Between Iraq and a Hard Place

Thank goodness the sanctions against Iran are like virtually all sanctions: leaky as a sieve. Seldom is there sufficient unanimity to make even relatively concerted action effective.

Now it seems that some in the Pentagon are itching to redeem themselves – an actual government making indisputable threats. Iran is capable of closing the Straits of Hormuz, at least temporarily. But a "measured response" might not reopen the waterways. Would you write a (large) insurance policy on slow and vulnerable supertankers? (Arithmetic: 2 million barrels at $100 per barrel is $200 million) My guess is NO!

The threat, in other words, is more potent than it might seem. The US and its allies will find their ability to see that oil continues flowing more limited than most imagine.

However, as long as Iran can sell oil, they have multiple reasons – in units of US dollars billion – not to shut off the flow of oil. That is, as long as the sanctions are leaky.

If the sanctions "bite" then this calculus changes: there is no longer a downside for Iran, financially. As to domestic politics? Well, the government is hardly popular, but if they really are under attack… That's not such an incredible story, and it's not just the recent dead physicist, it's also our sponsoring Iraq in their 1980-88 war. (Remember our good ally Saddam Hussein? – whatever happened to him?)

So again, thank goodness the sanctions aren't working. Let's pray that continues.

[PS: if you're an economist, you can reframe this as a "game".]

[Sources: See Economic sanctions reconsidered by Gary Clyde Hufbauer, Jeffrey J. Schott, Kimberly Ann Elliott, a two-volume study published in 1990 by the Peter G. Peterson Institute for International Economics. It analyzed roughly 300 examples of international sanctions, essentially all those available at the time. In their judgment less than a handful proved effective in achieving their purported (political) goal. Sanctions thus seem to be aimed at domestic constituents as much as foreign enemies.]
[Addendum of 25 January: I listened to part of the Republican primary candidate in Florida. Ron Paul's argument against involvement in Iraq employs a similar logic. Of course part of what I had in mind was our embargo of Japan in 1941; some in Japan interpreted that as a de facto declaration of war. Paul claims we've already done the same for Iran with the stationing of ships in the Persian Gulf. As far as I know, however, we are not actually forcing oil tankers to stop, and so I stop too from seconding Paul's interpretation.]

The End of the University of ... [insert your state]

The Washington Post reported [here, Dec 14th] on the budgetary crunch at Berkeley, amidst a claimed more general trend towards less state support for higher education. As an economist, I wonder why this trimming of support took so long – not because it's laudable, but rather because it is what basic economics permits. After all, why should my state spend money to educate someone who with high likelihood will work in someone else's state? If we close down all of our state schools, businesses may have a harder time recruiting managers, but given current unemployment levels…we here in Virginia can be free riders. But the logic is the same for each and every other state: all will cut. And if the Post is on target with its story, they are doing so.^[1]

Can we find other evidence of this sort of behavior? Yes.

The generally abysmal quality of education in the old cotton-and-tobacco South reflects this logic. Plantation crops in the old days relied on brute labor, not brains; why pay for fieldhands to learn to read? That would increase their mobility, threatening the ability to get the crop harvested rather than making the local economy more productive. Equally important, a body is able to work by high school, if not by age 12 or 13. You want to spend money to keep them out of the fields?? That was true for coal mining and textile towns, too. Even in the north, my grandfather had to leave the farm to board in the city so that he could attend high school. Why, today, should residents of Florida retirement communities tax themselves to pay for the education of someone else's grandchildren? My sense is that, increasingly, they don't.

At the global level, society benefits from the constant stream of innovation that has lifted incomes for the past two centuries in industry after industry. Furthermore, by the late 1800s "basic" research underlay invention. But basic science in itself is unproductive. Few research projects pan out; those that do may have no obvious application. Even if they do, there's a (large) gap between laboratory bench and commercial product.^[2] So why bother with basic science? The answer is that most of the world doesn't. Would Mongolia benefit from spending 2% of GDP on R&D? Instead, just buy the finished products, or use hints and the poaching of the odd employee. Of course basic research provides a great training ground for high potential grad students. But such workers are internationally mobile. Why should we pay?

To use jargon, education creates a positive externality: the benefits to society increase by more than the output of the (marginal) individual. We're much more productive when we can assume that employees, suppliers and customers are literate and numerate and (nowadays) know how to use computers.

The incremental benefits to education diminish with more years of schooling. Part of the reason is that job skills aren't generic, and so it's not realistic to think that college will provide them: you can add more knowledge, and an improved ability to learn and to communicate. Valuable, but only incrementally so. Now occasionally community colleges will pair with local employers for discrete programs, particularly when there are several companies with similar needs. That helps offset one of the defects of on-the-job training, that employees will take their skills to firms that pay a bit more, enabled because they train a bit less. In general, though, college cannot, and does not try to give, "day one" job capabilities.

That doesn't mean a college education does nothing. It also socializes students (generally for the better, unlike high school) and generates a pedigree that reflects some combination of acumen, ambition, persistence and willingness to do grunt work. Employers generally value all four. So even if a diploma provides little insight into the mix, employers are nevertheless willing to pay something for a diploma. However, now that everyone who is anyone has a diploma, that alone doesn't distinguish a graduate: you need higher higher education, a masters...

So why should we fund universities when their graduates have a hard time finding jobs, when many of the courses are esoteric and unworldly – as though the Greek and Latin education of the 19th century elite wasn't! Maybe we are educating too many for too long. But cutting back on funding won't somehow lead to more "practical" training – the sheer diversity of needs in today's economy precludes that – or to would-be employers not asking to see that diploma. Instead turning our public schools private will squeeze out those youth whose parents don't have the wherewithal to pay tuition,^[3] or the sophistication to push them while young to win the scholarship marathon.

Mike Smitka

Notes:
[1] California is remote from the East Coast, at least as reflected in the job hunting practices of my seniors. Now Washington and Lee is far from average, so I don't want to read too much into that – indeed, my suspicion is that Hollywood and Silicon Valley pull workers from throughout the US, if not from throughout the world. But to the extent it's true for the state as a whole, then Californians should be less willing to see the UCal and CalState systems pared than the rest of the country.

[2] Complete Digression: Xerox

The photoelectric electric effect relied upon lab results, and the lunchtime jottings of an employee of the Swiss patent office in 1905. The cost: a pencil and some paper. While it led to a Nobel prize for Einstein in 1921, there were no practical applications. Turning it into an invention relied up the efforts of Chester Carlson, working in the family kitchen in Queens during 1936-39, to succeed in developing a "proof of concept" using light to turn words into static charges on a selenium plate in 1939, to which sulfur dust could be made to adhere. Now this work involved a bigger budget than did Einstein's, but it was within the realm of his modest Depression-ear salary. Further development at the Battelle Institute ate through rather more, at least $200,000, a tidy sum in those days. In the process they developed a better plate, an effective toner and other core pieces of a working machine. However, the first commercial product didn't arrive until the Haloid Corporation took over development work, and invested much more money. The first shipment of the Xerox Model A Copier came in 1949; the first really successful version took until 1959, after significant additional investment. Now some of this required individuals with a knowledge of physics, and chemistry, and mechanical engineering, drawing in fact from many fields. But it drew upon the stock of knowledge, and lots of good engineering. For this I draw upon Hillkirk, John and Jacobson, Gary (1986). Xerox: American Samurai. New York: MacMillan. But I double-checked this` out of curiosity against Wikipedia.

[3] Some might object that the market will handle everything: academically able students can borrow and succeed even without financially able parents. But in today's environment of dim job prospects, don't the risks to both the bank and the would-be student mean that the only sensible strategy is "to neither a lender nor a borrower be?"

First Greece, then California?

We know that Greece is in trouble. But what of California? It too is a sovereign entity within a monetary union. Chapter 9 bankruptcy, the provision that covers local governmental entities, is not available for state governments; under the US Constitution they fall outside the jurisdiction of such Federal legislation. And it's large -- 12% of the US economy, much larger than Greece is within the EU. So it may be Too Big To Fail -- perhaps we need to create the term "SIPEs" for "Systemically Important Political Entities" (cf. SIFI).

We would first need basic data. I've outlined what I know and what I think we need to know below. This is a work in progress, so will read choppily until such time as I rewrite in one sitting from beginning to end. Oh, and conclusions are at the very bottom.

1. What is the total volume of California bonds "at risk"? State finances are potentially complex -- there can be taxes that are legally earmarked for the repayment of specific bonds, e.g. highway bonds matched against gasoline taxes all covering highway maintenance separate from the general budget. So the first approximation would be General Obligation Bonds (or their equivalent), that are backed only by the full faith and credit of the state government.

• A quick google search suggests that about $80 billion are outstanding. (See "Seeking Alpha" from January 2010; the California State Treasurer gives the December 2011 General Obligation Bond total as $72 billion.) If so, then the amounts are really pretty small: with the GDP of California at about $1.8 trillion, it comes to 4% of state GDP, while Greece's (gross) debt is 116% of GDP.
• In addition the state has contingent liabilities. The big item is likely unfunded pension obligations, rumored at about $500 billion. If we use $600 billion as a total, then debt is 1/3rd of GDP. But it's not clear that the bond market factors that in, since the need to lay out cash is down the road and the amount fluctuates with the stock market.
• On 30 November 30 year Treasuries had a yield while California bonds of roughly the same maturity traded at 4.5% according to MunicipalBonds.com, or nearly a 2% premium despite their more favorable tax status -- indeed, for someone in the top income tax bracket, that would be the same as 7.6% on a US Treasury bond, a very stiff premium.

2. Who holds these bonds? Are they held by individuals who for various reasons might have a hard time "dumping" them? For example CALPERS, the state pension fund and the world's largest institutional investor, may hold so many bonds that it is unrealistic to think that they would "dump" them and be forced to book a loss. Or bond holders might be widely dispersed and typically hold only a few. In the former case, this would mute any crisis.

• My hunch is that debt however is in fact widely held, albeit almost entirely within the state of California because state debt is tax exempt and marketed within states, for example there are mutual funds restricted to California bonds. Furthermore, it is likely held by a combination of individuals and pension funds, not banks (licensed or shadow) and so would not have some of the spillover observed with sovereign debt in the EU.

3. What is the maturity of the debt? In general, the government will refinance debt by rolling it over when it comes due. So a crisis could be accentuated if there is a current deficit that would have been debt financed, and maturing debt that would have been rolled over. More generally, a non-crisis gradual increase in borrowing costs to match perceived risk only affects new debt; the longer the average maturity, the longer it takes for an increase in interest rates to increase the average interest rate on state debt and hence the share of tax revenues needed just to pay interest.

• I have no information though the unfunded pension liabilities are long-term so my hunch is that only $20 billion is short-term -- a drop in the bucket in US financial markets, even in their current stressed state (or should that be "states currently stressed"?). But that's not so small relative to general revenues in California, which I think are on the order of $75 billion.
• Floating rate debt accentuates the impact any any short-run issues. Ditto bank loans. In January 2010 (Seeking Alpha) there was $5.5 billion in floating rate notes and $6 billion in bank loans. So at that point it was over 10% of all general state debt. 

4. What of other debt? -- there is likely seasonality in tax receipts and (perhaps less so) in expenditures. How is that financed? -- bank loans? The private sector analog is "working capital".

• See above -- old data. So I don't know.

5. To what extent is California an "open" economy? -- the greater the share of trade, the smaller an impact a decline in expenditures would have.

• I'm sure California is more "open" than Greece, in that it has never been an independent nation. However it is large and physically remote from the rest of the US economy so the short-run multiplier might be pretty big.
• Greece is small, with a population of 11 million, while California has 37 million.

6. How large is the government? Again, parts of the government may be funded by taxes that can't be tapped to cover general budget items -- a debt crisis might not affect those areas at all.
CA state-level GDP is about $1.8 trillion, state and local government is about $0.2 trillion or about 11% of the economy. However there is no breakdown for the state government vs local governments. Furthermore it is not clear whether transfer payments are included (normally they would not be) and how these are handled within the state fiscal system.

• My recollection from a year or so ago is that current expenditures at the state level are about $100 billion, but that the budget was not unified and reporters in Sacramento felt that no one really had a comprehensive grasp, certainly not those in the state legislature. But this means that the state government only accounts for 5% or so of the economy.
• In contrast, for Greece we are talking about the central government, which has total expenditures of 47% of the economy and an overall budget shortfall of roughly 8% of GDP. That is very different in scale from a state government in the US, even if we lump city and country governments and the many semi-independent school, water, sewage, transit, port and other units in with the state.

7. How interrelated is government? To what extent would a debt crisis at the state level impede the operations of local government, which probably employs far more people? Most state governments transfer significant amounts of funds to local governments, particularly in support of public education. Is that the case for California?

• My guess is that the state directly employs relatively few people, indirectly many. In normal times local school systems might have the ability to tide over a temporary shortfall in funds. I very much doubt that's true now.
• However, under the California constitution education has seniority over debt service; it may be therefore that if crunch turns into default, in the first instance bondholders would be left holding the bag, not state employees. In the second instance, I suspect that the axe would fall on a great many, and that education would be affected through indirect channels.

8. Would Federal-level "automatic stabilizers" mute the impact?

• My hunch is that state employees fall outside the unemployment insurance and pension guarantee systems. Furthermore, unless I'm mistaken unemployment insurance, medicaid and various other social safety nets are actually administered by, and operate in part with funds from, the state level. So they could suffer from spillover effects that would magnify the more narrow state government component.

9. What of contagion?

• I think it quite realistic to think that local governments would have a hard time issuing bonds, even if they themselves are fiscally sound. After all, potential purchasers can always purchase Treasuries if they want long-term bonds, though for tax reasons they are imperfect substitutes. (Interest income on state obligations is not subject to either state or Federal income taxes, whereas Federal bonds typically are exempt from state taxes but not Federal taxes.)

10. What of contagion?

• If California runs into trouble, then surely Illinois also would. And local governments therein (Chicago?). Sipes! (Structurally important political entities!)

11. How big an adjustment?

• At least one mitigating factor is that the numbers I know are smallish. A current budget shortfall of $25 billion is 1.4% of California's GDP. Add in pension shortfalls of $500 billion and (spread over several years) we get a rather bigger number, but one that is still far below the 8% structural deficit in Greece. Of course this is in the context of a continuing recession and a continuing drop in real estate prices and high level of foreclosures that may mean revenues will continue to fall rather than stabilize.

• Furthermore, the political system is byzantine, not Greek. Because of the referenda system, the legislature has limited powers; it could take a long while to change the state constitution, even if the will is there, because of the mechanics involved.

12. Should we worry?

• I can't answer that question. But I don't think it can be brushed aside -- though Dani Rodrik concludes that in a November 2011 blog post. Part of the answer would be whether there is any trigger. What is clear is that the underlying structure is not fiscally sustainable. Will it however generate a "crisis"? Or a slow increase in interest rates on state debt and other pressures that will lead to a non-traumatic resolution? I certainly hope the latter, but wonder whether that is politically realistic. After all, the potential for Europe's current problems was fairly clear before the Euro was launched -- Martin Wolf of the Financial Times wrote about it in the early 1990s.
• Nevertheless, the numbers above seem pretty small, under $100 billion, not factoring in cities, counties, school districts and other bond issuers within the state that may well be tarred and feathered by what goes on in Sacramento. If a crisis developed, but were limited to California -- a big if -- then it would not be big enough to affect the US as a whole.
• In the late 1970s, before heading off to graduate school, I worked on Wall Street on Eurodollar syndicate loans to Latin America, and served as a representative of Japanese banks to the IMF organized restructuring of Jamaica's debt in 1980. (I didn't stick around to be part of the team for Brazil and other borrowers.) That was horrific in its impact on the average Jamaican, and the economy has never fully recovered. But a default by a US state would be quite different; once Jamaica began running out of US dollars, importing food and oil became problematic, as no foreign party would accept Jamaican currency. That issue would not be relevant for a subnational entity (and is not relevant in the EU -- incomes in Greece may have fallen, but if someone has a job, the euros they earn have held their value). It's important to keep that limit on the downside in mind, for Greece and for California.

Economic Policy: Treating Symptoms, Treating Causes?

Mike Smitka

...Inaction is the Best Medicine?...

The question: can we use an analogy from medicine, that we should treat the disease rather than the symptoms?

1. Of course treating the common cold or a mild case of the flu may not be worth the effort (tamiflu?!) -- take 2 aspirin, drink lots of fluids and go to bed.
   
2. Where there is no direct treatment, or the symptoms themselves are dangerous (and the diagnosis pending) then treating symptoms may be the best policy. That's the standard plot on House, someone's dying, treat the symptoms while the detective work progresses. Of course, to fill up the hour the first choice backfires (or works but then new problems crop up).
   
3. Sometimes though the effects of the disease don't, or won't ever, reverse themselves. The stroke is over, blood is flowing but...or the rheumatic fever has subsided, but the heart valve is shot and won't heal itself. Treat the aftereffects, not the cause.
4. The patient may not cooperate. In the (really) old days of cable bindings skiers broke bones with alacrity. You could set the bone and mostly get it to heal. But keep on skiing ... well, you haven't treated the disease and next time it may be a joint that can't be fixed. I suppose a better example is obesity: few doctors will tell someone "get lost until you lose weight." Now it's good for business, and many patients may be too addicted to snacking and watching TV to shift their net caloric intake (fighting alcoholism may be easier, after all our bodies can survive without drinking, but you can't stop eating). In economic terms, political economic calculations may mean you know what you ought to do, but don't.
   

So in fact when I think more deeply about the medicine analogy, it suggests there is no quick answer for what an economist ought to propose.

I still hold that best practice remains diagnostic-based treatment. But let me return to the list above.

1. Being reticent to act is not a bad thing. There are always "shocks" to an economy, good and bad, but in developed countries our economies are both very big and resilient. The effect of most shocks is transient, even when the impact can with hindsight be discerned in the data. Policy has side effects, it can be hard to change and hard to reverse if it creates "winners" (an example is the capital gains tax exemption in the US, originally put in as a response to the distortions caused by the late 1970s inflation). In the macroeconomic context, textbook models suggest that adroit fiscal and monetary policy can eliminate the business cycle, but getting the timing right is hard because the "normal" cycle is short (reverses itself) and we tend to use the wrong policy tools (monetary policy to slow an economy, fiscal policy to boost -- the opposite is ideal). So we have both side effects (higher real interest rates coming and going) and may be giving the wrong medicine (no need to push down body temperature once the fever's gone).
   
   The losses from Japan's earthquake were horrific and even if we can rebuild, we reverse death or undo privation. But from the perspective of the economy as a whole it was still a fairly small event, and even if Toyota and Honda lost a lot of production, rivals were less affected. So the underlying competitiveness and complexity of a modern economy means there are lots of substitutes. So while there was a short-term impact there's no reason that macroeconomic policy need change. (But every reason to devote resources to recovery...at the local "microeconomic" level.)
   Back to the practical problems of real-time policymaking. This was Milton Friedman's bete noire -- after all he used the same Keynesian analytic framework, so it was not theory that drove him but pessimism about policy makers and the policymaking environment. He wanted a world of rules. Unfortunately the world proved too complex for simple rules, which he himself recognized in his latter years. As long as we permitted innovation in financial services, rules would need to evolve. Ideological correctness is insufficient: with irony, it was Greenspan the conservative/libertarian who poured fuel on the flames of a financial system fixated on short-term returns while trading long-term instruments. Financial innovation provided insurance policies, yes, but not as fast as financial innovation multiplied risk.
2. Does the economy always quickly recover? Clearly, no. We should be chary of panicking at every sign of recession or the cry of inflation that comes every commodity spike (we are wont to confuse shifts in relative prices from aggregate inflation when it comes to the prices of gasoline and veggies.) That's point #1.
   
   But neither should we bury our heads in the sand and say things will pass when all evidence speaks to the contrary, when unemployment or inflation is suddenly a multiple of desirable and presumably feasible levels.
   So when the patient may be dying, provide stimulus. If that doesn't work, provide more. It's not hard to back off of emergency measures -- the Civilian Conservation Corps was folded pretty quickly. [President Eisenhower found it harder to trim the War Department, by then artfully renamed the Department of Defense, but its growth was never premised upon macroeconomic necessity, even though commentators from at least the 19th century had pointed out that wars on other people's land weren't so bad, particularly when in the post-draft era they are from a policymaker's perspective fought by other people's children.]
   Keynes in fact was a good example. On matters economic he was a conservative, but he had warned about the large macroeconomic flows built into Treaty of Versailles reparations as something that would be beyond the bounds of normal macroeconomic adjustment. Then, in the 1930s, he found himself staring at 20% unemployment in Great Britain, well, it was clearly not a run-of-the-mill downturn. Worse, he was looking into the abyss of socialism -- in Germany, the National Socialist Party of Adolf Hitler, and there was populism and radicalism at home.  Something was sorely amiss, and sitting on his hands wasn't an option, even if as the creator of modern macroeconomics he was at times groping and unsure of his way (or more precisely, incoherent.) Keynes didn't view his task as that of a plumber fixing the odd leak along a dike; he saw a dike about to collapse with raging floodwaters set to inundate hist beloved England.
3. Macroeconomic damage is fundamentally irreversable. If you've lost your job and can't find one for 9 months, it becomes increasingly difficult in many industries to get hired back to a similar position. You can never make up for lost consumption -- the pain of telling kids "no" can't be undone. When it lasts long enough, small businesses fail and teachers get fired and roads don't get maintained and communities lose coherence. If you've lost your house, it can take a while to rebuild your credit rating, not to mention build up the downpayment on another house. And if in the interim you've been unable to afford healthcare and haven't been able to pay college tuition, there's long-term damage. These affect society as a whole, too, and not just those hit directly by economic trauma. So while we may not be sure what's causing unemployment, we certainly can engage in direct job creation or pay extended unemployment benefits and offer subsidies to state and local school systems and hospitals to mitigate the side effects of recession.
4. A financial system that collects fees up front for selling assets that are long-lived has a built-in conflict of interest. Straight bank loans to small businesses are less problematic, because they tend to have a shorter maturity (lessening the mismatch between the time horizon of a bank's assets and liabilities) and because banks can't sell such loans to others as readily and so are more careful in their decision-making. (Asides: the 90-day line-of-credit is illusory, since most businesses structure themselves as ongoing entities; maturity mismatch remains. Likewise the bankers who originally made the loans may well have moved on, and not suffer the consequences of bad decisions.)
   
   But straight banking is now a small fraction of our financial system. The securities industry, which is what banks have morphed into, is huge, and with a regulatory system that emphasizes the letter of the (common) law, we seem unable to restrain the growth of "shadow banks". When money is "tight" shadow banks and securities firms have a harder time raising funds, and the yield curve can work against them. But it's like a case of AIDS, with a combination of basic regulation and normal monetary policy we can restrain its ability to cause illness but to date we can't eliminate HIV entirely. Lapses in medication lead to bad outcomes.

So perhaps medical analogies have their use. There is however no (simple?) diagnose-and-treat lesson to be had. Rather, it is that the economy, like the human body, is very complicated, and textbooks will only get you so far. Medicine remains rooted in apprenticeship. Economics must as well

Perry and Treason

Mike Smitka

...(your) Unemployment is Good! (for me)...

Treason is a serious charge; I would hope that a presidential candidate would not bandy it about lightly.

But first, I find it unsettling that Rick Perry seems to have flunked Economics 101 in his diatribe yesterday against the Fed, that it should not "print money." He fails to understand that in our (and every other) modern economy banks create money, not the government. That was true when the US was on the Gold Standard, too. The Federal government does print paper bills – but it is Treasury that oversees the Comptroller of the Currency; the Fed has nothing to do with it. Is it too much to ask that someone wanting to be chief executive know a little bit about the tools of governance, or at least listen to people who do?

Second, Perry exhibits a lack of intellectual principles. He charges the Fed with treasonous behavior. He seems to be unaware of Milton Friedman's 1963 magnus opus with Anna Schwartz, A Monetary History of the United States, 1867-1960. Whatever flag of conservatism Perry might be claiming to wrap himself in, it's not Friedman's. Friedman and Schwartz do deride the Fed, justly, for turning the 1929 market crash into a depression – but for not printing enough money, not for printing too much!^{[Note 1]} So Perry wants not only to repeat the budgetary idiocy of Herbert Hoover, he wants to repeat the monetary idiocy of Roy Young and Eugene Meyer, the successive Chairmen of the Board of Governors of the Federal Reserve System during 1927-1933. So Perry makes it clear that he has no conservative principles, only campaign ones.^{[Note 2]}

This campaign focus extends to moral principles; Perry displays an ethic that is, well, so self-centered that I find it hard to fathom: he wants the Fed not to print money because it might create jobs and lessen his election prospects. Yes, for his own vanity he wants to keep millions of Americans unemployed.

I'm resigned to the occasional bad student; academic firepower isn't all that matters. Diligence does; even my bad students do their homework, and learn to stick to a consistent line of argumentation. But to lack principles -- well, at Washington and Lee Honor Code violations get you expelled, though guilty verdicts in practice are hard to come by.

I hope primary participants quickly expel Perry from the race. As President he would take an oath to uphold the Constitution, the opening sentence of which states that one purpose of the Federal government is "...to promote the general Welfare...." He must believe that once someone is unemployed they are no longer worthy of being considered a citizen. But that's not what the Constitution says: even slaves counted (though not for much).

Perry is apparently quite willing to destroy livelihoods for his own political benefit. But I don't bandy around the charge of treason lightly; however reprehensible I find that stance, I don't think it merits accusing him of seeking to destroy the country.

 

Note 1: Ben Bernanke lauds their work; I do as well, though I am uncomfortable with the monocausal view of the causation of A Monetary History. The link to Wikipedia provides a start for those who want to know more of the details.

Note 2: Obama is little better in practice: his stated goals are not pernicious, he on occasion talks a good talk on policy. But refuses to walk the walk, neither leading nor following through. Perhaps he too cares only about his standing in the polls.

Bugger Gold

Mike Smitka

...Gold is for Fools...

The case for commodity metals as an investment must rest either on a supply/demand story or on expectations. Now platinum is valuable as a chemical catalyst. However, dear to an economist's heart, when prices rose for legitimate scarcity reasons, then lo and behold! -- there are other catalysts out there. Gold has some industrial uses, due to its chemical inertness and electrical conductivity. But not many, at current prices. Then there is jewelry. OK, the world's middle class population is growing, though "bling" tends to fads. However, inventories are huge relative to that demand. So gold's value rests fundamentally upon speculation.

Worse, that speculation is driven by one story: inflation. As a Japan specialist, I'm more familiar with the opposite: Japan has seen consumer price deflation, admittedly at low levels, for a baker's dozen of years, while the domestic corporate goods index has fallen on an episodic basis for 25 years. Yet this is despite an increase in base money that in the old days economists of all stripes would have presumed a harbinger of hyperinflation.

Well, the US and EU are set to follow Japan's path. Underlying a rise in prices must be an increase in the largest single cost in a modern economy, labor. I don't see that happening anytime soon. Institutional rigidities make downward wage adjustment slow -- compensation systems in large employers in Japan are highly bureaucratic. But such employment didn't expand; contingent employment did. Japan is now a nation of part-time and short-term contract workers, at least among the young and women and older workers. Worse (better? -- consider the alternative!), productivity also rose. Paired, they meant falling costs.

Institutions in the US and the EU differ; our bias is towards unemployment rather than falling wages. But all in all I'm betting on mild deflation -- and hence I'm not buying gold.^[note] There's a flood coming, and the foundation of today's prices is muddy, not even sand. Gold prices should be falling since 2008, not rising.

In Edgar Allen Poe's whimsical short story "The Gold Bug" there is method in madness. In today's markets there is only madness.

Note: To be honest, I'm the unintended owner of two houses, so I've no leeway to buy anything!

Who Feeds Leviathan? -- Children!

Mike Smitka

...Leviathan is the creation of 10-year-olds...

What of Leviathan? Let's rely upon data, here the Bureau of Labor Statistics Employment Situation Table B-1. [note]

First, where are all those bureaucrats I hear about in the local coffee shop? Their level peaked in 1991, a consequence of the policies of the Reagan era. Yet in the following decade our population, our national income and the complexity of our economy increased. We're trying to provide basic government services on the cheap. Now Social Security checks no longer require an army of paper pushers to get them out each month. But checking for food stamp, tax and medicare fraud -- that requires more, and more skilled workers, not fewer. Don't moan to me about welfare cheats in the same breath you complain about the size of government!

So who created Leviathan? – children did! The only significant source of government employment is education. As our population rose, so did the number of teachers.  Despite continued population, increases, however, their numbers were down by 250,000 going into the summer; given budget pressures, it's anyone's guess how many additional cuts will become visible as school starts. But those I hear railing against Big Government in the local coffee shop are retired or approaching retirement; they have no stake in what happens 10 years from now, when today's kids hit the job market. In contrast, tax cuts are immediate...

Note: BLS data don't include those on active military duty, an artifact of the days when military service was involuntary.

Tea Party and Tea Tax

The Tea Party makes liberal reference to the "founding fathers" as the bedrock, the principals upon which their principles rest. So what of taxes on tea?

For the answer I checked that old stalwart, Davis Dewey, Financial History of the United States, New York: Longmans, Green, 1902. 1791-1901, which apparently was "the" text for public finance in the early part of the last century, as there was a new edition every few years through at least 1920. See pp. 80-82 for details.

Given the exigencies of the time, a tax bill was submitted to Congress even before George Washington was inaugurated; the bill passed on July 4, 1789. So what did they tax? -- tea! And not modestly, but at a rate of 6¢ to 20¢ per pound. Furthermore, if the tea was carried on a foreign vessel, then that rate was doubled. By the 1870s -- that particular tariff was abolished in 1872 -- it was raising roughly $10 million per year, a tidy sum for that day and age.

For the Founding Fathers, tea was an important symbol (and practical target) for the need for revenue to support the functions of government that underlay the shift from the Articles of Confederation to our current constitution. The fight hadn't been against taxes, the challenge wasn't limiting government, it was finding sources of revenue to support the expansion of government to provide the services that the British would not. Patriots gave their lives for a government that would serve the people, for the right to levy taxes, if need be (and the need was there) for higher taxes.

Mike Smitka, August 3, 2011

Earthquakes, Man-made and Natural

Mike Smitka

...the source of the red ink is an economy run amok, not a government run amok..."

Most of my analysis is of the Japanese economy; in the next day I'll post more there. One of the lessons from disasters is that decision-making under crisis is imperfect, as is decision-making in general. So we ought not be surprised if a natural earthquake is followed by a man-made one.

At this point in time, the real estate bubble is best viewed as a natural catastrophe; the origins lie in the early 2000s, with regulatory forbearance and too easy of monetary policy as contributing factors in a world with large global imbalances.

Enough said. The issue is to keep from reacting in a manner that generates a second, man-made quake.

One of the consequences the first earthquake, the popping of the bubble, has been a steep recession that cut severely into government revenue -- income taxes are the biggest item, corporate and personal, and incomes have fallen. Meanwhile the government (at the Federal level) automatically raised outlays for unemployment while more people "retired" and began drawing social security. Then there's our wars. So of course the deficit expands, but it's not expansionary, it at best keeps the economy from falling as far as fast.

What happened (and continues to unfold) at the state and local level is similar in that revenues have taken a hit, and will continue to do so, as real estate prices fall. Expenditures are stagnant (ditto sales tax receipts in states and localities where that's relevant), and the income tax story is the same. But unlike the Federal government, institutional factors and "hard" borrowing constraints mean that expenditures get cut. So we're gutting public education and otherwise firing people in the midst of a severe downturn.

The net effect is that despite large deficits the government as a whole is cutting jobs, not providing stimulus. Now (sensibly) a stimulus package was passed [the American Recovery and Reinvestment Act of 2009]. However, about half of it was smoke-and-mirrors, and the other half was only big enough to offset what was happening at the state and local level. (Such detailed calculations don't mesh well with the blog format, contact me if you want the numbers.)

That package however was deliberately temporary -- under the expectation that we'd now be in the midst of a recovery. Well, we're not. Obama listened to a limited circle of "inside" advisors. Those from Wall Street emphasized they could stabilize the financial system, looking back to Black Monday in 1987, while the handful of economists among them drew on a specific set of models that emphasized an economy's tendency towards "normalcy" as well as the efficacy of monetary policy. All of that reflected President Obama's own apparent conservative bent; he's no centrist. (Indeed, if he is to the "left" of his predecessor on economic policy, it's not by much.) Of course the temporary aspect also reflected political reality.

The bottom line is that the Federal government is pulling back on its expenditures even though state and local governments continue to cut. There's no stimulus now.

But our politicians are lawyers, and are not only unsophisticated in approach to budgets, but often show little ability to do basic arithmetic. They focus on red ink and rhetoric, never mind that the source of the red ink is an economy run amok, not a government run amok.

So now we appear poised to "pass" (or pass on) a large expenditure increase that does nothing to help the economy now, and does much to harm it down the road. Federal debt is roughly $15 trillion. A downgrade to our credit rating will raise borrowing costs 50 bp (basis points, .01 percentage points = 0.5 percentage points). Now in the short run monetary policy can and will continue to hold short-term interest rates at zero. But the funding costs of long-term debt will rise, and as our debt is "rolled over" we will end up spending $750 billion a year in addition interest. The other interest rates most closely tied to long-term government bonds are home mortgages. What we need in our current economy is a boost in mortgage rates to cool our overheated housing market, right? But that's not an earthquake, that's slow bleeding.

If the debt ceiling isn't raised, we won't be cutting just a few Federal jobs, we'll be cutting a lot, overnight. We'll also not be cutting social security and unemployment and healthcare checks. Yet some of those most adamant about not raising the debt ceiling claim preach that "confidence" is the real issue. They can't be bothered by the lack of consistency, how can retirees shop for anything if they aren't confident they'll be getting the retirement pensions towards which they contributed for decades?

Now that will be an economic earthquake, and it will entirely man-made.