Inflation, again

About six months ago I posted about the nonsense in worrying about inflation in the middle of a weak recovery. Since the topic keeps coming up as an argument against further monetary stimulus I want to point out that I was right then, and I still am. This is a dangerous thing to do in the economics profession: Irving Fisher, one of the greatest economists of all time, is best remembered for his statements about the “permanently high plateau” of stock prices months before the 1929 crash. But confidence abounds. Inflation won't take hold until capacity utilization is higher than average, driving the cost of production (and then prices) up[1]. The Fed can greatly influence inflation by raising (to lower inflation) or lowering (to increase inflation) interest rates.

It is pretty obvious that capacity utilization is still below average (think about the spare labor capacity). The people who have preached doom about inflation have been wrong now for four years, and have had a detrimental influence on government policy the whole time. In fact, since my original statement on the non-threat of inflation, inflation has dropped by over a percentage point.

Other measures of inflation tell much the same story.

Along with the fear of inflation, the Fed has been criticized for punishing savers and investors by keeping interest rates so low. Jim Demint recently admonished the Fed Chairman that he was costing Americans “about $400 billion a year on lost interest”. I didn’t bother finding out where the figure comes from because, though I understand the logic behind it, it is wrong.

All of this is related because during and after a financial crisis it is deflation that is the true threat. As Irving Fisher pointed out, the sever deflation that set in after the crash caused real debt burdens to increase. That is, deflation increased the value of outstanding debts faster than individuals, governments, and businesses could pay them off. The collective action of reducing spending to pay off debts merely increased the rate of deflation. 

 

The unshaded portions of the "1933" bars represent the amounts in 1929 $s. Notice that while national wealth decreased greatly internal debt actually rose.

The solution was easy, looser monetary policy to bring prices and inflation back to “normal” levels. By acting quickly and unprecedentedly this time around, the Fed stopped deflation and kept the downward spiral from kicking in. Since the average American household had debt of over 130% of disposable income, the Fed’s actions have saved Americans money by keeping their real debt burden from growing uncontrollably.

Economics, Politics, Sailing, and Realism

"The same persons who cry down Logic will generally warn you against Political Economy. It is unfeeling, they will tell you. It recognises unpleasant facts. For my part, the most unfeeling thing I know of is the law of gravitation: it breaks the neck of the best and most amiable person without scruple, if he forgets for a single moment to give heed to it. 
The winds and waves too are very unfeeling. Would you advise those who go to sea to deny the winds and waves - or to make use of them, and find the means of guarding against their dangers? My advice to you is to study the great writers on Political Economy, and hold firmly by whatever in them you find true; and depend upon it that if you are not selfish or hard-hearted already, Political Economy will not make you so."

- John Stuart Mill

Outsourcing is a Good Thing

Recently the topic of outsourcing has again become popular in the news. The scandal is currently over whether Mitt Romney was working at Bain Capital when they closed down some companies and moved jobs overseas. I would like to point out that if these companies had not either already gotten themselves into trouble or been out-competed elsewhere, a company like Bain wouldn't be buying them. It’s not Bain’s fault the most profitable thing they could do was declare bankruptcy. Second, it doesn’t matter if Romney was at Bain when they outsourced jobs. Outsourcing is in fact good for the world economy, and good for the poor. As economist Paul Krugman put it back when he was still cool:

“The lofty moral tone of the opponents of globalization is possible only because they have chosen not to think their position through. While fat-cat capitalists might benefit from globalization, the biggest beneficiaries are, yes, Third World workers.”

The jobs that have left the United States in search of cheap labor left because wages here are too high relative to destination countries to economically justify keeping them in the United States. This is a good thing; it means we are a developed country. The flip side of this is that the wages outsourced jobs offer to developing country workers are as good or better than the alternatives for those workers, otherwise they would not take the jobs. The increased availability of outsourced jobs increases competition for workers, and increases wages of the world’s poorest. And there is overwhelming evidence of this in the 1 billion people who have been raised out of poverty in the past couple decades.

It gets even better, because outsourcing is good in net for the countries that jobs leave. First, outsourcing, if rational, reduces the cost of production, which inevitably gets passed on to consumers. The effect is upward pressure on the real wages of consumers who can now buy more for the same money. And many of our imports are inputs for final production in the United States, meaning more profitable production, and thus more jobs here.

In spite of all this it could very well be possible that the effect on jobs and wages is negative for developed country workers, but only in the short run. Increasing wages in developing countries eventually reduce the incentive to outsource jobs in the first place. Already thousands of jobs that were outsourced to China are returning to the United States as wages rise in China. And there is much higher domestic demand for products all around the world in developing countries. The United States’ trade deficit has closed considerably in recent years. And despite decades of outsourcing the export sector in the remains one of the bright spots in our economy.

Mitt Romney should stand up for himself. He need not have been motivated by anything more than profits to have brought benefits to the poor in developing countries, and to consumers in developed countries. And the opponents of outsourcing and globalization should realize that their opposition keeps people poor for the benefit of the few, hardly a sound strategy to reduce inequality.

What's the Fed up To?

Given the bad economic news of late, many eyes have turned to the Fed as it seems to be the only institution left with the ability to act. Central Banks the world over have been stepping in: The Bank of England started a new round of Quantitative Easing[1], the European Central Bank, the Bank of Korea, the Central Bank of Brazil, and of China have lowered their target interest rates to ease lending[2]. 

Though it has not made big news, the Fed did recently act by embarking on a second installment of “Operation Twist” (OT). OT is a process where the Fed tries to twist the yield curve for government bonds to push down long term interest rates and push up short term interest rates (see out of date graph below). The Fed does this by selling its short term bonds and buying long term bonds, in this way the action puts no upward pressure on inflation. Basically, when one buys a bond they are purchasing the future stream of interest payments that bond will generate should the borrower not default, therefore, the higher the bond price the lower the real interest rate. Reducing long term interest rates is the more important goal because it will stimulate (in theory) capital investment and housing demand.

But this additional action is more appearance that substance. The effectiveness of the practice in general is still highly debatable. The law of diminishing returns holds that each additional bond sold and bought by the Fed will have less and less of an effect, another round of OT will thus be less effective than the first (which hasn’t exactly fixed the economy). The Feds stock of short term bonds is not infinite and it would be very unwise to sell them all and reduce the diversity of bonds held. According to Macroeconomic Advisers (a consultancy I enjoy referencing), as the Fed sells off its short term bonds it will eventually need to sell off short term bonds of a longer maturity, decreasing its effectiveness further.

So why do it? The Fed has constantly been saying that if the economy slowed further it would take stimulative action. In fact they just yesterday teased at this prospect again. Given their statements, and the poor state of the economy when the first round of OT ended, doing nothing more would have the appearance of withdrawing stimulus. Put simply, the Fed has acted to keep people from noticing that it has not really acted. 

That being said I think the Fed is a great institution. If only other institutions, such as the FDA and EPA were as politically independent with as clear a mandate. 

June Jobs Report

 
Another terrible jobs report, only 80,000 jobs were added in June. The numbers for previous months were barely changed (red line). Just like last year, the economy has stagnated after a strong winter. The trend is now pretty ingrained and growth forecasts the world over are being cut. In other news inflation has decreased and is below the Fed’s low 2% target. So unemployment is above target (ie. “The natural rate”) and inflation is below target. The Fed is now missing on both ends of its mandate rather than just the employment side, yet it doesn’t act. And crazy people continue to worry about inflation.

At the end of this year we face what is being appropriately called a “fiscal cliff”. Taxes across the board are going to go up and discretionary spending (the part that isn’t contributing to our unsustainable debt) will be slashed. The combined effect of this will likely put us back into a recession. The CBO recently estimated that the full effect of the fiscal cliff will cut growth to 0.5% of GDP next year (it is currently around 2%). And unemployment will rise above 9%. What CBO projections don't include is psychology. If growth decreases that suddenly and unemployment increases the negative effect on confidence and expectations could easily put the economy into a recession. If politicians continue to fail us, this may be the best economy we'll see for years.