The NYT ran a column by former Los Angeles Mayor Richard Riordan and Tim Rutten which purports to present a plan to “avert the pension crisis.” The piece hugely exaggerates the funding problem faced by pensions because of a simple logical error in its assessment of discount rates.
At one point it tells readers:
“America’s state and municipal pensions concede that they are underfunded by more than $1 trillion. If a more realistic expectation of returns on investment is pegged at 5 percent, then that collective liability climbs to $2.7 trillion. Moody’s further estimates that the median state has financed only 48 percent of its future pension liabilities.”
The $1 trillion figure is based on return assumptions that are derived from rates of projected economic and profit growth from authoritative sources like the Congressional Budget Office and the Office of Management and Budget. In spite of Moody’s assessment (yes, that is the credit rating agency that rated trillions of dollars of mortgage backed securities as investment grade), the pension funds are making realistic assumptions in reaching this figure. (Here is a fuller discussion of the issue.)
It is easy to see the source of Riordan and Rutten’s confusion on returns. They write:
“California’s giant state pension fund, the world’s sixth largest, continues to assume it will earn 7.75 percent on its investments, even though its actual returns have been less than half that for a decade. Los Angeles continues to project similar annual yields on its investments, when the actual average returns are closer to 5 percent. As a consequence, the city’s unfunded pension obligations probably will grow to around $15 billion over the next four years.”
Their problem is basing future return assumptions on returns in the last decade or a slightly longer past. The key issue here is the return on the stocks in which pensions typically keep close to 70 percent of their assets. Rather than being an indication of future returns, sharp movements in the market (either up or down) will push future returns in the opposite direction.
The logic is simple. Stocks represent a claim to corporate profits. While these vary from year to year, they do not change very much over the long-term as a share of GDP. This means that we can think of shares of stock as providing an amount of profits that grows roughly in step with the economy.
If there is a sharp run-up in the stock market, as was the case in the 1990s, then pension funds and other stock holders must pay lots of money for each dollar of corporate profits. (The ratio of stock prices to trend earnings rose to more than 30 in the 1990s stock bubble.) In this case, their future returns will be low.
On the other hand if stock prices fall, then the price of a dollar of corporate earnings is lower. This means that pension funds can anticipate higher future earnings. Therefore Riordan and Rutten have things completely backward when they imply that pension funds should expect lower returns in the future because stock prices fell in the recent past. (If the recent run-up continues, then return assumptions may have to be re-examined, but this would also mean that pension fund assets are higher.)
The take-away is that there are pension funds that definitely face problems, but this is almost always the result of politicians refusing to make required contributions. This is not a general problem. Many funds did make overly optimistic return assumptions in the 1990s and the last decade when price to earnings ratios were far above historic averages, however their current return assumptions are very much in line with economic realities.
Addendum:
Some quick responses to points raised below.
First, pension funds hold a lot private equity (too much for my liking in many cases) so they would come pretty close to the story where they pick up new companies quickly in their holdings. So they should do better than the performance of just the S&P or even publicly traded companies as a group.
On the question of liquidity — they are not 100 percent in stock. They will have short-term assets providing very low returns and also an inflow of money from current participants. It should very rarely, if ever, be the case that funds would have to sell stock at depressed prices to meet current obligations.
As far as Rithloz’s charts, I’m not sure of his data source. (I’m not a subscriber to the service that made the charts.) I can say that the Fed’s data shows a somewhat higher ratio of stock prices to nominal GDP than does Ritholz. (Here’s my paper giving sources.) We look at roughly a 100 year period and find current ratios are roughly in line with the long-term average. Most other analysts who have looked at long-term stock returns, most notably Ibbotson, have come up with similar numbers. (btw, we always use trend earnings, so it doesn’t matter whether the current profit share is inflated.
The NYT ran a column by former Los Angeles Mayor Richard Riordan and Tim Rutten which purports to present a plan to “avert the pension crisis.” The piece hugely exaggerates the funding problem faced by pensions because of a simple logical error in its assessment of discount rates.
At one point it tells readers:
“America’s state and municipal pensions concede that they are underfunded by more than $1 trillion. If a more realistic expectation of returns on investment is pegged at 5 percent, then that collective liability climbs to $2.7 trillion. Moody’s further estimates that the median state has financed only 48 percent of its future pension liabilities.”
The $1 trillion figure is based on return assumptions that are derived from rates of projected economic and profit growth from authoritative sources like the Congressional Budget Office and the Office of Management and Budget. In spite of Moody’s assessment (yes, that is the credit rating agency that rated trillions of dollars of mortgage backed securities as investment grade), the pension funds are making realistic assumptions in reaching this figure. (Here is a fuller discussion of the issue.)
It is easy to see the source of Riordan and Rutten’s confusion on returns. They write:
“California’s giant state pension fund, the world’s sixth largest, continues to assume it will earn 7.75 percent on its investments, even though its actual returns have been less than half that for a decade. Los Angeles continues to project similar annual yields on its investments, when the actual average returns are closer to 5 percent. As a consequence, the city’s unfunded pension obligations probably will grow to around $15 billion over the next four years.”
Their problem is basing future return assumptions on returns in the last decade or a slightly longer past. The key issue here is the return on the stocks in which pensions typically keep close to 70 percent of their assets. Rather than being an indication of future returns, sharp movements in the market (either up or down) will push future returns in the opposite direction.
The logic is simple. Stocks represent a claim to corporate profits. While these vary from year to year, they do not change very much over the long-term as a share of GDP. This means that we can think of shares of stock as providing an amount of profits that grows roughly in step with the economy.
If there is a sharp run-up in the stock market, as was the case in the 1990s, then pension funds and other stock holders must pay lots of money for each dollar of corporate profits. (The ratio of stock prices to trend earnings rose to more than 30 in the 1990s stock bubble.) In this case, their future returns will be low.
On the other hand if stock prices fall, then the price of a dollar of corporate earnings is lower. This means that pension funds can anticipate higher future earnings. Therefore Riordan and Rutten have things completely backward when they imply that pension funds should expect lower returns in the future because stock prices fell in the recent past. (If the recent run-up continues, then return assumptions may have to be re-examined, but this would also mean that pension fund assets are higher.)
The take-away is that there are pension funds that definitely face problems, but this is almost always the result of politicians refusing to make required contributions. This is not a general problem. Many funds did make overly optimistic return assumptions in the 1990s and the last decade when price to earnings ratios were far above historic averages, however their current return assumptions are very much in line with economic realities.
Addendum:
Some quick responses to points raised below.
First, pension funds hold a lot private equity (too much for my liking in many cases) so they would come pretty close to the story where they pick up new companies quickly in their holdings. So they should do better than the performance of just the S&P or even publicly traded companies as a group.
On the question of liquidity — they are not 100 percent in stock. They will have short-term assets providing very low returns and also an inflow of money from current participants. It should very rarely, if ever, be the case that funds would have to sell stock at depressed prices to meet current obligations.
As far as Rithloz’s charts, I’m not sure of his data source. (I’m not a subscriber to the service that made the charts.) I can say that the Fed’s data shows a somewhat higher ratio of stock prices to nominal GDP than does Ritholz. (Here’s my paper giving sources.) We look at roughly a 100 year period and find current ratios are roughly in line with the long-term average. Most other analysts who have looked at long-term stock returns, most notably Ibbotson, have come up with similar numbers. (btw, we always use trend earnings, so it doesn’t matter whether the current profit share is inflated.
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I have been harshly critical of budget reporting in the media for being uninformative to readers. I think the NYT is trying to help me make my point. It ran an article telling readers about GOP plans to have a $40 billion cut in food stamp spending.
Okay how much money is that? Will all of us taxpayers see big savings if we cut back food stamps by this amount?
Well, if we go to the Center for Economic and Policy Research’s new super neat budget calculator we would see that $40 billion is equal to 1.2 percent of projected spending this year.
But wait! If I’m not mistaken — yes, while it is not mentioned in this article, these cuts are actually for a 10-year appropriation, starting in 2014. According to the calculator that would be 0.086 percent of projected spending over this period. (Hey one year, ten years, who can keep track?) This means that the cuts may be a big deal for the people affected, but probably will not allow for many extra vacations for ordinary taxpayers.
Come on folks, these articles are supposed to be providing information to readers. This one did not.
I have been harshly critical of budget reporting in the media for being uninformative to readers. I think the NYT is trying to help me make my point. It ran an article telling readers about GOP plans to have a $40 billion cut in food stamp spending.
Okay how much money is that? Will all of us taxpayers see big savings if we cut back food stamps by this amount?
Well, if we go to the Center for Economic and Policy Research’s new super neat budget calculator we would see that $40 billion is equal to 1.2 percent of projected spending this year.
But wait! If I’m not mistaken — yes, while it is not mentioned in this article, these cuts are actually for a 10-year appropriation, starting in 2014. According to the calculator that would be 0.086 percent of projected spending over this period. (Hey one year, ten years, who can keep track?) This means that the cuts may be a big deal for the people affected, but probably will not allow for many extra vacations for ordinary taxpayers.
Come on folks, these articles are supposed to be providing information to readers. This one did not.
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Okay, I am not really writing this to make fun of my friend Paul Krugman for whom I have enormous respect. The point here is that reporters should be trying to express budget numbers in terms that are understandable to their audience.
Krugman was apparently misled by news accounts (like this one) reporting that the Republicans wanted to cut food stamps by $40 billion which did not point out that this cut was over ten years, not one year. I have been ranting about this point for a while. If reporters made a point of putting budget numbers in context, for example by expressing them as a share of the total budget, you would not get silly mistakes like this. (See CEPR’s super keen budget calculator so you can get these numbers right.)
If the standard budget reporting can mislead Paul Krugman about the budget then I think it’s fair to say it’s got serious problems. Who exactly is being informed by it?
Okay, I am not really writing this to make fun of my friend Paul Krugman for whom I have enormous respect. The point here is that reporters should be trying to express budget numbers in terms that are understandable to their audience.
Krugman was apparently misled by news accounts (like this one) reporting that the Republicans wanted to cut food stamps by $40 billion which did not point out that this cut was over ten years, not one year. I have been ranting about this point for a while. If reporters made a point of putting budget numbers in context, for example by expressing them as a share of the total budget, you would not get silly mistakes like this. (See CEPR’s super keen budget calculator so you can get these numbers right.)
If the standard budget reporting can mislead Paul Krugman about the budget then I think it’s fair to say it’s got serious problems. Who exactly is being informed by it?
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Steven Pearlstein had a strange piece in the Post today arguing that Janet Yellen would be a better Fed chair than Larry Summers because Summers is too closely tied to the Democratic Party and we need a chair who is politically independent. While a politically independent Fed chair might be desirable, the Fed’s biggest mistake over the last two decades has been its unwillingness to take steps to burst bubbles: the stock bubble in the 1990s and the housing bubble in the last decade. The country has paid an enormous price for this failure.
One possible explanation for this failure is simple incompetence. That would mean Alan Greenspan either didn’t recognize the bubbles or didn’t realize the impact that their collapse would have on the economy.
An alternative explanation is that Greenspan was aware of the risks posed by the bubbles, but knew that Wall Street was making vast amounts of money off both of them. (They were backing IPOs in the stock bubble and mortgage backed securities in the housing bubble.) Insofar as this is the case, then the real need for independence at the Fed is independence from Wall Street. We need a Fed chair who is prepared to take steps against a bubble even if means taking away a big money-maker from Wall Street.
On this score Yellen also would have a clear edge. Summers has received millions of dollars in consulting and speaking fees from Wall Street banks and hedge funds in the years when he was not in government. This raises questions about the extent to which he would be prepared to crack down on dangerous practices by the financial industry. While Yellen also did not advocate cracking down on the bubbles in her various public policy positions at the time, she does not have a history of receiving large payments from the financial industry.
Steven Pearlstein had a strange piece in the Post today arguing that Janet Yellen would be a better Fed chair than Larry Summers because Summers is too closely tied to the Democratic Party and we need a chair who is politically independent. While a politically independent Fed chair might be desirable, the Fed’s biggest mistake over the last two decades has been its unwillingness to take steps to burst bubbles: the stock bubble in the 1990s and the housing bubble in the last decade. The country has paid an enormous price for this failure.
One possible explanation for this failure is simple incompetence. That would mean Alan Greenspan either didn’t recognize the bubbles or didn’t realize the impact that their collapse would have on the economy.
An alternative explanation is that Greenspan was aware of the risks posed by the bubbles, but knew that Wall Street was making vast amounts of money off both of them. (They were backing IPOs in the stock bubble and mortgage backed securities in the housing bubble.) Insofar as this is the case, then the real need for independence at the Fed is independence from Wall Street. We need a Fed chair who is prepared to take steps against a bubble even if means taking away a big money-maker from Wall Street.
On this score Yellen also would have a clear edge. Summers has received millions of dollars in consulting and speaking fees from Wall Street banks and hedge funds in the years when he was not in government. This raises questions about the extent to which he would be prepared to crack down on dangerous practices by the financial industry. While Yellen also did not advocate cracking down on the bubbles in her various public policy positions at the time, she does not have a history of receiving large payments from the financial industry.
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The NYT has an article today on the enormous savings available to people who had major surgeries performed in Europe rather than the United States. The piece reports that the cost of hip replacement or knee replacement surgery in the United States are more than five times higher than they are in comparable quality facilities in Europe. (The gap would be even larger with facilities in Thailand and India.)
This shows the enormous potential gains from increased medical trade. In effect, our hospitals, doctors, and medical equipment makers benefit from tariffs on the order of 500 percent or more. If the Obama administration really is interesting in promoting growth through trade it would be difficult to imagine a sector with larger potential gains than trade in medical care.
The agreements would focus on setting clear liability rules, accreditation systems, and removing obstacles for insurers and government programs that prevent them taking advantage of lower cost medical services in other countries.
If the trade deals do not include major openings on medical trade then it would be a clear example of why these deals are in fact about selective protectionism rather than free trade. Past trade deals have been quite explicitly focused on putting U.S. manufacturing workers in direct competition with the low paid manufacturing workers in developing countries.
Anyone who believes in free trade would want U.S. doctors and other professionals subjected to the same sort of competition. Otherwise, they really only want to use trade to lower the wages of less educated workers to benefit the wealthy. (Low wages means cheap help.) It is dishonest to call that policy “free trade.”
The NYT has an article today on the enormous savings available to people who had major surgeries performed in Europe rather than the United States. The piece reports that the cost of hip replacement or knee replacement surgery in the United States are more than five times higher than they are in comparable quality facilities in Europe. (The gap would be even larger with facilities in Thailand and India.)
This shows the enormous potential gains from increased medical trade. In effect, our hospitals, doctors, and medical equipment makers benefit from tariffs on the order of 500 percent or more. If the Obama administration really is interesting in promoting growth through trade it would be difficult to imagine a sector with larger potential gains than trade in medical care.
The agreements would focus on setting clear liability rules, accreditation systems, and removing obstacles for insurers and government programs that prevent them taking advantage of lower cost medical services in other countries.
If the trade deals do not include major openings on medical trade then it would be a clear example of why these deals are in fact about selective protectionism rather than free trade. Past trade deals have been quite explicitly focused on putting U.S. manufacturing workers in direct competition with the low paid manufacturing workers in developing countries.
Anyone who believes in free trade would want U.S. doctors and other professionals subjected to the same sort of competition. Otherwise, they really only want to use trade to lower the wages of less educated workers to benefit the wealthy. (Low wages means cheap help.) It is dishonest to call that policy “free trade.”
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Between 1990 and 1998, Russia’s economy suffered perhaps the worst downturn of any major country that was not the victim of either war or natural disaster. The proximate cause of course was the collapse of the Soviet Union and the replacement of its system of central planning with a market economy. Larry Summers played a large role in shaping this transition, first as chief economist for the World Bank, then as the undersecretary for international affairs at the Treasury Department and later as the Deputy Treasury Secretary.
Since Russia’s economy had been guided largely by central planning for close to 70 years, this transition would have been difficult even under the best of circumstances. However the actual transition was hardly the best of circumstances. Corruption infested every aspect of the privatization. Those with connections in the government were able to become billionaires almost overnight, as they were allowed to buy Russia’s businesses and resources at a small fraction of their market value.
According to the World Bank, Russia’s government was paid just $8.3 billion from privatizing assets over the years 1990-1998, a period when most of its economy was turned over to private control. By comparison, Lukoil, Russia’s largest private oil company, had a market value of $268.8 billion on August 2, more than 30 times as much as the payments that Russia’s government received for all the assets it sold over this 8-year period.
The data clearly show the devastation that this failed transition imposed on the Russian people. According to the United Nation’s Human Development Report, Russia’s per capita income fell by one-third between 1990 and 2000, a decline that dwarfs the falloff in the Great Depression in the United States. This had enormous consequences in the daily lives of the Russian people as the system of social supports that provided basic services collapsed with nothing to replace it. The Development Report shows a drop in life expectancy fell from 68 in 1990 to 65 in 2000, a drop implying that millions of people would be dying at a younger age than would have been the case a decade earlier.
The Development Report has no shortage of grim statistics about the plight of the Russian people in the 1990s. (Those getting depressed by this story should know that Russia made rapid progress in most measures of economic and social well-being after breaking with the Summers agenda in 1998. By 2012, the losses of the 1990s had been more than completely reversed.) However, the question remains whether we can blame Larry Summers for this disaster?
At the American Economic Association convention in January of 1994, Larry Summers gave a talk about the successes of the first year of the Clinton administration. He boasted how “this administration” (a phrase repeated many times) had created more than 1.8 million jobs. He also boasted about the 2.0 percent growth the economy had seen to date. [Note: These were weak numbers. The economy was coming out of the 1990-1991 recession. We might have reasonably expected 3-4 percent growth and 3 million jobs.]
This was peculiar for two reasons. First, the economy almost always creates jobs and grows; the relevant question is the rate of job creation and the pace of economic growth. Boasting that jobs are being created and the economy is growing is a bit like taking credit for the sun rising. The other reason that Summers’ talk was peculiar was that he was making these boasts to economists, all of whom know that the economy typically creates jobs and grows.
Alan Blinder, who was also on the panel and one of Summers’ colleagues in the administration as a member of the Council of Economic Advisers, provided an interesting contrast in his own presentation. Blinder managed to talk forthrightly about the fact that the economy was not growing as fast as the administration wanted, nor was it creating as many jobs as was hoped. He did this in a way that provided useful insights to the audience while not providing any of the reporters in the room with fodder for embarrassing headlines in the next day’s paper.
But the point of this digression is Summers, not Blinder. Summers apparently felt that the Clinton administration deserved credit for the meager number of jobs and slow growth that the economy had generated up to that point. If that’s the case, then by the Summers standard, surely we can hold Mr. Summers accountable for the devastation that Russia’s transition inflicted on its people in the 1990s.
Call it item # 412 in the case for Larry Summers for Federal Reserve Board chair.
Between 1990 and 1998, Russia’s economy suffered perhaps the worst downturn of any major country that was not the victim of either war or natural disaster. The proximate cause of course was the collapse of the Soviet Union and the replacement of its system of central planning with a market economy. Larry Summers played a large role in shaping this transition, first as chief economist for the World Bank, then as the undersecretary for international affairs at the Treasury Department and later as the Deputy Treasury Secretary.
Since Russia’s economy had been guided largely by central planning for close to 70 years, this transition would have been difficult even under the best of circumstances. However the actual transition was hardly the best of circumstances. Corruption infested every aspect of the privatization. Those with connections in the government were able to become billionaires almost overnight, as they were allowed to buy Russia’s businesses and resources at a small fraction of their market value.
According to the World Bank, Russia’s government was paid just $8.3 billion from privatizing assets over the years 1990-1998, a period when most of its economy was turned over to private control. By comparison, Lukoil, Russia’s largest private oil company, had a market value of $268.8 billion on August 2, more than 30 times as much as the payments that Russia’s government received for all the assets it sold over this 8-year period.
The data clearly show the devastation that this failed transition imposed on the Russian people. According to the United Nation’s Human Development Report, Russia’s per capita income fell by one-third between 1990 and 2000, a decline that dwarfs the falloff in the Great Depression in the United States. This had enormous consequences in the daily lives of the Russian people as the system of social supports that provided basic services collapsed with nothing to replace it. The Development Report shows a drop in life expectancy fell from 68 in 1990 to 65 in 2000, a drop implying that millions of people would be dying at a younger age than would have been the case a decade earlier.
The Development Report has no shortage of grim statistics about the plight of the Russian people in the 1990s. (Those getting depressed by this story should know that Russia made rapid progress in most measures of economic and social well-being after breaking with the Summers agenda in 1998. By 2012, the losses of the 1990s had been more than completely reversed.) However, the question remains whether we can blame Larry Summers for this disaster?
At the American Economic Association convention in January of 1994, Larry Summers gave a talk about the successes of the first year of the Clinton administration. He boasted how “this administration” (a phrase repeated many times) had created more than 1.8 million jobs. He also boasted about the 2.0 percent growth the economy had seen to date. [Note: These were weak numbers. The economy was coming out of the 1990-1991 recession. We might have reasonably expected 3-4 percent growth and 3 million jobs.]
This was peculiar for two reasons. First, the economy almost always creates jobs and grows; the relevant question is the rate of job creation and the pace of economic growth. Boasting that jobs are being created and the economy is growing is a bit like taking credit for the sun rising. The other reason that Summers’ talk was peculiar was that he was making these boasts to economists, all of whom know that the economy typically creates jobs and grows.
Alan Blinder, who was also on the panel and one of Summers’ colleagues in the administration as a member of the Council of Economic Advisers, provided an interesting contrast in his own presentation. Blinder managed to talk forthrightly about the fact that the economy was not growing as fast as the administration wanted, nor was it creating as many jobs as was hoped. He did this in a way that provided useful insights to the audience while not providing any of the reporters in the room with fodder for embarrassing headlines in the next day’s paper.
But the point of this digression is Summers, not Blinder. Summers apparently felt that the Clinton administration deserved credit for the meager number of jobs and slow growth that the economy had generated up to that point. If that’s the case, then by the Summers standard, surely we can hold Mr. Summers accountable for the devastation that Russia’s transition inflicted on its people in the 1990s.
Call it item # 412 in the case for Larry Summers for Federal Reserve Board chair.
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This exchange (here, here, and here) between my friend Jared Bernstein and Casey Mulligan is worth a brief comment. As I’ve told several people who followed it, Mulligan is absolutely presenting the mainstream position in the profession, but Jared is right.
The question, if we ignore silly semantics, is whether the economy typically faces a problem of insufficient demand. In other words, if companies, families, or the government went out and spent $500 billion tomorrow would this boost growth or just cause inflation. (Yes, I used all three interchangeably because if the problem is a lack of demand it doesn’t matter who spends the money, the short-term effect on the economy is the same.)
Mulligan presents the orthodoxy, periods where lack of demand is a problem are the exception. As a general rule the economy is at or near full employment. In that context the primary result of more spending is higher inflation as we lack the ability to actually produce more goods and services. In this view, the way we get the economy to grow is by increasing supply side factors, like giving workers more incentive to work, training them better, getting more and better capital, and improving technology. By contrast, Jared is making the argument that if workers had higher wages they would be spending more money, which would lead to more output and possibly more investment as well (yes, a supply side effect).
Mulligan acknowledges that we could be in such a situation now, but that this is an exception. This sort of demand shortfall would not generally be an issue. (There was a similar sort of exchange between Paul Krugman and Joe Stiglitz earlier this year with Krugman taking the Mulligan position. [It is the mainstream position.])
In agreeing with Jared and Stiglitz I would like to introduce the widely discussed “savings glut” from the last decade as a major piece of evidence. While many of the people who knowingly talked about this glut may not know it, a savings glut means a shortfall of demand. In a world with a savings glut the problem is that people are not spending enough money to buy up all the goods and services that the economy is capable of producing.
This means that anyone who believed there was a savings glut in the last decade agrees with Jared and Stiglitz, the economy had a serious problem of inadequate aggregate demand. In this world, if workers get higher pay, this translates into more jobs and higher GDP. (We won’t call it “growth” in deference to Mulligan.)
There are some other propositions that would follow from the savings glut as well. In this world government deficits are helpful to the economy. They boost demand. That’s bad news for the folks who want to say the Bush tax cuts wreck the economy. (No, I have not become a fan of giving money to rich people, but no one pays me to shill for the Democrats.)
The basic economic problem becomes how to find ways to either increase demand on a sustained basis or adjust to a situation in which we will maintain a lower level of output without hurting people with inadequate incomes. (Can anyone say reduced workweeks and longer vacations?)
Anyhow, this is about the most fundamental point that we can have in economics. It is amazing how much confusion exists on the topic.
Addendum:
I see from the comments that this note has prompted confusion. Let me clarify a couple of points. My comment about the Bush tax cuts was not an endorsement of the tax cuts, I was just making the point that the deficits they created did not hurt the economy. We needed the demand and if we didn’t get them from the tax cuts, then we would have seen slower growth and higher unemployment. It would have been better both from the standpoint of boosting demand and reducing inequality if the tax cuts were focused on low and middle income people. It would have been even better if the money was used to support education and infrastructure, but the deficits themselves were good news, not bad news.
As far the existence of a savings glut, this is usually discussed in a worldwide context. The argument is that the world has more savings than it knows what to do with. The U.S. has run large balance of trade deficits over the last 15 years, which means that we have been taking some of savings generated elsewhere in the world. This would leave people unemployed in the United States, since incomes generated in production are being spent overseas. The counter to this has been the stock bubble in the 1990s and the housing bubble in the 2000s, both of which prompted large amounts of consumption, and therefore low household savings.
So this picture is totally consistent with a story of savings glut. What would be inconsistent is if we saw low savings rates even when trade was near balanced or in surplus. That has not happened.
In any case, the immediate issue here is simply the concept of a savings glut. It means that our problem is inadequate demand. Many people who talk of a savings glut do not seem to realize this fact.
This exchange (here, here, and here) between my friend Jared Bernstein and Casey Mulligan is worth a brief comment. As I’ve told several people who followed it, Mulligan is absolutely presenting the mainstream position in the profession, but Jared is right.
The question, if we ignore silly semantics, is whether the economy typically faces a problem of insufficient demand. In other words, if companies, families, or the government went out and spent $500 billion tomorrow would this boost growth or just cause inflation. (Yes, I used all three interchangeably because if the problem is a lack of demand it doesn’t matter who spends the money, the short-term effect on the economy is the same.)
Mulligan presents the orthodoxy, periods where lack of demand is a problem are the exception. As a general rule the economy is at or near full employment. In that context the primary result of more spending is higher inflation as we lack the ability to actually produce more goods and services. In this view, the way we get the economy to grow is by increasing supply side factors, like giving workers more incentive to work, training them better, getting more and better capital, and improving technology. By contrast, Jared is making the argument that if workers had higher wages they would be spending more money, which would lead to more output and possibly more investment as well (yes, a supply side effect).
Mulligan acknowledges that we could be in such a situation now, but that this is an exception. This sort of demand shortfall would not generally be an issue. (There was a similar sort of exchange between Paul Krugman and Joe Stiglitz earlier this year with Krugman taking the Mulligan position. [It is the mainstream position.])
In agreeing with Jared and Stiglitz I would like to introduce the widely discussed “savings glut” from the last decade as a major piece of evidence. While many of the people who knowingly talked about this glut may not know it, a savings glut means a shortfall of demand. In a world with a savings glut the problem is that people are not spending enough money to buy up all the goods and services that the economy is capable of producing.
This means that anyone who believed there was a savings glut in the last decade agrees with Jared and Stiglitz, the economy had a serious problem of inadequate aggregate demand. In this world, if workers get higher pay, this translates into more jobs and higher GDP. (We won’t call it “growth” in deference to Mulligan.)
There are some other propositions that would follow from the savings glut as well. In this world government deficits are helpful to the economy. They boost demand. That’s bad news for the folks who want to say the Bush tax cuts wreck the economy. (No, I have not become a fan of giving money to rich people, but no one pays me to shill for the Democrats.)
The basic economic problem becomes how to find ways to either increase demand on a sustained basis or adjust to a situation in which we will maintain a lower level of output without hurting people with inadequate incomes. (Can anyone say reduced workweeks and longer vacations?)
Anyhow, this is about the most fundamental point that we can have in economics. It is amazing how much confusion exists on the topic.
Addendum:
I see from the comments that this note has prompted confusion. Let me clarify a couple of points. My comment about the Bush tax cuts was not an endorsement of the tax cuts, I was just making the point that the deficits they created did not hurt the economy. We needed the demand and if we didn’t get them from the tax cuts, then we would have seen slower growth and higher unemployment. It would have been better both from the standpoint of boosting demand and reducing inequality if the tax cuts were focused on low and middle income people. It would have been even better if the money was used to support education and infrastructure, but the deficits themselves were good news, not bad news.
As far the existence of a savings glut, this is usually discussed in a worldwide context. The argument is that the world has more savings than it knows what to do with. The U.S. has run large balance of trade deficits over the last 15 years, which means that we have been taking some of savings generated elsewhere in the world. This would leave people unemployed in the United States, since incomes generated in production are being spent overseas. The counter to this has been the stock bubble in the 1990s and the housing bubble in the 2000s, both of which prompted large amounts of consumption, and therefore low household savings.
So this picture is totally consistent with a story of savings glut. What would be inconsistent is if we saw low savings rates even when trade was near balanced or in surplus. That has not happened.
In any case, the immediate issue here is simply the concept of a savings glut. It means that our problem is inadequate demand. Many people who talk of a savings glut do not seem to realize this fact.
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Sometimes it can be painful to read the newspaper. The NYT had a fascinating piece yesterday that implied S&P is lowering its standards for investment grade ratings in order to attract business.
According to the article, S&P had tightened its standards considerably following the financial crisis. This was causing it to lose market share. In order to regain market share it has recently lowered its standards so that banks can count on much better ratings from their new issues from S&P than the other two major rating agencies.
While this story is striking, the piece neglected an important little bit of recent history. There actually was an effort to crack down on this problem in the recent past.
Senator Al Franken proposed an amendment to Dodd-Frank that would have required the banks to call the Securities and Exchange Commission (SEC) when they wanted to have a new mortgage backed security rated. The SEC would then pick the agency. This takes the hiring decision out of the hands of the bank and removes this obvious conflict of interest. Franken’s amendment passed overwhelmingly, getting bi-partisan support. (Note: I had been writing about this idea since 2008 and had consulted with Franken’s staff.)
In the House-Senate conference over the bill, Barney Frank replaced the original wording with a two-year study by the SEC (which took almost 3 years). In the course of this study, the SEC was bombarded by comments from the industry all of which said that picking a bond-rating agency was too complicated for the SEC. As a result, the Franken amendment was killed and we now have the NYT telling us that a major bond-rating agency appears to be lowering its standards to attract business.
Sometimes it can be painful to read the newspaper. The NYT had a fascinating piece yesterday that implied S&P is lowering its standards for investment grade ratings in order to attract business.
According to the article, S&P had tightened its standards considerably following the financial crisis. This was causing it to lose market share. In order to regain market share it has recently lowered its standards so that banks can count on much better ratings from their new issues from S&P than the other two major rating agencies.
While this story is striking, the piece neglected an important little bit of recent history. There actually was an effort to crack down on this problem in the recent past.
Senator Al Franken proposed an amendment to Dodd-Frank that would have required the banks to call the Securities and Exchange Commission (SEC) when they wanted to have a new mortgage backed security rated. The SEC would then pick the agency. This takes the hiring decision out of the hands of the bank and removes this obvious conflict of interest. Franken’s amendment passed overwhelmingly, getting bi-partisan support. (Note: I had been writing about this idea since 2008 and had consulted with Franken’s staff.)
In the House-Senate conference over the bill, Barney Frank replaced the original wording with a two-year study by the SEC (which took almost 3 years). In the course of this study, the SEC was bombarded by comments from the industry all of which said that picking a bond-rating agency was too complicated for the SEC. As a result, the Franken amendment was killed and we now have the NYT telling us that a major bond-rating agency appears to be lowering its standards to attract business.
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I somehow missed this Post article touting the 1.7 percent growth rate reported for the second quarter as better than expected. First it is incredible that the piece would leave readers with the impression that this strong growth, at one point telling readers:
“Some economists anticipated that the better-than-expected GDP report, if coupled with encouraging data in the job market, could encourage the Fed to pull back its support for the economy sooner.”
The economy’s rate of potential growth is generally estimated as being between 2.2-2.5 percent. This means that rather than making up some of the 6 percentage point gap between potential output and actual output, the gap increased in the second quarter. Is the Post trying to tell us that a growing output gap will move up the date at which the Fed withdraws support for the economy?
But wait, it gets worse. The GDP data released on Wednesday also included revisions to prior quarters’ data. The revision to the prior three quarters’ growth rate (Table 1A) were sharply downward lowering growth over this period by 1.3 percentage points or an average of 0.4 percent per quarter. With the revised data, growth over the last year has been just 1.4 percent. This is supposed to be a justification for withdrawing stimulus?
I somehow missed this Post article touting the 1.7 percent growth rate reported for the second quarter as better than expected. First it is incredible that the piece would leave readers with the impression that this strong growth, at one point telling readers:
“Some economists anticipated that the better-than-expected GDP report, if coupled with encouraging data in the job market, could encourage the Fed to pull back its support for the economy sooner.”
The economy’s rate of potential growth is generally estimated as being between 2.2-2.5 percent. This means that rather than making up some of the 6 percentage point gap between potential output and actual output, the gap increased in the second quarter. Is the Post trying to tell us that a growing output gap will move up the date at which the Fed withdraws support for the economy?
But wait, it gets worse. The GDP data released on Wednesday also included revisions to prior quarters’ data. The revision to the prior three quarters’ growth rate (Table 1A) were sharply downward lowering growth over this period by 1.3 percentage points or an average of 0.4 percent per quarter. With the revised data, growth over the last year has been just 1.4 percent. This is supposed to be a justification for withdrawing stimulus?
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