My new column for National Journal is about mounting fears of recession next year. (lt starts with a discussion of a recent piece for the FT by Larry Summers. That article is here.)

Alarm about the state of the economy and the risk of outright recession next year continues to mount. In the Financial Times on November 25, former Treasury Secretary Lawrence Summers — a more astute or experienced observer would be hard to find — raised eyebrows when he seemed to put the chances of recession at better than 50-50, even assuming that policy is changed to address the danger:

Three months ago it was reasonable to expect that the subprime credit crisis would be a financially significant event but not one that would threaten the overall pattern of economic growth. This is still a possible outcome but no longer the preponderant probability. Even if necessary changes in policy are implemented, the odds now favor a U.S. recession that slows growth significantly on a global basis. Without stronger policy responses than have been observed to date, moreover, there is the risk that the adverse impacts will be felt for the rest of this decade and beyond.

Summers points to three main factors. First, the housing market continues to tank. There are signs (in derivatives markets) that house prices may eventually fall by a quarter from their peak — about as big a drop as between 1925 and 1933, the only other housing-market crunch that comes close. So far, the market is not even halfway there. Second, the implications of all this turmoil have hardly yet begun to work their way through the economy. Mortgage foreclosures could double next year. Banks and other financial firms have to date acknowledged losses arising from the crisis of only around $50 billion; actual losses are undoubtedly much bigger, some think as high as $400 billion. Third, the flight to quality in credit markets continues, meaning that troubled banks will find it harder and more expensive to attract capital, just as their need to do so is at its greatest.

What, then, are the remedies? Summers wants the Fed to "get ahead of the curve" and ease interest rates more aggressively. He says that fiscal policy should be on standby to deliver a big new stimulus. And he wants new institutional measures to deal with the credit contraction. The Treasury sees the so-called superconduit as part of the answer — in effect, a coordinated mutual support arrangement in which banks get together and acquire assets from the weakest — but Summers is skeptical. He wants details: So far, he says, this plan is too vague.

In addition, Summers calls for bolder steps to keep finance flowing to creditworthy homebuyers, either through government-supported direct lending or through expanding the operations of Fannie Mae and Freddie Mac (the "government-sponsored entities" that channel finance to mortgage lenders). He also wants regulators to go further in helping distressed mortgage borrowers refinance their debts, for instance by establishing standard templates for restructuring, instead of treating every instance case by case.

The Summers agenda seems to make good sense, so one is bound to ask, why is all this not happening already?

The rest of my NJ column tries to explain. You can read the whole thing here (free link expires in a week).

Thomas Sowell questions the current US preoccupation with inequality.

Americans in the top one percent, like Americans in most income brackets, are not there permanently, despite being talked about and written about as if they are an enduring "class" — especially by those who have overdosed on the magic formula of "race, class and gender," which has replaced thought in many intellectual circles.

At the highest income levels, people are especially likely to be transient at that level. Recent data from the Internal Revenue Service show that more than half the people who were in the top one percent in 1996 were no longer there in 2005.

Among the top one-hundredth of one percent, three-quarters of them were no longer there at the end of the decade.

These are not permanent classes but mostly people at current income levels reached by spikes in income that don’t last.

And Robert Samuelson takes a similar line.

Contrary to media coverage, the findings in three recent Pew studies qualify mostly as good news:

— When compared with their parents in the late 1960s, families today have a median income that’s 29 percent higher at $71,900 (and this understates gains in living standards, because families are about 25 percent smaller and the income figures exclude fringe benefits and non-cash government benefits).

— About two-thirds of today’s adults have incomes higher than their parents did — a result that is roughly similar for both blacks and whites (the children of the middle-income group of blacks were not typical).

— Almost 60 percent of the children born of the poorest families moved up the income distribution (23 percent into the second poorest fifth and 6 percent into the richest fifth).

Indeed, the high degree of intergenerational economic mobility is Pew’s most interesting finding. What happens at the bottom of the income scale also happens at the top. About 60 percent of children born of the richest fifth of parents do not themselves end up among the richest fifth; about 23 percent drop into the next to highest group and 9 percent fall to the bottom. Parents influence their children’s destiny but do not determine it.

Everyone knows that economic inequality has increased in recent decades. The richest 10 percent to 20 percent of Americans have gotten richer faster than the rest. But the people at the top are not all the same people or even the children of the same people. This vindicates one version of the American Dream. There is opportunity. People do move up — in both total income and class rank. Economic success is not static.

All true, but as I have pointed out before, the most surprising evidence on economic mobility compares the United States with other countries. The findings do not give strong support to the idea that America is the land of opportunity. Movement out of the top and bottom quintiles  is lower than in many other countries, including Canada and (maybe) Britain. Yes, there is opportunity, and people do move up–but not as readily (out of the lowest quintile, anyway) as elsewhere.

VoxEU has an intriguing post by Keith Head, Thierry Mayer and and John Ries, about their work on distance effects in trade in services. Surprisingly, they find some.

Using theory and estimated distance effects, we are able to measure the extent to which geographic separation insulates local workers from foreign competition. The calculations reveal that, from the point of view of a London service purchaser, workers in Oxford can be paid 99% to 373% more than workers in Bangalore in productivity-adjusted wages and yet still be more attractive, once service-delivery costs are taken into account. This is because the Bangalore workers are 100 times more distant from London than the Oxford workers.

Those results indicate that geographic barriers offer high-wage workers substantial insulation from low-wage competitors based in remote countries. Distance has long acted as a serious impediment to international transactions. Unfortunately, most of what we know about the effects of distance on international transactions is based on studies of trade in goods. A consensus appears to be forming that freight costs cannot explain the strength and functional form of the distance effect for goods. Instead, physical distance seems to be picking up some combination of the barriers imposed by cultural differences, the continued desire for face-to-face communication, and the geographically-biased structure of social and business networks. These factors apply to services as well as goods. Thus, there are two senses in which Mankiw is right to say it does not matter whether imports arrive by ship or by broadband. First, there will be potential gains from trade in either case. Second, there will be distance costs that limit the realisation of those gains.

How much should high-wage workers fear competition from much lower paid workers in India and China? Our findings suggest that distance still provides significant protection. Since these estimates reflect averages across a range of services, there are surely services where competition is especially acute. Moreover, service delivery costs associated with distance appear to have fallen over the last decade to a level that is slightly below the level estimated for goods. Unfortunately, the data do not clearly indicate whether distance costs for services will continue their downward trend or level off. We suspect that persistent cultural differences, as well as locally-biased social networks, will maintain distance costs at a high enough level to forestall the small, flat world envisioned by some journalistic accounts.

It makes sense of course that cultural differences and social networks should affect costs in delivering services. What I find a bit more puzzling is that those effects should be significantly correlated with distance. Isn’t Britain closer in those dimensions to the United States or Australia, say, than it is to France? Well, maybe not.

Fragile as the recent improvement in security in Iraq may be, it poses a problem for Democrats, as I argue in a new column:

The big question is whether the improving security now speeds America’s exit from Iraq, or strengthens its commitment to stay. You can argue it both ways. Lower levels of violence give cover for a withdrawal of troops without seeming to betray Iraqi victims of the war. Alternatively, diminishing violence shows that larger forces were needed – at the very least, it undermines the claim that America’s presence is making things worse – and thus lends support to the view that America should stay until the job is done. Pushing the same way, improved security lessens the American electorate’s opposition to staying engaged: losing a war, not fighting one, is what the country cannot tolerate. As the news from Iraq has improved (and as news on the economy has worsened), the war has begun to slip down the list of issues that voters say most concern them.

The gruelling option I reluctantly advocated before – a large continuing military commitment, in support of more modest goals – looks a little more feasible. Without delay, it needs to be supplemented with efforts to restore and improve Iraq’s economy. Electricity supplies have reportedly improved, but provision of water and sewerage has not. The health and education systems are in disarray. One in three Iraqis is unemployed. If the improvement in security persists, it offers an opportunity to begin addressing these issues. The aim should be to capitalise on Iraqis’ perception that their situation is at last improving.

The better news, though, poses a challenge for Democrats as the election approaches. Opposition to the war has been their chief theme. This still commands broad and strong support, of course, but the intensity could continue to fade. Republicans will seek opportunities to accuse Democrats of wanting the US to fail, or of wishing to snatch defeat from the jaws of victory – and those charges will acquire some force if the view that the surge has worked takes hold. For Democrats, even putting the recent fall in violence in its correct context poses a political risk, because it can be portrayed as failing to recognise the military’s efforts and achievements. If the Republican presidential contenders have any sense, they will tread very carefully here – while hoping that Democrats fall into the trap and helping them to if the opportunity presents itself.

You can read the whole column here.

Ruth Marcus of the Washington Post launches an angry attack on Paul Krugman’s recent column on Social Security, which accused Barack Obama of being played for a sucker on the issue.

The argument has two equally dishonest components. The first is to deny that Social Security faces a daunting financing problem — one that will be much easier to fix (and less onerous for the low-income retirees that the head-in-the-sanders purport to care about) sooner rather than later. The second is to mischaracterize the arguments of those who advocate responsible action, accusing them of hyping the system’s woes.

One prominent practitioner of this misguided approach is New York Times columnist Paul Krugman. "Inside the Beltway, doomsaying about Social Security — declaring that the program as we know it can’t survive the onslaught of retiring baby boomers — is regarded as a sort of badge of seriousness, a way of showing how statesmanlike and tough-minded you are," Krugman wrote last week. "In fact, the whole Beltway obsession with the fiscal burden of an aging population is misguided."

Somebody should introduce Paul Krugman to . . . Paul Krugman.

"[A] decade from now the population served by those programs [Social Security and Medicare] will explode. . . . Because of those facts, merely balancing the federal budget would be a deeply irresponsible policy — because that would leave us unprepared for the demographic deluge, with no alternative once it arrives except to raise taxes and slash benefits." (July 11, 2001)

[and so on]…

In addition to this fiscal amnesia, Krugman misrepresents responsible voices in the debate.

First, he quoted a new paper by Congressional Budget Office Director Peter Orszag and CBO analyst Philip Ellis. Notwithstanding "all the attention paid to demographic challenges," they conclude, "our country’s financial health will in fact be determined primarily by the growth rate of per capita health care costs."

True, but Krugman omits any mention of Orszag’s latest book, inconveniently titled "Saving Social Security." Orszag and co-author Peter Diamond wrote that "Social Security’s projected financial difficulties are real and that addressing those difficulties sooner rather than later would make sensible reforms easier and more likely."

Paul Krugman replies on his blog, under the headline, "They hate me! They really hate me!":

What I was arguing then was not that Social Security itself was in crisis, but that the rest of the government budget should be run responsibly — basically, that the lockbox should be honored. As I explained later,

Four years ago, I and many other economists urged policymakers to think about the future cost of Social Security benefits, not because we thought there was anything wrong with Social Security itself, but because we regarded the future costs as a compelling reason not to cut taxes even if the overall budget was in surplus.

As for what I wrote in 1996: the world looked very different then. On one side, Social Security projections were much more pessimistic than they are now, basically because the projections assumed that the 1973-1995 era of very slow productivity growth would go on forever. On the other side, the 90s were the era of the great pause in health expenditures, the (it turned out) brief era in which the rise of managed care stabilized health spending as a share of GDP. So Medicare and Medicaid looked less important as sources of fiscal problems than they do now.

John Maynard Keynes is supposed to have said, “When circumstances change, I change my opinion. What do you do?”

I think Paul’s rebuttal is correct, so far as the "circumstances" are concerned. But the circumstances are of course not the only thing to have changed since he opined on this topic in the past. His modes of analysis and expression have changed too, and radically, in ways that often seem calculated to obscure the fact that he is one of the four or five most brilliant economists of his generation. This is not incompetence or inadvertence on his part; it appears to be a conscientious choice. He wants to fuel the rage of the administration’s opponents more than he wants to help people think through the arguments. He feels that this now serves the greater good. Bush and his people are too wicked for dispassionate analysis, he believes; there will be time for Seriousness later.

In my view, for what little it may be worth, this is a disservice to Paul’s own remarkable talents as well as to the greater good. But this is a complaint which, by now, he has heard a thousand times.

Below the fold is my own view of the Social Security "crisis".

(more…)

The rules of US monetary policy have changed: the Fed has revised its reporting procedures in a potentially significant way. The first set of the more detailed minutes of FOMC meetings that Ben Bernanke promised last week was published on Tuesday, covering the meeting that took place on October 30-31.

I’m still unsure whether it is correct to regard the new regime as de facto inflation-targeting, as many Fed-watchers are suggesting. The case for this interpretation is that (a) the Fed is now publishing three-year-ahead inflation forecasts; (b) these forecasts are conditioned on "appropriate monetary policy"; and (c) three years is long enough for "appropriate monetary policy" to get inflation to the desired rate. But there are a couple of complications. One is that the Fed publishes a range of inflation forecasts, encompassing the individual projections of FOMC members. For 2010 the range is 1.5 percent to 2 percent. But this does not quite mean that the FOMC collectively regards a range of 1.5-2.0 as appropriate. Even assuming that all the members agree with (c), which they may not, it means that at least one member thinks a rate of 1.5 percent is appropriate in 2010 under expected circumstances whereas at least one other thinks that a rate of 2.0 percent is appropriate.

Well, since the range is narrow, one could overlook this–especially if the spread continues to be just half a point in future. We will see about that. But I would still hesitate to call this even a de facto inflation-target regime. The big thing that is missing is accountability. There is no real pressure on the Fed to hit its supposed "target". When the Bank of England overshoots its inflation target, it has to explain itself, and it cannot tell the Treasury, "Well, it was only a forecast." If inflation in 2010 is less than 1.5 percent or more than 2.0 percent, I’m willing to bet that that is exactly what the Fed will say. Unless, of course Bernanke tweaks the rules again in the meantime.

James Hamilton has questions, too, though he definitely leans towards the inflation-target interpretation. I found his comments enlightening–and note that they have an actionable corollary.

[T]he FOMC is saying that, if the Fed…does what they [the FOMC] think it should, GDP is going to be growing more slowly and inflation is going to be lower three years from now than a forecast that did not condition on the assumption of such Fed behavior would have anticipated. I believe the spirit of this exercise is to communicate to us that if GDP is growing at 3% in 2010 but inflation is not under 2%, they intend to raise interest rates to bring both down.

For comparison, the 10-year expected CPI inflation implicit in the nominal-TIPS yield spread is over 2.3%. Taken at face value, the Fed is trying to warn us that it intends to be tougher on inflation than markets currently are betting on, and, as I commented last week, the market at the moment appears if anything to be surprisingly confident in the Fed’s ability and commitment to keep inflation low.

Now, that raises the question– If at some point in the future the Fed is going to surprise the market with a more hawkish policy than is currently anticipated, when will that surprise come? One obvious answer– at the coming December 11 FOMC meeting, for which fed funds options and futures presently seem to be betting pretty heavily on seeing another cut in the fed funds target. If the Fed means what it says with these just-released minutes, the market is wrong to assume that the fed funds target will be lowered to 4.25% on December 11.

We will see what happens on December 11.

I’ve just ordered my Kindle, and felt the world would wish to know. (Early-onset blogo-narcissism, clearly.) A strange name, don’t you think? Burning books, as widely noted, does spring irresistibly to mind. And a peculiar-looking object too. I’m wishing the Apple design team had given it a once-over, as soon as they had stopped laughing. But the functionality is the draw, especially for one who, for the first time in his life, has finally run out of bookshelves and acceptable substitutes for bookshelves and, over the course of the cycle, is now having to discard a book for every new one he buys. Like pay-go rules for Congress, an intolerable state of affairs.

An interesting debate involving my FT colleague Willem Buiter, who thinks that a falling dollar could become very bad news for the US economy, and Paul Krugman and Brad DeLong, who are much more relaxed. Since all three know their international macro, I speculate that the difference turns not on economic insight but on a European as against an American perception of the issue. A currency depreciation as big as the one the dollar has already experienced–to say nothing of the prospect of a further drop–would be a big inflationary problem for a small, open economy like Britain (which still has a currency of its own). The effect is muted for the US, because its economy is bigger, less open (not because of import restrictions, but by virtue of its size), and because exporters selling to America are more inclined to price to market. Come to think of it, that is just three different ways of saying, "its economy is bigger".

Willem address the point explicitly:

With US long-term real interest rates now set largely by world markets rather than by domestic monetary and fiscal policy,  the US policy makers  will have to get used to operating in a setting that is quite unlike the closed economy paradigm that they grew up with, and more like like a small open economy.  On the financial side, it has, effectively, already happened.

Paul says:

One way [to argue that the results of a dollar fall might be very bad] is to argue that the Fed will have to raise interest rates more than is necessary to stabilize employment. The usual reason given is that the falling dollar will be inflationary, so the Fed will have to support the dollar with higher interest rates to ward off this inflation. OK, this could be right, but I have a hard time making the numbers look big enough to get worried about: imports are only 16 percent of GDP, and exchange rates are much less than fully passed through into import prices. The big dollar fall from 1985 to 1988 wasn’t notably inflationary.

Paul goes on:

Another argument I used to make was that a dollar plunge would pop the housing bubble, setting in motion a rapid fall in domestic demand that would outpace any rise in exports. But the bubble popped all on its own, so I don’t think this is still valid.

Finally, there’s a fairly subtle argument about term structure and timing.
You see, the Fed only controls short-term interest rates, while investment spending depends on long-term rates. Meanwhile, the effects of a weak dollar on exports take a while, maybe as much as two years, to take full effect.

So there’s a story that runs something like this: a plunging dollar will eventually be very expansionary, and will force the Fed to raise rates to cool off the economy — not now, but a year or two from now. But the expectation of this future rise in short-term rates will push up long-term rates now, causing a recession even if the Fed does nothing. This story depends on the effect of interest rates on demand working faster than the effect of the exchange rate on exports.

I guess this could work. But it’s a fairly tricky story, and a lot subtler than the alarm I’ve been hearing.

The American economy–to my British eyes–does seem astoundingly immune to the inflationary implications of currency depreciation. By itself, this would incline me to Paul’s and Brad’s view of the matter. But now add oil prices into the mix, and the risk that they might yet go higher. If nothing else, this adds another complication to the Fed’s calculations. And the popping of the housing bubble is not an all or nothing thing, as Paul seems to say. Higher interest rates could turn the slump in the housing market into a rout; debtors are screaming already. However you look at it, this is an environment in which short-term interest rates are being asked to shoulder a much larger burden than they can carry. I think it would be better if an abrupt flight from the dollar stayed in the realm of thought-experiment. 

Other things equal, I am a tax-cutter not a tax-increaser. The leftist instinct to regard a tax increase on the rich as a good thing in itself–that is, to see a tax increase on the rich as a good thing even if the revenues were spent uselessly–repels me. Having declared that prejudice, I find nothing to disagree with in this new appraisal of the Bush tax cuts by the (left-leaning) Center on Budget Policy and Priorities.

Since 2001, the Administration and Congress have enacted a wide array of tax cuts, including reductions in individual income tax rates, repeal of the estate tax, and reductions in capital gains and dividend taxes.  Nearly all of these tax cuts are scheduled to expire by the end of 2010.  Making them permanent would cost about $3.5 trillion over the next decade (when the cost of additional interest on the federal debt is included).

Because important decisions about these tax policies must be made in the next few years, it is essential to understand their effects on deficits, the economy, and the distribution of income.  Supporters of the tax cuts have sometimes sought to bolster their case by understating the tax cuts’ costs, overstating their economic effects, or minimizing their regressivity.  Here, we address some of the myths heard most frequently in recent tax-cut debates.

The center’s analysis is well worth reading in full.

Barry Eichengreen has a post on Voxeu about how difficult it would be for a country to make an orderly exit from the euro. (The column draws on a longer NBER working paper.) The strength of the euro is squeezing Europe, and especially Italy, very hard. There is some talk of pulling out of the euro system. If only. Italy would surely benefit if it could. But, as Eichengreen explains, it literally cannot without precipitating a really fearsome financial crisis.

In 1998, the founding members of the euro-area agreed to lock their exchange rates at the then-prevailing levels. This effectively ruled out depressing national currencies in order to steal a competitive advantage in the interval prior to the move to full monetary union in 1999. In contrast, if a participating member state now decided to leave the euro area, no such precommitment would be possible. The very motivation for leaving would be to change the parity. And pressure from other member states would be ineffective by definition.

Market participants would be aware of this fact. Households and firms anticipating that domestic deposits would be redenominated into the lira, which would then lose value against the euro, would shift their deposits to other euro-area banks. A system-wide bank run would follow. Investors anticipating that their claims on the Italian government would be redenominated into lira would shift into claims on other euro-area governments, leading to a bond-market crisis. If the precipitating factor was parliamentary debate over abandoning the lira, it would be unlikely that the ECB would provide extensive lender-of-last-resort support. And if the government was already in a weak fiscal position, it would not be able to borrow to bail out the banks and buy back its debt. This would be the mother of all financial crises.

What government invested in its own survival would contemplate this option? The implication is that as soon as discussions of leaving the euro area become serious, it is those discussions, and not the area itself, that will end.

A cynic’s instinct would be to say that scholarly articles explaining why the euro system cannot break up mark the beginning of the end–but Eichengreen’s logic seems impeccable. Italy would surely have been better off if it had never joined the system (an isssue Eichengreen does not go into here), but it is too late for regrets now.  The title of the column is the only mistake I can see. "The euro: love it or leave it?" That  surely ought to be: "The euro: like it or lump it [no question mark]."