May 24, 2003

Fear of a Quagmire

The New York Times finally gives Paul Krugman enough space on the op-ed page for him to talk about liquidity traps and the current state of the business cycle:

Fear of a Quagmire? The Fed still has some tricks up its sleeve. Now would be a very good time to announce an inflation target. But it's also clear that the Fed could use some help, at home and abroad. Alas, it's not getting that help.

The Fed's European counterpart, the European Central Bank, has been far less aggressive in cutting rates. There are economic, institutional and psychological reasons for this passivity, but the central bank's immobility is one main reason why Germany seems set to follow in Japan's footsteps. European governments aren't much help, either. Bound by the "stability pact," which limits the size of the deficits they are allowed to run, they have been cutting expenditures and raising taxes even as their economies falter.

The Bush administration is, of course, notably unconcerned about deficits. Aren't the tax cuts in the pipeline exactly what the economy needs? Alas, no. Despite their huge size -- if you ignore the gimmicks, the latest round will cost at least $800 billion over the next decade -- they pump relatively little money into the economy now, when it needs it. Moreover, the tax cuts flow mainly to the very, very affluent -- the people least likely to spend their windfall.

Meanwhile, state and local governments, which are not allowed to run deficits -- we have our own version of the stability pact -- are slashing spending and raising taxes. And both the spending cuts and the tax increases will fall mainly on the most vulnerable, people who cannot make up the difference by drawing on existing savings. The result is that the economic downdraft from state cutbacks (only slightly alleviated by the paltry aid contained in the new tax bill) will almost certainly be stronger than any boost from federal tax cuts.

In short, those of us who worry about a Japanese-style quagmire find the global picture pretty scary. Policymakers are preoccupied with their usual agendas; outside the Fed, none of them seem to understand what may be at stake.

Of course, it's possible, maybe even likely, that their nonchalance will be vindicated. Most analysts don't think we'll find ourselves caught in a liquidity trap. And even the Fed believes -- or is that hopes? -- that a surge in business investment will save the day.

May 24, 2003

Fear of a Quagmire?

By PAUL KRUGMAN

Suddenly the d-word is on everyone's lips. Last weekend the International Monetary Fund released a rather ominous report titled "Deflation: determinants, risks and policy options." The report made headlines by suggesting that Germany is likely to join Japan in the falling-price club. Alan Greenspan hastened to reassure us that the U.S. isn't at imminent risk of deflation. But alert Greenspanologists pointed out that he seemed to hedge his bets, and the fact that he even felt obliged to discuss the issue showed that he was worried.

Though talk of deflation fills the air, most of that talk is subtly but significantly off point. The immediate danger isn't deflation per se; it's the risk that the world's major economies will find themselves trapped in an economic quagmire. Deflation can be both a symptom of an economy sinking into the muck, and a reason why it sinks even deeper, but it's usually a lagging indicator. The crucial question is whether we'll stumble into the swamp in the first place -- and the risks look uncomfortably high.

The particular type of quagmire to worry about has a name: liquidity trap. As the I.M.F. report explains, the most important reason to fear deflation is that it can push an economy into a liquidity trap, or deepen the distress of an economy already caught in the trap.

Here's how it works, in theory. Ordinarily, deflation -- a general fall in the level of prices ? is easy to fight. All the central bank (in our case, the Federal Reserve) has to do is print more money, and put it in the hands of banks. With more cash in hand, banks make more loans, interest rates fall, the economy perks up and the price level stops falling.

But what if the economy is in such a deep malaise that pushing interest rates all the way to zero isn't enough to get the economy back to full employment? Then you're in a liquidity trap: additional cash pumped into the economy -- added liquidity -- sits idle, because there's no point in lending money out if you don't receive any reward. And monetary policy loses its effectiveness.

Once an economy is caught in such a trap, it's likely to slide into deflation -- and nasty things (what the I.M.F. report calls "adverse dynamics") begin to happen. Falling prices induce people to postpone their purchases in the expectation that prices will fall further, depressing demand today.

Also, deflation usually means falling incomes as well as falling prices. In a deflationary economy, a family that borrows money to buy a house may well find itself having to pay fixed mortgage payments out of a shrinking paycheck; a business that borrows to finance investment may well find itself having to pay a fixed interest bill out of a shrinking cash flow.

In other words, deflation discourages borrowing and spending, the very things a depressed economy needs to get going. And when an economy is in a liquidity trap, the authorities can't offset the depressing effects of deflation by cutting interest rates. So a vicious circle develops. Deflation leads to rising unemployment and falling capacity utilization, which puts more downward pressure on prices and wages, which accelerates deflation, which makes the economy even more depressed. The prospect of such a "deflationary spiral," rather than the mere prospect of deflation, is what scares the I.M.F. -- and it should.

A decade ago all of these fears might have been dismissed as mere theoretical speculation. But in Japan the whole nasty scenario is playing out, just as the theory predicts. And about five years ago I and other economists began writing academic papers pointing out that what can happen in Japan can happen elsewhere. (Part of the I.M.F. report draws on my work on the subject.)

So how seriously should we take the risk that something similar will happen in the world's other major economies? Neither the United States nor Europe, outside Germany, is likely to experience serious deflation in the next year or two. But that's the wrong question -- and we should bear in mind that Japan's economic malaise took a long time to turn into all-out deflation.

In fact, it's striking how gradually Japan's catastrophe unfolded. When the stock bubble of the 1980's burst, Japan's economy didn't fall off a cliff. By and large the economy continued to grow, if slowly, and the nation didn't have a severe recession until 1998. But year after year, Japan underperformed, growing less than its potential. Though the Japanese government tried to stimulate the economy using the usual tools -- deficit spending, interest rate cuts -- it was never enough. By 1995 or so the economy had slid into a liquidity trap; by the late 1990's it had entered into a deflationary spiral.

Our own situation is strikingly similar in some ways to that of Japan a decade ago. Like Japan circa 1993 or 1994, the United States is now facing the aftermath of a huge stock market bubble -- the Nikkei and the Standard and Poor's 500 both tripled in the five years before their respective peaks.

Also like Japan, we face a problem not of sharp downturn but of persistent underperformance -- an economy that grows, but too slowly to prevent rising unemployment and falling capacity utilization.

What's different is that we have Japan as a cautionary example. Is forewarned forearmed?

Whatever reassurances Mr. Greenspan may offer, the staff at the Fed is very worried about a Japanese scenario for the United States -- a concern reflected in their research agenda. In a major study of Japan's experience published last year, Fed economists reached two key conclusions. First, Japan could have avoided its current trap if policymakers had been aggressive enough, soon enough. But by the time they realized the danger, it was too late. Second, the Japanese weren't stupid: their relatively cautious policies in the first half of the 1990's made sense given not only their own forecasts, but also those of independent analysts. But the forecasts were wrong -- and the Japanese had failed to take out enough insurance against the possibility that they might be wrong.

The Fed has taken these conclusions to heart. Once the U.S. economy began to falter, it cut rates early and often, trying to get ahead of the problem. Those cuts certainly helped moderate the slump; but at this point, with the overnight interest rate down to 1.25 percent, the Fed has almost run out of room to cut. (Fed officials believe, for technical reasons, that going below 0.75 would be counterproductive.) And the economy remains weak.

The Fed still has some tricks up its sleeve. Now would be a very good time to announce an inflation target. But it's also clear that the Fed could use some help, at home and abroad. Alas, it's not getting that help.

The Fed's European counterpart, the European Central Bank, has been far less aggressive in cutting rates. There are economic, institutional and psychological reasons for this passivity, but the central bank's immobility is one main reason why Germany seems set to follow in Japan's footsteps. European governments aren't much help, either. Bound by the "stability pact," which limits the size of the deficits they are allowed to run, they have been cutting expenditures and raising taxes even as their economies falter.

The Bush administration is, of course, notably unconcerned about deficits. Aren't the tax cuts in the pipeline exactly what the economy needs? Alas, no. Despite their huge size -- if you ignore the gimmicks, the latest round will cost at least $800 billion over the next decade -- they pump relatively little money into the economy now, when it needs it. Moreover, the tax cuts flow mainly to the very, very affluent -- the people least likely to spend their windfall.

Meanwhile, state and local governments, which are not allowed to run deficits -- we have our own version of the stability pact -- are slashing spending and raising taxes. And both the spending cuts and the tax increases will fall mainly on the most vulnerable, people who cannot make up the difference by drawing on existing savings. The result is that the economic downdraft from state cutbacks (only slightly alleviated by the paltry aid contained in the new tax bill) will almost certainly be stronger than any boost from federal tax cuts.

In short, those of us who worry about a Japanese-style quagmire find the global picture pretty scary. Policymakers are preoccupied with their usual agendas; outside the Fed, none of them seem to understand what may be at stake.

Of course, it's possible, maybe even likely, that their nonchalance will be vindicated. Most analysts don't think we'll find ourselves caught in a liquidity trap. And even the Fed believes -- or is that hopes? -- that a surge in business investment will save the day.

But few analysts saw the Japanese quagmire coming either, and there is now a significant risk that we will find ourselves similarly trapped. Even so, we won't have deflation right away. But by the time we do, it will be very hard to reverse.

Like the Fed, I hope that doesn't happen. But hope is not a plan.   

Posted by DeLong at May 24, 2003 09:34 AM | TrackBack

Comments

This tax cut is more expensive than the original Administration proposal and more slanted to the most wealthy because of the reduction of the capital gains tax rate. We had better hope Alan greenspan is right in forecasting a capital spending revival by business in the near future. What I do not understand is in an economy at 74-75% capacity, why should industry invest significantly in capacity? Where is the new demand coming from to spur capacity expansion?

This is an excellent excellent essay!

Posted by: anne on May 24, 2003 10:08 AM

Remember, though the dollar has fallen sharply against the Euro so has China's currency. We may find that there is far less of a gain in exports than we hope for because Asia currencies are pegged to the dollar or not appreciating in value, and so Asian exports will be very very competitive with American exports.

Again, Europe is slow and slowing in growth and not in a position to add to world demand.

Paul Krugman has the analysis right as usual.

Posted by: jd on May 24, 2003 10:34 AM

Our host just mentioned, in a post a little while back, the difficulty he had in cutting down the material so as to not run over in a two hour lecture on deflation and the liquidity trap. With that in mind, what was the most important point Prof. Krugman would have (should have) made except for the space/ink shortage at the Times?

My nominees: (a) the role of the collapse of the Japanese financial system. I thought that collapse was a major reason monetary policy failed in Japan, and a big reason that the US ought to be able to avoid their experience. Which does not mean it can't happen here, just that Japan may not be a good example. So far, not so good.

(b) The efficacy of fiscal stimulus in Japan. They have had massive spending on public works, and huge budget deficits (offset, we presume, by huge private savings). If it is not working, what does it mean?

(c)And there is the pro-cyclical effect of state/local spending, which P Krugman mentions briefly. How much did this contribute to the 90's boom, how much is it hurting us now? And where are the numbers? I thought that was why you guys had research assistants, since their future job prospects are nil (another DeLong-referential wisecrack...)

Seriously, is there some obvious source that aggregates Federal, State, and Local revenues and expenditure? Seems like an obvious series to want, but I have never looked for it, and it is the weekend...

Have a good one.

Posted by: Tom Maguire on May 24, 2003 10:44 AM

Yay! That's the Krugman that I love, and the Krugman that I think most effectively utilizes his space at the Times. Yes, I would have liked a bit more discussion about how the administration's economic policies are *disastrous* in this scenario (if we're Japan in 1994, then imagine Japan in 2002 forced to enact large tax increases). On the other hand, it's possible that given the possible importance of this piece, he wanted to avoid the appearance of partisan sniping as much as possible so as to appeal to the widest possible audience.

Regarding the Japan comparison and the lack of the efficacy of stimulus there (public works, etc.). It's my understanding from reading here and elsewhere that the biggest difference between the US and Japan—and why what happened there very well may be unlikely to happen here—is the enormous systemic problems they have in banking and elsewhere. I don't really understand this, but hasn't Brad written here that these endemic problems have acted as a sort of a sink that has absorbed the stimulus and eliminated its effectiveness?

Posted by: Keith M Ellis on May 24, 2003 11:06 AM

Note - The Japanese financial system did NOT collapse. This is important to remember. The Japanese government has protected larger "city" banks, and a number of smaller local banks have been quite profitable.

Fiscal stimulus in Japan has not reversed the deflation, but it HAS worked to keep employment fairly high and to keep wages increasing for middle class workers.

Paul Krugman has noted this partial efficacy of Japanese fiscal policy. I strongly suggest we look at what HAS worked to protect the Japense economy and middle class through the last decade. We have been impressed with how Japanese families have faired through this slow growth period.

There are a number of reports on the contribution of State and Local spending to economic growth. Brookings is a source.

Posted by: jd on May 24, 2003 11:16 AM

Japanese families have a much larger savings cushion than American families, and remember that low interest income on savings is not a problem when prices are falling. Few Japanese families lost money in the stock market, and they have been readily able to meet mortgage payments.

American families are savings short, and the federal government has swung from surplus to deficit rapidly and fiercely. The federal deficit will be an added problem with families savings short and boomers aging.

Frankly, I love all of Paul Krugman!

Posted by: jd on May 24, 2003 11:24 AM

What is often taken for Japan's structural problem is a desire to protect workers from this period of slowing in growth. I suggest we consider carefully whether this is a weakness. Japan has a strong economy, and is well positioned through Asia in investments. Look at the Japanese balance of payments strength.

Would you have Japan go to 10% unemployment to force restructuring? Well, the Japanese will not do that, and may come out stronger in time for all the slow restructuring.

Posted by: dahl on May 24, 2003 11:37 AM

I wonder about that surge of business investment, too. Corporations are sitting on a lot of cash. Assuming that some small, but significant percentage of corporate executives are partisan Republicans with devotion to the Cause, perhaps the message from Rove is "Hoard your money in 2003 - spend like drunken sailors in 2004"? Nobody will blame a business for not spending money in 2003. And if businesses start spending money in 2004, some Democrats may be suspicious, but nobody is going to complain. Perhaps there might be a significant drop in the price of oil as well.

Is this possible? Or is it too paranoid?

Posted by: roublen vesseau on May 24, 2003 11:55 AM

Interesting. Why is it that we take it so much for granted that the only way to get rapid growth in Japan is at the expense of middle class workers? The Japanese seem determined to prove otherwise. We should look carefully and respectfully at the Japanese experience. The social safety net in Japan really does include a committment to well paid secure employment.

Posted by: lise on May 24, 2003 11:55 AM

Though corporation may be sitting on cash, why should they spend it in America when capacity use is so low? American companies have been investing in Asia, especially in China, because there is such a cost advantage. Why should that stop?

The federal tax cut stimulus should be largely offset by the cuts and tax increases on state and local levels. New claims for unemployment insurance keep at more than 400 thousand week after week. I would say we are in for fairly slow growth for another year.

Posted by: anne on May 24, 2003 12:09 PM

Terrific analysis. Cheers for the courage of Krugman and DeLong.

Posted by: bill on May 24, 2003 12:41 PM

A very enjoyable piece. As always, high-quality, though-provoking, and easy to read (I think most of this has already been said here, though). The most intriguing thing in it, though, was a parenthetical remark: Fed officials believe, for technical reasons, that going below 0.75 would be counterproductive. Could someone explain that? That left me rather frustrated! I know no financial economics, so if someone else does, could they explain why rates < 0.75% would be counterproductive?

Posted by: Julian Elson on May 24, 2003 01:06 PM

Anne wrote, "What I do not understand is in an economy at 74-75% capacity, why should industry invest significantly in capacity? Where is the new demand coming from to spur capacity expansion?"

Excellent question. And no one I am aware of has given a credible answer to this question. The reason, I strongly suspect, is that there is absolutely no reason to expect any significant new demand - certainly I can't think of any scenarior that would increase capacity utilization enough to make massive new business spending necessary.

The fact of the matter is that a tax cut to the rich will not significantly increase demand. Again, I'm not aware of any credible argument that would explain how it could.

Simply put, current Administration economic policy is beyond stupid, to malignly harmful. They can't possibly be this stupid. Therefore they must know what they are doing and not care.

Posted by: Ian Welsh on May 24, 2003 02:20 PM

Anybody know what the technical reasons for not setting the Fed Funds rate below 0.75%, alluded to by Krugman, are?

Posted by: stefan on May 24, 2003 03:14 PM

Lets suppose for argument's sake that Krugman, Brad, and other like-minded economists (maybe I should include Greenspan here) who view the liquidity trap as a real risk take control of fiscal & monetary policy - what are the prescriptions? Increased public works? Didn't Japan try that? What should be done?

Posted by: Chad Williams on May 24, 2003 03:16 PM

I can only see that one might want to maintain the Fed Funds rate above the discount rate so that banks borrowing from the discount window can make for sure arbitrage profits, as they do now, with access to the discount window being rationed (by the Fed) or discouraged by financial markets as a bad signal. This lets the Fed give banks in trouble grant aid, albeit a bit disguised.

But this doesn't strike me as a sufficiently important reason to keep the Fed Funds rate above 0.75%. But I cannot quantify this hunch off to top of my head.

Posted by: stefan on May 24, 2003 03:23 PM

Krugman mentions "economic, institutional and psychological reasons" and "European governments aren't much help, either".
In the case of the government of my country (the Netherlands) I sometimes think there is also a kind of "religious" reason: some calvinistic idea
that suffering is OK.
In the meantime I get the impression that both in Europe and the states there is "some problem" as to how to spend in a way that is (most) beneficial to fight the danger of deflation and stimulate a "sustainable growth" worldwide.

Posted by: FransGroenendijk on May 24, 2003 03:40 PM

The capital gains cut does not spur demand, nor do capital gains tax cuts ever spur demand. They spur the ability to shift capital, which can be good, and they spur the ability to shift investement demand to consumption demand among the very wealthy - which has little economic benefit in general.

Because, as much as playing the ponies in the stock market is fun and profitable, from the economic standpoint, the equities market has a much less glamourous function - provide a pool of liquidity which will allow companies to get liquidity to expand production. This means new issues, sales of company owned stock and initial public offerings. If this pool of liqidity is in line with demand capacity - the theoretical top limit of demand - for capital expansion, then the market is making a positive contribution. If there is too large a pool of liquidity, providing more is pushing on a string, and creates a bubble. If there is too little then there is insufficient expansion.

At the moment it is clear that there is still a huge surplus of liquidity in investments over capital expansion capacity - and hence, more liquidity would not help things.

We'd be better off if the government just bought everyone a pick up truck and ran high speed cable to everyone's doorstep, because that, at least would soak up excess capacity and increase demand for capital expansion.

Posted by: Stirling Newberry on May 24, 2003 04:16 PM

"Meanwhile, state and local governments, which are not allowed to run deficits -- we have our own version of the stability pact -- are slashing spending and raising taxes."

Yes, this is not only demanded by the various state constitutions...it's demanded by the federal Constitution. (Of course, the federal government stopped paying any attention to the federal Constitution shortly after FDR left office.)

The Founding Fathers, in their incredible wisdom, knew about the moral hazard of states running large debts, and then coming to the federal government to pay those debts off. That's why they required that ALL federal expenditures be for the "general welfare of the United States." (This wording was actually a LIMITATION on federal spending, which has been stood on its head to actually permit MORE types of federal spending.)

The Founding Fathers knew that special interest spending (which is exactly what payments to states would be) would essentially be the death of the Constitution, and result in virtually unlimited federal spending. Which is exactly what's happened.

Posted by: Mark Bahner on May 24, 2003 04:22 PM

Stefan, here's the answer to your .75% question:

"But there are limits to how low the Fed can push interest rates. Zero is obviously a lower bound: at that point cash dominates securities. The Fed actually sets the bound higher: it believes that pushing rates below 0.75 would drive mutual funds out of business, damaging the financial system's "plumbing"."

http://www.pkarchive.org/economy/042203Follow3.html

Posted by: Bobby on May 24, 2003 04:32 PM

If there's going to be a liquidity trap, and the Fed is ready and willing to target long-term rates, why did Krugman lock in interest rates on his home loan? If inflation is just around the corner, as Krugman said not less than two or three months ago, then it would seem this liquidity trap we are menaced with, isn't really such a trap.

Anyway, that great sucking sound you hear is foreign investors converting their dollars into euro and yen. And they're doing that precisely because Krugman and co. are taken seriously in the U.S., which means there is a significant probability that the U.S. will debase the value of its currency in the months or years to come. (So, of course, investors are doing the debasing for them ahead of schedule.) Crash in the dollar (by which I mean weaker than 1.35 euro)? Or crash in American property values? Which will come first?

And I would like someone to explain to me how monetary policy is going to lead to *real* growth, as opposed to nominal growth. And I hope the answer is not, "monetary policy can stop us from heading into a liquidity trap!"

Posted by: Andrew Boucher on May 24, 2003 04:38 PM

"Lets suppose for argument's sake that Krugman, Brad, and other like-minded economists (maybe I should include Greenspan here) who view the liquidity trap as a real risk take control of fiscal & monetary policy - what are the prescriptions? Increased public works? Didn't Japan try that? What should be done?
Posted by: Chad Williams on May 24, 2003 03:16 PM
"

A liquidity trap comes out of Keynesian theory - that point where the aggregate demand for consumption has been satiated versus aggregate demand for liquidity. In otherwords, the point where the expected rate of return on doing nothing is better than the expected rate of return on doing anything. In otherwords, the point where the central bank can't give money away.

So what to do to avoid a liquidity trap? Soak up excess capacity. Japan spent on public works - but the public works used up construction labor and concrete - neither of which were in immediate oversupply. It cushioned the blow of the real estate crash for a sector of the economy, but did not address the problem of oversupply of capacity. More or less, the rest of the world was buying as much from Japan as Japan could afford.

There are two ways to saok up extra capacity. One is, of course, to hire it for government projects. The New Deal era in the US had a tremendous oversupply of labor, and so hiring it cheaply for public works was good policy. Another way to soak up excess capacity is to retire it. Retiring excess capacity means - shifting capacity to other uses, obsoleting old capacity by forcing new technological innovations into mainstream use, giving write offs or write downs favorable tax treatment and so on.

Traditionally the most effective means of soaking up excess capacity is to have a war. It hires out factory capacity, technical capacity, and by creating favorable conditions for wholesale destruction of capital, creates a shortage of capacity, and a tremendous increase in demand capacity to rebuild bombed out cities and so on. The present US Executive has shown that it has no aversion to either allowing the retirement of excess Manhattan office space, or to shifting construction and drilling demand to occupied areas as a means of soaking up excess capacity.

If war is not your preferred economic policy, then it is wisest to avoid liquidity traps in the first place. But once stuck in one, the simplest means of dealing with the problem is for the government to mandate technological improvements be put into place as a cost of doing business. If HDTV is standard, then it creates artificial demand for replacing NTSC televisions. If high speed internet is standard, it creates demand for replacing computers which cannot effectively use it. If vehicle emissions standards are tightened, it retires vehicles currently on the road - and so on. But the best program available for shifting capacity would be to remove economic inefficencies in large sectors of the current economy. In the US, one of the largest of these is in the medical industry. Removing the high overhead costs of health care delivery and insurance would simultaneously reduce costs of production, and it would also create a large new catagorey of demand.

None of which is going to happen in the current environment


Posted by: Stirling Newberry on May 24, 2003 04:39 PM

Andrew Boucher
DeLong answered your question a while ago

http://www.j-bradford-delong.net/movable_type/2003_archives/001163.html

Easy monetary policy increases our utilization of capacity, which can be true if there are sticky prices, for which the evidence is overwhelming, or sticky wages. Decreasing interest rates is how you do this in normal recessions, and for a liquidity trap, monetary policy must increase the expected price level relative to the baseline if you are trying to get out of the liquidity trap. If you are saying that monetary policy only creates "nominal growth" and not "real growth," or rather only inflation instead of increasing capacity utilization, this is incorrect in practice.

If by "real growth" you are talking about growth of productive capacity, we are doing very well in that dept and no one is claiming that monetary policy does anything for capacity growth. It's just a question of demand and utilization of capacity.

Posted by: Bobby on May 24, 2003 06:07 PM

Andrew,

Think of the real interest rate (r). There is a real interest rate which is associated with the natural rate of unemployment. If r > the real interest rate associated with the natural rate of unemployment, then actual unemployment > the natural rate of unemployment. If r the real interest rate associated with the natural rate of unemployment and that we have the nominal interest rate (i) and expected inflation which is (Pe/P)-1.

r = i - ((Pe/P)-1)

To decrease r you must decrease i or increase ((Pe/P)-1)

Suppose also that i is fixed at i=0 and hence we are in a liquidity trap. Then your only choice for monetary policy is to increase ((Pe/P)-1)

Therefore to get out of the liquidity trap with monetary policy, you must conduct monetary policy so that Pe must increase faster than P. This decreases the real interest rate, and if it does so enough, you will get to the real interest rate associated with the natural rate of unemployment, and you will be out of the trap.

Posted by: Bobby on May 24, 2003 06:35 PM

Edited and corrected version of previous post

Andrew,

Think of the real interest rate (r). There is a real interest rate which is associated with the natural rate of unemployment. If r > the real interest rate associated with the natural rate of unemployment, then actual unemployment > the natural rate of unemployment. We have the nominal interest rate (i) and expected inflation which is (Pe/P)-1.

r = i - ((Pe/P)-1)

To decrease r you must decrease i or increase ((Pe/P)-1)

Suppose r > the real interest rate associated with the natural rate of unemployment and also that i is fixed at i=0 and hence we are in a liquidity trap. Then your only choice for monetary policy is to increase ((Pe/P)-1)

Therefore to get out of the liquidity trap with monetary policy, you must conduct monetary policy so that Pe must increase faster than P. This decreases the real interest rate, and if it does so enough, you will get to the real interest rate associated with the natural rate of unemployment, and you will be out of the trap.

Posted by: Bobby on May 24, 2003 06:42 PM

Good post Bobby. Stirling has good ideas for soaking up capacity. We are way overbuilt in fiber opitic networks and bandwidth availability. Those are being sold at fire sale prices.

Kevin Phillips gives an historical perspective on overcapacity bubbles. Overcapacity in railroads created a bubble, but it was not the railroads that led the ensuing recovery. It was other sectors. What about redirecting a stagnant economy to renewable energy?

I agree that health care is an inefficient sector that could use reform. However, it is essential and less subject to supply and demand. Desperation leads people to make sacrifices elsewhere that keep the health care demand high.

On another note, it is interesting that Dr. Krugman did not submit his usual Tuesday/Friday columns and the NYT ran a longer column on Sat. This is a direct response to critics of PK. I only wish he had more room to explain why the Bush fiscal policy is wrong. The PK bashers will have a tough time deconstructing this column. I will have to check poor and stupid Luskin to see how he responds.

Posted by: bakho on May 24, 2003 08:26 PM

"Traditionally the most effective means of soaking up excess capacity is to have a war.
Posted by Stirling Newberry at May 24, 2003 04:39 PM"

Aha! So our neo-conservative friends in the American Enterprise Institute are really just neo-keynesian pump-primers! There's already talk of invading or deposing the government of Iran; perhaps this will save us from the liquidity trap.

Seriously, it seems like renewable energy, health care, and bandwidth might be really good areas for someone who's serious about jump-starting the economy to focus on in order to create demand. Perhaps there's even some middle ground that economists like Krugman and the Bush team could be brought to agree on.

Posted by: Chad on May 24, 2003 09:25 PM

"Remember, though the dollar has fallen sharply against the Euro so has China's currency. We may find that there is far less of a gain in exports than we hope for because Asia currencies are pegged to the dollar..."

That would be true only to the extent that we export the same goods to the same markets.
E.g.: looking at my almanac re the US and China there doesn't seem to be a whole lot of overlap in either case (except on the market side for Japan, and that's only 8% of US exports.)

Posted by: Jim Glass on May 24, 2003 09:48 PM

Bobby - Sorry, BDL (in the link you provided) replies to a related objection, but I don't think to mine. That is I accept (and agree) that deflation is a short-term threat and inflation long-term. Fine. But Krugman is not just asserting that there may be deflation in the short-term. He is saying that it is the "bad" kind, the one, once you get in, creates all kinds of problems, and which requires super-human effort to get out of. (I guess I may be putting up a strawman here, but that's how I read it!) But it can't be so bad if there's already the threat of inflation, in the long-term, now.

Or consider it this way. The Fed is saying it will target long-term interest rates, by buying the 10-year bond. It is my understanding that Krugman supports this kind of (extraordinary) behaviour. Presumably that means the Fed will try to make the 10-year rate go even lower than it is today. Given that the market accepts there is an implicit backing of the Fannies by the federal government, mortgage rates should either stay steady or go lower. So why did Krugman lock in his mortgage rates because he thought such rates were going higher?

Now Krugman may in fact turn out to be right - the Fed, by trying to ward off deflation, pushes the country into inflation or even (gosh!) hyperinflation (say, because there is a crash in the dollar). But what he's not saying is, he will be right, only because the Fed is doing what he asked it to do, or only because the market thinks the Fed *will* do what he has asked it to do. He is, so to speak, frontrunning: he's taken a position (long mortgage rates) and then advocated precisely a policy - reflation at all costs - where his position becomes profitable.

Posted by: Andrew Boucher on May 24, 2003 10:06 PM

"... what was the most important point Prof. Krugman would have (should have) made except for the space/ink shortage at the Times?"

My #1: The potential Mother Of All Bubbles in the Japanese bond market and its implications for the proposed "inflation cure". Long bonds are paying 0.6%, so what if inflation *is* pushed up to say 2%-3% so the interest rate on them goes to 4% or 5% -- calculate the plunge in their value. Now think of hundreds of billions of dollars worth (or more) of these bonds embedded in the capital structure of the already barely propped up financial system. When their plunge takes it down with them and the big bankruptcies finally arrive as a result -- and the Japanese people see their pensions invested in government bonds largely wiped out -- will consumer spending *rise*?

Rudy Dornbusch, shortly before he died, posited this as a scenario to create the next Great Depression. He was Krugman's professor at MIT, if I understand correctly, and the "inflation cure" is Krugman's baby, so I don't understand why Krugman never even mentions this issue. Does he have a way to handle it?

"My nominees: (a) the role of the collapse of the Japanese financial system. I thought that collapse was a major reason monetary policy failed in Japan.."

Certainly -- and how it resulted from their political decision to prop up their equivalent of every Enron and failed S&L with government-directed bank loans that are now decaying in the banking system, preventing the money transmission mechanism from working, forcing the BoJ to become the only central bank in the world that must buy long bonds in the market to get money out, which has reduced the long bond rate to 0.6%, see my #1.

It's worth mentioning that Japan even keeps the managements of its failed institutions in place when it props them up. Just this week they bailed out Resona Holdings, their fifth largest bank, with $17 billion -- and left almost all its management in place. The bank "collapses" but everyone stays and business as usual carries on.

Now imagine if the US had not only propped up everyone from Keating's S&L to Enron through the commercial banking system but also had left all their managements in place to keep running the show -- what shape would the US economy be in today?

The comparative health of the US financial system is a big difference between the US and Japan. Things like bond bubbles, politics, and the quality and accountability of management don't show up in economists' IS/LM analysis, but in real life they make a big difference.

"I would have liked a bit more discussion about how the administration's economic policies are *disastrous* in this scenario (if we're Japan in 1994, then imagine Japan in 2002 forced to enact large tax increases)."

Japan is far worse in every respect. Their debt is worse, their deficits are worse, their government-financed Social Security and pension obligations are worse, their demographic decline in the number of workers they'll have available to tax to pay for all this is far worse, so the future tax increases those workers face are worse ... you name it.

"Note - The Japanese financial system did NOT collapse. This is important to remember. The Japanese government has protected larger "city" banks..."

Well, nothing collapses as long as it is propped up. The US could have avoided a whole lot of financial collapses, from the Lincoln S&L to Enron, if the government had decided to bail them out and prop them up to protect employment -- to the point of protecting their top managements' jobs as well. I'm not sure, though, that most people here would consider that enlightened policy.

Also, while the Japanese banking system hasn't "collapsed", the manner in which it has ceased to function has cost the Japanese people dearly. And other people as well.

The Economist notes that Japan's GDP is now as far below trend-line capacity as the US was at the bottom of the Great Depression -- the difference being the US plunged dramatically then came back, while with Japan it's been drip, drip, drip, dropping one or two or three percent further below capacity each year for more than a decade, with no end in sight. But having GDP 25% under where it should be is hugely costly in income, jobs, welfare. Not only in Japan, but in the other nations -- inlcuding many poorer developing nations -- that it trades with.

Posted by: Jim Glass on May 24, 2003 10:08 PM

I'm no econ whiz here, but isn't the problem with short-term deflation that interest rates are already close to the 0.75% floor? I've been checking the Treasury auctions for student loan purposes, and last week the 90-day T-bill went all the way down to 1.02%. Meaning further deflation couldn't lower interest rates a whole lot further than where they already are -it would just lead to fiscal policy measures or depression (or both). So even if the deflation were to last for a while, Krugman would still be justified in locking in his mortgage now. As long as inflation were to someday become a problem during his mortgage term.

Also, I don't think Krugman was saying that the anti-deflation measures would cause the inflation. Rather, the cause would be the large deficits that we'd see once both the backloaded tax cuts kicked in and the baby boomers started retiring. Or in other words, even if there was no short-term deflationary threat that required drastic present-day measures, I think Krugman would say he'd still be afraid of the threat of inflation in the long term.

Posted by: JP on May 24, 2003 10:51 PM

Andrew
It's bad because the deflation worsens and prolongs our present liquidity trap/recession and inflation begins long after it ends. Neither one offsets the other, so neither has any redeeming value.

The inflation years from now is NOT due to the fed fighting today's liquidity trap. It is a result of the temptation to inflate away huge debt resulting from huge budget deficits that occur years from now.

I'll plead ignorance as to why he wants a fixed rate, but here's my best guess:
The confusion is one between real interest rates and nominal interest rates.

Expected inflation years from now, aside from increasing a risk premium, will not affect real long term rates (r). Expected inflation does increase nominal interest rates (i) since (1+i) = (1+r)(1+Expected inflation)

The Fed fights recessions by decreasing r, that is the real interest rate. If it is decreasing r but in fact i is increasing due to an increase of Expected inflation that is faster than the decrease of r, the fed is still fighting the recession since investment (and likely consumption decrease in r.

Therefore, by conducting the unconventional monetary policy that you described, the fed can still be decreasing real 10-year interest rates while in fact expected inflation in those years is increasing the nominal rates.

Krugman's point is that bond markets have not yet realized this temptation to inflate away the debt yet. Once they do long term nominal interest rates are going through the roof, which makes Krugman's fixed *nominal* rate a good deal, even though real interest rates are decreasing.

Therefore these deficits will increase nominal interest rates for two reasons:
(1) deficits create debt to which creates the temptation to inflate away the debt and hence increases Expected inflation and increases the nominal interest rate.

(2) real interest rates rates increase since the government is borrowing savings that could be put in private investment and possibly there is a increased risk of default

Krugman is saying that much of the two aforementioned things, especially (1) have not been priced into the bond market yet. Therefore, by getting a fixed nominal rate Krugman is getting a good deal.

This is my best try. Sorry if it's completely wrong.
http://www.pkarchive.org/column/031103.html

Posted by: Bobby on May 25, 2003 12:20 AM

Wonderful discussion!

1. At .75% interest on federal funds high expense money market funds would be paying about .25% interest to investors. Too close to zero for comfort. Of course fund families could lower management fees, but you try getting fund families to charge more reasonable fees.

2. Though long term interest rates have indeed fallen sharply to "record" lows in the last 3 weeks and may gall further, I would lock in a 30 year mortgage immediately rather than holding out for a further drop. Who cares if you miss a basis point or so at these levels? Eventually the rapidly growing federal deficit will likely result in higher interest rates. Please do lock in a 30 year mortgage immediately.

3. Japan really is a democracy, really. The Japanese government and central bank have sought to avoid an austere push to economic restructuring. Perhaps, taking a long term view will allow for full recovery in Japan without a fearful price being paid by the middle class. Would you opt for 10% unemployment as opposed to 5, to force faster restructuring? I would not.

4. Many American and British economists seem to dismiss the attempt in Japan to limit damage to the middle class while the economy recovers ever so slowly as absurd. I say there is a time to think long long term when the well-being of a significant portion of the middle class seems to be at stake. Japanese middle class voters should be given some-much credit for intelligence in defending well-being.

5. China and India and several south-east Asian nations are rapidly rapidly becoming more competitive with America in trade. Stephen Roach writes frequently on this subject. The next time you eat an apple [hmmm], remember that China has quietly become a major world producer of apples and apple products. China has a competitor for Cisco. India is becoming an interesting competitor in "services." Yes, there is competition from Asia afoot.

Posted by: anne on May 25, 2003 04:40 AM

Having read the tax cut details, my sense is that we have gone from what was essentially a porportional tax system from middle income to wealthiest, to a regressive tax system. Warren Buffett has a fine gift [not wished for] even if Berkshire Hathaway does not pay dividends. Capital gains taxes have been lowered to 15%.

Though I sense the effect on economic growth of the tax cut will be too limited to get us back to healthy job creation, I am even more worried about the deficit impact. There was so much that could have been done to spur demand with a temporary payroll tax cut, why why why set social services in danger by such a deficit raising package?

Posted by: jd on May 25, 2003 04:56 AM

Bobby -

Terrific. Why you have a fine bargain take it, rather than blithely decide there will be more of a bargain tomorrow. Long term mortgages are a bargain these past few months. There will be a time when interest rates turn up, perhaps up in fairly dramatic fashion and for a long while.

Posted by: jd on May 25, 2003 05:01 AM

jd

That wasn't sarcastic, was it?

Posted by: Bobby on May 25, 2003 05:14 AM

Oh whoops. Yeah I gues it wasn't. Never mind . . .

Posted by: Bobby on May 25, 2003 05:35 AM

Accept for the fact that I wrote why for "when," the terrific was as always earned by you. I was just thinking, why guess precisely where interest rates are headed when each week is surprising? I "think" the economy is sadly going to grow to slowly to create the 200,000 jobs a month we need.

Hopefully, I will be wrong. Hopefully, interest rates will rise soon as economic growth picks up. In investment matters, I sat take the bargain you have now and get a fixed 30 year mortgage. Would you be buying long term treasuries just now? In fact, I do not know who is buying them and with what hedges. Curious curious bond market.

Posted by: jd on May 25, 2003 05:49 AM

Well, who is buying long term American treasuries and why? I just realized, I have no idea. The buyers have to be playing for the smallest of gains because it is too dangerous not to be using expensive hedging techniques to protect yourself at current prices. What long term investor would buy long term bonds now? Good grief.

Posted by: jd on May 25, 2003 05:57 AM

The bull market in bonds began in September 1981 and has continued till now. Bond yields are shockingly low, and you have to wonder whether there will continue be much demand for bonds by mutual fund investors. "Who is buying," indeed?

Strikes me, while bond yields may well fall if slow growth continues, I too do not understand this bond market. The Federal Reserve may really have to buy long bonds to take long term rates any lower.

Oops, I just remembered that in Japan there was still demand for long term bonds as interest rates fell below 3%.

Posted by: anne on May 25, 2003 06:22 AM

Thanks :)

Posted by: Bobby on May 25, 2003 06:34 AM

I think people - Paul included - are missing one of the key problems here: this deflation (if it comes, and it seems it is coming) will be global.

Now aren't we being a bit unimaginative. You can argue all you want, but I suspect Japan shows, that in the worst of all possible worlds, all technical solutions are off.

But what about the 'helicopter money' one. Obviously it is unlikely to work in individual nation states, if people hoard the money. But what if the rich countries printed money and -'metaphorically speaking' - dropped it from helicopters - with strings attached of course (institutional reform, structural investment etc). ie why not turn the EU formula into a global one.

In the end the solutions here are global. The WHO tobacco agreement was a good start.......

Posted by: Edward Hugh on May 25, 2003 07:05 AM

Deflation has taken hold in Japan, and is occuring in Hong Kong and China, and is near in Germany. Stephen Roach has written that there is deflation in several other Asian economies. Yes, the problem of sluggish economic growth is a global problem. Yes, unless we expect demand to take off in America and American imports to grow enough to stimulate Asia in particular, I do not think spurring growth in America alone is a complete answer.

Posted by: anne on May 25, 2003 07:34 AM

Edward, Krugman says that this is a global problem in his CBS Market Watch interview on deflation. And if we approach the curing of the liquidity trap with fiscal stimulus to offset any real devaluation of the dollar we will not be devaluing and not hurting and maybe helping countries abroad that suffer from deflation:

http://www.pkarchive.org/video1.html

Posted by: Bobby on May 25, 2003 08:39 AM

Bobby

Interesting....

Paul Krugman appears to be saying that a fiscal stimulus in America will involve a rise in demand that will increase imports. So then, the deline in the value of the dollar will be offset for other countries by a rise in our imports from them, and they will not be tempted to devalue in turn. Makes sense.

The whole question then is whether we have had enough of a stimulus with the tax cut. There is the question. Will American consumers continue to spend freely and even increase spending now?

Posted by: anne on May 25, 2003 08:59 AM

Anne

Whoops that second sentence was mine not Krugman's, although he may have implied it. I was employing the Mundell Fleming Model to address the global thing. Fiscal stimulus creates a domestic currency appreciation and decreases net exports for the domestic economy, which implies an increase of net exports for foreign countries. When one's own currency devalues nominally, some of that shows up as inflation at home and deflation abroad and some of it as a real devaluation, so we would be stimulating foreign economies and helping them fight deflation. Of course this has the effect of aiding our own deflation, so the stimulative benefit to us of fiscal stimulus is offset somewhat by this. But the size of this effect depends on how much the dollar appreciates. So who knows? Considering we should practice expansionary monetary policy, the effect of this and fiscal stimulus would probably offset each other and probably be in fact devaluation. The point is that fiscal stimulus allows us to fight the liquidity trap without as much devaluation as without fiscal stimulus.

Krugman did advise against devaluation of the dollar since that just puts the burden on foreign countries in this apparently global problem. So I was pretty much getting my statement from that.

By the way, I know nothing about international economics (ironic, right?), so beware.

Posted by: Bobby on May 25, 2003 09:23 AM

Utterly fascinating discussion here, not least because I have to decide when in the next 30 days to lock in a 30yr. rate. Kudos to all. But after all this analysis, it is still incredibly curious why long term rates are still falling. Something is missing from the theory. The budget deficits are about as real as anything that can be counted on; either they crowd out, or they don't.

Posted by: Russell L. Carter on May 25, 2003 09:44 AM

Russell. The question you must ask is: Which is shifting inward faster. (1) The supply of loanable funds? Or (2) the demand for loanable funds.

If the answer is (1), due to increasing budget deficits, then interest rates would increase

If the answer is (2), which is true because there was overinvestment before the recession, then interest rates decrease.

Right now the answer is (2), but eventually, when the recession ends, people will begin investing again which will increase interest rates, and, since we have budget deficits, (1) becomes operative and the crowding out begins. Also keep in mind that the prospect of future inflation may increase nominal long term interest rates even while we're still in the recession, and once this happens you've missed out.

Posted by: Bobby on May 25, 2003 10:07 AM

"Utterly fascinating discussion here, not least because I have to decide when in the next 30 days to lock in a 30yr. rate. Kudos to all."

Do it whenever it's convenient. It's not like the rates swing by large amounts, over a period of weeks.

On each $100,000 of loan value, you're probably talking about a difference of less than $20 per month, from the highest rate in the next 30 days, to the lowest rate in the next 30 days.

For example:

http://www.mortgage-calc.com/payment/javacalc.html

...from that site, a $100,000 at 5.5% interest (and with $1000 annual tax and $300 annual insurance) is $676 a month. At 5.0%, it's $645...a difference of only $31 per month. And that's on a 1/2 percent change...hardly any months have that big a change.

Posted by: Mark Bahner on May 25, 2003 10:53 AM

"Utterly fascinating discussion here, not least because I have to decide when in the next 30 days to lock in a 30yr. rate. Kudos to all."

Do it whenever it's convenient. It's not like the rates swing by large amounts, over a period of weeks.

On each $100,000 of loan value, you're probably talking about a difference of less than $20 per month, from the highest rate in the next 30 days, to the lowest rate in the next 30 days.

For example:

http://www.mortgage-calc.com/payment/javacalc.html

...from that site, a $100,000 at 5.5% interest (and with $1000 annual tax and $300 annual insurance) is $676 a month. At 5.0%, it's $645...a difference of only $31 per month. And that's on a 1/2 percent change...hardly any months have that big a change.

Posted by: Mark Bahner on May 25, 2003 10:54 AM

Bobby

Paul Krugman did believe that Japan could have allowed a decline in the value of the Yen to help get a round of domestic prices increases going. But, that was at a time when the American economy was far stronger. We might then have allowed the Yen to decline in value. Now, many economists are hoping a dollar devaluation will add to domestic demand in America. Stephen Roach has long held this thought. I worry the weakness of the "global" economy may offset any decline in dollar value as a domestic stimulus. Stephen Roach has warned that other nations may well not welcome the dollar deline and so counter.

Again, I think we have to pay attention to how much China in particular will benefit from a dollar decline, since the Chinese and Hong currencies are dollar pegged. China and Hong Kong are increasingly competitive with America in world markets.

Mark

I agree that mortgage rates are not likely to swing violently, still, when "convenient," I say get that 30 year fixed mortgage settled.

Mortgage rates are set each week according to the close of the 10 year treasury on Thursday. What puzzles me is who is buying the 10 year treasury at these rates? Wish I knew more about hedge fund trading.

Posted by: anne on May 25, 2003 05:07 PM

http://epinet.org/content.cfm/webfeatures_snapshots

Notice this interesting EPI analysis of whether the dollar is really declining. Analysts who are counting heavily on a dollar decline as a stimulus must be careful in noting the multiple currency moves. Any comments and arguments would be quite useful.

Posted by: anne on May 25, 2003 05:23 PM

I'm not an economist, so the discussion in this thread has been very interesting and informative--along with Krugman's Saturday NY Times column.

I've noted that many here have stated that the Bush administration is engaging in exactly the wrong policies for getting us out of this recession and any potential liquidity threat.

So, are the Bushies just pirates, as it appears to lay people like me? It appears that these really are crony capitalists of the Mississippi/Alabama ilk circa Civil WAr to the 1960's. All tax and spending policies are directed towards benefiting only their campaign contributors--there really is no overarching economic strategy in place.

Is it possible that that is what's going on? And if so, won't the American people wake up at some point?

Posted by: Pat M on May 26, 2003 03:45 AM

I'm not an economist, so the discussion in this thread has been very interesting and informative--along with Krugman's Saturday NY Times column.

I've noted that many here have stated that the Bush administration is engaging in exactly the wrong policies for getting us out of this recession and any potential liquidity threat.

So, are the Bushies just pirates, as it appears to lay people like me? It appears that these really are crony capitalists of the Mississippi/Alabama ilk circa Civil WAr to the 1960's. All tax and spending policies are directed towards benefiting only their campaign contributors--there really is no overarching economic strategy in place.

Is it possible that that is what's going on? And if so, won't the American people wake up at some point?

Posted by: Pat Murphy on May 26, 2003 03:46 AM

I'm not an economist, so the discussion in this thread has been very interesting and informative--along with Krugman's Saturday NY Times column.

I've noted that many here have stated that the Bush administration is engaging in exactly the wrong policies for getting us out of this recession and any potential liquidity threat.

So, are the Bushies just pirates, as it appears to lay people like me? It appears that these really are crony capitalists of the Mississippi/Alabama ilk circa Civil WAr to the 1960's. All tax and spending policies are directed towards benefiting only their campaign contributors--there really is no overarching economic strategy in place.

Is it possible that that is what's going on? And if so, won't the American people wake up at some point?

Posted by: Pat Murphy on May 26, 2003 03:47 AM

Republicans are increasingly committed to an economic policy of minimal public services with private market expansion to fill in. Texas is a perfect example of the philosophy. Also, policy makers are always subject to the influence of the most well-financed lobbies. Put it together. Less government, more private sector services, but the private sector influences the shift from government to private services....

Many many business leaders are happly as clams about Republican economic policy. Will Republican policy help or hurt the middle class? The middle class is being hurt, and will be hurt because the effects of present policy will be felt increasingly harshly in future. Will the middle class change voting habits? There are big big money political advertisers and a pattern of voting in Texas that is discouraging for Democrats. We can hope, and work to elect more Democrats.

Posted by: lise on May 26, 2003 04:50 AM

http://www.nytimes.com/2003/05/25/weekinreview/25LEON.html

Note Brad DeLong's remarks....

Posted by: jd on May 26, 2003 05:17 AM

Sunsets in the Tax Code

William Gale and Peter Orszag examine the sunset provisions of the new tax law approved by Congress. Among many findings, they conclude that removing all of the sunsets in the tax code would involve a revenue loss of almost $2 trillion over the next 10 years. This is roughly as large as the official costs of the 2001, 2002, and 2003 tax cuts combined.

www.brook.edu

Oh dear....

Posted by: anne on May 26, 2003 06:22 AM

Stunning Poverty Decline Examined

During the 1990s, concentrated poverty fell dramatically in nearly every major metropolitan area in the U.S, a complete reversal of the trend from prior decades. A new report from the Brookings Center on Urban and Metropolitan Policy examines this phenomenon.

www.brook.edu

Of course, this had nothing at all to do with the policies of the Clinton Administration. Duh.

Posted by: anne on May 26, 2003 06:27 AM

Well folks, I thought this new tax cut was extreme but how little I understood. Oh dear, oh dear. The cost will be far far more than I guessed, and the skew towards the richest of the rich is far far more.

Little did Warren buffett know when complaining of the dividend tax cut proposal.

http://www.brook.edu/views/op-ed/orszag/20030520.htm

http://www.brook.edu/views/articles/gale/20030602.htm

Posted by: anne on May 26, 2003 06:45 AM

Lind's "Made in Texas" gives insight into Bush's Texan political philosophy. The dominant area of Texas, East Texas, was a stronghold of the plantation-owner point of view -- a resource economy with a thin wealthy elite and an impoverished,powerless, and almost servile working class. Lind makes a comparison with the plantation economies of Latin America and speculates that if the South had won the civil war it would have extended its influence into Central and South America to produce a conservative plantation-owner bloc.

The servility, degradation and suffering of the lower orders is a good thing from the plantation-owner point of view, since the rabble don't deserve anything good.

Posted by: zizka on May 26, 2003 07:08 AM

Thanks Anne -

This tax cut bill seems more radical than the initial Administration proposal. We have gone further along toward "ending" the income tax on corporations, and if you are rich enough forget about having to pay anything like a fair share of taxes. Of course, charity will save us all. Deficits? I agree, "oh dear."

Posted by: lise on May 26, 2003 07:19 AM

"I agree that mortgage rates are not likely to swing violently, still, when "convenient," I say get that 30 year fixed mortgage settled."

Yes, I agree. There were comments to the effect of questioning why Paul Krugman has recently converted to a fixed mortgage, given Krugman's thoughts that deflation was a possible problem. (The answer was that, long run, Dr. Krugman thinks deficits will bring higher interest rates.)

I agree with the philosophy of locking in a fixed mortgage fairly soon. Unless one loses one's job, it's a very good time to have a fixed mortgage. Over any time frame beyond the next 1-5 years, it seems like interest rates certainly won't be much lower than they are now, and the preponderance of evidence is that they'll be higher.

I signed *my* papers on 9/11/01. Even though I knew that rates would probably go down (for a short period) from that time, I still don't think I made a really bad decision. Even by signing on 9/11/01, I'm getting a better deal (@ 6.625%) than I would have from continuing to rent. (Unless I lose my job soon.) And I *could* refinance.

Posted by: Mark Bahner on May 26, 2003 08:55 AM

Mark

Taking a 30 year mortgage in September 1991 made perfect sense. We have not had a mortgage for years and so know little about the costs of re-financing. Goldman Sachs has been telling clients that the latest waves of re-financing are being used to sustain consumption rather than pay off mortgages faster.

There are all sorts of problems I have with using a home as a loan bank, but I may not understand the matter well enough.

Anne

Posted by: anne on May 26, 2003 10:23 AM

The combination of dividend and capital gains tax cuts will foster a move away from "income" for the waelthiest investors. Why pay income taxes at a marginal rate of 35%, when you can pay dividend and capital gains taexs at 15%? This bill is more far-reaching than I realized.

Posted by: jd on May 26, 2003 10:32 AM

May 26, 2003

David Greenlaw - Morgan Stanley
Tax Cut - Stimulus Analysis

* Tax dividends under a new rate structure in 2003 through 2008 (sunset after 2008). Details of what would constitute a qualified dividend are still a bit sketchy, but even dividends paid by companies with no reported income would now qualify for the lower rate. Also, it appears that dividends paid by most foreign companies would be covered under this provision.

* Tax capital gains on sales of assets after May 6, 2003 under a new 15% rate structure in 2003 through 2008 (sunset after 2008).

The bottom line is that the near-term stimulative impact of the bill is significant. New withholding schedules are slated to be put in place during the next month or two. We estimate that about $50 billion will be freed up during the second half of this year due to lower tax withholding. Another $14 billion of rebate checks tied to the hike in the child credit will be mailed beginning in July. An additional $30 billion or so of the tax cuts for individuals will show up early next year in the form of increased tax refunds and smaller final payments. Factoring in the business tax breaks and the aid to states, this means that the overall stimulus associated with this legislation is worth about 1.5 percentage points of GDP during the next four quarters. This factor -- along with the impact of lower energy prices, a falling dollar, supportive financial market conditions and improving corporate profit trends -- is a big part of our call for a pick-up in US economic activity during the second half of 2003.

Posted by: jd on May 26, 2003 11:40 AM

Well, there we have someone who thinks it will be a significant short term stimulus. But I'm guessing their assumption is that the money gets spent - my guess is that most of it doesn't get spent, but goes into securities - and a fair chunk into overseas securities.

We'll see.

Posted by: Ian Welsh on May 26, 2003 12:07 PM

I second those who are suggesting a public works program to bring "last-mile" high speed internet to residential areas (a suggestion I've made before). One of the biggest bubbles was in the communications sector, which has been hit extremely hard due to overcapacity (much of which, I understand, is now sitting unused).

It wouldn't alleviate the sluggish economy completely, but I would think such an effort would provide a jump-start to several areas now suffering from oversupply. I can think of few areas that would result in greater return for our public dollar right now.

Jonathan

Posted by: Jonathan on May 27, 2003 06:28 AM

It's worth pointing out that long-term corporate bond rates have dropped significantly since the last FOMC meeting, not just the short-term rates. The posters here seem to assume that projected deficits 5-10 years from now will rekindle inflation; the problem is that financial markets appear to disagree. How do you respond to that "message from the markets"?

Public works: like any of us know what the next sector needing capital infusion is! Ha. In fact, encouraging dividend payments by corporations should increase the speed of capital redeployment and allow the next rapid expansion of capacity to occur more quickly and in obviously a more efficient manner than diktat by economic policymakers. This is an entirely retrograde suggestion.

Posted by: JT on May 27, 2003 10:26 AM

Uh, long term bond rates can drop because there is a lot of excess capital on the sidelines that is can not be productively invested in the climate of overcapacity. Stocks are overpriced. Short term rates are so low as to be worthless. Long term bonds offer a halfway decent return. Where else do people park their money?

Posted by: bakho on May 28, 2003 09:19 AM

monetarists seem to think that there is little or no real effect on output because interest rate decrease, investement increase, saving decrease so consumtion increase. what is your though about this and economy today??

Posted by: mm on July 19, 2003 06:26 PM

monetarists seem to think that there is little or no real effect on output because interest rate decrease, investement increase, saving decrease so consumtion increase. what is your though about this and economy today??

Posted by: mm on July 19, 2003 06:28 PM
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