. That should hurt Obama's prospects. The one downside in an Obama victory will be the analyses of those who argue high unemployement doesn't matter.)

Economic downturns do often send people streaming back to school, and this one is no exception. So there is a chance that it will lead to a surge in skill formation. Yet it seems unlikely to do nearly as much on that score as the Great Depression, which helped make high school universal. High school, of course, is free. Today’s educational frontier, college, is not. In fact, it has become more expensive lately, as state cutbacks have led to tuition increases.

Beyond education, the American economy seems to be suffering from a misallocation of resources. Some of this is beyond our control. China’s artificially low currency has nudged us toward consuming too much and producing too little. But much of the misallocation is homegrown.

In particular, three giant industries — finance, health care and housing — now include large amounts of unproductive capacity. Housing may have shrunk, but it is still a bigger, more subsidized sector in this country than in many others.

This is the Leonhardt I've grown to admire. These are the long-term "structural" problems with the U.S. economy.

Health care is far larger, with the United States spending at least 50 percent more per person on medical care than any other country, without getting vastly better results. (Some aspects of our care, like certain cancer treatments, are better, while others, like medical error rates, are worse.) The contrast suggests that a significant portion of medical spending is wasted, be it on approaches that do not make people healthier or on insurance-company bureaucracy.

In finance, trading volumes have boomed in recent decades, yet it is unclear how much all the activity has lifted living standards. Paul A. Volcker, the former Fed chairman, has mischievously said that the only useful recent financial innovation was the automated teller machine. Critics like Mr. Volcker argue that much of modern finance amounts to arbitrage, in which technology and globalization have allowed traders to profit from being the first to notice small price differences.

IN the process, Wall Street has captured a growing share of the world’s economic pie — thereby increasing inequality — without doing much to expand the pie. It may even have shrunk the pie, given that a new International Monetary Fund analysis found that higher inequality leads to slower economic growth.

The common question with these industries is whether they are using resources that could do more economic good elsewhere. “The health care problem is very similar to the finance problem,” says Lawrence F. Katz, a Harvard economist, “in that incredibly talented people are wasting their talent on something that is essentially a zero-sum game.”

In the short term, finance, health care and housing provide jobs, as their lobbyists are quick to point out. But it is hard to see how the jobs of the future will spring from unnecessary back surgery and garden-variety arbitrage. They differ from the growth engines of the past, which delivered fundamental value — faster transportation or new knowledge — and let other industries then build off those advances.

Obamacare and Frand-Dodd are good steps in the right direction but not enough. The housing bubble was deflating on its own and jobs were moving to other sectors until the financial crisis hit.

The rate at which new companies are created has been falling for most of the last decade. So has the pace at which existing companies add positions. “The current problem is not that we have tons of layoffs,” Mr. Katz says. “It’s that we don’t have much hiring.”

If history repeats itself, this situation will eventually turn around. Maybe some American scientist in a laboratory somewhere is about to make a breakthrough. Maybe an entrepreneur is on the verge of creating a great new product. Maybe the recent health care and financial-regulation laws will squeeze the bloat.

For now, the evidence for such optimism remains scant. And the economy remains millions of jobs away from being even moderately healthy.

What is needed is more government spending to help with aggregate demand and for Bernanke to get some Volckerian resolve. Inflation will help with deleveraging and inflation will get those sitting on money to invest and spend. It will boost the velocity of money.

Ideally, we would have a 21st century WPA program which could be modeled on the way the National Science Foundation doles out grants.

What Caused the Recession of 1937-38? by Douglas Irwin

If we are to avoid the mistakes of the past, it is important to have an accurate assessment of what those past mistakes were. The severity of the Recession of 1937-38 was not due to contractionary fiscal policy or higher reserve requirements. By contrast, the policy tightening associated with gold sterilisation was not modest – it did not simply reduce the growth of the monetary base by a few percentage points, it stopped its growth altogether. While the Federal Reserve is often blamed for its poor policy choices during the Great Depression, the Treasury Department was responsible for this particular policy error.

The recession of 1937-38 occurred long ago, but it does have policy lessons for today. It suggests that, in a weak recovery, a pre-emptive monetary strike against inflation (which was very low at the time, as it is today) is capable of producing a devastating recession.     

(via Mark Thoma)

Needed: A Clearer Crystal Ball by Robert J. Shiller

or "Risk Topograhy"

In fact, some people view the recent crisis as just another "black swan event," one of those outliers, as popularized by Nassim Taleb, that come out of the blue. And it’s clear that a lot of smart people simply didn’t see the housing bubble, the instability of our financial sector or the shock that came in 2007 and 2008.

But the theory of outlier events doesn’t actually say that they cannot eventually be predicted. Many of them can be, if the right questions are asked and we use new and better data. Hurricanes, for example, were once black-swan events. Now we can forecast their likely formation and path pretty well, enough to significantly reduce the loss of life.

Such predictions are a crucial challenge in economics, too, and they are why data collection need not be a dull or a routine field. If done correctly, it can be very revealing. ...

...

The Federal Reserve started work on its Flow of Funds Accounts in the Depression as well. These accounts, which go beyond G.N.P. and show the flow of funds from each kind of financial institution to another, offer a much better picture of the kinds of instabilities that led to the Depression. This innovation took a long time, too. The Fed didn’t begin publishing these accounts until 1955, backdating them to late in the Depression, in 1939. 

Eventually, these advances led to quantitative macroeconomic models with substantial predictive power -- and to a better understanding of the economy’s instabilities. It is likely that the "great moderation," the relative stability of the economy in the years before the recent crisis, owes something to better public policy informed by that data.

Since then, however, there hasn’t been a major revolution in data collection. Notably, the Flow of Funds Accounts have become less valuable. Over the last few decades, financial institutions have taken on systemic risks, using leverage and derivative instruments that don’t show up in these reports. 

Some financial economists have begun to suggest the kinds of measurements of leverage and liquidity that should be collected. We need another measurement revolution like that of G.D.P. or flow-of-funds accounting. For example, Markus Brunnermeier of Princeton, Gary Gorton of Yale and Arvind Krishnamurthy of Northwestern are developing what they call "risk topography." They explain how modern financial theory can guide the collection of new data to provide revealing views of potentially big economic problems.

Below I sketched out the gist of the arguments made by Robin Wells and Paul Krugman* in their piece The Slump Goes On: Why? as I understood it.

What's great about their article is that they confront some widely-held misperceptions on what has occurred and what's happening now.

Ostensibly, the piece is a book review of three books: Rajan's Fault Lines; Roubini and Mihm's Crisis Economics; and Koo's The Holy Grail of Macroeconomics.

Wells and Krugman are extremely dismissive of Rajan and argue he's just peddling conservative propaganda. Rajan believes that the Fed held rates too low in the past decade and Roubini and Mihm give this view qualified support. However as Wells and Krugman point out, the Fed was facing possible deflation after the tech stock crash when it lowered rates from 6.5 percent in 2000 to just 1 percent in 2003. Inflation had been at a thirty-five year low and Japan's lost decade was on people's minds at the time.

Rajan blames Democrats, the Community Reinvestment Act and Fannie and Freddie for the subprime crisis. Wells and Krugman say Roubini correctly points out how Rajan is wrong in that the huge growth in the subprime market was primarily underwritten by private mortgage lenders like Countrywide Financial.

Wells and Krugman say Roubini and Mihm give a good overview of Hyman Minsky's highly relevant work and that Crisis Economics  "is a very good primer on how finance gone bad can wreck an otherwise healthy economy." The book makes the essential point that bubbles are not uncommon. "Bubbles have happened in small economies and large, in individual nations and in the global economy as a whole, in periods of heavy public intervention and in eras of minimal government."

Koo's book focuses on the problems economies face in the aftermath of a "Minsky moment" (although he doesn't use that term or mention Minsky). Basically, there is a problem of red ink and deleveraging. Koo focuses on Japan whose nonfinancial corporations were saddled with debt after the real estate bubble burst in the late 1980s. Currently it is households who are deleveraging in America, not corporations. In a blog post Krugman argues that after the Great Depression, World War II inflated away much of the debt.

It will be interesting to see what Wells and Krugman argue in their second article. The current slow growth in GDP is reminiscent of the recoveries after the recessions of 1991 and 2001. However, "only once since World War II has the unemployment rate stood this high on Labor Day -- during the steep recession of 1982 under President Reagan. It has remained at 9 percent or higher for 16 straight months and is likely to surpass the 19-month record of such high rates set in 1982 and 1983."

The 1982 recession was caused in part by Fed Chairman Volcker jacking interest rates and it was ended by Volcker lowering rates once inflation was tamed. We went into the 2008-2009 recession with rates already low, whereas from 2000-2003 the Fed had room to lower rates from 6.5 to 1 percent.

Bernanke says the Fed has more tools to use if there's a double dip, but apparently these tools aren't worth using to maintain low unemployment. Instead we just get pathetic excuses about structural changes in the job market and the fact that "central bankers alone can't solve the world's economic problems." No, but the Fed's only missions are price stability and maintaining low unemployment and currently it's failing at both.

The Slump Goes On: Why? by Robin Wells and Paul Krugman

1938 in 2010 by Krugman

And so it goes

I am reading Liaquat Ahamed's Lords of Finance and really liked these two paragraphs about Keynes on page 166.

The gold standard had only worked in the late nineteenth century because new mining discoveries had fortuitously kept pace with economic growth. There was no guarantee that this accident of history would continue. Moreover, while the original rationale for the gold standard -- the commitment that paper money could be converted into something unequivocally tangible -- might have been necessary to instill confidence at some point in history, this was no longer the case. Attitudes toward paper money had evolved and it was not necessary to allow the supply of precious metals to regulate the creation of credit in a sophisticated modern economy. Central banks were perfectly capable of managing their countries' monetary affairs rationally and responsibly, [Keynes] argued, without any need to shackle themselves to this "barbarous relic."

Though the Tract was a technical monograph, the Cambridge undergraduate in Keynes could not resist lacing the book with the playful sarcasms that had made The Economic Consequences such a success. He flippantly dedicated the book, "humbly and without permission, to the Governors and the Court of the Bank of England," knowing very well that the members of that august body would disagree with almost everything he had to say. He poked fun at the self-importance of those "conservative bankers" who "regard it as more consonant with their cloth, and also as economizing on thought, to shift public discussion of financial topics off the logical on to an alleged moral plane, which means a realm of thought where vested interests can be triumphant over the common good without further debate."

I never studied World War I much, so I was interest to read the Lords of Finance's discussion of World War I reparations, and the Treaty of Versaille, which many argue led to the rise of the Nazi party in Germany.

By the end of the war, the European allied powers - sixteen countries in all - owed the United States about $12 billion, of which a little under $5 billion was due from Britain and $4 billion from France. In its own turn, Britain was owed $11 billion by seventeen countries, $3 billion of it by France and $2.5 billion by Russia, a debt essentially uncollectible after the Bolshevik revolution.

At an early stage of the Paris Peace Conference, both the British and the French tried to link reparations to their war debts, indicating that they might be prepared to moderate their demands for reparations if the United States would forgive some of what they owed America. The United States reacted strongly, insisting that the two issues were separate.

Keynes and many economists found the reparations* excessive. British historian A.J.P. Taylor believed that the reparations weren't as over-the-top as Keynes viewed them, but that they were punitive enough to cause resentment in Germany while still not punitive enough to prevent Germany from rising to power again. According to Wikipedia,

In many ways, the Versailles reparations were a reply to the reparations placed upon France by Germany through the 1871 Treaty of Frankfurt, signed after the Franco-Prussian War. Note however that the amount of the reparations demanded in the treaty of Versailles were comparatively larger (5B Francs vs. 132B Reichsmark). Indemnities of the Treaty of Frankfurt were in turn calculated, on the basis of population, as the precise equivalent of the indemnities demanded by Napoleon after the defeat of Prussia.

(By the way, Daniel Radcliffe will start in a new version of All Quiet on the Western Front.)

DeLong asks for comments on his chapter on World War I titled "Chapter 15: The Knot of War, 1914-1920." 

Meanwhile, the overclass is demanding punitive reparations after the victory in its war on the lower class.

Reuters reports: 

In a statement after annual consultations with U.S. authorities, the IMF raised its U.S. growth forecasts slightly to 3.3 percent for 2010 and 2.9 percent for 2011, but said unemployment would remain above 9 percent for both years.

The lofty jobless rate, coupled with a large backlog of home foreclosures and high levels of negative home equity, posed risks of a "double dip" in the housing market, it said. But the IMF said it did not think a renewed recession was likely.

"The outlook has improved in tandem with recovery, but remaining household and financial balance sheet weaknesses -- along with elevated unemployment -- are likely to continue to restrain private spending," the Fund said.

Yglesias notes that at least the IMF is forcasting that the rest of the world will be growing at a nice pace.
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*From Wikipedia "Under the Hoover Moratorium of June 1931 issued by the American president Herbert Hoover, which was designed to deal with the world-wide financial crisis caused by the bankruptcy of the Creditanstalt in May 1931, Germany ceased paying reparations." Creditanstalt was the largest bank of Austria-Hungary and the Lehman Brothers of the Great Depression.

Congressional hearing on the lessons from the New Deal.

Panel 1: Christina Romer, Chair, Council of Economic Advisors

Panel 2: James Galbraith, Professors DeLong, Winkler and Ohanian

(via Mark Thoma)