Some Politics of Housing

At a few points recently I've heard people argue that housing policy is either not politically salient, or has little to do with the sorts of macro outcomes that led to the housing crisis. So I was interested to receive an e-mail from my senator, Kay Hagan, pointing me to this Politico op-ed she co-wrote with Sen. Isakson and Sen. Landrieu:

Families are working hard to rebuild savings while the housing market remains unstable. Recent news from the Commerce Department shows that U.S. home builders continue to struggle despite signs of recovery in other segments of the economy. According to real estate data released this week, home prices in the first quarter of 2011 suffered their worst decline since 2008.

Yet banking regulators are dangerously close to issuing a rule that would put homes out of reach for many Americans and further cripple the fragile housing recovery. ...

But federal banking regulators last month proposed a 20 percent down payment requirement on QRMs. Regulators went for rigidity, rather than a balanced, flexible approach.

In contrast to our express intent — and despite repeated warnings from other members of Congress, consumer groups and bankers — regulators crafted a narrow definition that could unnecessarily slow the housing market recovery, increase costs to otherwise qualified homebuyers and dampen incentives for sound underwriting.

The 20 percent down payment requirement leaves millions of qualified potential homeowners with two grim alternatives: pay higher rates upfront for a mortgage that falls outside the regulators’ proposed QRM standard or delay homeownership for a decade or more to save for an onerous down payment.

Here we have three senators, two Democrats and one Republican, arguing against tougher regulation that would lead to higher lending standards. They obviously think this issue is salient enough to write an op-ed about it, at a time when most political attention is being paid to budget reform and other issues. And this is the first e-mail of this sort that I recall having received from Hagan's office. In fact, I'm not even sure how I got on their mailing list.

This is merely the most recent in a series of policy choices that incentivize home ownership in the U.S. The most notable of these is probably the mortgage interest deduction, which not only encourages home ownership, but also encourages the building and purchasing of larger homes. And the mortgage interest deduction is pretty firmly embedded in the U.S. political economy. In Showdown at Gucci Gulch, journalists Alan Murray and Jeffery Birnbaum describe how the proposal to end the mortgage interest deduction was almost immediately removed from early versions of the 1986 Tax Reform Act, because it was a political non-starter. Indeed, Congress was better able to reduce and eliminate subsidies to some of the interest groups usually considered to be among the most powerful -- finance and energy -- than subsidies for home ownership.

The 1986 Tax Reform Act did eliminate some loopholes in the tax code that incentivized tax sheltering through real estate investment, but these did not affect primary residences. And TRA1986 also eliminated tax deductions from other types of interest, such as on credit cards and other personal loans. But not mortgage interest on primary homes. Nor was TRA1986 able to reduce or eliminate the exemption of capital gains on home investment, so long as it was a primary residence and the capital gains were under $500,000 (for a married couple filing jointly). Some estimations have claimed that these subsidies increase home values by 15%. Considering that roughly 65% of the country are homeowners, and it is not uncommon for a majority of peoples' equity to be in their homes, it's no surprise that this is a politically salient issue.

This despite the fact that there is a broad consensus among economists, environmentalists, and urbanists that this policy skews behavior away from the social optimum. An inflated market incentivizes speculation and over-purchasing. It leads to too much investment. It also leads to suburbanization, and increased energy usage from heating/cooling/commuting. Consider as well that it benefits the middle-class and wealthy at the expense of the poor, particular those poor that live in urban areas. To make up for it, the government extends loans to lower-income (or otherwise less creditworthy) borrowers through Fannie Mae, Freddie Mac, and the Federal Home Loans Banks. These organizations fund or guarantee over $6tn in mortgages, or over 40% of U.S. GDP, representing nearly half of the country's real estate market. The GSEs are well-known to have a lot of political clout, and have resisted repeated calls for reform during every presidential administration since Reagan, at least. And, of course, they were the biggest originators of subprime (and Alt-A and interest-only) loans, the securitization of which was rewarded by the pre-crisis regulatory structure. (Note that current research indicates that the bulk of GSE losses were Alt-A, which are prime loans, if untraditional.) The GSEs held approximately 45-50% of all mortgages in the country throughout the 2000s. Fannie and Freddie were also the largest purchaser of AAA-rated MBS, which created a market for other mortgage lenders to lend subprime and securitize the loan, which fulfilled their requirements to support affordable housing, particularly for low-income borrowers*.

Other aspects of public policy incentivized home ownership (or real estate speculation) in less obvious ways. The large, persistent current account deficit did not lead to a currency crash as many had predicted, but it did lead to an increase in demand for non-tradable goods. Like housing. This current account deficit is not attributable to any single factor, but persistent budget deficits in the private and public sectors certainly played a major role. The large demand for AAA-rated financial instruments in which to invest a "global savings glut" also led to a demand for securitized home loans. Finance was happy to oblige. There were major geopolitical dynamics at play as well.

All to say that housing policy is an important political issue. It's important for citizens in the United States, and therefore for politicians. It's important for numerous interest groups, in the U.S. and abroad. The housing bubble wasn't engineered entirely by Wall Street, although they certainly worked hard to accommodate it. There was demand from many corners.

*I'm not trying to argue here, as many have, that the financial crisis was caused by the GSEs. It wasn't. I'm merely trying to demonstrate that public policy is oriented towards promoting home ownership in many ways that take many forms. The GSEs are part of that. The have a public mandate to extend loans to less-qualified borrowers, but that is not all of their business or even the largest part.

Against the "Evil Rapacious Bankers Wut Did It" View of Financial Crises

Gillian Tett:

For if you look at the personal financial decisions of the bankers involved in securitisation in that period – at the very heart of the credit bubble – it seems many believed their own hype. Many of them not only bought large quantities of housing stock at the worst possible moment (ie in 2005 and 2006), but also did so in some of the most “bubbly” markets, such as southern California. They then failed to sell those properties in time – and thus were left nursing losses after 2007. Or to put it another way, the bankers who were repackaging housing loans not only lived by the mortgage sword, but suffered under it too. ...

[The researchers] started by combing through the published lists of bankers who attended the 2006 American Securitisation Forum’s annual conference in Las Vegas and randomly selected 400 mid-level securitisation bankers from organisations such as Citigroup, Lehman Brothers and Wells Fargo. They then cross-referenced the names against publicly available data – extensive in the US – on subsequent real estate transactions and mortgages, and analysed whether those people had been trading properties, and whether they made or lost money.

Next, the three economists repeated a similar exercise for a randomly selected group of 400 lawyers and 400 Wall Street equity analysts who were not involved in housing analysis. The aim was to see whether patterns among those real estate transactions were unique to the housing experts – or just reflected something that all wealthy professionals tended to do.

The results were striking. Before conducting the research, the economists had expected that securitisation experts would be good at judging when to sell properties and how to avoid housing market losses; after all, they were close to the front line of the mortgage industry and supposed to know all about real estate. But in reality, the number-crunching showed “little evidence of securitisation agents’ awareness of a housing bubble and impending crash in their own home transactions”, as the paper says. The supposed experts “neither managed to time the market nor exhibited cautiousness in their home transactions”. Furthermore, they actually suffered bigger losses on housing than the random “control” group of lawyers who were not “experts” on housing at all.

Here is the underlying research. The question I have is whether the top-level executives behaved differently from the mid-level folks. I doubt it, but it's certainly possible.

The FCIC Report

I have been trying to make sense of the FCIC report released yesterday. I am apparently the only person who finds both the majority conclusion and the dissenting view unsatisfying and thus believes that we continue to misunderstand this crisis.

For those not paying attention, the FCIC majority view (six Democrats on the Commission) found that the crisis was avoidable and a result largely of excessive risk taking by financial institutions and regulatory failure by government agencies. The main dissent (there are 2) argues that these factors were clearly part of the story, but assign greater weight to "broad forces" such as the global savings glut.

I find both views unsatisfying because neither rests on any clearly identifiable macroeconomic model. The majority view seems to dispense with macroeconomic reasoning altogether. For them, the crisis is simply a matter of individual behavior; they seem willful in their refusal to embed this behavior in any macroeconomic context. The minority view seems to adhere to a model in which foreign savings generates a demand for safe assets which are available in greatest supply in the US. They don’t embed global financial markets in any broader macroeconomic model.

Because neither viewpoint offers a broader macroeconomic model, neither offers a satisfying answer to either of the two dimensions of the central question: why did the US experience a housing bubble? The majority view doesn’t address the “why US” question at all (a point nicely highlighted by the dissenting view). Nor does it answer the housing bubble question: between 2000 and 2006, residential investment in the US increased from 25 percent to 36 percent of total fixed investment while total investment didn’t increase as a share of GDP (get the data here). Deregulation, which affected the financial sector generally, doesn't explain this sectoral reallocation of investment. Hence, the majority viewpoint doesn't answer the second dimension of the question--why real estate?—either.

The dissenting view can't explain why foreign demand for risk-free assets caused by the savings glut sparked a housing bubble in the United States. This specific allocation of foreign savings (in terms of asset class and country) is hardly a deterministic (or even highly probable) consequence of a sudden increase in savings in the rest of the world. Indeed, the last time a set of countries emerged as major global creditors almost overnight (OPEC in the 1970s) excessive global credit financed sovereign debt (of the commercial bank variety) in Latin America. The financing of over-priced houses in Las Vegas was in no sense a necessary consequence of East Asian savings.

I think that answering these two questions requires one to embed the global savings glut and financial markets in a dependent-economy approach to open economy macroeconomics. The dependent-economy model, also known as the Australian model after the nationality of the key contributors (Salter, Swan, Corden), allows us to consider the impact of a current account deficit on the real exchange rate and the impact of the real exchange rate on the allocation of investment activity between traded and non-traded activities (or between manufacturing and housing if you wish to simplify).

The simple story is the following: a current account deficit causes real currency appreciation. Real appreciation raises non-tradable prices relative to tradable prices. This relative price switch encourages investment to shift away from traded to non-traded activities. More simply, with the dollar over-valued, domestic manufactured goods are less competitive with equivalent foreign goods. So, people invest in activities that don’t compete against foreign goods—e.g., building houses.

This simple mechanism explains one dimension of the crisis: given the US current account deficit, the dollar will strengthen and cause investment to shift into real estate. One would imagine that investment would also flow to sectors that support real estate (i.e., mortgage lending) as well as other areas sheltered from international competition. Hence, a reasonable hypothesis is that the reallocation of investment into real estate and away from other activities resulted from a real appreciation of the dollar caused by the current account deficit.

This leaves the second dimension of the question: why the United States? That is, what caused the US to have a current account deficit? Two mechanisms seem relevant. The first is the mechanism the dissenting viewpoint highlights—the current account deficit was a result of foreign demand for US assets. The second mechanism makes no appearance in the FCIC report—fiscal policy. A decrease in government revenue (2001 tax cut) and an increase in government expenditure (War on Terror) produce a federal budget deficit that reduces national savings. All else equal, the fiscal deficit increases the current account deficit.

As I said, we need not choose between the two mechanisms but we might want to think about their relative priority and importance. One might suggest that foreign enthusiasm for the dot-com bubble of the late 1990s generated a current account deficit and dollar appreciation. The popping of this bubble in 2000 should have seen adjustment, but the re-emergent fiscal deficit widened the current account deficit and kept the dollar strong. On top of this, the foreign quest for relatively safe assets reinforced the impact of the fiscal imbalance on the current account. A self-reinforcing element (mania-induced bubble) emerged as real estate prices began to rise. To that we could consider the consumption boom that resulted from HELOCs as home prices rose in value

In short, viewed through the lens of a dependent-economy model, the crisis was caused by the relative price consequences of a macroeconomic imbalance (the current account deficit). At least part of the blame for this macroeconomic imbalance lies with those who make fiscal policy (a group who seem to be the only government agents entirely absent from the report). There are other implications, but this post is already too long. More to follow.

Small Change in Cuban Cabinet...

Cuban President Raul Castro moved today to consolidate his power and control over the island nation by reassigning cabinet ministers left over from his older brother's reign, and replacing them with new ministers he believes are more in line with his vision for the future of Cuba. Raul is no stranger to experimentation and is well known to be more sympathetic to capitalist reforms of the beleaguered Cuban economy than Fidel. 

With the Cuban economy hamstrung by the world economy, Raul Castro may have decided it is time for him to make reforms of his own without worrying about second-guessing by his brother or his brother's allies, she said.

Vicki Huddleston, who led the Interests Section during the administrations of Presidents Bill Clinton and George W. Bush, and is a visiting scholar at the Brookings Institution in Washington, speculated that the changes could portend the government once again allowing private enterprise to flourish in Cuba.

Raul made these changes:

Felipe Perez Roque, the 43-year-old foreign minister, was replaced by his deputy, Bruno Rodriguez Aprilla.

Carlos Lage Davila, an economist, lost his job as Cabinet secretary, but no mention was made of removing him from his other post as vice president of the Council of State.

Lage, who helped guide the nation through its "special period" of dire economic times in the aftermath of the dissolution of the Soviet Union and the loss of billions in subsidies, was replaced by Brig. Gen. Jose Amado Ricardo Guerra.

Last year, Raul legalized the purchase of cellular phones, home computers, DVD players, and other technological goods as well as lifted the bans on renting hotel rooms in Cuban resorts. He did this even though Cubans themselves can not afford these goods on their own, but that's another story. 

Cuba relies heavily on imports of Venezuelan oil, food and other goods to keep their economy somewhat alive. However, with the steep drop in oil prices over the last 8 months, Venezuelan aid has begun to dry up as Hugo Chavez has faced budget shortfalls and a myriad of other domestic problems at home. His ability to financially support Cuba may be fading, and seeing this happen before his eyes, it seems that Raul Castro has decided that something must be done to get the Cuban economy moving or face the possibility of domestic turmoil in the near future. 

So what new reforms could he be considering? Here are a few that I think are on the table: 

1) Liberalize certain portions of the Cuban housing sector, especially in major cities. An underground market in apartment trading has sprouted over the last decade or so in Havana and by liberalizing the housing market, the government could seek to extract resources from housing transactions rather than allowing the trades and transactions to take place under the table. If you want to read more about the underground market for housing in Havana, this is a terrific article. 

2) Increase the fee on currency exchanges within the country. The government takes 10% out of each exchange of American dollars for Cuban dollars at this point in time. Increasing this to 15-20% and simultaneously hoping that the US raises the ceiling on remittances would be another way to extract resources.

3) Open up certain sectors such as oil and natural gas exploration, agriculture and manufacturing up to partnerships with foreign firms. Cuba has already done some of this, teaming up with German and Norwegian oil exploration companies, to explore a relatively large underwater oil field that was found off of the island's northern coast. This was mainly done because Cuba does not have the technology nor the capacity to do it by herself. Allowing certain public/private partnerships in carefully selected industries would increase government revenues and spur some economic development.

Notice that I have focused mostly on areas where the Cuban government can extract more revenue for their projects. Don't expect massive overhauls of the economic system, the establishment of private property,  or the sudden appearance of small businesses anytime soon. Raul's main goal is to consolidate his power. He will only implement those policies that enhance this goal, rather than seek to increase Cuba's growth and prosperity for the benefit of the populace. He is weary that the growth of a middle class and wealth among the citizenry would be a threat to the Communist experiment that has consumed the island for the last fifty years. 

P.S. Cuban VP Carlos Lage also just so happens to be one of my great-uncles. Interesting connection I know. At least he is still VP and didn't get completely canned, so if I fail my regression and game theory mid-terms this week, hopefully he knows who the hell I am and can offer me a job because I know I won't be able to find one in the US!

The Politics of Housing Is Salient

Another anecdote:

An unprecedented alliance of organizations from the real estate industry, new home builders, mortgage companies, banks, civil rights groups and other lobbyists have descended on Washington, D.C. lawmakers to push against legislation that would require 20% down payments for a mortgage.

The Qualified Residential Mortgage “QRM” proposal would limit the number of home buyers qualified to make a purchase, require higher credit scores and send mortgage underwriting back more than 30 years. Members of Congress are struggling to reach a balance to provide new regulations for home mortgages, implement financial reform legislation and provide realistic reforms on home mortgages. ...

“The Qualified Residential Mortgage (QRM) will define who will and who will not get the most affordable mortgage products, potentially prohibiting a significant segment of qualified borrowers from being able to achieve homeownership,” said Mortgage Bankers CEO David H. Stevens. “Allowing more time for comment will enable us to prepare a more thoughtful and comprehensive analysis and response.” ...

Groups from both major political parties wrote to the six federal agencies last week implementing mortgage changes, which are the SEC, FDIC, HUD, the Office of the Comptroller of the Currency, the Federal housing Finance Agency and the Federal Reserve to urge them to focus of “sound underwriting, safe loans,” mortgage borrowers’ ability to repay loans and fully documented loans, and not to require larger down payments as they work on regulations to improve the mortgage finance system.

When major elements of both political parties line up with citizens' groups, finance, and a major industry (construction) on the same side of a policy, is it any wonder that policy gets pushed in that direction? This was what I was driving at in my previous posts on housing politics and the blame game.

Via Arnold Kling, who says that part of this is wrong: this is anything but "unprecedented"; it's been the same political dynamic for the past 20 years (some of which Kling observed directly, working at the Fed and Freddie Mac).

The Dollar and the Housing Market, Again

1. One simple expectation: a real exchange rate appreciation raises the return to non-traded goods relative to traded goods. The intuition is straight forward: as the currency gains value, prices of manufactured goods (traded goods) fall, while prices of goods and services that do not readily cross borders (houses, for example) do not. Consequently, as a currency appreciates, people ought to invest less in the traded goods sector and more in the non-traded goods sector.

2. Two Simple Graphs:
A. Graph 1 (top) shows the dollar's substantial appreciation in real terms between 1995 and 2003; the dollar remained high relative to the early 1990s until 2005.
B. Graph 2 (bottom) shows the substantial increase in housing prices that began in 1995 and peaked in 2005.

3. One simple hypothesis: The real estate bubble was at least in part a consequence of the dollar's sharp real appreciation between 1995 and 2005.

4. One simple extension of temporal scope: Notice that the 1980s real estate boom also occurred in a strong dollar era.

5. Broader point: the Fed's current dilemma--target the dollar's external value or target the financial system--is merely the continuation of a deeper problem. The low-interest rate policy of the early 00s fed the housing bubble, but higher interest rates at that time would have yielded an even stronger dollar (and hence stronger incentives to shift into non-traded goods). Lower interest rates might have slowed the dollar's rise, but also fueled an investment boom somewhere else. Hence, pick your poison.

The deeper problem, of course is that the Fed has two policy targets (the exchange rate and the domestic economy) and only one policy instrument. The policy appropriate to meet one target is not always appropriate (and can have perverse consequences) for the other.

US Unemployment Rate Higher than Europe's?

It is expected that when the April international unemployment numbers are released, the United States will have a higher jobless rate than Europe. The United States' rate is already on par with European averages, a factoid that would have surprised many just a few months ago. 

For many years, unemployment in the United States was lower than in Western Europe, a fact often cited by people who argued that the flexibility inherent in the American system — it is easier to both hire and fire workers than in many European countries — produced more jobs.

In April, the rate in the United States rose to 8.9 percent. When the European figures are compiled, it seems likely that the American rate will be higher for the first time since Eurostat began compiling the numbers in 1993.

For men, the unemployment rate in the United States surpassed that of the 15 original European Union countries in December. By March, it was 9.5 percent in the United States, compared with just 7.5 percent for women. The figures for men and women in the 15 European countries, however, are close together, at 8.4 percent and 8.5 percent.

How did that happen during a worldwide recession? First, it appears that the safety nets in many Western European economies made it easier for people to keep their jobs as the economy declined. In Germany, programs allow companies to get government help in paying workers, for example, keeping them employed. If the recession becomes severe enough and long enough, of course, it could turn out those programs do not so much avoid the pain as defer it.

In the United States, there has been more movement of workers from depressed areas to places where the employment outlook is brighter. But the housing crisis appears to be hampering such movement because some workers own homes that are worth far less than the amount they owe on their mortgages.

Among the 15 European Union countries, the national unemployment rates range from 2.8 percent in the Netherlands to 17.4 percent in Spain. That is a wider spread than the ones among American states, where the rates range from 4.2 percent in North Dakota to 12.6 percent in Michigan.

So I guess I'll add to the speculation. Another reason may be the extent and quality of European re-training programs and their ability to get workers back into the labor force after shorter adjustment periods. A vast chunk of the increase in American unemployment has come from financials, insurance, housing and retail (as well as unemployed graduate students argh!). Europe may simply have been less exposed to the problems in financials and housing. 

The rigidity of European labor markets also play a role; it is harder to lay off workers in Europe, thus causing a higher level of stickiness in labor markets. As the downturn drags on, we can expect larger increases in European unemployment levels. The United States sheds jobs at a quicker pace (because of relatively less sticky labor markets), with most lay-offs concentrated towards the beginning of a recession. Europe may simply be dragging on the labor market adjustment period with their generous social insurance programs and rigid labor markets. 

So the United States' unemployment rate could rise above Europe's in the short-run, but may be surpassed by Europe's as the downturn continues and as the (predicted) expansion begins. We may simply be observing a wider band for American unemployment rates over time, and a smaller band for the average European rate. 

Who is to Blame?

Who should we blame for our current economic difficulties? I have been thinking about this question for the past week. Not because I wonder who we should blame, but because I am puzzled by the quest to find the person or persons who are responsible. The consensus places primary responsibility on Alan Greenspan. A few, such as Fred Bergsten, blame the IMF as well (for what, exactly, remains unclear). There appears also to be a consensus that Bernanke is to blame for failing to respond correctly to financial weakness (whatever that means) in order to make things better.

I find the search for a culprit puzzling for two reasons. First, the blame game rests on faulty reasoning. Those who assign blame implicitly compare what did happen with a utopian counter-factual of what would have happened had a different policy been followed. Greenspan is to blame because he cut rates too much and fueled the housing bubble. Asserting that these rate cuts were mistaken (and thus G is to blame) requires one to believe that not cutting rates would have produced a much better outcome. Yet, what would have happened had G not cut rates? We might have had a severe rather than a mild recession in the early 2000s. Then we would blame him for not cutting rates (fully unaware, of course, that cutting rates would have produced a housing bubble). So, when we assign blame we assume that the path not taken was a better path without having any good reason to believe this.

Second, when we assign blame we assume that individuals can control highly complex systems. Yet, our understanding of the relationship between monetary policy instruments and economic activity has not yet reached the status of Newtonian mechanics. There is considerable uncertainty about how financial markets work, and how they respond to changes in monetary policy. Whatever imperfect understanding does exist is constantly in flux as financial markets innovate. Is it reasonable to expect the Fed to anticipate the emergence of the new and highly complex financial instruments that drove the sub-prime lending boom? How reasonable is it then to argue that the housing bubble was foreseeable (and foreseen) by Greenspan? This is, of course, the inverse of the first flaw in reasoning; we assume that the future consequences of our current decisions are knowable and we can therefore avoid bad futures.

So why do we insist on assigning blame? I don't know, maybe it reflects our discomfort with the uncertainty that pervades all of the decisions we make and our inability to accept how little direct control we have over the broader forces that shape our lives. Or, perhaps it reflects the exigencies of democratic politics. In a world in which we expect so much from our government, we have lost the capacity to distinguish between those things that a government can be reasonably expected to do and those things we think it should be able to do. As a consequence, we expect unreasonable things from our government, and these expectations create opportunities that those seeking office can exploit to their electoral advantage.

Housing Policy and Labor Bargaining Power

I'm starting a new research project on how foreign direct investment affects the collective action problems labor faces in developing countries. So, of course my ears are tuned to anything related to centralized wage bargaining. Felix Salmon was on NPR this evening discussing a recent Fannie Mae housing survey on Americans' opinion on home ownership. Salmon's main point is that home ownership makes labor less mobile and that this is bad for efficient markets as well as for individuals' wages. This made me wonder if there has been much political science research on housing policy and centralized wage bargaining. A quick google search turned up nothing.

It would be interesting to see if:

1) Pro-home ownership policies decrease union power

2) Pro-business groups actually lobby for pro-home ownership policies to decrease the ability of workers to collectively bargain

Such a dynamic would be particularly interesting given the strong rhetorical connections between pro-labor social welfare programs and tax policy and government subsidies that favor home ownership. Of course, I could also buy the logic that when labor becomes less mobile due to home ownership, workers are better able to overcome collective action problems because they do not have the option of moving to where there are higher wages. Thus, immobile workers may be more willing to bear the costs associated with centralized wage bargaining.

Anyone out there with some references to work on this subject?

7 Year Old Politics

Henry Farrell goes after me over this post, and says he'd rather be an unsophisticated 6 year old than... whatever I am. Dan Nexon seconds the motion. Really Farrell's making a much bigger point about IPE and is using me as an illustrative case. He's written about this before.

This puts me in a weird position. I tossed off that post, mostly because I was short of time and because Krugman perpetually annoys me. The point of the post was intended to be that Krugman's constant moralizing doesn't get us anywhere, not even as far as the most basic view of democratic politics. The point was not that the most basic view is the right one. I tried to caveat a bit ("first approximation", "doesn't always work"), but that obviously didn't get across. So I guess Farrell's response is just desserts for being lazy. I'll try to flesh out what I meant better in this post. While I don't want to run away from what I wrote, much less what I intended to convey, I also don't want to get the shit kicked out of me for something I don't really think. So this will be at least as long as Farrell's post, and much longer than Nexon's.

As (I think) Farrell knows, I agree with many of his points about IPE in general. I agree that IPE does a very poor job of explaining preference aggregation, and a pretty poor job of preference formation (although, ideally, we could just import at least some of that from comparative politics). In fact, I'd extend it: I think IPE has a generally poor view of the political space, and like other subfields of political science is too reductionist. I agree that IPE does not have a very good sense of how interest groups and elites influence policy in democracies. I agree that we should pay more attention to subfields that examine these questions in detail. As he says, IPE generally infers preferences from economic theory, then applies some crude form of the median voter theorem (if that) to explain outcomes*. IPE generally assumes (implicitly) that voters are fully informed, and actually care about whatever issue we happen to be studying.

This is lazy even when it's not entirely wrong, and a big part of my dissertation is dedicated to more rigorously exploring how interest groups shape policy in a global context. So, as a jumping-off point, I don't mind him taking me to the rails. Except. He's writing this in defense of Krugman's purely elite-driven take. Here's what Krugman says:

The fact is that what we’re experiencing right now is a top-down disaster. The policies that got us into this mess weren’t responses to public demand. They were, with few exceptions, policies championed by small groups of influential people — in many cases, the same people now lecturing the rest of us on the need to get serious. And by trying to shift the blame to the general populace, elites are ducking some much-needed reflection on their own catastrophic mistakes.

Here's what Farrell says:

On many important policy issues, the public has no preferences whatsoever. On others, it has preferences that largely maps onto partisan identifications rather than actual interests, and that reflect claims made by political elites (e.g. global warming). On others yet, the public has a set of contradictory preferences that politicians can pick and choose from. In some broad sense, public opinion does provide a brake on elite policy making – but the boundaries are both relatively loose and weakly defined. Policy elites can get away with a hell of a lot if they want to.

These are two very different statements. On the issues we're talking about -- tax cuts, Iraq war, prescription drugs covered by Medicare, housing policy -- the public did have pretty clearly identifiable preferences about policy, and those happen to map onto policy debates (and resulting legislation) fairly well**. As I linked in the prior post (via Drezner), a majority of the public supported the Bush tax cuts and the Iraq war. The former represented the biggest policy proposal of Bush's 2000 campaign, the latter represented the biggest policy proposal of his 2004 campaign. He won both of them. (Okay, only kind of won in 2000.) Moreover, the public's representatives in the House and Senate voted for both policies.

Now we could believe that public preferences had nothing to do with the Bush tax cuts becoming law and the Iraq war being prosecuted. But then how to explain how a number of other policies supported by the same elites but not the public during the same period -- Social Security privatization, immigration reform, invading Iran -- did not become law or practice? If we're to discard polls and the votes of representatives, how else are we going to get at the public's preferences to know whether they're relevant?

That's not to say that elites don't have a huge role in shaping public opinion, crafting the specific nuances of policy, or even that they have quite a lot of flexibility to shape policy to their own ends. Of course they do. Legislation is written by elected elites, who are influenced by unelected elites and interest groups within their states/districts. One casual glance at trade law is enough to convince anyone of that. Medicare Part D gets closer to Farrell's last sentence. The public supported coverage of prescription drugs by Medicare. It seems likely to me that the public did not have strong preferences over precisely how that happened, other than that they would prefer not to have to pay higher taxes. So what we got was an unfunded bill that catered strongly to the interests of the drug industry. Similarly, the public supported tax cuts. The particulars of the Bush tax cuts met that demand, but in a way that also privileged powerful interest groups and likely Republican voters (see the cartoon in the Bartels paper Farrell links to). There is nothing in the Hacker/Pierson or Bartels studies that Farrell cites that disputes this interpretation***.

But here's the key point: the policy space that elites use to manipulate for their own ends does not exist without the broad support of mass publics****. Or, as Farrell says, "It is fair to say that the Medicare changes began in a shift in partisan patterns of competition over issues. However, it surely didn’t end there." No argument from me. That, however, is not what Krugman argues. He claims that the public had nothing to do with it at all. That this is purely a top-down disaster. This view is disputed by the Campbell and Morgan quote that Farrell reproduces:

More generally, gaining the support of powerful interest groups was essential in passing a reform that was likely to garner little Democratic support and was viewed skeptically by more conservative Republicans.

Right, but this was only important because the public wanted Medicare to cover prescription drugs in the first place. If they hadn't, a bill that both Republicans and Democrats were ambivalent about is unlikely to have become law. To gain passage, and thus satisfy the public demand, it became necessary to craft a bill in such a way as to get the necessary support from powerful interest groups. But that doesn't negate the public's interest in reform along the broad lines that reform occurred. A very similar process occurred during the PPACA ("Obamacare") deliberations.

Near the end Farrell writes:

One can certainly make a reasonable case that electoral politics plays a more important role than Krugman acknowledges. But one cannot make a good case that policies of the kind that Winecoff describes are a simple reflection of public preferences.

This where Farrell is misreading me. (And, I think, Drezner.) We're not saying that the public was perfectly represented, much less "reflected". Indeed, I think such a statement is all but meaningless. Drezner has written a book about how interest groups dominate regulation of the economy, particularly in highly-technical areas in which the public is unlikely to have much information or strong preferences. We're both very interested in how power and influence is filtered through political institutions/interactions. I'm just saying, contra Krugman, that mass publics are part of that equation. After linking to a bunch of surveys showing that the public broadly supported the policies Krugman says they had nothing to do with, I wrote in my post, "This [reference to public opinion] might not work all the time, but as a first approximation this sort of thinking holds up fairly well". Or, at least, to entirely excuse the public from the outcomes of policy you should first have to show that they didn't create the political space for those policies to be enacted. Krugman can't do that. That's the point.

(As for housing policy, I'd refer Farrell (and anyone else interested) to the CPE/IPE research done by Seabrooke and Schwartz (also here and this special issue of Comparative European Politics). Ragu Rajan has argued that the rise of credit was encouraged by policymakers to offset stagnating median wages. Oatley has an argument that "what we're experiencing right now" is a result of a number of macro policies, operating within an international context, that both elites and the public broadly supported, culminating in disaster. I think, though I've done no research to back it up, that home ownership was encouraged by major public policies -- including the mortgage interest deduction and Fannie/Freddie -- supported through a host public policies by administrations and majority Congresses from both major parties across several decades, and that the most recent housing crisis is only the most recent, not the only. In many cases, bipartisan elite opinion is/was that these policies distort the economy and should be abandoned. Which mass publics wanted less access to credit and higher interest rates? Sure, finance liked it also, but they weren't the only ones. I.e., We got the housing finance we got because the public wanted credit, the politicians wanted votes, and the financiers wanted profits. NOTE: I slightly modified this parenthetical after initial posting to improve clarity and fix typos.)

*Usually IPE just pumps POLITY into a regression and mumbles something about transparency or checks and balances and then moves on.

**As for "On other [issues], [the public] has preferences that largely maps onto partisan identifications rather than actual interests"... Who's lazily inferring interests now? Why can't partisan identification be an interest?

***The dearly departed George Rabinowitz used to befuddle his Intro to American Politics students every year by assigning Showdown at Gucci Gulch, a journalistic account of the passage of the 1986 tax reform act. It does a great job of explaining how the pressure for tax reform was generated by the mass public, but how the vagaries of getting it passed heavily involved elites and interest groups.

****For one thing, saying "elites did it" doesn't actually tell us anything at all. There are elites on both sides of every issue. Krugman himself is an elite now, as he was during all of the 2000s, and yet he disagreed with most major policies enacted during that period. Which elites get to control policy is decided, among other things, by the publics.

(Not Snarky) Response to Comments

Anonymous left some good comments on my deflation post. Let me reply to two points s/he makes.

"you make the same mistake many economists and all journalists make: deflation is not a decrease in prices. It is a decrease in the money supply (money+credit). The decrease in prices is the result, not the cause, of deflation."

Well, yes, except for when it isn't. To invoke quantity theory, PQ=MV. Thus, deflation can occur because M falls more rapidly than Q, or because Q rises more rapidly than M. Hence, deflation is what happens to P as consequence of the relationship between M and Q. In the current instance, concern about deflation is clearly a concern about M falling as a consequence of the credit crunch. In the late 19th century, deflation was a consequence of Q growing more rapidly than M.

In selecting a definition, we want one that incorporates all possibilities. Hence, deflation is a sustained decrease in the general price level caused by a reduction in M relative to Q.

The critic continues: And don't forget who put us in this mess: the Fed and the easy credit.

I know this is the popular take, but I fail to see how this makes sense in an open economy framework. Here's why I am puzzled.

Suppose Greenspan raises interest rates in 2001-02. What happens? It doesn't push us into recession. It merely sucks in foreign capital. Capital inflows appreciate the dollar; the dollar appreciation creates incentive to invest in the non-traded sector (housing). The result: a bubble fueled by foreign capital. Think here of the S&L crisis of the 1980s.

Suppose Greenspan keeps interest rates low, what happens? Less foreign capital gushes in; the dollar appreciates less; yet the inflows fuel a housing bubble.

Seems the choice the Fed faced, therefore, was between a bigger and a big bubble. You blame it for choosing the big one; I think that given its options, it made the right choice.

What we should focus on are those factors that created this choice: fiscal policy. Government dissavings driven by tax cuts and military expenditures and the associated current account deficit created the need to import foreign capital. These inflows strengthened the dollar and financed the bubble. So policy responsibility in my mind lies with Congress (to which the constitution assigns authority over revenue) and the current administration rather than with the Fed.

This is why I am truly puzzled about why everyone blames the Fed and more narrowly Alan Greenspan. Please explain why my read is mistaken.

China's Growing Pains

Jon Western goes to China, and comes away impressed. Not impressed with China's improvements, although that too, but with its challenges. In a way, they are the same problems the US faces, but magnified:

1. ... In many ways, America's challenges with the future of Social Security pale in comparison to what China faces in the coming decades...

2. ... This has led to rising inequality in housing consumption as well as a new homeless population. Furthermore, while the financial industry is largely protected because of strict regulations and high downpayment requriements (a problem that ironically exacerbates the challenges to reduce domestic savings rates and jump start domestic consumption among young males), the housing prices -- especially in urban cities -- are at all-time speculative highs and many analysts now anticipate major price corrections that could well send significant shock waves through the economy. ...

3. Though China's domestic industry has grown more competitive throughout the world, there is some question about the degree and magnitude of technology upgrades in its domestic industries -- a key requirement for future development and growth. ...

For us IR scholars, we tend to focus on the data points that suggest American decline -- the US budget deficit, its military over-commitments, and the dysfunctional national politics and such. Yet, if we look closer at the internal issues within China, despite its impressive levels of economic growth over the past two decades, it's not at all clear that we are on the verge of some kind of global power transition -- at least not any time soon.

We've sounded similar notes before here, and I think it is important to remind people that growth is a long, uneven process. Over the past three decades China has shown a lot of resilience and agility, but the challenges continue to mount. I'm not a China doomsayer -- I think they'll continue to grow and modernize -- but it won't necessarily be at a linear pace. And in terms of global power, there is too much space, and too many intervening variables, to be talking in terms of "power transition" yet. China has quite a lot of maturing to do before then.

Romney and the Language of Entitlement

I'm interested in the reactions to Romney's "secret video". My initial thoughts on it were not the same as most. I was first impressed by Romney's campaign playbook. He recognizes that to win the election he has to get 5-7% of the electorate who voted for Obama in 2008 to vote for him this time. He knows that he can't get those votes from the 47% or so that are strict Obama partisans; he has to attract those in the middle. He understands that the best way to do this is not to vehemently attack Obama from the right -- as right partisans wish him to -- but to say "Obama's a nice guy and all, and he means well, but he's just not up to the job and I can do better". This, to me, explains quite a lot of Romney's campaign so far.

And it explains why partisans in both camps, and the partisan media on both sides, are puzzled by elements of the Romney campaign. It's because they think he should try to win over everyone (left) or speak primarily to the base (right). And he's not. He's not trying to persuade the unpersuadable. He's ignoring those on both sides who are partisans. He's targeting a very specific, very narrow audience. In purely strategic terms I think this is the right way for Romney to campaign. I think his understanding of the political space is actually pretty savvy. His crassness in targeting that middle group reinforces my priors as a materialist, so I like that too. He's basically admitting that his campaign strategy is only about getting the median voter on his side.

At first I didn't understand why Obama partisans were so offended by Romney's characterization of the voters that are off-limits to him. I read him as saying "They have a fundamentally different ideology from mine, one which believes that the government is well-suited to solve the problems of the day and which is based on an understanding that everyone is entitled to health care, food, and housing." I didn't read him as saying that the 47% of the population that are in Obama's camp are literally the exact same 47% of the population that pays no federal income tax. (I agree with Gelman's assessment that there is a correlation between the two variables, but nowhere near 100%.) Perhaps I was giving Romney too much benefit of the doubt. I see now that many Obama supporters in one 47% but not the other felt that they were being called free-riders. Since they're not they feel that they are compassionate. Hence, offense. Fair enough, I suppose, but for me that's the least interesting part of his remarks. It only sets up the rest, which is about campaign strategy. I found the outrage to be at least somewhat manufactured, as Twitter and Facebook got whipped up into a frenzy and "fact-checkers" worked overtime to parse the semantics of an improvised remark. This missed the broader point.

As the discussion has evolved -- in my case on Facebook and Twitter, but also on blogs and MSM -- I've become more interested in something else: why the right revert to the language of entitlement so quickly, and why the left gets so angry about it. It is my understanding that a central plank of the Obama platform is that the social safety net is defensible not only on grounds of economic utilitarianism, but on grounds of social justice: humans have a fundamental right to food, to housing, to health care, to education. Any just society will ensure a minimum standard of living for the worst-off among them. To make this argument is to claim that every member of a society is entitled to a minimum standard of living by virtue of being a member of that society. If this is true, then Romney's characterization of the ideology (rather than composition) of Obama partisans might be inelegant, as he said, but it isn't fundamentally wrong.

The left tends to hate it when the right accuses them of supporting entitlement programs. This I cannot understand. It seems to me that the appropriate response to this is not "Who does Romney think he is, calling us 'entitled'" but "Damn right we believe we're entitled to health care and food. Oh, and a living wage too". This is not only sensible philosophically, but pragmatically: Hayek and Friedman believed in the same thing. Rather than getting defensive, the left should use this to go on the offensive: "You don't believe in a minimum standard of living? You don't believe people are entitled to a safety net when capitalists like you blow up the economy?"

This is especially perplexing, to me, because that argument has already been won. The Romney-Ryan attack on the Affordable Care Act is now that it cuts too much from Medicare. Alright, the left should say. Let's increase Medicare spending too. The Romney campaign has now pledged to keep the biggest parts of the Affordable Care Act intact, repealing outright only the mandate tax. The Romney-Ryan campaign is not pledging to cut Social Security -- or even privatize it -- or end the food stamp program or cut education spending or in any other significant way reduce the size of the welfare state. So why not declare victory on "entitlements"? Why not own the term?

The other interesting thing about the Romney video is that he put all his cards on the table. He knows that he's the underdog. He knows which groups he has to win over. He knows he has to appeal to Hispanic voters. He knows he has to attract women voters. He knows that Obama has 40-something% of the voters locked up, and that he (Romney) has 40-something% of the voters locked up. He knows that he has to get 5-7% of voters in play to vote for him, and he knows that's going to be hard because many of them were previous Obama voters. He knows he can't win on foreign policy. He knows that Obama's signature policies -- health care, tax cuts for poor/middle class, tax increases on the wealthy -- are popular. So he's not even going to fight against Obama on the merits. His entire campaign rests on a non sequitur: the country isn't perfect, therefore I should be president.

He just gave the left his playbook, and the left complained about the font used on the title page. That strikes me as being short-sighted.

Finally, I agree with Gelman's conclusion: "I continue to be disturbed by claims that all or even most voters or one party or another are fools, dupes, moochers, bitter, etc etc, the idea that Democrats are a mix of deadbeats and trustfunders, or that Republicans are a mix of fat cats and religious fanatics."

The ECB, Asymmetric Shocks, and Monetary Policy Dilemmas

Standard theories of monetary union suggest that they work best when the participating countries experience the same shocks. They work least well when they experience asymmetric shocks. I have always found it difficult to teach this, because until now the EU's monetary union has not really had to deal with a big shock. The fall out from the US sub-prime crisis is imposing an asymmetric shock on euroland. Consequently, we now begin to see the dilemma that EMU creates for its members and its single central bank.

The core problem is that the ECB must choose between inconsistent objectives. As the Telegraph summarizes, "Mr Trichet has to tread a delicate path between the eurozone's Germanic and Latin blocs, pulling ever further apart. The credit and housing booms have begun to deflate in the Club Med region. The Bank of France's governor, Christian Noyer, said this week that Europe was facing a "huge shock" as contagion spread from the US sub-prime crisis...Spain in particular is now in serious trouble, with a "staggering" current account deficit of 9pc of GDP and a huge overhang of unsold property from the housing bubble."

Germany, in contrast, is struggling with rising inflation: "The hard-line bloc [is] led by the two German council members, Bundesbank chief Axel Weber and the ECB's chief economist Jurgen Stark. The latest spike in oil and food costs has pushed German inflation to 3pc, the highest since the launch of the euro and fast approaching the level where it may erode popular support for the currency."

Thus, one monetary policy but divergent economic developments across euroland. Someone has to accept a monetary policy that not only fails to address their current needs but will actually further worsen their situation. The dilemma is complicated by uncertainty; the more German unions question whether the ECB will use policy to keep inflation down in Germany (i.e., the more they believe that monetary policy will target Spain and the Med) the larger the nominal wage increases they will seek. Hence, to keep inflation down in Germany, the ECB must be hard line and build a reputation. But, being willing to raise interest rates to build this reputation risks making things even worse for "club med."

Not surprisingly, this "technical decision" is spilling over into politics, as French and Italian politicians have chastened Trichet for the hard line he is adopting.

It is precisely this problem that caused me to write, more than ten years ago, that EMU is not obviously a very good idea.

Slow Start

Tyler Cowen does not think Barack Obama is off to a good start:

The simple truth is that so far economic policy has fallen short of being good. Some (not all) left-wing bloggers may be reluctant to say this so early in the tenure of such a long-awaited administration, but perhaps a few of them are thinking it. There is the stimulus, the Geithner banking plan, and the housing plan. Of course there are differences of opinion but perhaps it is fair to say he is straining to be one out of three?

This does not even include his ramp-up of protectionism in Canada. I said this on Wednesday, in a more casual setting:

the stimulus bill was a piece of [junk] by almost any definition short of "anything is better than nothing" and contained very little actual stimulus, the much-anticipated Geithner "plan" was actually no plan at all (it amounted to "we're maybe gonna think about doing something about things at some point"), the mortgage bailout is ill-conceived and probably pointless, the protectionism coming from "Buy American" provisions and bailouts for GM workers in the US while GM workers in the EU are getting laid off is [bothering] the rest of the world to the point that CHINA is screaming at the US to keep trade open. and let's not forget Geithner's China-bashing during his confirmation hearing.

it's not insignificant that Obama's first trip is to Canada and Hillary's is to the Far East: Obama's already [irked] a lot of finance ministers around the globe, including our most important trading partners, and they're trying to keep [things] from spinning completely out of control. meanwhile, there has been literally no proposal for reforming/restructuring the financial regulatory system, no proposal for recapitalizing (or liquidating) the banks, no proposal for policy coordination with other countries, and Obama didn't even send a high-ranking official from his administration to Davos. without stability in the banking sector, the already-small potential positive effects of the stimulus bill will be greatly lessened. meanwhile, the stimulus bill contained the largest earmark in the history of the world, which will be used to build a coal gasification plant in illinois that has [irritated] environmentalists. Fed policy is in limbo, waiting to see what the Treasury is gonna do, and the Treasury has no idea what it's going to do. the entire thing is a [disaster] so far, and i honestly can't believe that Summers and Romer are pleased about the way economic policy has taken shape.

what is really needed is sectoral adjustment, and there is no indication that obama understands that fact or is willing to deal with it. most of his proposals are designed to prop up the old system rather than ease the transition to a new one. his approach to the Big 3 so far confirms this, as does his housing bailout plan. in fact, there doesn't even seem to be any sort of unified plan from the obama camp. his advisors are hardly speaking in public about the plans, and when they do they say things like "the president believes" rather than "we are doing this because the empirical evidence says...". the difference may seem a bit subtle, but it's powerful.

[edits in brackets because this is a family-ish blog]

I wrote that in anticipation of Obama doing "damage control" during his trip to Canada, as Alex anticipated yesterday. Back in October, I hoped that Obama was lying about his preferred trade policy -- and I still hope he's lying -- but it now appears more likely that he is actually interested in pursuing damaging trade policies in the middle of this Great-ish Depression. (i call dibs on that term, by the way.)

There is still a chance that whatever Geithner comes up with will be good, but I haven't been encouraged by the performance of the Obama administration over the past month. Indeed, given the political landscape it would have been difficult to do much worse in such a short period of time, and I say this as someone who voted for Obama largely because of the economic advisors he had chosen.

Obama put together a very good economic team before taking office. I really wonder what they really think about the policies so far enacted.

Oops

Via McMegan, Paul Krugman in 2002:

The basic point is that the recession of 2001 wasn't a typical postwar slump, brought on when an inflation-fighting Fed raises interest rates and easily ended by a snapback in housing and consumer spending when the Fed brings rates back down again. This was a prewar-style recession, a morning after brought on by irrational exuberance. To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble.

The Great Crash 2008, Part One

In "Cause and Consequences", the last chapter of The Great Crash 1929, JK Galbraith offers his explanation for why the Great Depression rather than a typical recession followed the stock market collapse. Or, as he put it, why the economy was "fundamentally unsound" in the run-up to the stock market crash that led to a prolonged slump. There are five reasons given (beginning on pg. 177 of the 2009 Mariner paperback, for those wishing to follow at home), and it's worth thinking about each to see how they may or may not relate to today. I'm going to do them in a series for the sake of brevity. This is the first.

Galbraith's first reason given for why the stock market collapse plunged the real economy into deep depression is the large amount of income inequality. Galbraith writes:

This highly unequal income distribution meant that the economy was dependent on a high level of investment or a high level of luxury consumer spending or both. The rich cannot buy great quantities of bread. ... Both investment and luxury spending are subject, inevitably, to more erratic influences and to wider fluctuations that the bread and rent outlays of the $25-a-week workman. This high-bracket spending and investment was especially susceptible, one may assume, to the crushing news from the stock market in October of 1929.

It's well-established that US income inequality increased dramatically over the two decades prior to the 2008 crash. Here's a snapshot of the share of national income going to the top 10% of income earners from the famous Piketty/Saez historical study of the American income distribution (labelled and discussed by Krugman here)



The graph ends a few years before 2008 but the trend didn't reverse in that time. What I like about Galbraith's explanation of the role of income inequality in the Great Depression is that there is a plausible causal story: with increased inequality the economy becomes more dependent on the fortunes of the high-bracket folks to maintain demand and investment; a shock to their finances via a financial crash thus hurts more than it otherwise would. This can link up with demand-side and structural explanations of the sclerotic US recovery. Too often discussions of contemporary income inequality lacks such a mechanism, and are much more normatively framed and politically charged. That's fine, but it doesn't really help us understand how income distribution affects the broader economy.

The question is whether Gailbaith's causal story matches the present. Let's look at some data on private investment. We know that there was a slump in housing, so let's check that first:




It drops off a cliff, but notice that that begins in late-2005. This is in line with the usual story that the housing collapse preceded and perhaps caused the financial collapse by deteriorating the value of the underlying assets on which securities were backed. For Galbraith's story to be true, we'd need to see investment drop off after the financial collapse destroyed the wealth of those at the top of the income distribution. And we do:



Note that in percentage terms, the dropoff post-2008 is more severe than what occurred during the 2001 recession. My back of the envelope estimate is that investment at the trough post-2001 was ~ 88% of the pre-2001 peak; In 2008 it was 78%. Moreover, investment fell more steeply more quickly post-2008 than post-2001. But it also rebounded in a sharper V-pattern than in 2001. If Galbraith's logic held, we might expect to see the opposite: a deeper, longer investment drought. Sometime like an 'L'- or 'U'-shaped pattern of recovery.

Let's look at some consumption data:



Here we see a much bigger dropoff post-2008 than post-2001, and it persists for much longer. While we've gotten back to pre-2008 levels, we haven't yet caught back up to trend. But is this slack enough to explain the persistent malaise in labor and financial markets? And is the slack in spending and investment attributable to income inequality rather than high unemployment? Is high unemployment attributable to income inequality? There's no obvious mechanism that explains it. At least not that I can think of.

It may be that increased inequality was a symptom of structural shifts in the global economy that pre-dated the crash. An effect rather than a cause. Post-crash inequality becomes a cause of ongoing economic weakness. However as a first explanation for the Lesser Depression I'd look elsewhere.

In any case, the major political battles in the US since the financial crisis have been on issues related to income distribution: health care, financial regulation, and progressive taxation vs. expenditure austerity. Maybe we could add classic Phillips-curve battles over unemployment/inflation tradeoffs.* This suggests that the cleavages in the economy break down along at least some of these lines. But this could be a consequence of the weak economy rather than a cause of it, especially since the political scene has shifted from fire-fighting to deficit-cutting.

*Krugman and others argue that right now there isn't much of a tradeoff and I tend to agree, but neither the political leadership of the GOP nor most pundits seem to believe him.

The State of Things

The new TNR econ blog passes along a juicy anecdote:

As another illustration of this, consider an example I got from Orin Kramer, a hedge fund manager and prominent Obama supporter. Kramer has a friend who recently bid on a bundle of home-equity loans the government was auctioning off (presumably after having seized a bank that owned them). The homeowners in this case weren’t subprime deadbeats but people with solid credit histories who were scrupulously making their payments. Still, the friend was the highest bidder at a measly 14 cents on the dollar—and, Kramer says, “I have another friend who claims he overbid.” (The government decided not to sell because it didn't like the price.)

This might sound like a classic "irrational despondence" issue—only 14 cents on the dollar for a bundle of perfectly upstanding loans? But there’s one big problem, as Kramer points out: None of the homes have any equity left in them. Thanks to the cratering housing market, these people's first mortgages exceed the value of their homes, which makes them good candidates to simply stop paying (both the original mortgage and the home equity loan).

The government essentially has three choices: let homeowners default on the loans and enter bankruptcy, destroying their credit and making banks endure the costs of foreclosure in exchange for a devalued house; force the banks to rewrite the terms of the mortgage; or take the risks of mortgage-default away from the banks, write-down the mortgages, and take the financial hit. President Obama's new housing plan tends towards a combination of second and third. But right now the banking industry is in a persistent state of flux. Obama should choose one of the three options, and go for broke with it.

Brad DeLong Versus Political Science: Grasping Narrative with Both Hands

DeLong, in Democracy:

If there was a single moment when Mitt Romney lost the 2012 presidential election, it was in May when he stood in front of the $50,000-a-plate audience at Sun Capital honcho Marc Leder’s home in Boca Raton and spoke his soon-to-be-infamous words:

"There are 47 percent of the people who will vote for the President no matter what…. There are 47 percent who are with him, who are dependent upon government…who believe that government has a responsibility to care for them, who believe that they’re entitled to health care, to food, to housing, you name it…. These are people who pay no income tax…. My job is not to worry about those people—I’ll never convince them that they should take personal responsibility and care for their lives…"

John Sides, at Salon.com:

To commentators used to thinking of campaigns like a boxing match, [the 47 percent video] seemed like the knockout blow.

In reality, the impact of the video was much more muted. This is the argument UCLA political scientist Lynn Vavreck and I make in our forthcoming book on the election, “The Gamble.” ... 

It is always tempting for those following a presidential election closely — pundits, reporters and political scientists alike — to assume that every new twist is the proverbial game-changer. But in retrospect, the 47 percent video did not live up to the hype.

Models predicting Romney's loss well before the video emerged -- those based on economic fundamentals -- performed very well. The 47% video had almost nothing to do with the electoral outcome.

The rest of DeLong's essay -- essentially a defense of the welfare state against the entreaties of Nicholas Eberstadt -- is fine enough if a bit boilerplate. But if he's going to deliver lectures on how folks should understand the basic tenants of macroeconomics if they are to comment on them, then he should understand the basic tenants of political science if he is to comment on it.

Was I Wrong to Be Worried About Deflation?

Last fall Dr. Oatley told me not to freak out about deflation as price indices fell despite the fact the Fed had dropped interest rates practically to zero. Since that time the Fed has engaged in unprecedented "quantitative easing" policies while keeping interest rates near the zero bound. Thankfully these actions, along with the bailouts and stimulus policies of the Bush and Obama Treasury Departments, have kept the American economy out of a deflationary spiral. The most recent data show a core CPI inflation rate (excluding energy and food prices) in the black.

So was I overreacting? I don't think so. For one thing it was not clear back in November that the Fed would engage in quantitative easing, or that those actions would have much traction. It also was not yet clear how long the credit crisis would persist, what actions the Treasury Department would take, or what effect a stimulus bill that was still months away would have. In fact, some of those questions are still unanswered.

But one thing is clear. The ECB and Bank of Japan adopted less drastic monetary and fiscal policies than the U.S., and the result has been record-setting falls in their price levels. They are still not in end-of-the-world territory yet (especially in Europe), but they are firmly in the danger zone. As Dr. Oatley wrote back in November, this is cause for concern for following reasons:

1. Debtors suffer as the real value of their debt rises. Hence, more difficulties to service loans (think about housing price collapses and mortgage foreclosures). Rising debt service problems can harm financial institutions (that's an ironic understatement).
2. Creditors benefit as the real value of their assets rises. Of course, this assumes that debtors continue to pay.
3. Consumers benefit, because things get cheaper every day.
4. Not so good at the aggregate level. If we expect everything to be cheaper next month, we won't buy it this month. If we all defer our purchases in expectation of lower prices in the future, our aggregate demand falls and we produce less--which means we employ fewer people. With less income from lower production, prices fall further, so we push our big purchases off to the future again. And so on and so on. Deflationary spiral, I believe it is called. This is pretty much what happened in 1929-1933.

And while arguing by anecdotes is logically fallacious, acknowledging them can be fun. So I observed with bemusement Emmanuel's suit-shopping adventure, in which he bought a Hugo Boss suit at a low rate. Looking sharp, Emmanuel, but couldn't you have gotten them to toss in a better tie?