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Growth Theory v. Monetary Economics: Mandel v. Thoma

Mark Mandel weighs in on a Mark Thoma critique of a column written by Chris Farrell – but seems to have missed the point of the Farrell-Thoma debate. Farrell and Thoma were discussing the role of monetary policy and the business cycle. As Mandel accuses Thoma of missing the point, he changes the discussion to one of long-term growth theory:

Let me explain the difference between the hairshirts and the growth proponents. Remember that long-term productivity growth–which is our ultimate goal–is driven by three forces: Physical capital, human capital, and intellectual capital … What’s interesting is that capital investment only accounts for about 40% of long-term productivity growth, while multifactor productivity accounts for a bit more than half. Now, here’s where the hairshirts and the growth proponents come in. The hairshirts, explicitly or implicitly, focus on the capital investment component of growth. They talk about the need to cut personal consumption and the budget deficit in order to free up more money for business investment … The growth proponents give equal weight to both technology and investment. They argue that it’s more important in the long run to focus on funding research and development spending, encouraging start-ups and venture capital, appropriately regulating (and sometimes encouraging) new technologies, and getting the right intellectual property policies. In practice, hairshirts and growth proponents advocate very different short-run policies. The hairshirts want to cut the budget deficit, even if that means stinting on R&D spending … The growth proponents are willing to let the economy run ‘hot’, arguing that a boom encourages risk-taking and corporate spending on both R&D and capital equipment (companies tend to set R&D budgets as a percent of sales, so industry R&D spending rises during boom times).

If Mandel has not heard of the Denison residual in growth accounting, he might perhaps read Solow’s 1987 lecture describing the history of economic growth theory. Solow notes the importance of savings and investment – Mandel’s hairshirts. I had told Mark Thoma that I’m not a monetary hairshirt economist in the Farrell sense – and I don’t think Solow was either. But most students of growth theory realize the importance of capital investment. Solow also notes the Keynesian insight that prolonged recession tend to be associated with weak investment demand. Also note the following from Dr. Solow:

The formal model omitted one mechanism whose absence would clearly bias the predictions against investment. That is what I called “embodiment”, the fact that much technological progress, maybe most of it, could find its way into actual production only with the use of new and different capital equipment. Therefore the effectiveness of innovation in increasing output would be paced by the rate of gross investment. A policy to increase investment would thus lead not only to higher capital intensity, which might not matter much, but also to a faster transfer of new technology into actual production, which would. Steady-state growth would not be affected, but intermediate-run transitions would, and those should be observable.

Simply put – embodiment implies that the diffusion of new technology is faster if investment is higher so these two factors complement each other.

Finally, I suspect Mandel believed the shouting from Bill O’Reilly about R&D during the 1980’s v. the 1990’s in that debate with Paul Krugman, but it seems the facts did not support O’Reilly’s shouting.

Mark Thoma asks what contribution was made by Mandel’s column. I don’t see any. But Mr. Mandel might consult a good growth theory textbook.

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One more thought about today’s FOMC statement: at a certain point, one starts to wonder why the FOMC can’t just use plain English when trying to convey its intentions. Currently, economists and financial market participants spend considerable time and energy trying to interpret exactly what the FOMC is signaling with its statements. So why can’t they just come right out and tell us? What would be the harm if the statement read something like this:

“We fully expect to continue our current policy of raising interest rates by 0.25% per meeting for at least the next two or three meetings. And if economic growth continues at current levels, we’ll continue this policy at least through the end of the year. Note, however, that this could change if there are dramatic changes in economic conditions. Obviously.”

The Fed has gradually moved toward greater and greater transparency. Wouldn’t plain English be another good step in that direction?


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Another Rate Hike

The FOMC just released its statement announcing that it has decided to increase the Federal Funds rate yet again by 0.25%, to 3.25%. This was expected. The only point of uncertainty was exactly what signal the Fed would send the market about future rate hikes. Would they suggest that this period of interest rate increases is coming to an end (as some commentators speculated this week), or do they still think that the economy is strong enough to withstand further rate increases?

Here is today’s FOMC statement compared to May’s statement. New additions to the statement are in boldface, while portions that were in the May statement but eliminated this time around are crossed out.

The Committee believes that, even after this action, the stance of monetary policy remains accommodative and, coupled with robust underlying growth in productivity, is providing ongoing support to economic activity. Recent data suggest that the solid pace of spending growth has slowed somewhat, partly in response to the earlier increases in energy prices. Although energy prices have risen further, the expansion remains firm and labor market conditions continue to improve gradually. Pressures on inflation have picked up in recent months and pricing power is more evident. Pressures on inflation have stayed elevated, but longer-term inflation expectations remain well contained.

The Committee perceives that, with appropriate monetary policy action, the upside and downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal. With underlying inflation expected to be contained, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured. Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.

My reading of this is that the FOMC thinks that the economy is doing fine, and doesn’t intend to stop its pattern of quarter-point rate hikes any time soon. (Of course, I’m assuming that the committee won’t have to revise this statement to correct a mistake, like they did last month…)

The chart below probably has something to do with this. With today’s rate increase, the real federal funds rate (which I’ve measured by subtracting the 12-month change in the GDP deflator from the interest rate) is just below 1%. But this is still far, far short of where the real federal funds rate typically is during periods of reasonably good economic growth.

If one believes in an exogenously ‘neutral’ real federal funds rate (as Greenspan seems to), the chart suggests that such a neutral fed funds rate is probably somewhere in the neighborhood of 3-4%. If inflation remains in the 2-2.5% range this year, it will take the FOMC more than 12 more months until the Fed’s “policy accomodation” has been fully removed at the current “measured pace” of quarter-point hikes. We still have a long way to go, in other words.

But I have my doubts about the concept of an exogenously ‘neutral’ interest rate. The reason is because I wonder if relative interest rates aren’t sometimes just as important as absolute levels of interest rates when it comes to influencing business and consumer spending decisions. So while today’s interest rates are indeed low in an absolute sense, I worry that raising interest rates will still chill economic growth from its current level, which is only mediocre to begin with.

However, I am also sympathetic to the idea that the Fed needs to store up ammunition for the next economic slowdown, and thus needs to raise interest rates today while it can. This leaves me feeling fairly ambivalent about whether the Fed should keep raising interest rates.

At any rate, I’m not the one making the decision. That’s up to Alan Greenspan. And from today’s statement, it looks like we’re in for further increases in short-term interest rates, for at least a little while. After that, it’s anyone’s guess.


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An Amazing Story

In the wake of last week’s bid for Unocal by the Chinese oil firm CNOOC, the press has been full of stories about China’s newly emerging economic might. That economic power is real, and without a doubt will gradually change the way the world looks over the coming decades. From the US’s point of view, not all of those changes will necessarily be for the better.

But while I was looking for some data on China’s savings rate for yesterday’s post about differences in savings behavior, I was impressed by the multitude of statistics that I encountered that illustrate just how dramatically life has tangibly improved for hundreds of millions of people in China over the past decade or two. The following statistics portray how China’s rapid economic development has caused a marked improvement in living standards for a mind-bogglingly large number of people.

Sources: Poverty figures from the ADB report, “Poverty in Asia” (2004); other figures from China Statistical Yearbook and World Development Report.

Such dramatic improvements in the quality of life for such a large number of people is probably unprecedented in all of human history.

There’s a lot to criticize about China’s government and its policies. But say what you will, it is hard to argue that China’s recent economic success has not lead to vastly improved lives for hundreds of millions of people – a sizeable proportion of the entire human race. It’s an achievement that deserves to be appreciated and celebrated by all of us.


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A Rising Tide That Used to Lift All Boats

The following chart shows household real income for the tenth and twentieth percentiles per the data in table A3 of the Census Bureau’s Income, Poverty, and Health Insurance Coverage in the United States: 2003 (issued August 2004).

Donald Luskin’s STILL MOVIN’ ON UP is supposed to appear in the National Review print edition on July 4 – with the text available here:

The Journal and the Times are exercised by reports that, over the last three decades, a new class of what the Times calls the “hyper-rich” has arisen in the United States, resulting in a disparity in incomes between rich and poor not seen since the 1920s: the most severe income inequality in the developed world today … But none of this is exactly man-bites-dog material. What the Times reports as news is a pattern that should be familiar to economic historians: Times of great prosperity have been associated with greater income inequality (for example, the 1920s), and conversely times of economic decline have been associated with greater equality (the 1930s). The lines of causality here are complex, and no doubt run in both directions: Prosperity is both the cause and the effect of inequality, and decline is both the cause and the effect of equality. So ideological advocates of income equality for its own sake ought to be careful what they wish for … We need to focus, then, on the question: What harm has it done to have this new class of the hyper-rich on the American scene? … Average after-tax, inflation-adjusted income has risen for every income quintile in the population. Yes, it has risen the most for the highest quintile, and risen the least for the lowest—but this can be explained to some extent by the great wave of immigration over the same period. The fact remains that income has risen for all: The rising tide has lifted all boats.

This claim that faster growth causes greater income inequality is rebutted by Brad DeLong. The rising tide claim may have been true for the last 33 years of the twentieth century, but our chart shows real income for the tenth and twentieth percentiles have fallen since 2000. The chart shows the rather unsurprising tendency for real income of poorest among us to be cyclical. Let’s also look at the past 36 years in four stages. For the 11-year period ending in 1978, real income for the poorest among us grew by around 20%, but grew by less than 6% for the 11-year period ending in 1989. Real income growth poorest among us was almost 10% for the 11-year period ending in 2000, but the decline in real income since 2000 has wiped out much of the gain in real income for the poorest among us that we enjoyed during the 1990’s.

While Luskin may be correct that the rising tide lifted all boats before 1979 and during the Clinton years, the rather weak growth of the past few years has been accompanied by a decline in real income for the poorest among us. While one might reasonably conclude that part of the reason for the fall in real income among the poor is the continued weak labor market, Luskin wants his readers to believe that economic growth has been sensational in the last few years. Alas, average annual growth over the past five years has not been great and real income for many of the poor has declined.

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International Saving Comparisons

Following up on yesterday’s post about the capital flow puzzle, I thought I’d examine savings and consumption patterns more closely, since differences in savings behavior are (as I argued) the crucial determinants of the odd pattern that we currently see wherein poor countries are lending vast sums of money to the wealthy United States. The table below presents a snapshot of the tremendous disparities in savings and consumption behavior between developing Asian economies and the US. All data is for 2003 unless otherwise noted.

Notes: Japan gross savings data for 2002; China household savings data from 2000.
Sources: Gross savings rates from OECD and ADB; household saving rates from OECD and sundry national statistics agencies; consumption and CA balances from IMF.

Rates of gross national saving – which include saving by households, firms, and the government – are double or triple the US rate in most of the countries in the table. Generally, much of the difference is accounted for by higher rates of savings by households. (Note that it is surprisingly difficult to come by household savings data for developing countries; I’d appreciate any data tips to help fill in my table.)

Another way of looking at the same thing is to examine how much consumption spending each country does. Unsurprisingly, the US leads the pack when it comes to consuming; by contrast, several Asian countries have extremely low rates of consumption spending. As I mentioned in yesterday’s post, the problem in Asia is too little consumption, if anything.

The last column in the table shows the effect of these divergent savings and consumption patterns: net international borrowing or lending, or the current account balance. Nearly every country in the world right now is a net lender, with almost all of those funds going to the US.

What explains these dramatic differences in savings and consumption patterns? It turns out that there’s no consensus on a single answer. Numerous possibilities have been examined in the literature to explain different savings rates across countries (see this World Bank paper for an example of a fairly thorough overview), including income levels and growth rates, financial sector development, credit constraints, fiscal policy, and pension institutions. Needless to say, different explanations seem to work for different countries at different times, and savings differences are usually due to a combination of several factors.

But my favorite theory, at least in this case, is that the high rate of saving in many Asian economies is primarily due to the inertia of consumption spending.

It is an increasingly well-established empirical fact that consumption displays a great deal of inertia – people’s consumption habits only change slowly, even when their income rises or falls dramatically. If a country is experiencing rapid economic growth, this could well explain why savings rates are high in those countries: households’ consumption has not yet caught up to their increased income, so they save the difference. Of course, to some degree the causation may run the other way (i.e. higher savings may lead to faster growth), but the evidence seems to suggest that the primary direction of causation is from higher growth to higher savings.

This helps to explain why some of the fastest growing economies like China have some of the highest savings rates. It might also help to explain why Japan, which has experienced a dramatic slowdown in growth over the past 10 years, has also experienced a dramatic fall in its household savings rate over the same period of time, from about 15% in 1990 to about 7% today.

At any rate, the upshot is that the US will continue to borrow from the rest of the world until it starts to save more, or households around the world start to consume more of their income. So the real question then becomes this: what will make either of those things happen?


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Tom DeLay Understands Cost-of-Living Adjustments

While this story covers the $3100 increase in Congressional pay, let’s go to the end of the article:

“It’s not a pay raise,” said House Majority Leader Tom DeLay, R-Texas. “It’s an adjustment so that they’re not losing their purchasing power.”

The Congressman is exactly right as the percentage increase in nominal pay is less than 2%. And yet we hear so many GOP leaders trying to claim that nominal increases that are less than the increase in the cost of living represent benefit increases rather than cuts.

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Explaining the Capital Flow Puzzle

I think I have to disagree with Brad DeLong’s assessment of Glenn Hubbard’s WSJ op-ed from the other day. Brad suggests that Hubbard may indeed have identified an important piece of the puzzle – the puzzle being why poor Asian economies are lending so much money to the United States.

Hubbard’s point boils down to this: China and other developing Asian economies are investing large quantities of money in the US because they don’t have good investment opportunities at home. That’s not because the domestic rates of return are no good, but because bad domestic institutions make domestic investment opportunities risky. In other words, the risk-return ratio is better in the US.

But I don’t think this explains today’s pattern of international capital flows. I agree that corrupt and inefficient domestic institutions in many developing countries are major impediments to growth. And there are lots of examples where citizens have sent their savings overseas because they were worried about losing it if they kept it in domestic assets. (Think about many Latin American countries during the 1980s, or most of Africa during the last 50 years, for examples.)

But Asia today does not fit this story.

There are two reasons that I say this. First, the agents that are actually buying the assets in the US are not private individuals in Asian countries, but rather Asian central banks. And we’re reasonably certain that the reason they’re buying US assets is not because they’re seeking the highest or most risk-free return, but rather because they are trying to manage their exchange rate. There’s scant evidence that private individuals in Asian countries are fleeing to foreign assets because they don’t trust their domestic institutions.

Second, the surplus of funds in Asia stems not from an insufficiency of domestic business investment, but rather from an insufficiency of private consumption. Investment spending in countries like China is, if anything, too high – in China it’s currently running at over 40% of GDP, compared to less than 20% in the US. Apparently, individuals and firms see plenty of good investment opportunities in China and other developing Asian economies, and are willing to put money into them.

The problem is that private savings rates are also extraordinarily high in those countries. Furthermore, while such high savings rates are found in countries with questionable institutions, like China, they are also found in countries with impeccable financial credentials, like Singapore. So I don’t believe that weak domestic institutions are what is causing households in a wide variety of Asian countries to decide to save their income rather than spend it.

No, I think that we must look elsewhere to explain the bizarre pattern of poor developing countries (along with many rich countries) lending vast sums of money to the US. Note that the two things that make this pattern possible right now are (1) the fact that the US is living far beyond its means, and borrowing the difference (both at the private and governmental levels); and (2) the fact that households in developing countries like China are saving rather than spending their income. So if you want to explain the pattern of international capital flows today, I think you need to explain facts #1 and #2. I don’t think Hubbard’s story explains either of them.


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On the Non-relationship Between the Dollar and the Deficit

Michael Hoffman forwarded to us an interesting short paper showing the lack of an empirical relationship between the exchange rate and the current account. He summarizes the underlying theoretical construct as two conventional claims:

(1) A cheap (depreciated) dollar causes the current account deficit to shrink.
(2) A current account deficit causes the dollar to depreciate.

My reply to him was simply the following shorter version:

Net exports are a function of real exchange rates and other factors, while real exchange rates are also an endogenous variable. It is well established that correlations between endogenous variables tell us little about the underlying structural relationships.

I wish to thank Michael for this contribution and hope our readers enjoy it.

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