The Risk of a Fiscal Crisis

CBO offers a useful issues brief.

Stocks Look Cheap

Do Kindergarten Teachers Matter More than Parents?

New research on the value of kindergarten teachers is remarkable. 

In fact, it seems a bit hard to believe. If kindergarten teachers matter as much as this new research suggests, then you would think that parents would have a large influence on their kids' adult outcomes. After all, you spend a lot more time with your parents than in your kindergarten class. But much research in behavioral genetics finds very little evidence for significant parental effects. (See Judith Harris's The Nurture Assumption.) So I am puzzled.

Update: Judith Harris emails me:

I guess it's been a while since you read my book. In Chapter 11 of The Nurture Assumption I described the case of a gifted first-grade teacher, "Miss A," who had a long-lasting beneficial effect on her students, and I proposed an explanation of how and why this happened.

Yes, it has been a while, and since I am now at the Jersey shore, I don't have a copy handy. I much appreciate the correction.

Update 2: From Raj Chetty, one of the authors of the study:

I'm writing in reference to your interesting comment about our Kindergarten paper. I think our results are actually consistent with your perfectly sensible intuition that parents should matter more than teachers, for two reasons:

(1) the Kindergarten class effects are large in aggregate but explain a small share of the variance in earnings (less than 5%) overall. A better class leads to higher average earnings (3% higher earnings for a 1 SD improvement in teacher quality), but there is a lot of variation around the mean.

(2) The best evidence I've seen on the long term impacts of parents is this quasi-experimental paper by Bruce Sacerdote published in the QJE. It shows that parental characteristics explain about three times more of the variation in adult outcomes than KG classes, consistent with your intuition.

Thanks!

Readings for the Pigou Club

1. Gib Metcalf makes the case.  (He suggests that club members email their support for higher Pigovian taxes to the National Commission on Fiscal Responsibility.)
2. USA Today joins the club.

Al Roth

Forbes profiles my Harvard colleague.

The Mid-Session Review

The Obama administration has just released the Mid-Session Review of the Budget.  (As one of my friends snarkily puts it, "Release at 4 pm on Friday...who could have expected when we're living in a new era of fiscal responsibility?")

This budget document shows what would happen to the federal budget under the Administration's economic forecast and assuming that all the President's proposed policies are adopted.  What does the document show?  Based on a quick read, here is what I see:

• The Administration believes we will have real growth about 4 percent over the next four years.  Unemployment is projected to fall steadily, reaching to 5.5 percent at the end of 2015.
• Deficits are projected to shrink but will not fall below 3.4 percent of GDP over the ten-year budget window.
• The ratio of debt to GDP rises in each of the following ten years, with no end in sight.
• The document once again holds out the hope that the fiscal commission will save the day by somehow finding a way to put the budget on a sustainable path.

Econ Jargon Watch

A friend of mine who is an editor read the Solow piece I posted yesterday and emailed me this comment:

I was particularly interested to read the following sentence:

"But this is not a bad FIRST APPROXIMATION in many cases."

I don't think I have edited one econ manuscript that has not used the phrase "first approximation" many, many times. When econ PhDs are given out, are you all required to sign a secret agreement that says you must use this phrase in anything you write?

Note that I have not found a similar phrase in the other disciplines for which I've edited several books (chemistry, biology, anatomy, physiology, genetics, physics, political science, and history).

Solow on DSGE Models

Bob testifies in front of Congress on the topic (believe it or not).

Thanks for Arnold Kling for the pointer.

Harvardians in the FT

• Ken Rogoff
• Larry Summers
• Niall Ferguson

The Dodd-Frank Anti-Stimulus Bill

The Wall Street Journal reports:

The nation's three dominant credit-ratings providers have made an urgent new request of their clients: Please don't use our credit ratings.

The odd plea is emerging as the first consequence of the financial overhaul that is to be signed into law by President Obama on Wednesday. And it already is creating havoc in the bond markets, parts of which are shutting down in response to the request.

Standard & Poor's, Moody's Investors Service and Fitch Ratings are all refusing to allow their ratings to be used in documentation for new bond sales, each said in statements in recent days. Each says it fears being exposed to new legal liability created by the landmark Dodd-Frank financial reform law.

The new law will make ratings firms liable for the quality of their ratings decisions, effective immediately. The companies say that, until they get a better understanding of their legal exposure, they are refusing to let bond issuers use their ratings.

That is important because some bonds, notably those that are made up of consumer loans, are required by law to include ratings in their official documentation. That means new bond sales in the $1.4 trillion market for mortgages, autos, student loans and credit cards could effectively shut down.

There have been no new asset-backed bonds put on sale this week, in stark contrast to last week, when $3 billion of issues were sold. Market participants say the new law is partly behind the slowdown.

Government Spending by Another Name

Wise words from Marty Feldstein:

When it comes to spending cuts, Congress is looking in the wrong place. Most federal nondefense spending, other than Social Security and Medicare, is now done through special tax rules rather than by direct cash outlays. The rules are used to subsidize a wide range of spending including education, child care, health insurance, and a myriad of other congressional favorites.

These tax rules—because they result in the loss of revenue that would otherwise be collected by the government—are equivalent to direct government expenditures. That's why tax and budget experts refer to them as "tax expenditures." This year tax expenditures will raise the federal deficit by about $1 trillion, according to estimates by the congressional Joint Committee on Taxation. If Congress is serious about cutting government spending, it has to go after many of them....

If tax expenditures are not cut, taxes on households and businesses will have to rise to prevent an explosion of the national debt, which is now projected to increase to 90% of GDP by 2020 from today's 63%. When benefits for Social Security and Medicare are set aside, the rest of the outlay side of the budget is too small—7.5% of GDP—to provide much scope for reducing annual budget deficits that are now projected to average 5% of GDP for the rest of this decade. In contrast, total tax expenditures are now 6.4% of GDP.

Merle Hazard on the Greek Debt

The principle of comparative advantage applies even to union picketing

A reader alerts me to this amusing story:

To Protest Hiring of Nonunion Help,

Union Hires Nonunion Pickets

Billy Raye, a 51-year-old unemployed bike courier, is looking for work.

Fortunately for him, the Mid-Atlantic Regional Council of Carpenters is seeking paid demonstrators to march and chant in its current picket line outside the McPherson Building, an office complex here where the council says work is being done with nonunion labor.

"For a lot of our members, it's really difficult to have them come out, either because of parking or something else," explains Vincente Garcia, a union representative who is supervising the picketing.

So instead, the union hires unemployed people at the minimum wage—$8.25 an hour—to walk picket lines. Mr. Raye says he's grateful for the work, even though he's not sure why he's doing it. "I could care less," he says. "I am being paid to march around and sound off."

Jeremy Siegel's Forecast

The Wharton economist is optimistic:

If post-World War II patterns hold for the future, he calculated last week, prospects for stock investments are excellent: there would be a 96.6 percent probability of a positive return for the next 5 years, going up to 100 percent for 10- and 20-year periods. Average real returns would be stellar — about 11 percent annually in holding periods from 1 to 20 years.

Median Duration of Unemployment

Click on graphic to enlarge.

This recession looks very different, and much more troubling, than those in the recent past.  I wonder how this dramatic change in the nature of unemployment will alter traditional macroeconomic relationships, such as Okun's Law and the Phillips curve.

Some research suggests that the long-term unemployed put less downward pressure on inflation.  If that is indeed the case, then the increase in long-term unemployment may mean that we will see less deflationary pressure than we might have expected from the high rate of unemployment.  In other words, the NAIRU may have risen, perhaps quite substantially.  This is mostly conjecture, however.  It seems likely we will see more work on this topic in the coming years.

The Problem with Biofuels

Some people who oppose Pigovian taxes, such as a gasoline tax, say we should reduce our gasoline consumption by subsidizing substitutes, such as biofuels.  A new CBO report estimates how expensive that is:

The costs to taxpayers of using a biofuel to reduce gasoline consumption by one gallon are $1.78 for ethanol and $3.00 for cellulosic ethanol.

Given the magnitude of that number, isn't it far better to tax gasoline and reduce income taxes than to subsidize biofuel, which in turn requires increasing taxes to pay for it?

Kudos to Senator Bingaman for raising the issue.

The CEA's Impossible Job

The ARRA, the fiscal stimulus act passed last year, gave the Council of Economic Advisers an impossible job: measuring how many jobs the act created.  Here is the CEA's latest attempt.  As far as I can tell, there are two kinds of evidence here.

First, there are model simulations.  That is, the CEA took a conventional Keynesian-style macroeconomic model and used those set of equations to estimate the effect the stimulus should have had.  Essentially, the model offers an estimate of the policy's effect, conditional on the model being a correct description of the world.  But notice that this exercise is not really a measurement based on what actually occurred.  Rather, the exercise is premised on the belief that the model is true, so no matter how bad the economy got, the inference is that it would have been even worse without the stimulus.  Why?  Because that is what the model says.  The validity of the model itself is never questioned.

(Moreover, the fact that other organizations simulating similar models come to similar conclusions is no evidence about the validity of the model's simulations.  It only tells you the CEA staff did not commit egregious programming errors when running their computer simulations.)

Second, the CEA offers some statistical evidence that things got better after the stimulus passed.  Some of this evidence comes early in the document in the form of simple graphs.  Some comes later by examining deviations from forecasts based on a two-variable vector autoregression.  But the nature of the evidence is basically the same: Post hoc ergo propter hoc.

Of course, there were a lot of other things going on in the economy at this time.  Monetary policy, for example, has gone to extraordinary measures to get the economy going.  TARP was also an unusual intervention that seems to have done its job of returning the economy to some degree of financial normalcy (even if leaving the bad taste of increased moral hazard).  Giving credit for the economic improvement to the fiscal stimulus is a large leap.

In the end, I do not find this CEA document very persuasive.  At the same time, I feel the CEA's pain.  The stimulus act instructed them to do the (nearly) impossible.  Perhaps someday someone will conduct a study that credibly measures the macroeconomic effects of this particular fiscal stimulus.  But it won't be easy.  And it won't look much like the study released today.

The Return of Command and Control

As I discuss in Chapter 10 of my favorite textbook, economists usually favor market-based solutions to control pollution over command-and-control regulations.  Sadly, it looks like policy is moving in the opposite direction.  The WSJ reports:

The original U.S. cap-and-trade market, which succeeded in slashing the power-plant emissions that cause acid rain, is in disarray following the issuance of new federal pollution rules.

The collapse in the pioneering market where power producers trade permits that allow them to emit sulfur dioxide and other pollutants that cause acid rain comes as policy makers seek to establish a similar market to curb the emissions of carbon, a cause of climate change.

The acid-rain market has struggled for the past two years as utilities, states and investors waited for the Environmental Protection Agency to issue new rules. The rules, released last week, put tougher limits on emissions by power plants but rely less on trading. As a result, the allowances that utilities now trade to allow them to emit sulfur dioxide are expected to become worthless.

The Trilemma

Click here to read my column in Sunday's NY Times.

The Root Cause of the Crisis

According to Raghu Rajan: Skill-biased technological change, followed by ill-advised policies.

Prices adjust when the exchange rate can't

A Harvard student emails me the above photo.  He says,

I'm on holiday in Mykonos, Greece, and just spotted the sign in the attached photo....Could a real exchange rate adjustment finally be on the way for Greece?

Are stimulus skeptics logically incoherent?

Paul Krugman writes:

There’s now a lot of talk about the fact that U.S. corporations are sitting on a lot of cash, but not spending it. I don’t find that particularly puzzling: with huge excess capacity, why invest in building even more capacity. But almost everyone seems to agree that if we could somehow get businesses to spend some of that cash, it would create jobs.

Which then raises the question: how can you believe that, and not also believe that if the U.S. government were to borrow some of the cash corporations aren’t spending, and spend it on, say, public works, this would also create jobs?....

I have never seen a coherent objection to this line of argument.

A coherent objection to this line of argument might be the following: If the government borrowed the money to spend, it would need to eventually pay the money back. That means higher future taxes, on top of the future tax increases that President Obama already will need to impose to finance his spending plans. Higher future taxes reduce demand today for at least a couple reasons. First, there are Ricardian effects to the extent that consumers take future taxes into account when calculating their permanent income. Second, those future taxes are not likely to be lump-sum but will be distortionary; it is plausible that at least some of those future tax distortions may adversely affect the incentive to invest today.

That is, businesses may be reluctant to invest in an economy that they expect to be distorted by historically unprecedented levels of taxation in the future.  The more the government borrows, the higher taxes will need to go, the more distorted the future economy will be, and the less attractive is investment today.
 
I am pretty sure Paul would not find this line of argument persuasive.  As far as I can tell from reading his commentary over the years, he does not believe that the distortionary effects of taxes are particularly large and so they do not figure much into his policy analysis.  But many other economists (and I suspect many stimulus-skeptics like the tea-partiers) believe that taxes have significant incentive effects and can prevent the economy from reaching its full potential.  Their argument seems logically coherent, even if it relies on a different set of parameter values for the relevant elasticities than Paul believes to be true.

Addendum: In another post, Paul plots investment and the output gap, points out the well-known fact that investment is highly procyclical, and then concludes that investment is down because the economy is weak.  I wish figuring out cause-and-effect were so easy!

When I first learned Keynesian economics, the causation was often taken to go in the other direction: Animal spirits drove investment, which in turn drove the business cycle. Unfortunately, eyeballing time series rarely tells us what causes what. Correlation is not causation, even in the blogosphere.

An Interview with Bob Hall

Via the Minneapolis Fed.

The Ubiquitous Ken Rogoff

• A NY Times profile of Reinhart and Rogoff.
• Ken confirms his membership in the Pigou Club.

A New Problem for Insurance Markets

An article in the Wall Street Journal notes that scientists have identified genetic markers for the proclivity to live a long life.  This raises a host of interesting economic questions:

• Will insurance companies start offering better life-insurance rates to those with these markers? 
• Will they require annuity purchasers to take this test and offer the long-lived worse rates? 
• If insurance companies do not use these markers, perhaps because of regulation, will the availability of these tests cause the markets for life insurance and annuities to unravel because of increased adverse selection?
• In light of the above considerations, what should public policy be toward insurance companies using these tests?
• To the extent that public policy is  motivated by utilitarian concerns, should there be redistribution based on the outcome of these tests?
• If so, in which direction should it go?  Away from those who are long-lived and can work a long life, or toward them, as they have longer periods of old age and retirement to finance?

The Influence of Alberto Alesina

From Businessweek.