The Folly Of Stimulus -- A Data Driven Approach

The argument in favor of government stimulus generally go as follows:

1) In a recession, demand falls
2) This causes (economic activity) GDP to fall
3) When GDP falls, employers must lay off employees
4) Those employees stop spending money, which causes demand to fall further
5) To stop this, the government must prop up demand with deficit spending
6) Doing so will create more jobs than in the "do nothing" case

There are two assumptions here:
1) That propping up demand will prop up GDP
2) That propping up GDP will create jobs

Assumption 1 is not really controversial (at least in the short term). GDP is defined as

C (Consumption) +
I (Investment) +
G (Government Spending) +
NX (Net Exports)

Increasing G (goverment spending) has a direct effect on GDP. This is econ 101 stuff. The really interesting question is whether or not GDP increases actually create jobs.

Well it turns out there's an economic theory relating the unemployment rate to GDP, and it's called Okun's Law.

And yet here we are: GDP growth recovered nicely in mid/late 2009, but the unemployment rate barely budged. What happened?

If you were to go to the St. Louis Fed's research website and start pulling data series, you would find that the graph of "non farm payrolls" (i.e. the number of jobs in the economy) against quarterly real GDP increases looks like this:



This is a nice tight pattern. Lower/Negative GDP leads to Lower/Negative job growth in the economy. No surprise here. Now let's isolate just "Consumption" the first (and largest) piece of GDP.



So far so good. Investment?



Again, a nice tight bunch, and a pretty obvious pattern. So I would imagine that government spending will exhibit the same pattern, which would justify the logic of "government spending as job creation"



...or maybe not.

As it turns out, government spending doesn't correlate very well with job growth. You can see a big blob centered around the averages, and no real pattern. Looking at the far right of the chart, you can see a few quarters (some of them very recent) where government spending increased dramatically, but payrolls did not [note: data goes back to 1947]. If I were showing you actual statistics instead of just charts, you would see that the relationship between G and nonfarm payrolls is not statistically strong.

"Ah," you say. "Government spending tends to increase in recessions, and I have read on MSNBC that payrolls are a 'trailing indicator'. I'm sure if you showed me a delayed series the relationship between government spending and payrolls would be clear as day!"





Again, not so much. The charts above show the relationship between Government Spending in Quarter 1 and the change in payrolls in quarter 2 and 3. In other words, a one-quarter delay and a two-quarter delay. Not only is the relationship not any tighter, it's actually slightly negative, implying that government spending is a pretty poor, possibly negative indicator for the employment situation 3 and 6 months out. Meanwhile, compare this to our better indicators, like investment:



Or consumption:




Here's The Bottom Line:

A business will hire a new employee in two -- and exactly two -- situations: Either they have more business than their employees can handle, or they expect that in the future they will have more business than their employees will be able to handle.

When consumption rises, and business is booming, hiring increases because "my employees have too much work."

When investment rises (for example, building a new factory), it means that the people making the investment expect business to be good in the future, and hiring increases to meet that need (i.e. hiring people to work in the new factory).

When government spending rises ... neither of those things happen (unless you happen to be in a business which primarily serves the government). Hand-wavy arguments about aggregate demand and New Deal mythology aside, there just isn't a lot of data to suggest that government spending impacts unemployment in a consistent and robust way.

It's time to put this debate to rest and focus on rebuilding the private economy.

McChrystal vs. MacArthur

Pragmatic returns from nowhere with a short history lesson.

A Reuters article today compared the recent Obama-McChrystal controversy with an episode involving Douglas MacArthur in 1951:

"The episode has evoked memories of military-civilian tensions when President Harry Truman stripped Gen. Douglas MacArthur of his Far East command in 1951 for flouting U.S. policy and openly advocating expansion of the Korean conflict to China."

Opinions aside of what should happen to McChrystal, this is a ridiculous comparison. In 1951, Douglas MacArthur was a popular World War II hero with national name recognition/popularity and was widely considered to be the front-runner for the Republican presidential nomination in the next elections.

The guy was the de-facto ruler of Japan for 6 years during the beginning of the US occupation of Japan. Not like, advisor. He was the freaking ruler of Japan. When the Korean War broke out, the UN made him in charge of the United Nations Command. When he came to the United States, they threw him giant parades attended by hundreds of thousands of cheering Americans. He was a big deal.

He was a way bigger deal than McChrystal and what he did was way worse. MacArthur didn't just give a magazine interview where his advisors told bad jokes. He made multiple public statements criticizing overall US foreign policy as "appeasement and defeatism." Then, in March 1951, the Joint Chiefs of Staff issued a cease-fire proposal that MacArthur was to pass on to the Chinese. Instead, MacArthur called the Chinese and demanded that they surrender personally to him.

That was freaking insubordination.

If there is one lesson from history in all of this, it's that people are a lot less bad-ass and crazy nowadays.

Greece and the Euro

Krugman has written another column about Greece and the Euro, with the specific half-suggestion that they should think about leaving the Euro in order to voluntarily devalue.

Look. Paul Krugman is a trade expert. And I understand that Paul Krugman is specifically an expert in the types of trade in which "industrial policy" make sense (that is, his research focuses on the way a strong central economic planner can improve economic growth by encouraging certain industries to develop at home, although he probably doesn't use the term "central economic planner" very often).

I get that. I get that he's a government guy, and he thinks there's a government solution for everything. And I get that he's a trade guy, and trade guys tend to see things in terms of relative currency levels and not much else.

But let's get something straight. The Greek Economy is import oriented, service oriented, public-sector oriented, and had credibility problems long before this crisis emerged.

In a magic alternate reality where Greece was on the Drachma and not the Euro (and still somehow has the same debt problems) a devaluation would not make one whit of sense.

The point of devaluation is to make your exports cheaper in your customers terms, i.e. a 100 drachma tin of Greek olive oil costs $5 instead of $10 at the new rate. But it works both ways, because a $5 can of American shrimp now costs you 100 drachmas instead of 50. So, when you use your currency to buy foreign products more often than than you sell your products to foreigners, you want your currency to be strong and stable.

Devaluation would almost by definition hurt their economy more than it helps. It would cause intense inflation immediately and for the foreseeable future as all of their raw inputs (oil, steel, olive presses, whatever) would increase in cost. No one would trust their currency anymore, if they ever did. Their trade partners would be furious, and Brussels would be going even more nuts than they are right now. Their cancerous public sector would still be eating the rest of the country, because the real money value of all those nice government jobs and pensions and health care contracts would be decreasing (to the extent they aren't indexed to inflation, in which case their deficit problems just get magnified). In short, they would become Turkey in the mid-90s.

That's not to say devaluation wouldn't happen -- it just wouldn't be voluntary. Right about now they'd be looking at an incredible capital flight, and in order to prop up their currency, they would have to spend basically all of their capital reserves buy dollars and euros. Or they would have to restrict capital flow across their borders, which is (a) awful for your economy and (b) probably in violation of some Euro treaty. So yes, the Drachma would be in a nose-dive. And yes, it would be a disaster for Greece and its citizens.

But back in the real world, Greece obviously doesn't have it's own currency, it has the Euro. The main benefit of the Euro is that -- recent moves notwithstanding -- the Euro isn't really in any danger of plummeting. So the Greek economy, while in awful shape, isn't quite in, "let's delete our financial records Fight-Club-Style and start over" mode. Your 5000 Euro savings account is still worth something. So, they will restructure their debt, they will try to re-orient their economy around something other than their ludicrous public sector, they will languish for a decade or so, and eventually they'll be fine.

So remind me again why leaving the Euro is even remotely desirable? They'd still have the same structural problems, namely no export base and a bloated public sector, but now with a devalued stock of funds. They'd be an economic pariah. They'd have 15-20% inflation, minimum. The government would still be unable to make good on their promises, which means their citizens would still be turning over cars. And now they'd have the added fun of trying to keep their currency devalued, but not in a freefall.

If Greece leaves the Euro it's going to be with a boot-shaped impression in their back. A voluntary withdrawal is just about the last thing anyone over there should be thinking about.

Paul Ryan Is Really Smart

Paul Ryan is one of the few politicians out there in either party who can be counted on to speak intelligently on complicated issues.

Watch this video. He's taking a truthfully complex issue -- how do we mitigate systemic risk without encouraging the market to create systemically risky situations -- and dealing with the meat of the fundamental policy disagreements. Now contrast his approach to that of a Krugman, Boehner, or Obama, who all seem content to simply throw rocks at what they perceive to be "the other side" in the hopes of scoring the political point.

We could certainly use a few more like Mr. Ryan in Washington.

Anatomy Of A Krugman Argument

You know, I spend a lot of time complaining about Paul Krugman. Sometimes I feel bad about it. Sometimes I look at his academic work on International Trade, for which he deservedly won a Nobel Prize, and I think, "you know, he seems like a well-intentioned guy, he's a good economist when he applies himself, his job is to be controversial every 3 days, maybe I can cut him some slack."

And then he writes something like this and I remember why I do what I do.

This is the holy grail of Krugman argumentation. It has all of his favorite crutches: a cheap shot aimed at a Republican, a hastily constructed analogy, an assertion whose only support is the fact that "Paul Krugman Said It", a gross misunderstanding of current and proposed policy -- everything!

Distilled down to the essence, this is Krugman's position:

When a large bank or financial institution fails, it can cause collateral damage to the economy. Collateral damage is bad. We need some way to prevent that.

You can see him making arguing that point here:

Since the 1930s, we’ve had a standard procedure for dealing with failing banks: the Federal Deposit Insurance Corporation has the right to seize a bank that’s on the brink, protecting its depositors while cleaning out the stockholders. In the crisis of 2008, however, it became clear that this procedure wasn’t up to dealing with complex modern financial institutions like Lehman or Citigroup. So proposed reform legislation gives regulators "resolution authority" which basically means giving them the ability to deal with the likes of Lehman in much the same way that the F.D.I.C. deals with conventional banks.

Now, this is a perfectly...reasonable...opinion. Personally, I support the creation of a resolution authority, which I understand as a way to allow complex institutions to fail without dragging down the rest of the economy. The question of course is HOW the resolution authority works. Does it wipe out the equity of the existing bank shareholders? Does it separate out bad assets and leave the good assets to exist again? Does it fully nationalize the bank? Does it merely recapitalize the bank and send it on its way? Do we bail out the bank's creditors by paying off the failing bank's debt? Is that really a bail out? What about their counter-parties? What about their employees? Who gets what, and when, and in what order?

Everything I just mentioned was debated during the 08 financial crisis. To one degree or another, they are all "bail outs" in that they socialize private losses in order to prevent broader economic harm. Recapitalizing a bank (what most people would consider a bailout) is a tool given to the new oversight board by the Dodd bill. It allocates a pool of $50b to potentially be used to "resolve" failing institutions. Mitch McConnell does not like that provision, believes that it perpetuates the possibility of a bailout. He thinks it is important for banks to believe that they will be allowed to fail in order to contrain their risk taking from the inside. He believes this bill sends the wrong message. He has a point. You can argue that point with him. You can argue that it's a minor provision. You can argue that the rest of the reforms make it much harder for banks to ever get to the point of needing a bailout. You can say many things.

The point here is that rather than address this fundamental policy disagreement head on, Krugman decides to belittle McConnell's argument with an unfair analogy, make an arbitrary claim, and then support his claim with the assertion that his opposition is somehow "fighting for the banks", whatever that means.

First, the analogy. A failing bank is in some respects like a burning skyscraper. In other ways it is not. For example, a failing bank that receives government money frequently turns into a profitable bank, like for example Bank of America A burning building that is extinguished by the NYFD is usually a burned out husk. Banks have an incentive to make incredibly risky bets to make outsized profits if they aren't worried about the consequences of failure. Building owners do not have an incentive to pour kerosene on their carpets, despite the presence of municipal fire departments.

I could go on. The point here is it's a pretty weak analogy. But to really hammer home the point, Krugman attacks the GOP's MOTIVE.

So don’t be fooled. When Mitch McConnell denounces big bank bailouts, what he’s really trying to do is give the bankers everything they want.

The evidence for this? A series of assertions centered around the fact that "he and other Republican leaders have held meetings with Wall Street executives and lobbyists". Well, I'm sold.

McConnell's rhetoric is heavily populist, and anti-bank. It is very anti-bailout. He wants the banks "to burn", as Krugman helpfully points out. It takes a very questionable leap of reasoning to assume that he is saying all of this in order to benefit large banks. And by "reasoning" I of course mean "bullshit."

Aside from that, the funny thing about argument by association is that it ususally goes both ways. See this recent GOP claim that Barack Obama is just doing favors for his largest campaign donor, Goldman Sachs.

Just weeks ago, Paul Krugman wrote a column in which he claimed that bank regulation is complicated, and that reasonable people can disagree about the best way to achieve fairly common goals (fewer and less severe financial panics and an end to bailouts generally etc). As it happens, he was right. But closing your eyes and pretending that an entire political party is being insincere does not make it so.

A Tale of Two Summits

Pragmatic goes nuclear.

The Nuclear Proliferation Summit hosted by the United States in Washington, DC has just wrapped up and this weekend will be an alternative summit hosted by Iran also tackling the problem of nuclear weapons. These two summits, seemingly covering the same world issue, will be extremely different, and they represent two competing narratives on nuclear weapons put forward by the two hosts, Iran and the United States.

The American Narrative
This is the one that might sound more familiar to you. The United States is very aware of the risks of nuclear weapons, having come to the brink of nuclear warfare with the former USSR a couple of times during the Cold War. Luckily, with the end of the Cold War, the majority of the world's nuclear weapons are safe in the hands of nations that are too stable, reasonable and prosperous to use them. The only challenge is to make sure these weapons don't get into the hands of states who might use them. Iran, North Korea, and one time Iraq, were these types of states.

The Iranian Narrative
If you look under the blustery rhetoric, Iran has a pretty good story as well. The theme of the upcoming conference is "Nuclear energy for all, nuclear weapons for none." In this narrative, nuclear weapons are extremely dangerous, but despite this, the powerful, developed countries of the world (all of the UN P-5 Security Council members have nuclear weapons caches) have to decided to keep them while hypocritically punishing other countries for attempting the same. This plays into the same bitterness in many parts of the developing world have about the fact that Western countries industrialized without worrying about carbon emissions, but now restrictions are being forced on countries attempting to industrialize in the present day.

While the American story is that of a world community where we are attempting to stop the spread of dangerous weapons to unstable, belligerent and irrational actors, the Iranian story is that of bullying Goliaths versus righteous Davids. Although it may seem very clear to us as Americans that we are in the right and that the Iranian leadership obviously doesn't believe in a nuclear free world, it's a story that many of the traditionally non-aligned countries - mostly in the global South - want to believe.

American involvement in oil-rich regions; its support for Israel, a country that has activiely avoided the NPT; and recent military invasions all play into the narrative of a power hungry hegemon. The United States' harsh rhetoric concerning Iran sounds to many countries as unreasonable and aggressive, especially considering that even the US intelligence community has not been able to prove that Iran is actively attempting to build nuclear weapons. The United States is doing a disservice to its credibility as a reasonable and fair nation for attacking Iran so harshly in developing its nuclear technology. This puts the US in a tough spot, as every advance in the civilian program is still a big step toward nuclear weapons for Iran. However, I would advocate that the US draw its line little farther back. Here's why.

President Ahmadinejad is unpopular among the Iranian people. He has an approval rating of about 30% (I can't prove this online, but I'm taking it from a SAIS presentation I saw this week), but he has chosen to make nuclear energy an issue to rally the Iranian people around. Nuclear energy and energy independence on the other hand, are very popular causes in Iran. I'm not sure why, but then again, I'm not sure why Republicans are so particularly fixated on offshore drilling as a miracle solution. When the United States tries to coerce Iran to stop its march toward nuclear weapons, Iranian leaders present it as the United States trying to keep Iran from energy independence, and they gain more popularity by trying to defend this right.

Iran's story will seem less credible in the eyes of the Iranian people as well as in the eyes of the developing countries of the world (who make up the majority of the borderline anti-American UN General Assembly) if the US instead draws the line between nuclear energy and weaponization. Unfortunately for most people concerned with US national security and the security of Israel, that would be waiting too long.

It's definitely a hard issue, but people should recognize that Iran's narrative sounds more credible than we Americans think and we're only making them look better.

Frank Rich Is To Blame For Everything

Ok, Frank Rich isn't to blame for anything except for diluting the intellectual density of the New York Times, but I still think it's a cool title.

No One Is To Blame For Anything

This is an odd column to try to respond to. His point here -- I'm guessing -- is to show that modern America has some sort of "culture" for deflecting blame. (I suppose this is what passes for insightful analysis nowadays. People don't want to be blamed for things?? GO ON...) But in making his point, he bounces from person to person like a hyper active nine-year-old.

Consider: he spends three paragraphs alluding to Greenspan's now infamous 70/30 comment before hitting the Catholic Church, Michael Steele, David Paterson, Charlie Rangel, David Letterman, Tiger Woods, the entire Bush Administration, Goldman Sachs, and Robert Rubin over the next four. It's all very disorienting.

However, disorientation might be the name of the game here, because his fundamental argument is so weak. If I may be so bold as to distill the essence of this column down to a single quote, it would be this one:

It’s remarkable how often apologists for Wall Street’s self-inflicted calamity mirror the apologists for Washington’s self-inflicted calamity of Iraq. In the case of that catastrophic war, its perpetrators and enablers almost always give the same alibi: “Everyone” was misled by the same “bad intelligence” about Saddam Hussein’s W.M.D. Hence, no one is to blame and no one could have prevented the rush to war. That, of course, is no more true than Greenspan’s claim that “everyone” was ignorant of the potentially catastrophic dangers in the securitization of subprime mortgages.

This is a completely erroneous comparison.

First of all, let's ignore that Frank Rich has no understanding of finance or economics, and (judging by the phrase "self-inflicted") apparently views the financial crisis as a "bad thing" that wall street "did" to itself and the rest of the country. Wandering into his murky world of cause-and-effect is dangerous, and I don't have a first aid kit. Let's just keep moving.

At the core, Rich seems to be arguing the financial crisis (and by analogy, Iraq) was an error that could have been avoided by more careful attention to counter-evidence. First of all, I'm not at all convinced of that premise. Financial risk is a probability, not true-or-false future that can be determined with enough smarts or evidence. I think most people understood the inherent risk and decided to push forward with the housing boom because it was to so many people's advantage (homeowners, homebuilders, politicians, finance people, the economy as a whole) that it keep going. You can probably fairly claim that they underestimated the risk, particularly the management at certain banks, but to assign "fault" to any one person or group of people based on that is kind of a stretch.

HOWEVER, let's grant him that point for the sake of argument. What we have here is two partially analogous situations:

a) Evidence shows housing bubble to not be dangerous to economy as a whole
b) As a result, Alan Greenspan does not raise interest rates to try to deflate it

1) Evidence shows Iraq to possess WMD
2) As a result, we invade a country

The main difference? The first of these is passive, and the second is active. It is INDISPUTABLY TRUE that George Bush could have prevented us from invading Iraq. He is the commander in chief. He can simply decree it.

Alan Greenspan probably could not have prevented the financial crisis. First of all, he would have had to figure out the dangers very very early in the cycle, like probably late 2004, or it would have been too late. Then he would have had to perfectly time his interest rate actions to slow down housing without causing a financial panic in the process. Then he would have had to deal with the political fallout of essentially causing a recession on purpose (since at that time, housing was by far the biggest driver of our economic growth). There would have been many foreclosures, they would be called "avoidable", and both parties would have complained equally.

The moral of this story is that Frank Rich probably didn't choose this analogy because he thought through all the details. He probably picked it because it's another "bad thing" that a Republican did that he doesn't like, and he simply wants to equate them for his own reasons. Of course when your worldview seems to be Republicans == Hitler, then yeah, I can see how you would consistently gravitate to those sorts of arguments.

There is a deeper problem with Rich's "reasoning". The economy is an unbelievably complex system. This crisis really isn't anyone's "fault". Many people had to make serious, coordinated mistakes for this to occur. Tiger Woods, Charlie Rangel, David Paterson, David Letterman, and Frank Rich's editor, on the other hand, are entirely to blame for their various problems. Those are simple problems. Even the Bush administration is significantly to blame for its failures of intelligence gathering, although even then it seems pretty clear that Saddam was proactively misleading us into believing certain things. Still, they are at fault for willfully ignoring counter-evidence that we now know exists.

Search google for "economic prediction" and you will find many well-reasoned, well-evidenced arguments for entirely contradictory outcomes (not to mention lots of poorly reasoned ones with no evidence). Whenever something happens, no matter how unlikely, you'll always find people who "predicted" it. That's the nature of the beast. There are people calling for Gold to hit $5000/oz. There are others calling for a catastrophic deflation. Both of those things can't be true. Neither of them is likely. But both of them are possible.

Sifting through that complexity to accomplish even one goal -- stable inflation -- is hard enough. Alan Greenspan did a very difficult job very well for a very long time, and the climate of stability he helped engender was criticalto the enormous growth and prosperity we experienced between say, 1990 and 2007. It is unfortunate that some people are so desperate for a scapegoat (especially a REPUBLICAN scapegoat!) that they are trying to destroy his pretty excellent record.