Argentina in December 2001 versus Europe in December 2011

This month marks the ten-year anniversary of Argentina’s massive sovereign debt default, an event with many lessons for the European sovereign debt crisis of today, though analogies are far from perfect.

First, as has been discussed and debated on planet money and naked capitalism, the Argentine economy actually recovered quickly from the painful default and crisis of 2001 after it negotiated a substantial write-down of its sovereign debt.

Second, the experience of Argentine’s neighbor Uruguay shows that the economic pain of such crisis is less severe if a more orderly restructuring is employed from the start rather than a chaotic default. Such an orderly restructuring could have taken place in Greece two years ago as it did in Uruguay ten years ago as veteran debt expert Carlos Steneri and I discuss with Juan Forero in this NPR price "What Greece Can Learn from South America" which aired last week. (I worked closely with Steneri during the Uruguayan crisis when I was US Treasury Under Secretary).

Third, and most important, despite the immediate and sharp impact of the default in Argentina, there was very little international contagion at the time of the default. This outcome was contrary to many warnings at the time that such a default would have large contagion effects much as the Russian default three years earlier in 1998. The first chart shows the contagion following the Russian default in terms of emerging market bond spreads in Asia. The second chart shows, using the same measure, that there was virtually no contagion following the Argentine default.

In my view the reason for this remarkable difference is that the IMF and the international policy community was clear (at least following an increase in loans in August 2001) that the bailouts of Argentina would stop, making a debt restructuring inevitable or at least more predictable than the surprise withdrawal of support for Russia in 1998 which caused the contagion then. Contagion is not automatic if the policy is clear and predictable.

As the investigative reports in the Wall Street Journal this week make clear, this same type of fear of contagion (expressed, according the the WSJ story, very strongly by Jean-Claude Trichet during the past two years) is why a restructuring of Greek sovereign debt has been kicked down the road so many of times. Instead of reducing the role of bailouts as occurred for emerging markets around the time of Argentina, the role of bailouts in European policy has increased and this has made policy even less predictable. As the prospects of bailout increased, the political incentives to take action to reduce deficits and debt decreased as evidence in Italy over the past year and made the crisis much worse.

The Return of the Best Economics 1 Lecturer Ever -- Plus One

This fall was a great quarter to teach the introductory course (Economics 1 at Stanford) with plenty of good examples from Occupy Wall Street, the crisis in Europe, the continuing debate in Washington over economic policy, and the rising federal debt. Unfortunately nothing much has changed about the debt as I tried to illustrated with the return of a guest lecturer.  

In 2009 I invited this guest lecturer to my Economics 1 class to illustrate the burdens of the debt on future generations.  Though only a few months old, the guest lecturer turned out to be the best ever (here is a  video excerpt). Students in that class still remember her message as she looked up at the exploding debt chart on the big screen, and said "fix it."

So this fall I invited her back to this year’s Economics 1 class , and her brother joined her, as seen in this second video excerpt (click on the closed caption option as the audio is weak).  Again she looked up at the chart on the big screen in the lecture hall , and again it was "scary." In fact, it was even worse! Unfortunately, no one has fixed it, either in 2009,  2010, or 2011. I said I'd like to keep bringing them back as guest lecturers until it is fixed. 

(The chart in the first video was developed from Congressional Budget Office data from the long term projection made in 2009; the chart in the second video is from the CBO long-term projection made in 2011.)

Economic Freedom in the News

People are writing about economic freedom a lot these days. George Will’s recent Washington Post column Testing the Waters of Economic Liberty focusses on a big deviation from economic freedom in the State of Washington with implications for America. Jeb Bush’s recent Wall Street Journal article Capitalism and the Right to Rise summarizes the great benefits of economic freedom to improve people's lives.  My new book, First Principles, out in January, shows that America has deviated from the principles of economic freedom in recent years, and proposes ways to get back to them.  

Of course the concept of economc freedom has been a pillar of basic economics courses for years. When I lecture about economic freedom to Stanford students  I like to build on the Stanford motto which translates from the German words on the Stanford seal as “Let the Winds of Freedom Blow” 

Krugman is Wrong

Paul Krugman is wrong in his criticism of my brief summary of last week’s economic policy conference at Stanford’s Hoover Institution. Krugman was not at the conference, which lasted a full day and went well beyond previous research by the participants.  In general people focused on policies to restore strong economic growth and reduce unemployment in the United States.

First, Krugman incorrectly claims that I mischaracterized the research of my Stanford colleague Nick Bloom and his coauthors Scott Baker and Steve Davis presented at the conference. Krugman says my conference summary suggested that “Bloom, Baker and Davis had showed that fear of Obama was holding the economy down.” No, my summary said or implied no such thing; there is no mention of Obama, Bush, or any politician in my summary. It simply says that these authors “presented their empirical measures of policy uncertainty and showed that they were negatively correlated with economic growth.” And that is what they did at the conference. Second, Krugman claims that my summary mischaracterized the presentation of my Stanford colleague Bob Hall, making it look like something it wasn't. My summary referred to Bob’s interesting presentation at the conference. As part of his presentation Bob said that now and going forward we should assume “no chance of conventional fiscal expansion; rather, possible cutbacks motivated by excessive federal debt.” That is why Bob focused his paper at the conference on monetary policy and the problem of the zero lower bound, and that was what all the discussion of his paper was about, rather than on his earlier work on the multiplier, which is now part of a huge literature recently nicely reviwed by Valerie Ramey.

I stand by my brief summary of the conference as a being accurate. Lee Ohanian and I, as co-organizers of the conference, hope that we can soon get a book published containing the full proceedings (written versions of the individual presentations and many comments by participants), as has been done with other recent Hoover economic policy conferences: The Road Ahead for the Fed and Ending Government Bailouts As We Know Them. We hope the results of each author will be read carefully by policy makers and other researchers.

Restoring Robust Growth in America

Why has the recovery been so slow? What can we do about it? Alan Greenspan, George Shultz, Ed Prescott, Steve Davis, Nick Bloom, John Cochrane, Bob Hall, Lee Ohanian, John Cogan and I recently met at the Hoover Institution at Stanford to present papers and discuss the issue with other economists and policy makers including Myron Scholes, Michael Boskin, Ron McKinnon and many others. Here is the agenda.

We plan to publish a book on the conclusions, but here is a very brief summary of the presentations. George Shultz led off by arguing that diagnosing the problem and thus finding a solution was extraordinarily important now, not only for the future of the United States but also for its leadership around world. Tax reform, entitlement reform, monetary reform, and K-12 education reform were at the top of his pro-growth policy list. Alan Greenspan presented empirical evidence that policy uncertainty caused by government activism was a major problem holding back growth, and that the first priority should be to start reducing the deficit immediately; investment is being crowded out now. He also recommended starting financial reform all over again because of the near impossibility of implementing Dodd Frank. Nick Bloom, Steve Davis and Scott Baker then presented their empirical measures of policy uncertainty and showed that they were negatively correlated with economic growth.

Ed Prescott had the most dramatic policy proposal which he argued would cause a major boom and restore strong growth. He would simultaneously reform the tax code and entitlement programs by slashing marginal tax rates which would increase employment and productivity. John Cochrane focused on the bailout problems in the European and American financial sectors, arguing that they would continue to be a drag on growth until policy makers stopped kicking the can down the road.

Bob Hall argued that fiscal policy was not working, and focused on alleviating the zero lower bound constraint on monetary policy. One of his proposals was a gradual phase-in of a tax reform in the form of a consumption tax, which would make consumption today relatively cheap and thereby increase aggregate demand. I presented research with John Cogan on fiscal policy showing that it had not been successful in raising government purchases and was ineffective regardless of the size of the multiplier. Finally Lee Ohanian showed that unemployment remained high in part because of restrictions on foreclosure proceedings which increased search unemployment by allowing people to stay in their homes for longer periods of time.

In sum there was considerable agreement that (1) policy uncertainty was a major problem in the slow recovery, (2) short run stimulus packages were not the answer going forward, and (3) policy reforms that would normally be considered helpful in the long run would actually be very helpful right now in the short run.

Omitted Facts in a Speech on Omitted Variables

Christina Romer gave a speech at Hamilton College earlier this month which criticizes my findings that recent temporary tax rebates had little or no effect on aggregate consumption. Romer claims that in analyzing this “relationship between two variables” I did not consider the impact of third variables “influencing both of them.”

Romer’s claim is wrong. In fact, in my paper which Romer cites (first presented on January 4, 2009 at the AEA meetings and published in the American Economic Review), I explicitly state that one must take account of other variables. Here is a quote from that paper: “policy evaluation requires going beyond graphs and testing for the impact of the rebates on aggregate consumption using more formal regression techniques….an advantage of using regressions is that one can include other factors that affect consumption.” In that investigation, which focused on the 2001 and 2008 rebates, I used monthly data and included in the regressions monthly data on oil prices, which rose dramatically in the first half of 2008 and which would be expected to reduce consumption around the time of the rebates. Indeed, oil prices had a highly significant coefficient in the regressions, and yet I found no significant effect of the rebates as shown in Table 2 of the paper. In another paper published in the Journal of Economic Literature, (discussed in the blogosphere here and here) I used quarterly data to investigate the 2001 and 2008 stimulus packages and also the 2009 stimulus. With quarterly data, I also included a household net worth variable from the Fed’s flow of funds accounts, along with the quarterly average of oil prices. The net worth variable had a significant effect, and yet I still found no statistically significant impact of the temporary payments as shown in Table 1 of the JEL paper.

In sum, my research does consider the impact of third variables, contrary to what Romer claimed. And the results I reported are robust to adding such variables, contrary to what Romer conjectured.

More on Nominal GDP Targeting

Several people have asked me to comment on nominal GDP targeting, as recently proposed by Scott Sumner, Christina Romer and Paul Krugman. I did research on nominal GDP targeting many years ago and found that such targeting proposals had a number of problems, which I summarized in the paper “What Would Nominal GNP Targeting Do to the Business Cycle?” Carnegie-Rochester Series on Public Policy, 1985. Although much has changed in the past quarter century I find many of the same problems with the recent proposals.

One change is that, in comparison with earlier proposals, the recent proposals tend to focus more on the level of NGDP rather than its growth rate. This removes some of the instability of NGDP growth rate targeting caused by the fact that NGDP growth should be higher than its long run target during the catch up period following a recession. But it introduces another problem: if an inflation shock takes the price level and thus NGDP above the target NGDP path, then the Fed will have to take sharp tightening action which would cause real GDP to fall much more than with inflation targetting and most likely result in abandoning the NGDP target.

A more fundamental problem is that, as I said in 1985, “The actual instrument adjustments necessary to make a nominal GNP rule operational are not usually specified in the various proposals for nominal GNP targeting. This lack of specification makes the policies difficult to evaluate because the instrument adjustments affect the dynamics and thereby the influence of a nominal GNP rule on business-cycle fluctuations.” The same lack of specificity is found in recent proposals. It may be why those who propose the idea have been reluctant to show how it actually would work over a range of empirical models of the economy as I have been urging here. Christina Romer’s article, for instance, leaves the instrument decision completely unspecified, in a do-whatever-it-takes approach. More quantitative easing, promising low rates for longer periods, and depreciating the dollar are all on her list. NGDP targeting may seem like a policy rule, but it does not give much quantitative operational guidance about what the central bank should do with the instruments. It is highly discretionary. Like the wolf dressed up as a sheep, it is discretion in rules clothing.

For this reason, as Amity Shlaes argues in her recent Bloomberg piece, NGDP targeting is not the kind of policy that Milton Friedman would advocate. In Capitalism and Freedom, he argued that this type of targeting procedure is stated in terms of “objectives that the monetary authorities do not have the clear and direct power to achieve by their own actions.” That is why he preferred instrument rules like keeping constant the growth rate of the money supply. It is also why I have preferred instrument rules, either for the money supply, or for the short term interest rate.

Rules for the instruments are what monetary policy needs, not excuses for discretionary actions. I welcome more research looking for better instrument rules which are explicit and operational enough to be evaluated with empirical economic models. Even an historical comparison of different rules would be welcome, and Allan Meltzer's monumental History of the Federal Reserve would be a good foundation to build on. As he summarized in a speech this week, “Economists and central bankers have discussed monetary rules for decades. A common response of those who oppose a rule, or rule-like behavior, is that a central banker’s judgment is better than any rule. The evidence we have disposes of that claim. The longest period of low inflation and relatively stable growth that the Fed has achieved was the 1985-2003 period when it followed a Taylor rule. Discretionary judgments, on the other hand, brought the Great Depression, the Great Inflation, numerous inflations and recessions. The Fed contributed to the current crisis by keeping interest rates too low for too long.”

Price Explosion for Stanford Oregon Tickets

We just finished Week 7, and Lecture 27, in Economics 1 with a midterm exam coming up next week. What a great time to be teaching and learning economics, with the questions about the bailouts and the top 1 percent coming out of OWS, debate over another stimulus package, the debt crisis in Europe, presidential candidates proposing major tax reform, and great sports examples, especially at Stanford with football nationally ranked at No 2 in the USA Today poll and No 3 in the AP top 25.

Of course that’s a learning experience not only for the fans and players in class who have to allocate scarce time to prepare for the Stanford-Oregon game tomorrow and the midterm next week, but also for anyone who wants to understand markets and the role of prices in allocating scarce resources, namely tickets to the crucial game tomorrow. The price of tickets to the game has exploded in the seven weeks since the term started. As the chart shows the price of an average ticket has gone from $124 when we started the course to $302 now, an increase of 142%. Some tickets are going for as a high at $650 today according to StubHub.

More On Economic Freedom and Monetary Policy

My Wall Street Journal article today is quite critical of recent interventionist fiscal and monetary policies in the United States. In my view, they have not only been unhelpful to the American economy, they have also been unhelpful to the world economy. The monetary and fiscal policies I am criticizing go back to before the start of the Obama administration, as I showed in this article on fiscal policy recently published in the Journal of Economic Literature and in this piece on monetary policy published in November 2008 by the Bank of Canada. So I view this criticism as being non-partisan, as has been my historical review of the swings between rules and discretion.

In a long rebuttal to my criticism in today’s Wall Street Journal article, David Glasner argues that I mischaracterized America when I wrote that it was a leader in economic freedom following World War II, when it helped Japan and Europe recover and helped create the GATT and other international financial institutions. It is certainly true that American economic policy was not perfect with its regulations and high marginal tax rates, but comparatively speaking the American model was a far cry from what was being set up in the large areas of the world which were not free either economically or politically. 

Another quite different part of his rebuttal is the argument that I had a different view of monetary policy as implemented in Japan in the early 2000s, when I was U.S. Under Secretary of Treasury for International Affairs, a period which I reviewed in my book Global Financial Warriors. I had similar views in the 1990s when I was a foreign honorary adviser to the Bank of Japan.

For several reasons, the economic policy situation in Japan in the 1990s and early 2000s, when I was in the Treasury, was quite different from the situation in United States today  In the 1990s, but especially in the early 2000s, there was a deflation in Japan: the GDP deflator fell from 1999 to 2003. In the United States we have seen no such prolonged declines in the GDP deflator in recent years.

Second, the purpose of increasing the monetary base in Japan, as I argued in those days, was to get the growth rate of the money supply (such as M2+CD) back up. As I showed when I was an adviser to the BOJ, a decline in money growth was largely responsible for the deflation and for the poor economic performance in the 1990s. So the goal of the Japanese policy in the early 2000s, which I was approving of while I was at Treasury, was to get money growth back up. It was not to try to drive up temporarily the price of mortgage securities or stock prices, which is what is frequently used to justify the quantitative easing by the Fed today. Here are my specific views on Japan written while I was an adviser to the BOJ.

A third difference is related to the rules versus discretion debate. If a central bank follows a money growth rule of the type Milton Friedman argued for—and which is quite appropriate when the interest rate hit zero in Japan—then the central bank should increase the monetary base to prevent money growth from falling or to increase money growth if it has already fallen. In other words such an easing policy can be justified as being consistent with a policy rule, in this case a rule for the growth of the money supply. The rule calls for keeping money growth from declining. But the large-scale asset purchases by the Fed today are highly discretionary, largely unpredictable, short term interventions, which are not rule-like at all. It is the deviation from more predictable rule-like policy by the Fed (which began in 2003-2005 and continues today) that most concerns me.

The Texts They Are A-Changin'

How should the introductory economics text change in response the financial crisis, the recession and the very slow recovery? The question will be discussed at a big economics teachers’ conference in New Orleans this week. I will be there to give a talk on the issue by describing the just released 7th edition of my text with Akila Weerapana of Wellesley. We incorporated many crisis issues in the 6th edition in 2009 (the first text to do so), and gained experience for the 7th which I will share with other teachers at the conference.

The answer to the question depends a lot on what you think caused the crisis. If you think that it shows our economic theory—especially our macroeconomic theory—was wrong, and thereby gave the wrong policy prescriptions, then you have to think about massive changes. If you think the crisis shows that our economics was basically correct and that policy deviated from the recommendation of the theory, then you want to revise the text differently, and show with example after example how this happened. It is a unique teaching moment.

While there is some truth in both of these views, my research has led me to conclude that the second is closer to the reality. Certainly room should be given for different views, but this second view must be represented. My principles text with Akila Weerapana reflects this.

Here are the slides for my talk

Congratulations and Thanks to Tom Sargent and Chris Sims

The Nobel Prize committee made an excellent choice in awarding the 2011 economics prize to Tom Sargent and Chris Sims for their influential contributions to macroeconomics.

One of the first papers of Tom Sargent I read was his little “Note on the Accelerationist Controversy” published 40 years ago in 1971. It showed how commonly-used statistical tests rejecting the vertical long run Phillips curve were flawed because they did not take expectations into account properly. Then his 1975 Journal of Political Economy paper with Neil Wallace, which showed that monetary policy was ineffective in models with rational expectations and perfectly flexible prices, made it clear to me that we had to find a tractable way to put sticky prices into rational expectations models. Tom’s 1978 paper with Robert Lucas “After Keynesian Macroeconomics” pointed out many of the problems with Keynesian approach to economic policy. I recently found that our current policy experiences, 30+ years later, confirm that view. Tom’s emphasis on “cross equation restrictions” in rational expectations models set new standards for empirical estimation as he showed in his 1980 paper “Formulating and Estimating Dynamic Linear Rational Expectations Models” with Lars Hansen. Tom has also made his technical research accessible to economics students. His book Macroeconomic Theory published in 1979 is an early example, and last spring we used his more recent textbook with Lars Ljungqvist in the first year Ph.D. program at Stanford. His 1986 book Rational Expectations and Inflation made the technical subjects accessible at a non-technical level.

Chris Sims introduced the use of vector auto-regressions into macroeconomics in his1980 paper “Macroeconomics and Reality.” This work has had a deep and pervasive effect on macroeconomics which persists today. I first used his methodology in a paper published that same year (in the same journal and issue as the Hansen-Sargent paper mentioned above) to demonstrate that the stochastic dynamics of the business cycle in all the major industrial countries could be explained by a combination of a monetary reaction function and a particular form of staggered price setting, revealing a trade-off between output and price stability. Work I did in 1985 on nominal GDP targeting used estimated and theoretical impulse response functions as suggested by Sims. That research indicated that nominal GDP targeting had several flaws and pointed the way to a different kind of policy rule.

Both Chris Sims and Tom Sargent are of the school that you should evaluate policy proposals rigorously with estimated and theoretically well-founded models, rather than just speculate on how a policy would work or did work, and that is also an important model to follow.

Congratulations and thank you, Tom and Chris.

Higher Inflation Is Not the Answer

Today's NPR Morning Edition presented two sides to the question "Does The Economy Need A Little Inflation?"  By "a little" they mean 5 percent per year for a few years.   The former IMF chief economist and Harvard professor Ken Rogoff argued in the affirmative and was featured in the radio segment, as he has been arguing this view along with his successor at the IMF, Olivier Blanchard, for a while now. I argued for the negative in the segment saying it would do more harm than good to the economy, a point Paul Volcker has been making forcefully. A recent column by George Will puts the issue in the broader context of U.S. economic policy and also comes out on the negative side.

The Dangers of Misrepresenting Past Economic Debates

“What’s past is prologue,” says Future, the statue at the National Archives. But in macroeconomic policy—monetary and fiscal—the past is often misrepresented, and that unfortunately leads Future astray.  A common misrepresention these days pertains to past views of economists about monetary and fiscal policy. Consider David Frum’s recent opinion piece for NPR’s Marketplace Radio claiming that “The Great Recession has changed the way many conservatives talk about economic policy.” I don’t see the kind of change Frum and others claim has taken place.

Frum says that in the past “Liberals favored active government measures: government spending to fight recessions, tax increases to curtail inflation. Conservatives by contrast preferred monetary instruments: raise interest rates to stop inflation, loosen money during recessions.” And because many conservatives are now against the monetary activism of the Fed, they have “changed their minds,” says Frum.

But nowhere in his piece does Frum refer to the major distinction between liberals and conservatives in economic policy: liberals prefer active interventionist policy and conservatives prefer predictable rule-like policy. At least since the macroeconomic debates began in Washington in the 1960s, this has been the major difference. Consider two of the most influential policy documents published in the 1960s: The 1962 Economic Report of the President, largely authored by James Tobin, who was recruited by Paul Samuelson to go to Washington, and Capitalism and Freedom authored by Milton Friedman and published that same year. The Report made the case for macroeconomic activism—both monetary and fiscal. Capitalism and Freedom made the case for rules and less discretion—both monetary and fiscal, and argued strongly for less interventionist policies. Earlier Friedrich Hayek was making the same conservative arguments against Keynesian activism when Keynes himself was on the other side.

And this is exactly what conservative are saying now. Stop all the interventions—the short-term discretionary fiscal stimulus packages and the massive quantitative easings and the operation twists of monetary policy. The unpredictability caused by these policies is causing uncertainty and holding the recovery back. Instead put in place more permanent reforms which will create economic recovery and return the economy to the kind of performance we saw in the 1980s and 1990s.

So conservatives have not changed their minds, at least not in the way Frum claims. He may believe, as he says in his piece, that “conservatives have little useful to say.” But when rules-based, less intervnetionist policies were followed we saw good economic preformance as in the 1980s and 1990s.

Good Economics Is Good Politics

My oped today with John Cogan in the Wall Street Journal shows that temporary fiscal stimulus packages are not good politics.  Historical evidence reveals that politicians who enact them tend not to get re-elected.  Our previous Wall Street Journal articles here and here showed that these packages are not good economics either. 

The lesson for students of economics is that, more often than not, good economics is good politics.   

In Praise of an Extraordinary Teacher of Economics

Those of us who teach economics stand on the shoulders of those who taught us economics.

I just heard the sad news that one of my truly extraordinary economics teachers, E. Philip Howrey, recently died in a biking accident. When I was an undergraduate, Phil taught me an approach to macroeconomics—very new at the time—which has served me well throughout my career, and for which I will forever be grateful. Several years ago Robert Leeson asked me “Who influenced you most when you were an undergraduate at Princeton? What sparked your interest in policy rules?” I talked mostly about Phil in my answer.

Looking back I would say that Phil Howrey had the most influence on me, at least in areas that turned out to be closely related to my career as an economist. Phil had a great deal of interest in time series analysis as it applied to macroeconomics. For example, he had written an important paper on the "Long Swing" hypothesis with Michio Hatanaka. Hatanaka had published a book in 1964 with Clive Granger on Spectral Analysis of Time Series. Granger visited Princeton at the invitation of Oscar Morgenstern who had an interest in applying frequency domain techniques to economic data. While I met Morgenstern then, I did not meet Granger until many years later.

I think my initial interest in policy rules goes back to a course I took from Howrey. Except for Economics 101, it was probably my first introduction to macroeconomics. But we didn't study ISLM or the other textbook models of the time; instead we studied dynamic models of the economy, with equations that included lags and shocks defining the stochastic processes. In retrospect it was quite unusual that I had the opportunity to learn about these methods as an undergraduate, but at the time I had no idea that it was unusual. The methods forced me to think of the economy as a moving dynamic structure. So the only way one could think about policy was with some kind of policy rule. You couldn't say let's shift the LM curve by increasing the money supply by one unit or do whatever people would be doing at the time. Instead you had to have some kind of policy rule. So to me it was natural. I couldn't think of how else you would do it in those models.

When it came time to choose a topic for a senior thesis, I approached Phil Howrey saying that I was interested in macroeconomic policy issues and wanted to work with the types of models we studied in his course. He suggested that I look into stabilization policy in a model that combined economic growth and the cycle, which we called "endogenous cyclical growth" at the time; he said that no one had done this before, and so it sounded like a great topic and that is what I did. In the preface to my senior thesis I thanked Phil "for suggesting the topic and indicating how I might proceed." In the end the thesis was about simulating different types of monetary policy rules.

Day 1 of Economics 1

I find the first day of the school year to be exciting, especially when a lot of first-year students are in my classes as is the case with Economics 1, the introductory economics course I teach at Stanford and the course which this blog is named after. Many Day 1 questions are interesting and revealing of the times: Q: “Is this course Keynesian or Austrian?” A: “Adam Smithian.”

On Day 1, of course, we focus on the central idea that economics is about choices people make when faced with scarcity and the interaction between people when they make these choices. Accordingly, we modify slightly the Stanford motto, “The Winds of Freedom Blow” (Die Luft der Freiheit Weht) to get the Economics 1 motto: “The Winds of Economic Freedom Blow.  Examples of opporunity costs this year were hi-tech leaders Mark Zukerberg, Steve Jobs and Larry Ellison, who considered the opportunity cost of college, dropped out, and did pretty well—or Eric Schmidt, John Chambers, and Art Levinson (Google, Cisco, Genentech) who also considered opportunity cost of college, stayed in, and also did pretty well.

This year we are trying out a new Economics 1 lecture hall, CEMEX Auditorium in Zambrano Hall, named after the Mexican-based global cement company and its CEO Lorenzo Zambrano, who also didn’t drop out of college and then did well enough to donate the money for the lecture hall.

Not More of the Same Model Simulations!

Simulations of Mark Zandi’s economic model, which are reported in the press to show that a new temporary stimulus package will create 1.9 million jobs, are being touted as evidence that it will work. This is the same type of model simulation that predicted the very similar 2009 stimulus package would create millions of jobs, and the same type of simulation that claimed that that package worked. Andrew Ferguson reviews the predictions in a recent article in Commentary.

But simulations of such models do not provide such evidence, as I have explained on this blog before, for example here and here. They are wrong because they assume “multipliers” for temporary one-time payments or tax changes far in excess of the basic “permanent income” or “life cycle” models (which we teach in Economics 1). They are wrong because they assume that state and local government infrastructure and other purchases respond to federal stimulus grants in a mechanical way, unlike what we have seen practice, as I explained in this article with John Cogan. And they are wrong because they do not take account of the negative growth effects of expected future permanent increases in tax rates. I have debated Mark Zandi on these topics many times before, for example on the NewsHour and in congressional testimony.

However, the terribly weak economic recovery has forced an important change in the way that these predictions are put forward by modelers like Zandi. They have to admit that even their exaggerated estimated impacts of the temporary stimulus packages are, yes, temporary. Macroeconomic Advisers reports the same thing: “the GDP and employment effects are expected to be temporary” and more specifically that “these proposals will pull forward increases in GDP and employment, not permanently raise their level.”

In other words, even if, on balance, jobs are created by the package (which is doubtful), they will be destroyed as soon as the temporary package is over, according to Zandi. Thus even the promoters of such temporary packages agree that they will not jump-start the recovery, which is what is needed to really reduce unemployment.

Perhaps more than anything else, this is the reason why we need to do something besides “more of the same,” and instead follow the wisdom put forth in this speech (video, transcript)  by George Shultz upon winning the first Economic Club of New York Award for Leadership Excellence this past week.

When So-Called Hawks Are Really Doves

The Fed's dual mandate of “maximum employment” and “stable prices” is in the news again. At the recent presidential debate, the major Republican candidates made the case for repealing the dual mandate, while the President of the Federal Reserve Bank of Chicago, Charles Evans, made the case for doubling down on it. 

It's an important issue to understand and discuss. In my Bloomberg News article yesterday, I argued that history indicates that removing the dual mandate will actually help lower unemployment by reducing discretionary interventions and encouraging more predictable rule-like policy.

In this regard the frequently used terms monetary "hawk" and "dove" are quite misleading. A hawk is usually defined as someone who would like the Fed to focus on long run price stability.  But according to the evidence I discuss in my article, such a focus would better characterize a dove in that unemployment would be lower not higher. 

Two Congressional Hearings on the Second Stimulus and Alternatives

Congress was busy working on fiscal policy today. This morning, over on the House side, it held its first hearing on President Obama’s fiscal stimulus proposal. As one of the witnesses, I argued that the fiscal policy responses thus far to the unemployment problem have not been effective. Consisting mainly of short-term temporary and targeted interventions, the policy has not had a sustainable impact on economic growth and unemployment. Instead, the policy has increased the federal debt and raised uncertainty, which is an impediment to economic growth. Unfortunately, the proposals made by President Obama on September 8 consist largely of the same type of temporary and targeted interventions that have been tried for the past several years. Recent experience and past experiences show that this type of fiscal policy will not increase economic growth, certainly not on a sustained basis. It will not therefore bring the unemployment rate down to pre-recession levels which should now be the goal of policy.

Over on the Senate side this afternoon, there was a hearing on more comprehensive tax and budget reform. I testified there too, along with Alan Greenspan and Martin Feldstein.  I briefly laid out a more permanent and predictable alternative to the President's temporary and targetted proposal—a budget strategy to raise economic growth with revenue-neutral tax reform. It builds on the Budget Control Act and brings spending to the level of 2007 as a share of GDP.

The Financial Front in the War on Terror

Few Americans now remember that the United States launched its first post-9/11 attack on terrorists from a very unusual front—the financial front. As President George W. Bush put it, “the first shot in the war was when we started cutting off their money, because an al Qaeda organization can't function without money.” Here is my Bloomberg News  piece about this financial aspect of the war on terror. The detailed story of the people and what they did is fascinating as I try to describe in more detail in my book Global Financial Warriors: The Untold Story of International Finance in the Post-9/11 World. I will be talking with Tom Keene and Michael McKee about it on Sunday at noon. They will be broadcasting on Bloomberg Radio live from the World Trade Center site.

I was head of Treasury’s international affairs division when the operation began. Under U.S. law, the president had the authority to call on U.S. financial institutions to freeze the accounts of terrorists. In the years before 9/11, however, that law was not used very aggressively. As described later in the 9/11 Commission’s Monograph on Terrorist Financing, “Terrorist financing was not a priority….the Treasury organization charged by law with searching out, designating, and freezing Bin Laden assets, lacked comprehensive access to actionable intelligence and was beset by indifference of higher-level Treasury policymakers.”

Our first action was to end the indifference and define the mission clearly: first to freeze terrorist assets and thereby thwart future attacks; second to trace their assets and thereby get information about terrorists.

We had to have international cooperation; without it, the terrorists and their financiers could escape a U.S. freeze by moving their money to banks abroad. No mechanism for cooperation existed, so we had to create one. We began with the G7 and then fanned out. As Treasury press spokesperson, Michele Davis, said at the time, “We’re talking to everyone under the sun.” A report sponsored by the Council on Foreign Relations in 2002 found that: “The general willingness of most foreign governments to cooperate with U.S.-led efforts to block the assets…has been welcome and unprecedented.”

A total of 172 countries issued freezing orders, 120 countries passed new laws and regulations, and 1,400 accounts of terrorists were frozen worldwide. The total value of frozen accounts was $137 million, much during the crucial months in the fall of 2001. Valuable information from tracking money helped prevent attacks, and to obtain more information about terrorists, we partnered with a global financial messaging service called SWIFT, the Society for Worldwide Interbank Financial Telecommunication. Using this information, intelligence experts mapped terrorist networks and filled in missing links.

Don't Stay the Course

Here is my New York Times oped Not More of the Same on why it is urgent to change the course of economic policy.

My critique of Keynesian countercyclical policy, which is summarized in the NYT article, has been challenged by Fred Bergsten of the Peterson Institute who said at the Jackson hole meeting last week that the Reagan tax cut is an example of a countercyclical policy that successfully stimulated the economy, and therefore disproves my case.   But as Larry Summers famously described it, Keynesian countercyclical policy is "temporary, targeted, and timely."  The Reagan tax cut was certainly not temporary. And it wasn't targeted either; it was across the board. And it wasn't timely because it lasted well beyond the recession and the recovery. In fact, it is just the kind of "permanent, pervasive, and predictable" policy that we need now. 

On the New Greatest Generation

With the 10-year anniversary of 9/11 approaching people have been asking me to write about the impact of 9/11 on economic policy making in Washington, where I ran the international division of the U.S. Treasury at the time, and to reflect on how the world has changed since then. One request for 150 words came from the Stanford News Service. While there are many amazing economic stories to tell, I thought the first one should reflect on the new greaest generation which will help lead the way out of the difficult times we are still in.

Ten years after 9/11 we now have a "new greatest generation" of Americans on the scene and ready to lead. It includes, of course, all the post 9/11 Afghanistan and Iraq veterans to whom Time Magazine dedicates its cover this week. Fifty-one have enrolled at Stanford with more to come. As [Stanford President] John Hennessy and [Stanford Provost] John Etchemendy say, "We are honored and proud to have many excellent current students and alumni who have served in the military.

But I see a new greatest generation that also includes equally dedicated civil servants, like those at the US Treasury who froze terrorists' assets after 9/11 or funded new schools in Afghanistan; young entrepreneurs, who through ingenuity and hard work have been developing new products to improve peoples' lives; and the teachers, the doctors, the engineers who are just beginning their careers.

This is the best news and the most promising.

The Economic Past is Economic News

You cannot really understand monetary economics or monetary policy without knowing economic history. No self-respecting monetary economist goes to work without knowing the ins and outs of historical periods like the Depression of the 1930s or great works on such periods, such as Milton Friedman and Anna Schwartz’s Monetary History of the United States, Allan Meltzer’s History of the Federal Reserve, or Amity Shlaes recent popular book The Forgotten Man: A New History of the Great Depression building on the research of Harold Cole and Lee Ohanian.

Among fields of economics, this is especially true of monetary economics, where the theories can get quite abstract and thus benefit greatly from historical groundings, though it applies to other field as well. That’s why I took economic history as one of my Ph.D. fields along ago, and why I’m happy that my department at Stanford has always emphasized economic history with historians like Ran Abramitsky, Paul David, Avner Grief, Nate Rosenberg and Gavin Wright, even as it has been de-emphasized in other departments.

That's why I'm also pleased that the new opinion page at Bloomberg News has decided to establish a blog called Echoes overseen by Amity Shlaes under the courageous assumption that “The past is news,” as Amity puts it. Echoes should remind traders that today’s profit opportunities can often be found in the economic echoes from the past, or at least remind policy makers that opportunities to improve policy can also be found there.

Here are a few pieces I wrote for Echoes since it was established in late May, mostly on policy lessons, including one from today, where I write that Fed officials should listen to a few of those echoes as they gather in Jackson Hole tomorrow:

As Fed Meets, Two Lessons from 30 Years at Jackson Hole, August 24

“Steady As You Go” Still Good Policy for Uncertain Times, August 11

Done Right, A Debt Agreement Could Still Yield Positives, July 31

A Two-Step Approach to Solving the Budget Impasse, July 13

On the 10th Anniversary of the Keynesian Revival, July 7

Paul Volcker's Most Important Lesson, June 22

Government Is More to Blame for Weak Recovery Than Fading Stimulus, June 9

History Lesson for Entitlement Reform, June 2

After Revolution, the Hard Part, May 26

Why the M2 Growth Spurt?

Quantitative Easing (both I and II) has caused the monetary base—the sum of currency and bank reserves—to explode in the past three years, but has not resulted in similarly large increases in the growth of broader measures of the money supply such as M2. Instead banks have largely held the extra money that the Fed created in order to finance its purchases of longer term Treasuries and mortgage backed securities. You can see this in the following time-series chart. As the monetary base (right scale) increased sharply, the ratio of M2 to the monetary base—the M2 multiplier (left scale)—has moved in the opposite direction in complete lock-step fashion. Thus changes in the multiplier have offset increases in the monetary base.

But if you look closely at the lower right of the graph, you can see that this pattern may have shifted recently as the M2 multiplier increased. In fact, over the past couple of months, M2 growth has spurted, as you can see in the next chart showing monthly M2 averages through July. 

It's important to find out why. Is quantitative easing finally leading to a rapid increase in the supply of the broader money aggregates? If so, the Fed will need to be concerned about the ultimate effect on inflation, and perhaps start reducing the size of its balance sheet (and thus the monetary base) sooner than it would otherwise. Or is the increase due to a sudden rise in the demand for M2, which, with the elevated level of the monetary base, would not require additional adjustments. It’s probably too early to tell for sure, but the Fed’s weekly Money Stock Measures, released each Thursday afternoon, will be important to monitor in the weeks ahead.

The next chart shows the weekly data on M2 through August 8, which were released last Thursday afternoon. Based on a scan through the release, it looks to me like demand deposits and savings deposits at banks are the two components of M2 that are most responsible for the recent increase in M2. I have plotted the sum of those two items below M2 in the chart to demonstrate this (note the dual scale with M2 on the right and the sum on the left). Other components of M2 such as currency, small denomination time deposits, and other checkable deposits have not increased in this way.

What’s the reason for the sharp increase in demand deposits and savings deposits at banks? Perhaps the collapse of interest rates on Treasuries and the risk that Treasury prices could fall from these high levels have made such deposits more attractive, recalling the phrase of Keynes that the bond bulls "join the bear brigade." The newly announced policy at Bank of New York Mellon that large depositors will have to pay to lodge their funds is consistent with this story. If so, we are seeing a shift in the demand for money. But stay tuned.

So Much For People To Learn About Medicare Reform

There is so much more for people to learn about the various Medicare proposals out there. Many people I talked to were surprised to learn that both the Ryan and the Obama Medicare proposals reduce the growth of federal outlays on Medicare by very large amounts compared with current law, as Dan Kessler and I pointed out in our article in the Wall Street Journal this week. In commenting on our article Arik Roy emphasizes this little known fact (he had pointed it out earlier), suggesting that “an excellent reform plan for a GOP Presidential candidate to take up: the Ryan plan, tweaked to adhere exactly to the Medicare target growth rates advocated by the President…Such an approach would completely neutralize the charge that Republicans (or Democrats, for that matter) were unfairly cutting Medicare, and allow the candidates and the country to have a more substantive debate.”

Some commenters on our article were surprised to hear that President Obama even had a Medicare proposal, assuming that reform was part of Obamacare passed last year. But the Obama Medicare reform proposal was just put forth in an April 13, 2011 speech. Here is the fact sheet from that speech which calls for "setting a more ambitious target of holding Medicare cost growth per beneficiary to GDP per capita plus 0.5 percent beginning in 2018, through strengthening the Independent Payment Advisory Board (IPAB).”

Some commenters said that people could learn more about the proposals with a numerical side-by-side comparison of federal outlays under the two proposals going out into the future. Well I agree, and CBO has prepared such a comparison of current law versus the Ryan plan, but they said they could not estimate the impact of the April 13 proposal because the Administration did not provide enough information in the proposal. Here is a video of CBO Director, Doug Elmendorf, explaining that “We don’t estimate speeches. We need much more specificity than was provided in that speech for us to do our analysis.”

Some questioned our claim that physicians have begun requesting additional fees—‘concierge’ or ‘retainer’ payments—from Medicare beneficiaries to remain part of their practices, saying that they are illegal. But such fees are legal if the doctors accept Medicare and charge on top of this for services uncovered by Medicare, such as telephone or email consultations, though one can see fuzzy lines between this and billing extra for a covered service, which is illegal.

Some were surprised to hear that the Ryan reform proposal is much like the already existing Medicare Part D, which benefitted many at much less cost than experts predicted. This should help remove doubts—which obviously still exist in some quarters—that markets and competition can be a positive force to create better services for each dollar spent.

No Near-Consensus Among Economists for Another Stimulus Package

Sunday’s Weekend Edition on NPR gave listeners a chance to hear different economic views on how to reduce the high unemployment rate. Joe Stiglitz represented the view that we need another deficit-financed stimulus package with more spending now and tax increases later. I represented the view that the 2009 deficit-financed stimulus didn’t work and that we need to address the problem of expanding debt and regulations, which are holding back investment and job creation, and that we should not increase taxes. In selecting excerpts from an earlier taping, I think the NPR editors gave a fair representation of the views that are out there. 

In the meantime, an article in the New York Times over the weekend suggested that there was a new consensus for the view which Joe put forward. I see no such consensus. Some economists such as Joe, Paul Krugman, and Robert Reich have that view, but that is not new for them. And it is nothing new for Warren Buffett to argue for tax increases as he did in an New York Times op-ed today: When he was an adviser to Arnold Schwarzenegger in the 2003 California recall election, Buffett recommended tax increases, but Arnold told him to cool it or do 500 pushups for punishment. And there are plenty of economists who think that gradually reducing spending and not increasing taxes is better for job creation.  In June, for example, 150 economists (including me) wrote that a debt deal “that is not accompanied by significant spending cuts and budget reforms would harm private-sector job growth”

When Economic Principles Were Ignored

In televised speech on Sunday evening August 15, 1971, Richard Nixon shocked the world with these words: “I am today ordering a freeze on all wages and prices throughout the United States for a period of 90 days,” (see video) and “I have directed Secretary Connally to suspend temporarily the convertibility of the dollar into gold or other reserve assets…” (see video).

There are many lessons learned from this Nixon shock, as Amity Shlaes, Joe Thorndike and I wrote in pieces this week on Bloomberg Echoes here, here, and here, respectively.  Perhaps the most important lesson, a warning actually, is how a presidential administration with economic principles emphasizing free markets and limited government intervention can end up implementing an economic policy of controlled markets and extensive government intervention, with terrible consequences. By reading contemporary reports, such as the Newsweek columns of Milton Friedman mentioned in my piece, you can see how politics drove the decision making and how administration economists either succumbed or were overruled. In marked contrast, a decade later another free-market, limited-government administration came into power in Washington and stuck to its principles—and the economic performance turned out to be far better.

For a useful quick summary of how these momentous decisions were made (with candid commentary by Milton Friedman and George Shultz), watch this short 5-minute video from Commanding Heights.

Regulatory Capture across the Hudson

The book Reckless Endangerment by Gretchen Morgenson and Joshua Rosner is filled with examples of regulatory capture which the authors uncovered in their investigative reporting of the financial world. Here is my review in the Washington Post. Many of the examples are useful for teaching Economics 1—including what the authors see as a cozy connection between the New York Fed and the Wall Street firms it regulates.

Orley Ashenfelter, President of both the American Economic Association and American Association of Wine Economists, has done some of his own investigative reporting on the other side of the Hudson River. As he explains in a recent oped, the New Jersey liquor lobby has captured the State legislature, and has done so since the Great Depression.

I think these examples are better than the financial industry examples for teaching, at least at the principles level. Liquor stores are easier to visualize and explain than structured investment vehicles and the examples nicely illustrate the advantages of free markets, the dangers of government regulation, the role of special-interest lobbying, and how to reform the system, now that the wine growers in the state have started to rebel and change the law. Better than Jersey Shore as one of the commentators on the oped pointed out.

More on the S&P Downgrade

Two years age in an article in the Financial Times I wrote that “Standard and Poor’s decision to downgrade… should be a wake-up call for the US Congress and administration.”  At that time I was not, of course, referring to the decision of last Friday, but rather to S&P’s downgrade of “its outlook for British sovereign debt from ‘stable’ to ‘negative’.”  In that May 26, 2009 FT article I listed several reasons why I was concerned that Washington might “sleep through that wake-up call,” and many of those played out, at least until the elections of last November which brought in many new members to Congress who woke up and came to Washington. As a result we have the Budget Control Act of 2011, which is a good first step in a longer term plan to reduce spending.

I have received several comments on my post yesterday on whether or not S&P’s initial assumptions about spending growth in its downgrade report represented a “difference of opinion” with other views or a “math error.” To my knowledge, the initial calculations which are in dispute have still not been made public, so perhaps we will never know for sure, but the main issue seems to be a “difference of opinion” about spending growth following the Budget Control Act (BCA).  The argument that it was a “math error” is based on the idea that the BEA caps on discretionary spending are a fixed dollar amount and that S&P did not use those dollar amounts in their initial calculations. 

I have been quite positive about the accomplishments of BCA, but its actual impact on spending may be less than the dollar amounts assumed by S&P in its final draft and closer to those apparently assumed in its first draft.

First, some of the deficit reduction could come in the form of tax increases (if the Joint Committee proposes some tax increases and they are approved) rather than spending reductions; in this case the change in tax revenues would have the same static dollar effect on the deficit, but then there are many potential offsetting effects, such as the current proposal to extend the payroll tax reduction or the slower economic growth if tax rates are raised. 

Second, BCA excludes Iraq, Afghanistan, and related discretionary spending; I hope and expect these to come down compared to CBO baseline, but there are differences of opinion.  

Third, BCA caps can be changed or altered in the future, perhaps when appropriators find it difficult politically to pass legislation to achieve the caps. Several people have emailed me about this problem in questioning my view that BCA is an accomplishment.

Fourth, and this relates specifically to the chart in my post of yesterday, BCA does not apply through the whole period of the long term budget outlook, which uses CBO’s alternative fiscal scenario.

To clarify these issues, the Treasury and S&P could put out the details of their dispute, including the before and after assumptions and calculations. On the other hand, I do think people should move on. 

Treasury Versus S&P on the Downgrade: It’s Not a Math Error

The White House and the Treasury are accusing Standard and Poor’s of making an elementary arithmetic mistake in the recent downgrade decision.  Treasury’s John Bellows writes about what he calls a “$2 trillion mistake” saying that “After Treasury pointed out this error – a basic math error of significant consequence – S&P still chose to proceed with their flawed judgment by simply changing their principal rationale for their credit rating decision from an economic one to a political one.”  White House adviser Gene Sperling adds that “The magnitude of their error combined with their willingness to simply change on the spot their lead rationale in their press release once the error was pointed out was breathtaking."  

But if you examine the details of the S&P--Treasury--White House dispute, rather than a “math error” you will find what is better described as a “difference of opinion” about a forecast for future government spending.  In other words, the issue is about the appropriate “baseline” for government spending in the absence of more actions. Since when did different views or assumptions about the future become a math error?

In their original draft report, S&P evidently assumed that discretionary government spending would grow by about 5 percent per year over the next 10 years if no further action were taken (beyond the Budget Control Act of 2011). In the final draft, at the urging of the Treasury, they assumed that discretionary spending would grow at about 2.5 percent per year if no further actions were taken.  The first assumption leads to a higher level of debt than the second.  Over 10 years the difference is about $2 trillion.

So this is a matter of different assumptions rather than a math mistake.  In fact, the alternative assumption of faster spending growth is not so unreasonable, and whether or not S&P put it in their final report it is something they or anyone else should worry about.  In fact this assumption is used by CBO in their “alternative fiscal scenario,” which I and others have used to project debt into the future as in the exploding debt chart below.  CBO devoted part of its January 2011 Budget Outlook to considering such alternatives. See in particular Table 1-7 of that CBO report where they show that increasing discretionary appropriations at the rate of nominal GDP growth (assumed to be about 5%) increased the debt by $1.8 trillion, or about $2 trillion over ten years, compared with the 2.5% assumption.

There are of course reasons to dispute the downgrade decision of S&P, but a math error is not one of them. It would be more productive for government officials to move on and to use their time to find ways to reform taxes or entitlements, fix the exploding debt problem, and thereby prevent the likelihood of the outcome in this chart, which shows CBO forecasts (during the past three years) under their alternative fiscal scenario explained in more detail here.

Debating History and Policy with Reich and Krugman

Tonight’s NewsHour debate between me and Robert Reich was about the role of Keynesian fiscal policy in the context of the today’s budget agreement. Reich was not supportive of the agreement because it precluded another stimulus package which, in his view, would create jobs.  I was supportive because it was a start on budget consolidation path to restore sound fiscal policy which would reduce uncertainty over the exploding debt and thereby create investment and jobs.  I think Jeffrey Brown gave us both a chance to make our case and provide historical evidence on what works and what doesn’t.

Such historical evidence will certainly play a role in the upcoming debates about the role of government in the economy. In this regard I see that Paul Krugman is on the attack again, this time about an article I wrote in the Wall Street Journal.  Here is the paragraph from my article he criticizes following the pull out quote from Richard S. Grossman which he links to.   

“With lessons learned from the century’s tougher decades, including the Great Depression of the ’30s and the Great Inflation of the ’70s, America entered a period of unprecedented economic stability and growth in the ’80s and ’90s. Not only was job growth amazingly strong—44 million jobs were created during those expansions—it was a more stable and sustained growth period than ever before in American history.”

So what’s the problem?  No one can deny that the 1930s and the 1970s were tough decades for the economy.   And job creation in the expansions of the 1980s and 1990s was amazing: There were two long expansions in the 1980s and 1990s: 1982-1990 and 1991-2001. In November 1982—the start of the1980s expansion—total non-farm payroll employment was 88,770 according to BLS historical statistics. In March 2001, the peak of the 1991-2001 expansion, it was 132,500. The difference in those 220 month was 43,730, about 44 million.  There is no other 220 month period in the post war period where so many jobs were created. Note that this is not just the Reagan expansion; it includes all of the Clinton years.

And as the following graph illustrates the 1980s and 1990s were a period of “stable and sustained growth.” In fact because of the stable and sustained growth the period is called the Great Moderation which has been documented by many economists. Here is the Wikipedia entry which uses the same chart and contains many references. Unfortunately, the Great Moderation ended with the Great Recession and the non-existent recovery.  

Paul Krugman also links to some total factor productivity plots to make his argument, but they are more supportive of my points. The charts show that productivity growth declined in the early 1970s (more evidence that the 1970s were one of the “tougher decades”). They also show that productivity growth picked up after the return to better macro and micro policies in the 1980s and 1990s. Of course, the pickup occurred with a lag most likely because of the slow diffusion of technology for the reasons emphasized by my colleague economic historian Paul David.

Why Much Was Accomplished in the Debt/Budget Negotiations

Many are still debating how much was accomplished in the debt/budget agreement approved by the House today with the Senate to vote and the president to sign tomorrow. In my view, much was accomplished, and credit goes to all those who have been laying out the arguments and fighting hard for a return to sound fiscal policy as part of a pro-growth program to get the economy moving again.

You can see the impact of the agreement on spending with the following chart, which I have used before to show the recent federal spending binge and how to reduce it in a credible way.

It shows total federal government outlays—including both entitlements and discretionary spending—as a share of GDP for the past decade and the next decade under the various budget proposals. In previous posts and articles in the Wall Street Journal I have shown the top line, which is the original White House budget proposal submitted last February, and the bottom line, which is this year’s House Budget resolution due to Paul Ryan; this House proposal brings the budget into balance without any increase in taxes. The issue all year has been where between these two lines we would end up, and what would remain to be settled during the 2012 election.

The middle two lines show what has been accomplished this year. The line labeled “After BCA (Budget Control Act) Tranche 1” is the result of spending reductions agreed to in the Continuing Resolution of last spring and this past weekend’s agreement to cut and cap discretionary spending as part of the first $900 billion increase in the debt limit, along with adjustments in the CBO baseline. This all adds up to $1.4 trillion. The next line shows the additional spending cuts that will occur as a result of the second part of the debt limit increase, scheduled for the end of this year—another $1.5 trillion. (The “Tranche 2” line is drawn by distributing the $1.5 trillion amount to each year in the same pattern as outlay reductions in the “Tranche 1” line, though the actual pattern is yet to be determined.)

So it is clear that the budget has come a long way from the Administration’s first spending proposal—about half way to the House proposal—and it was accomplished without any tax increases. Some are disappointed that Washington did not do more, but there is no question that this represents a very big shift, even though the heavy lifting will go on with a good debate in the upcoming elections.

In addition to the hard work of those deeply concerned about the debt, the deficit, and the economy, an important idea or principle also deserves credit. This is the negotiating principle that “any debt limit increase has to be matched by spending reductions”—call it the Boehner principle. I wrote favorably about the principle in the Wall Street Journal in June and signed a letter with other economists supporting it when it was viewed as controversial, or even, as John Boehner said about himself today "when everyone thought I was crazy for saying it." But because of its simple reasonableness and good economic rationale, it helped carry the day and achieve an important agreement.