Is the persistently high unemployment rate a secular, rather than cyclical, occurrence? Is it, in other words, a basic shift in the labor market that will leave us with semi-permanently higher joblessness for years or decades to come — no matter what we try to do about it?

Ed Lazear of Stanford and James Spletzer of the U.S. Census Bureau dug into the matter and presented their findings over the weekend at the Fed’s Jackson Hole economic gathering. Lazear also summarized the research in The Wall Street Journal. “The unemployment rate has exceeded 8% for more than three years,” wrote Lazear.

This has led some commentators and policy makers to speculate that there has been a fundamental change in the labor market. The view is that today’s economy cannot support unemployment rates below 5%—like the levels that prevailed before the recession and in the late 1990s. Those in government may take some comfort in this view. It lowers expectations and provides a rationale for the dismal labor market.

Lazear and Spletzer looked at what happened in particular industries and specific jobs, asking whether the real problem is that some industries are too old and aren’t coming back and whether there is substantial “mismatch” between job requirements and worker skills that prevent jobs from being filled. No doubt the economy is always changing, and few industries or jobs stay the same forever, but they found, for example, that

mismatch increased dramatically from 2007 to 2009. But just as rapidly, it decreased from 2009 to 2012. Like unemployment itself, industrial mismatch rises during recessions and falls as the economy recovers. The measure of mismatch that we use, which is an index of how far out of balance are supply and demand, is already back to 2005 levels.

Whatever mismatch exists today was also present when the labor market was booming. Turning construction workers into nurses might help a little, because some of the shortages in health and other industries are a long-run problem. But high unemployment today is not a result of the job openings being where the appropriately skilled workers are unavailable.

Lazear and Spletzer concluded that no, the jobless problem is not mostly secular, and we shouldn’t accept high unemployment.

The reason for the high level of unemployment is the obvious one: Overall economic growth has been very slow. Since the recession formally ended in June 2009, the economy has grown at 2.2% per year, or 6.6% in total. An empirical rule of thumb is that each percentage point of growth contributes about one-half a percentage point to employment.

The economy has regained about four million jobs since bottoming out in early 2010, which is right around 3% of employment—just the gain that would be predicted from past experience. Things aren’t great, but the failure is a result of weak economic growth, not of a labor market that is not in sync with the rest of the economy.

The evidence suggests that to reduce unemployment, all we need to do is grow the economy. Unfortunately, current policies aren’t doing that. The problems in the economy are not structural and this is not a jobless recovery. A more accurate view is that it is not a recovery at all.

The upside of this dismal situation is that we can do something about it. Think about what a different set of pro-growth policies could mean for American workers. Using Lazear’s very rough rule of “one point growth, half a point employment,” we can get an idea of what faster growth might yield in the labor market.

At today’s feeble 2% growth rate, we might expect to add several tens of thousands, or maybe a hundred thousand or two, of jobs each month. Over the next five years, at 2%, we might add something like seven million jobs. But that’s barely enough to keep up with population growth. Three percent growth, the historic average, meanwhile, would likely yield around 10 million net new jobs, 3 million more than at today’s 2% growth rate.

But three percent growth coming out of a deep recession and slow recovery is itself slower-than-usual recovery speed. It is certainly not an ambitious objective. Coming out of a slump like today’s we should be able to grow at 4, 5, or 6% for several years, as we did in the mid-1980s. Four percent growth for the next five years could add 14 million net new jobs, and 5% growth could add 17.5 million — meaning in 2017 something approaching 11 million more Americans would be working compared to today’s sclerotic 2% growth.

Keep in mind, these are rough rules of thumb, not forecasts or projections, and we’re leaving out lots of technical dynamics. There’s a lot going on in an economy, and we do not pretend these are precise estimates. The point is to show the magnitudes involved — that faster growth can provide jobs for millions more Americans in a relatively short period of time.

The problem is that U.S. policy before and after the financial panic and recession has not supported growth — I’d argue it has impeded growth. Faster growth is so important, we should be doing everything possible to enact policies that encourage it — or, if we can’t enact them today, then at least pointing the nation in the right direction.

A more efficient tax code that rewards rather than punishes investment and entrepreneurship would make a huge difference. Unfortunately, some in Washington and the states are proposing higher tax rates and new carve-outs and favors that will make real tax reform impossible. We need to ensure that Washington doesn’t keep consuming an ever greater share of the economy. But again, we’ve just seen a huge jump in the government-economy ratio, from 20% to 25%, and the current budget path just makes this ratio worse and worse over time.

Does anyone believe we have a regulatory system that promotes economic growth? In each of the last two years, the Federal Register of government regulations has grown by more than 81,000 pages. We’ve recently seen Washington drape vast new blankets of regulation over finance and health care and interfere at every turn with our energy economy — a sector that is poised to deliver explosive growth in coming years. Other regulatory actions, like FCC interference in broadband and mobile networks, can slow growth at the margins or, depending on how zealous regulators choose to be, severely disrupt an innovation ecosystem.

The economy is too complex to dial up exactly what we want. I am not suggesting a simple flip of a switch can achieve this dramatic improvement. But we should be giving ourselves — and American citizens — as many chances as possible. Given what’s at stake, there’s no excuse for not lining up policy to maximize the opportunities for faster growth.

— Bret Swanson

Can economic growth stop the coming fiscal inflation?

See my new Forbes column on the puzzling economic outlook and a new way to think about monetary policy . . . .

Raghu Rajan’s Fault Lines is perhaps the most thoughtful book on the financial crisis, and now Professor Rajan is continuing his incisive analysis at a U. Chicago blog. Here, he defends his own criticism of the Fed’s ultra-easy monetary (both leading up to the crisis and again today) against Paul Krugman’s crude Keynesianism.

Some excerpts:

Before saying the real problem is we are not providing enough monetary stimulus, should we not worry about why corporations did not invest then and what other problems will emerge as we  keep rates ultra-low while hoping corporations will see the light?

. . .

If the government raised taxes explicitly to provide the interest subsidy, everyone would scrutinize the use this money was being put to carefully. Because the Fed picks investors’ pockets silently and forcibly through its ability to set the short term interest rate, no one asks questions about cost.

. . .

Of course, the Fed now disingenuously claims that the worst excesses in the housing market were committed when it had already started raising rates, and therefore it is not responsible for the housing boom. But it was complicit in setting off the boom by keeping interest rates too low for too long before then!

I may disagree with Rajan’s take on “global imbalances” (as I wrote about here) but nevertheless think he has become one of the smartest academic analysts of today’s confusing economic landscape.

“The defenders of modern macroeconomics argue that if we just study the economy long enough, we’ll soon be able to model it accurately and design better policy. Soon. That reminds me of the permanent sign in the bar: Free Beer Tomorrow.

“We should face the evidence that we are no better today at predicting tomorrow than we were yesterday. Eighty years after the Great Depression we still argue about what caused it and why it ended.

“If economics is a science, it is more like biology than physics. Biologists try to understand the relationships in a complex system. That’s hard enough. But they can’t tell you what will happen with any precision to the population of a particular species of frog if rainfall goes up this year in a particular rain forest. They might not even be able to count the number of frogs right now with any exactness.

“We have the same problems in economics. The economy is a complex system, our data are imperfect and our models inevitably fail to account for all the interactions.

“The bottom line is that we should expect less of economists. Economics is a powerful tool, a lens for organizing one’s thinking about the complexity of the world around us. That should be enough. We should be honest about what we know, what we don’t know and what we may never know. Admitting that publicly is the first step toward respectability.”

— Russ Roberts, February 27, 2010

“I have only one project, one big idea: uncertainty. It crosses many different disciplines — math, political science, psychology, risk management — and I swing in between those, but it is always on what we call the epistemological question. There are two parts to this question: math and computation, and psychology. The second causes us to think we know more than we do. It is an endless topi. Bernanke has six problems: One, his education is in tools that aren’t helpful — and he doesn’t know it. Two, he studied the Great Depression, and he thinks he knows too much — this is nothing like the Great Depression. You can’t compare this and the Depression. Three, 99% of risk is tied to the debt/leverage and the explosion of connectivity. It’s like he did not see a truck coming right at him. Four, he has no notion of nonlinearities, and how monetary policies can be responsive in nonlinear ways. Five, he doesn’t understand fat tails. Six, he doesn’t realize that the biggest risk of failure is signified by the Federal Reserve: He thinks we need more regulation; we actually need smaller institutions. And not one person in Congress had the presence of mind to ask him these questions.”

— Nassim Nicholas Taleb, AI5000, Jan/Feb 2010

Fed chairman Ben Bernanke over the weekend gave a big speech at the American Economic Association annual meeting in Atlanta. He defended his and and Alan Greenspan’s unprecedented easy money through the 2000’s and acknowledged no connection between monetary policy and the financial crash.

Economist David Malpass, however, had the whole thing nailed back in 2002. Here’s Malpass in a note today:

Today’s New York Times front page has a David Leonhardt article on the Fed entitled “If Fed Missed Bubble, How Will It See New One?”  It criticizes Chairman Bernanke’s Atlanta speech: “This lack of self-criticism is feeding Congressional hostility toward the Fed.”

I’ve attached my 2002 WSJ article on the same topic (The Fed’s Moment of Weakness).  It argued that Chairman Greenspan was “letting himself off the hook” in 2002 by saying that the Fed couldn’t anticipate asset bubbles. The 2002 article concludes that: “If the value of the dollar is allowed to fluctuate as wildly in the future, then momentum will dominate the global economy as it did in the 1990s, creating constant boom/bust cycles.”

We expect Chairman Bernanke to be reappointed and the Fed’s lagging monetary policy to continue for at least one more cycle.  For now, this feels good to financial markets (everything is up today except the dollar — gold, oil, the euro, U.S. equities and especially foreign equities in dollar terms.)  However, this gradually channels capital away from the U.S. and especially from the many small businesses (and yet-to-be-created businesses) left out of Washington’s aggressive credit rationing process.  This undercuts U.S. growth and leaves unemployment much higher than it should be.

We often say hindsight is 20/20. Monetary policy is in a sorry state when the hindsight of the insiders lags the foresight of the outsiders. By eight years and counting.

(My own contributions to the debate here and here.)

“The flow of capital away from the U.S. is broad, deep and long-term. Investors can buy 20-year debt denominated in Brazilian reals or Chinese yuan, a monumental shift in the allocation of long-term capital. U.S. companies are shifting operations offshore in order to build and innovate more profitably. Meanwhile, the U.S. government is trapping billions of tech dollars — the lifeblood of innovation — offshore through an excessive repatriation tax. This is blocking much-needed industry consolidation, because an acquirer is forced to pay for the offshore cash without getting access to it.”

— David Malpass, August 20, 2009

Two years ago, Alan Reynolds’s book Income and Wealth poked a million holes in the argument that the gap between millionaires and everyone else was growing in an unprecedented and deeply distressing way. In his powerful critique of the pessimistic new arguments, Reynolds focused mostly on the misleading data and statistical analysis of quintiles and cohorts, the unexamined distinction between income and wealth, the changing nature of “households,” and the often ill-defined nature of income itself.

Now, in a new article, Reynolds’s colleague Brink Lindsey teases out many additional unappreciated factors in the apparent recent increase in wage inequality. Among the most important overlooked factors is the huge influx of immigrants over the relevant period:

Just two months after signing the Voting Rights Act, President Lyndon Johnson signed the Immigration and Nationality Act of 1965, ending the “un-American” system of national-origin quotas and its “twin barriers of prejudice and privilege.” The act inaugurated a new era of mass immigration: Foreign-born residents of the United States have surged from 5 percent of the population in 1970 to 12.5 percent as of 2006.

This wave of immigration exerted a mild downward pressure on the wages of native-born low-skilled workers, with most estimates showing a small effect. Immigration’s more dramatic impact on measurements of inequality has come by increasing the number of less-skilled workers, thereby increasing apparent inequality by depressing average wages at the low end of the income distribution. According to the American University economist Robert Lerman, excluding recent immigrants from the analysis would eliminate roughly 30 percent of the increase in adult male annual earnings inequality between 1979 and 1996.

Although the large influx of unskilled immigrants has made American inequality statistics look worse, it has actually reduced inequality for the people involved. After all, immigrants experience large wage gains as a result of relocating to the United States, thereby reducing the cumulative wage gap between them and top earners in this country. When Lerman recalculated trends in inequality to include, at the beginning of the period, recent immigrants and their native-country wages, he found equality had increased rather than decreased. Immigration has increased inequality at home but decreased it on a global scale.

In sum, immigration has been mostly good for overall U.S. economic growth and for the immigrants themselves, whose “low” U.S. wages are dramatically higher than were their home-country wages. But immigration has altered the statistics of aggregate “inequality” in a misleading way, rendering much of the debate moot.

Amid the crash in GDP, or income, John Rutledge reminds us about the also falling but still massive balance sheet, or assets, of the U.S.

Why is it that people know so much about something so small (GDP) but so little about something so big (total assets)? I think it is because since the 1930’s macroeconomics has developed into a discipline concerned almost exclusively with who is spending how much money. Very little attention is paid to the capital base, or balance sheet, that makes it possible to produce the goods and services measured as GDP.

Last night on Charlie Rose, Treasury Secretary Tim Geithner made an extraordinary admission. Here’s the exchange:

Rose: “Looking back, what are the mistakes, and what should you have done more of? Where were your instincts right but you didn’t go far enough?”

Geithner: “There were three broad types of errors in policy. One was that monetary policy here and around the world was too loose for too long.  And, that created just this huge boom in asset prices; money chasing risk; people trying to get a higher return; that was just overwhelmingly powerful.” 

Rose: “Money was too easy.”

Geithner: “Money was too easy, yeah . . . . Real interest rates were very low for a long period of time . . . .”

There you have it. Pretty simple. And yet it is the first time I can recall that any U.S. executive branch official, spanning the Bush and Obama Administrations, has admitted monetary policy was even one factor, let alone the central factor, leading to the crash. This is very big stuff. (more…)

Good historical analysis from Mike Darda:

Here we should look to three historical examples where aggressive monetary expansion was wedded to an aggressive fiscal policy: the U.S. during the mid-1930s, Germany through the 1930s, and Japan in the early 2000s. In each case there was a recovery, although policy errors led to significant setbacks. These episodes can help assess U.S. growth prospects, and the risks to a sustainable recovery.

The Great Depression in the U.S. came in two stages, a downturn from 1929-33 in which real GDP collapsed by 26.5% and unemployment rose to 25% from 3%, and a relapse in 1937-1938, with a 3.4% decline in real GDP and a rise in unemployment to 19% from 14%.

The first stage of the depression was associated with a collapsing equity bubble (1929), protectionist tariff legislation (1930), contractionary monetary policy (1931) and a sharp rise in tax rates (1932). Between 1934 and 1937, however, there was a rapid recovery, in part due to the severity of the downturn that preceded it. Real GDP expanded by 9.5% per annum, while the unemployment rate fell 11 percentage points.

The recovery was spurred in no small part by monetary policy. In 1933-34, the dollar was devalued against gold to $35 per ounce from $20.67 per ounce, which allowed the Fed to push reserves into the banking system. This allowed the Fed to finance FDR’s deficits with the printing press. After falling at an average rate of 6.7% per year from 1930-33, the Consumer Price Index rose by an average 2.7% per year from 1934-37.

I have a photo of my father from around 1982, standing on the tarmac of South Bend airport with Jack Kemp. The economy was in the tank, and America’s world standing was uncertain. My Dad had gone to pick up Kemp, who was to speak at an event for his fellow Republican, Jack Hiler, who was our friend and congressman from northern Indiana. I was maybe eight years old at the time. We were Reagan-Kemp-Hiler conservatives, interested in entrepreneurship, economic growth, and a muscular but prudent international stance.

Some 15 years later I would go to work for Kemp as an economic analyst. It was not preordained, but neither was it a complete coincidence, I suppose, that I spent several years working for the man who, more than any other public official, had articulated and even helped shape my, and my family’s, worldview. Kemp and I even shared the same birthday, July 13.

It is difficult to overestimate Kemp’s impact on history. For those who don’t grasp the importance of economics in politics and geostrategy, that will seem a wild overstatement. But I do think Kemp changed the arc of human events by helping to launch the U.S. on a much higher growth trajectory. By freeing American workers and businesses and attracting the world’s human and financial capital, the Reagan-Kemp economic strategy of tax cuts, sound money, and deregulation unleashed two and a half decades of amazing feats in technology and entrepreneurship. Within just a few years, the American boom of the 1980s shook the Communist world and allowed Reagan to peacefully conclude the Cold War. These events not only bolstered the wealth and ideological foundations of the West but freed hundreds of millions of people in the East and set the stage for the next great wave: the low-tax-free-trade phenomenon we call globalization, which has brought at least a billion more people out of poverty.

Kemp was not immune to the ego-pumping of life on the Potomac. But football and his middle-class upbringing had given him a healthy concept of “the team.” More than almost any politician I have encountered he was deeply interested in ideas. (What other politician would spend so much time — or any time at all — on the intricacies of monetary policy?) And in getting at the truth. And in building a positive sum politics through energy and persuasion, not cleverness or negativity. He was a builder, not a destroyer.

Having been a central player in creating the long boom, Kemp was also a long-time critic of the wildly gyrating monetary and dollar policies that led to the crash and ended this particularly prosperous period in American history. Not coincidentally, it is Kemp’s enthusiastic, expansive, inclusive brand of politics that might help his party regain its footing so it can help launch the next great American wave. Kemp would have no doubt whatsoever America’s biggest, best, brightest days are ahead. 

I join many friends and former colleagues in offering Mrs. Kemp, Jeff, Jimmy, and the whole Kemp family my condolences, and deep gratitude for sharing Jack with the world.

Associated Press

MORE REMEMBRANCES:

“Capitalist for the Common Man” – The Wall Street Journal

“The Jack Kemp I Knew” – Richard Rahn

“Jack Kemp: The Happy Warrior” – Bruce Bartlett

“Jack Kemp, Our JFK” – Mona Charen

“Will the GOP Forget Reagan and Kemp?” – Dan Henninger

“He Had the Power of the Happy Man” – Peggy Noonan

“The Life of His Party” – David Broder

“Jack Kemp: Conservative Hero” – The Economist

“Quarterback of GOP Ideas” – Ed Rollins

The motto of this blog is “Supply creates its own demand.” But in the current crisis, this central insight of economics is being turned on its head. After all this time, the argument over which comes first, supply or demand, is still in many ways the chief economic debate.

Here’s Russell Roberts with a good, brief explanation of why GDP accounting does not good economics make. GDP, or Consumption + gross Investment + Government spending + eXports – iMports, is just an “ex post” way of describing what happened, or what the component parts of past output were. The perennial line that “70% of GDP is consumption” is one of the most misleading slogans in all of economics. GDP is, after all, gross domestic product. Consumption, which is fairly easy to measure, is just a way at deriving production, or output, or supply.

Brian Wesbury and Bob Stein make yet another strong argument against the mark-to-market accounting regime:

The history seems clear. Mark-to-market accounting existed in the Great Depression, and according to Milton Friedman, who wrote about it just 30 years after the fact, it was responsible for the failure of many banks.

Franklin Roosevelt suspended it in 1938, and between then and 2007 there were no panics or depressions. But when FASB 157, a statement from the Federal Accounting Standards Board, went into effect in 2007, reintroducing mark-to-market accounting, look what happened.

Two things are absolutely essential when fixing financial market problems: time and growth. Time to work things out and growth to make working those things out easier. Mark-to-market accounting takes both of these away.

Larry Lindsey with a good summary of the quick confidence collapse in Obama’s new economic plans.

The Geithner announcement was repeatedly put off while each of the options was publicly discussed. In the end the political decisionmakers decided there was no politically acceptable decision. But expectations had been building, stoked higher with each postponement of the speech. When Geithner finally spoke and by omission essentially admitted that the Obama administration hadn’t come up with a solution, the stock market plummeted.

But it wasn’t only the stock prices of America’s publicly traded companies that collapsed. So did the stock of the Obama administration. A discredited stimulus package followed by an overly hyped but largely vacuous bank-rescue speech proved to be too much. The mainstream media, which had given Obama a free ride since the election, turned on their choice. In the space of just over three weeks, Obama and company squandered the greatest stock of political capital any president since Lyndon Johnson had inherited from an election.

Clive Crook has a long and lively exchange with Harvard’s Robert Barro on Keynesian multipliers, Ricardian equivalence, and economic etiquette.

Anatole Kaletsky says we don’t need to fix the existing economic models. We need to start over — a complete reboot.

The FT’s Martin Wolf is beyond pessimistic on the economy. “Worse than Japan,” he thinks. But probably not as bad as the 1930s. Wonderful. He does, however, think the U.S. and other government spending binges will at least help.

But Brian Wesbury unveils a new chart showing how government spending and unemployment are correlated, beyond the normal cyclical boosts in recessionary government spending. This reinforces work by Alberto Alesina, Robert Barro, and others.

Wesbury says government spending boosts unemployment.

Harvard’s Robert Barro interviewed about Keynesian spending, tax cuts, Paul Krugman, and. . .

Tax cuts are bound to be better. I think the best evidence for expanding GDP comes from the temporary military spending that usually accompanies wars — wars that don’t destroy a lot of stuff, at least in the US experience. Even there I don’t think it’s one for one, so if you don’t value the war itself it’s not a good idea. You know, attacking Iran is a shovel-ready project. But I wouldn’t recommend it.

Noam Scheiber navigates the waters between Larry Summers and Tim Geithner and . . . Hillary Clinton?

Steve Forbes with a resounding call for stable, low-entropy money.

Greenspan truly began to think he was a monetary philosopher king who could fine-tune economic activity by manipulating short-term interest rates. Greenspan’s Louis XIV “I am the state” proclivities were intensified when he fell under the sway of a strange theory of Ben Bernanke’s. Bernanke joined the Fed as a governor in 2002 and posited that the world was plagued by “excess” savings. China, India and other countries were saving too much money. Preposterous! In a properly functioning global financial system there can be no excess savings. The whole purpose of finance is to direct savings from one party to be invested with another party. The enormous amounts of liquidity that led to the housing and commodities bubbles of recent years cannot be blamed on thrifty Chinese but on the excess money creation of Greenspan and Bernanke. If their central goal had been a steady value for the buck, those bubbles would never have reached the sizes they did, and volatility in the financial markets would have been only a fraction of what it is today.

Here’s Forbes making the point from Davos.

See my latest on the nexus of China trade, monetary policy, and our current crisis in Monday’s Wall Street Journal. Contrary to the new conventional wisdom, which is gaining considerable steam, I argue that:

America did not underreact to the supposed Chinese threat. It overreacted. The problem wasn’t “global imbalances” but a purposeful dollar imbalance. Our weak-dollar policy, intended to pump up U.S. manufacturing and close the trade gap, backfired. Currency chaos led to a $30 trillion global crash, an energy shock, bank and auto failures, and possibly a new big government era. For globalization and American innovation to survive, we must first understand the Chinese story and our own monetary mistakes.

A “more competitive currency” and monetary “stimulus” cannot create new wealth. Only technology and entrepreneurship can do that. The “China currency” issue distracts America from all the important things that could actually make us more competitive –e.g., better K-12 education, much lower corporate tax rates, cutting-edge broadband networks, less (not more) centralization and power in Washington, and, of course, a stable dollar.

Excellent summary on the euro currency’s first decade of life:

As important, the creation of a single European Central Bank (ECB) has better insulated monetary policy from political manipulation. Politicians could no longer attempt to inflate their way out of their employment or fiscal problems. National central banks could no longer finance fiscal deficits, removing a source of economic instability.

The single economic space anchored by the euro has also forced European policy makers to compete for people, goods and capital with improved policies. While we had hoped to see more reform by now, the pan-European reduction in corporate tax rates is one fiscal benefit of the euro. Even Germany has cut corporate taxes, after its efforts to harmonize rates across the European Union failed.

Good sense from Greg Mankiw:

Usually, GDP is a reasonable proxy for economic well-being, so more is better, but that is not true in this example. Part of the problem here is that GDP includes government purchases at cost. If the government hires people to produce stuff that is worthless, that stuff is included in GDP just as much as if the government buys something valuable. When calculating GDP, the national income accountants do not pass judgment on the social utility of government spending. Anyone concerned with economic well-being has to go beyond thinking about GDP.

I’ve been a harsh critic of the Greenspan-Bernanke monetary policy that was the chief cause of our current economic mess. But it’s also true that, once the financial firestorm hit, Ben Bernanke, perhaps the world’s leading student of financial crises, has taken bold and creative action to douse it. Nobel laureate Bob Lucas thinks Bernanke is on the right track:

monetary policy as Mr. Bernanke implements it has been the most helpful counter-recession action taken to date, in my opinion, and it will continue to have many advantages in future months. It is fast and flexible. There is no other way that so much cash could have been put into the system as fast as this $600 billion was, and if necessary it can be taken out just as quickly. The cash comes in the form of loans. It entails no new government enterprises, no government equity positions in private enterprises, no price fixing or other controls on the operation of individual businesses, and no government role in the allocation of capital across different activities. These seem to me important virtues.

Gold’s on the move again, up to $867 an ounce this afternoon. It still does its job exposing the crucial monetary mistakes that drive our dramatic booms and busts.

The Wall Street Journal documents Japan’s endless series of profligate pump-priming “stimuli” in the 1990s.

The experiment, predictably, failed.

Here’s Dan Mitchell with a critique that goes beyond Japan:

That, it seems, is the economic prognosis of the Obama financial team, looking ahead at a total global “demand collapse” and the total failure of fragile states like Pakistan.

the sense I get from them is that they are very worried that the economy will get a lot worse before it gets better. Not just worse… a lot worse. As in — double digit unemployment without the wiggle factors. Huge declines in aggregate demand. Significant, persistent deficits. That’s one reason why the Obama administration seems to be open to listening to every economist with an idea and is stocking the staff with the leading lights of the field. . . .

Where the discussion isn’t going, at least in public,  (or the PR level), is the possibility that the first foreign policy crisis the administration will face will be the complete economic collapse of a large, unstable nation. To be sure, Pakistan is nearly broke, and U.S. policy makers seem to be aware of that; but a worldwide demand crisis could lead to social unrest in countries like Indonesia and Malaysia, Singapore, the Ukraine, Japan, Turkey or Egypt (which is facing an internal political crisis of epic proportions already). The U.S. won’t have the resources to, say, engineer the rescue of the peso again, or intervene in Asia as in 1997. 

Team Obama may believe this. And they may be right. But it probably doesn’t hurt their cause to make people think they believe this. If things do get much worse, they can say they anticipated it. If things improve, they can take credit for a heroic and historic rescue. (See, “Committee to Save the World.” ca. 1999.)

To a number of smart people, all this seems like too much “depression lust.”

Bill Frezza with a hilarious send-up of the “science” of macroeconomics.

I confess that the only Hayek book I made it through without my eyes glazing over was “The Fatal Conceit.” It’s a slim volume written later in life, apparently after Hayek discovered humbleness, an unusual discovery for an economist. His thesis is simple – “I don’t care how smart you are, you can’t keep track of all this s**t.”

Brian Wesbury expands on a chief cause of the vortex that took down the U.S. financial sector.

Suspending mark-to-market accounting will not keep institutions that took excessive risk from failing. Bad loans are still bad loans and there is no way to avoid the pain that they cause. It will, however, end the negative feedback loop, which drags everyone down. It allows time to see if the wind shifts and keeps the flames from spreading.

In the 1980s, loan problems took down thousands of banks, but because we did not force fair value accounting, the economy and stock market actually thrived. Every money center bank would have been insolvent in the early 1980s if they were forced to write down Latin American debt to 10 cents on the dollar. Add in bad oil loans which took down Pen Sqaure and Continental and bad S&L loans, and it is easy to see that the bank problems in the early 1980s were much more severe than those of the 2000s. But the rules were not as inflexible as their are today. Problems did not spread, many banks eventually recovered their principle on Latin American debt and the economy grew.

In contrast, today’s problems are expanding, and have now caused the government to put almost $4 trillion of taxpayer funds at risk to support the financial system. This is an amazing sum of money, equaling 28% of GDP, or 42% of total US stock market capitalization, or more than a quarter of all household debt outstanding, or nearly 40% of all private household mortgage debt, or three times the amount of subprime loans outstanding at their peak.

The government has tried multiple strategies. The only thing they have in common is that they are designed to offset or stop the damage caused by mark-to-market accounting.

Treasury Secretary Hank Paulson is back at it. Having presided over the debasement of the U.S. dollar, he is once again cajoling the Chinese over the value of its currency, the renminbi (or yuan). Paulson earns a few points for his semiannual Special Economic Dialogue that has facilitated U.S.-Chinese cooperation on some fronts and helped defuse some of the worst protectionist policy on both sides. But the Greenspan-Snow-Bernanke-Paulson weak dollar policy — which was in itself deeply protectionist, and ultimately highly self-destructive — utterly swamped any of Paulson’s good intentions vis-à-vis China.

Digging through some old files, I found a May 13, 2006, e-mail I wrote to a senior White House economic official, warning of the certain harmful effects of its weak-dollar policy. (I had, six months prior, met with the official in the West Wing to discuss the matter.) The morning of my e-mail, The Wall Street Journal, citing top Administration officials making clear their weak-dollar preference, had published a major story: “U.S. Goes Along With Dollar’s Fall to Ease Trade Gap,” with the subhed, “Quiet Acquiescence Holds Possible Risks for Economy; Surge in Exports in March.”

The previous week economist John Taylor, just off his post as Treasury Undersecretary, had, in another Wall Street Journal article, dismissed the views of Nobel laureate Robert Mundell and Stanford economist Ronald McKinnon. Mundell and McKinnon had been arguing against dollar weakness and urging dollar-yuan stability. Taylor’s offensive, moreover, had been previewed by yet another two articles, one from Martin Feldstein and another from Lawrence Lindsey, arguing for a “more competitive” dollar. That’s a euphemism for weak, as in competitive devaluation. (See, not supposed to happen in America).

Written in the heat of battle, I think my e-mail memo holds up pretty well:

From: Bret Swanson <bret.swanson@********.com>
Date: Sat, May 13, 2006 at 1:38 PM
Subject: stunning protectionist mercantilism
To: [senior White House official]

*** Warning: Blunt Statements to Follow ***

[senior White House official],

Even considering Treasury’s misguided currency stance these past few years, today’s news in the Journal that the White House approves of the further weakening of an already too-weak dollar is stunning and alarming. 

Using monetary policy to target the trade deficit instead of using monetary policy for its only legitimate purpose of price stability and currency stability, is massively irresponsible. The trade deficit is a mostly meaningless accounting number that if anything demonstrates the strength of the American economy, not its weakness. “Competitive devaluation” is what Third World nations did for decades. It’s what helped keep them poor. It’s what we did in the 1970s, a lost decade of malaise. In an era of globalization, currency devaluation is more damaging than ever when there is more cross-border trade and investment and a larger proportion of inputs into our final products and services come from abroad.

An already inflationary dollar will become more inflationary. Oil prices will rise further. Recession in 2007 now becomes a real possibility because the Fed will likely now overshoot on interest rates to combat inflation that they and Treasury created but which they never see until it’s too late. Why are we risking ruin of a robust economy?

The best economists I know are alarmed at the Fed’s lack of vigilance and the deepening of Treasury’s weak-dollar policy. Having now lost faith in the Fed and Treasury, these economists have changed their outlooks for the  U.S. economy from positive to negative.

Lindsey and Feldstein are 180-degrees wrong on monetary/currency/trade policy. Clearly their recent Journal articles were a set-up for this potentially disastrous currency move. John Taylor’s statements last week pooh-poohing Mundell and McKinnon — who are absolutely right on China — were equally discouraging. Not since Richard Nixon have Republicans stood for debasing the currency. It’s painful to agree with those who say this may be the most protectionist Administration since Herbert Hoover.

The U.S. Auto Companies and manufacturers want a weaker dollar — manufacturers always do — but the dominance of the Japanese auto makers is not a currency issue. Japan has just come out of a decade of deflation – the yen was way too strong, not artificially weak – exactly the opposite of what the auto makers say. Manufacturers in general face a huge challenge from China, but not because of the yuan, which is exactly in line with the dollar. The China challenge is real, not monetary. The U.S. must become more competitive via lower tax rates and less regulation. Currency is nothing but a scapegoat, and focusing on it reduces the chances we can solve our real competitive disadvantages on taxes and regulations. Because changing the unit of account cannot change the terms of trade, debasing the dollar does not make us more competitive; it makes us less competitive because it fosters inflation and possibly recession.

Furthermore, autos and manufacturing are a shrinking portion of our economy, and this misguided protectionist policy at their behest is highly damaging to the real, growing, leading edge sources of American wealth and power: our prowess in technology, finance, and entrepreneurship.

Please forgive my blunt statements. I make them with respect and concern for the success of this White House. I know you can’t comment on currency matters, but if I am overreacting or wrong on my interpretation of what appears to be happening, please let me know.

Very best,

Bret 

I then sent the following warning to a number of friends at the U.S. Chamber of Commerce, who had been seeking my views:

From: Bret Swanson <bret.swanson@*******.com>
Date: Sat, May 13, 2006 at 2:26 PM
Subject: ALERT: stunning protectionist mercantilism
To: [U.S. Chamber officials]

ALERT                       

I believe the outlook for the U.S. economy could be shifting. An article in this morning’s Wall Street Journal makes clear that instead of reversing the dollar’s decline and inflationary pressures, the White House and the Fed are actually encouraging a further fall of the dollar. Amazing. This means more inflation, a potential Fed overshoot on interest rates, and a slow-down and possible recession in 2007. None of this was necessary. We’ve had a very robust economy since mid-2003, and it could have easily continued. Debasing the dollar in a misguided protectionist attempt to reduce the trade deficit is hugely counterproductive. I warned of this possibility in my February memo but held out hope that the Fed and Treasury would reverse its inflationary/weak-dollar course in time to blunt these effects. No such luck.

What this means: The Chamber should prepare for a slow-down/recession in 2007-08. We should prepare for an inflationary environment. This policy means gas prices will probably stay high or go HIGHER. Some auto and manufacturing companies could benefit in the very short term, but overall this is bad for the larger economy, especially for technology and financial firms and for entrepreneurs. When the Fed figures out what’s going on, it will have to raise interest rates more than if it had gotten ahead of the curve in 2004-05. Commodity based businesses will continue to do well for a while, with intellectual property based businesses being hit the hardest. Eventually a recession would hurt everyone.

Currency volatility will also discourage international trade and investment, which could lead to slower global growth.

I’ll continue to think about what this means and how the Chamber should prepare.

Best,

Bret

Most of this scenario came to pass. Oil and commodity prices rocketed. Subprime loans, fueled by easy weak-dollar credit, kept flowing through 2006 and 2007. And the U.S., we now know, hit recession in “2007-08.”

Only the mechanism was a bit off. With elevated inflation, real interest rates never got very high — certainly not to the point that normally causes recessions. But the bursting of the adjustable-rate housing bubble, enabled by weak-dollar easy money, and the ensuing credit crisis had the same effect as a high real Fed Funds rate.

Many of the easy money mistakes had already been made by the Fed in 2003-2005. But this crucial period in 2006, when the U.S. government doubled down on a misguided weak-dollar strategy, told foreign capital to stay away, directly devalued all dollar assets, accelerated the financial collapse, and destabilized the globe. 

Please, Mr. Paulson, enough with the currency lectures.

(You can find a much more detailed history of the whole era within this longish economic history of China (1978-2008) or this shorter article.)

Robert Rubin famously was part of the “Committee to Save the World,” so dubbed by Time magazine, as he, Alan Greenspan, and Larry Summers supposedly prevented the Asian flu of 1997-98 from spreading around the globe.

But finally — finally — the mainstream press is wondering whether Rubin’s reputation over the years was justified. From today’s Wall Street Journal:

Mr. Rubin’s salary made him one of Wall Street’s highest-paid officials — and a controversial figure among Citigroup shareholders and some executives, who questioned whether his limited duties justified the big paydays.

“Even though he has no ‘operating’ responsibilities, he still has a fiduciary responsibility as a board member,” said William Smith, a New York money manager and frequent critic of Citigroup’s current management and board. “He has overseen the entire meltdown, yet been compensated as an operating employee while bragging about having no operating responsibility.” Mr. Rubin can’t “have it both ways,” Mr. Smith added.

Somehow, the most central factor — the fundamental cause — of both the late-90s Asian meltdown and our current crisis — namely monetary and dollar policy — has escaped much criticism. Yes, the argument that Alan Greenspan and Ben Bernanke held interest rates too low for too long in the 2003-06 period can now be discussed in polite company. But it often is thought to be peripheral, or more often it just gets lost in all the chaos.

The late-90s mistake was just the opposite of this decade’s easy-credit mistake, with predictable mirror image effects. Back then, Greenspan and Rubin held a super-tight squeeze on dollars, pushing the dollar ever higher versus foreign currencies and commodities, crushing all dollar-debtors across the globe, from Thailand, Indonesia, and Korea, to Turkey, Russia, and Argentina. The world’s capital abandoned hard assets and flooded into the U.S. in general and into our soft, intellectual assets like Microsoft, Cisco, and dot-coms in particular. Eventually, after the “Committee to Save the World” had worked its magic and basked in its cover-boy status, the deflationary Greenspan/Rubin policy in 2000 toppled the U.S. markets, too. 

Mr. Rubin likes to offer his wisdom “in an uncertain world” — the title of his memoir. But the world would be much less uncertain if the Rubin-Greenspan-Bernanke-Snow-Paulson monetary/dollar policy weren’t so manic.

P.S. Yes, to reiterate, these are supreme cases of the arsonist posing as heroic fireman.

Greg Mankiw agrees with Paul Krugman that Obama’s econ team so far is impressive but firmly rejects, with some objective references, Krugman’s assertion that Bush’s economists were “hacks and cronies.”

Mankiw’s right that Harvey Rosen, Ed Lazear, and Glenn Hubbard, among others, are highly-respected, first-rate economists. Too bad a few simple, bad decisions — like the indefensible and disastrous weak-dollar policy pushed by otherwise smart people like John Taylor and Martin Feldstein — completely swamped the demonstrably positive yield of Bush’s tax cuts.

We will be teasing out the different strands of Bush economic policy for a very long time.

Amity Shlaes, author of the terrific The Forgotten Man, a new history of the Great Depression, responds to criticism from Paul Krugman.

Dr Krugman makes a second charge, that I misrepresent John Maynard Keynes by associating Lyndon Johnson’s Great Society with Keynes when the Great Society was a social and not an economic program. In 1964 Johnson pledged to build a Great Society with an emphasis on social improvement in his Great Society speech, just as Dr Krugman said. My point was that the political engine of the 1960s treated any spending, including Great Society spending, as a stimulus. Keynesianism defined the very lexicon of policy – that is why Milton Friedman said “we are all Keynesians now.” TIME even gave Keynes a cover: “The Keynesian Influence on the Expansionist Economy,” read the banner in the corner. Keynesianism was crucial window dressing for the Great Society show. Spending on all sides became permissible, and that only made sense if you cared less about deficits and more about growth – Keynesianism. Thus in July 1965, after many pieces of new legislation, The New York Times was writing headlines such as: “Johnson Policy Will seek to Prolong Boom: Administration Commits Itself to Spur Economy by Tax Cut or New Spending…” The same story has Johnson saying his new budget would “include sharp increases in spending from programs enacted during the past few years.”

Greg Mankiw wonders about Obama’s stimulus plan: $280,000 per job?

Even by Keynesian standards, that’s pathetic.

“tax increases appear to have a very large, sustained, and highly significant negative impact on output.”

“tax cuts have very large and persistent positive output effects.”

tax cuts do “not have any clear impact on revenues at horizons beyond about two years.”

– Christina Romer, Berkeley economist and Obama appointee as chair of the Council of Economic Advisors, in two working papers, the most recent versions of which are very timely: November 2008 and July 2008.

It looks like Tim Geithner of the New York Fed is Obama’s pick for Treasury Secretary, beating out Larry Summers. Geithner is a wily technocrat good at working the bureaucracy and the press. Summers is an intellectual famed for the just the opposite — his lack of skill with colleagues and reporters. Especially at this dangerous economic moment, I would have preferred Summers’ substance over Geithner’s guile. But I know far less about Geithner’s policy views and will retain an open mind. Good luck to him.

Update: Missed this from the article: 

The president-elect might name Mr. Summers, a highly regarded economist and a former president of Harvard University, as a senior White House adviser, people involved in the transition said.

On second thought, maybe that’s the perfect arrangement.

Update II (Saturday night): Summers will be director of the National Economic Council in the White House. Good move.

Matthew Slaughter of Dartmouth’s Tuck School, one of today’s best thinkers on trade and globalization, says the consequences of any Big Three Auto bailout go far beyond the initial price tag.

First, it would hurt foreign direct investment in the U.S. and thus the insourcing of U.S. jobs:

In 2006 these foreign auto makers (multinational auto or auto-parts companies that are headquartered outside of the U.S.) employed 402,800 Americans. The average annual compensation for these employees was $63,538.

At the head of the line of sustainable auto companies stands Toyota. In its 2008 fiscal year, it earned a remarkable $17.1 billion world-wide and assembled 1.66 million motor vehicles in North America. Toyota has production facilities in seven states and R&D facilities in three others. Honda, another sustainable auto company, operates in five states and earned $6 billion in net income in 2008. In contrast, General Motors lost $38.7 billion last year.

Across all industries in 2006, insourcing companies registered $2.8 trillion in U.S. sales while employing 5.3 million Americans and paying them $364 billion in compensation.

Second, Slaughter says, a Big Three bailout could hurt U.S.-headquartered multinationals:

these companies employ more than 22 million Americans and account for a remarkable 75.8% of all private-sector R&D in the U.S. Their success depends on their ability to access foreign customers. . . .

This access to foreign markets has been good for America. But it won’t necessarily continue. The policy environment abroad is growing more protectionist. . . .

Will a U.S.-government bailout go ignored by policy makers abroad?

No. A bailout will likely entrench and expand protectionist practices across the globe, and thus erode the foreign sales and competitiveness of U.S. multinationals. And that would reduce these companies’ U.S. employment, R&D and related activities. That would be bad for America.

Rising trade barriers would also hurt the Big Three, all of which are multinational corporations that depend on foreign markets. In 2007, GM produced more motor vehicles outside North America than in — 5.02 million, or 54% of its world-wide total. 

Finally, a bail-out further endangers the dollar:

Will a federal bailout that politicizes American markets bolster foreign-investor demand for U.S. assets?

Not likely. Instead, America runs the risk of creating the kind of “political-risk premium” that investors have long placed on other countries — and that would reduce demand for U.S. assets and thereby the value of the U.S. dollar.

Read the whole thing.

Bailing out Detroit means bailing on free trade and American innovation.

The prolific Niall Ferguson with a long narrative of the financial crash in Vanity Fair:

The key point is that without easy credit creation a true bubble cannot occur. That is why so many bubbles have their origins in the sins of omission and commission of central banks. 

Alex Tabarrok wonders whether the U.S. should sell some of its massive land holdings to help pay for its latest binge, with more surely to come. Conceptually, it’s interesting. I and others like John Rutledge have long argued that we need to look at total U.S. assets when doing any macroeconomic analysis. This would include potential trillions worth of federal lands. But it’s not clear the government would actually have to sell the land to reap the gain. Merely owning it is useful collateral for issuing more debt. On the other hand, getting more land into private hands might be a good thing in and of itself.

Chief panic prophet Nouriel Roubini sees long-term decline:

The U.S. will experience its most severe recession since World War II, much worse and longer and deeper than even the 1974-1975 and 1980-1982 recessions.

There’s no hope of a V-shaped recovery: 

a U-shaped 18- to 24-month recession is now a certainty, and the probability of a worse, multi-year L-shaped recession (as in Japan in the 1990s) is still small but rising.

And there’s a real

risk that we will end in a deflationary liquidity trap as the Fed is fast approaching the zero-bound constraint for the Fed funds rate

leading to global

stag-deflation

When a permabear like Roubini has been right so often for the past year (lo for the wrong reasons) it may seem a tall order to refute him. But John Tamny does an admirable job:

just as housing was the hot asset class in the early and late ‘70s, so was it this decade not due to economic growth per se, but thanks to currency debasement that always leads to a flight to the real. In short, the subsequent moderation of home prices has not been an economic retardant so much as it’s been the result of economic sluggishness that always reveals itself when currencies are allowed to weaken.

Roubini holds the reputation of soothsayer at present, but the very analysis that has made him all-seeing was faulty on its face. Lower home prices are an undeniable good for less capital going into the ground, as opposed to the entrepreneurial economy. What led to housing’s moderation of late was paradoxically what caused its boom. When currencies decline, hard assets do well, and investment in real economic activity withers. . . .

In short, Roubini made the correct call a few years ago about looming economic difficulty, but the call ignored the real cause which decidedly was the weak dollar. Happily for Washington’s political class, Roubini’s suggestions for “stimulating” the economy absolve it of its own mistakes, all the while allowing it to do what it does best: spend the money of others.

Down from a decade ago:

With the government doing so many things so quickly to relieve problems it really doesn’t understand very well, what will be the results? Do we know? Do they? Not really. Not really at all. Just one unintended consequence among many cited today by Brian Wesbury:

Take, for example, the extension of unemployment benefits enacted in June. Normally, jobless benefits are available for 26 weeks. The extension, which will last temporarily through early next year, added another 13 weeks. Following this, between June and October – in only four months – the unemployment rate has risen from 5.5% to 6.5%, a full percentage point.

 

What’s odd about the jump in the jobless rate is that it has been accompanied by an unusual increase in the number of people who say they are looking for work. Normally, when the unemployment rate leaps upward we see a decline in the share of the population either working or looking for work (what economists call the participation rate). Not this time.

 

In order to receive unemployment benefits, a person must be looking for work, so the extension of benefits is artificially coaxing many people who would no longer be in the workforce at all to say they are still looking for work, just so they can continue to collect benefits. The unintended consequence is that the unemployment rate is boosted faster and further than normal in a recession, making it more likely that policymakers further extend benefits, boosting the deficit and pushing up future tax payments.

Among those suggested as probable Obama Treasury Secretaries or economic consiglieres are Larry Summers and Paul Volcker, who have been advising him for many months now. This is very encouraging to those of us who balk at much of Obama’s economic agenda. Summers and Volcker are very smart Democrats. Volcker helped get us out of the ’70s inflation mess. And anyone who earns the wrath of the Harvard faculty for telling the truth, as Summers did when he was the University president — enough to get fired — can’t be all bad either. 

I do have some reservations, of course. Lots more to say as the story evolves. . . .