…ending the day at $1.09…. The ECB’s QE has often been portrayed as currency war…. The term… is misleading. When one country’s currency falls because of easy monetary policy, its trading partners often ease as well to limit the damage of an appreciating currency. The net result is a tit-for-tat monetary expansion that boosts demand in everyone’s economy…. Denmark and Switzerland… Sweden… Thailand and Korea…. Central banks always seek to set the overall level of financial conditions which are a combination of short and long-term interest rates, equity prices and currencies, but they don’t get to choose the contribution of each. Faced with a stronger currency, the natural response is to lower interest rates in hopes of achieving the same economic goals with a different mix of instruments. Don’t call it a currency war. Call it textbook economics.
Category: Equitablog
Testing the permanent income hypothesis
The permanent income hypotheses is one of a class of assumptions that economists make about how people smooth their spending over time. These assumptions predict that people prefer to spread their consumption smoothly over their life based on their expected lifetime earnings. Variations of the permanent income hypothesis are frequently used to simplify the mathematics behind economic models so that they are easily solvable.
But this begs a question: Are the permanent income hypotheses and its variants reasonable assumptions? Because this hypothesis was developed and popularized in an era before data were sufficient to make them readily testable, it is important to periodically revisit these long held beliefs as new information becomes available. In a new National Bureau of Economic Research working paper, Michael Gelman and Matthew D. Shapiro at the University of Michigan, Shachar Kariv and Steven Tadelis at the University of California, Berkeley, and Dan Silverman of Arizona State University does just that—looking at whether and how government workers smoothed their consumption during the 2013 government shutdown.
The authors examine the consequences of the 16-day federal government shutdown in October 2013, when Senate Democrats and House Republicans could not pass a spending bill in large part due to disagreement over defunding the Affordable Care Act. According to an Office of Management and Budget report, the shutdown resulted in a combined total of 6.6 million lost work days amounting to $2.5 billion in compensation and lowered that quarter’s Gross Domestic Product by billions of dollars.
Using detailed data on spending and earnings from the Mint program (a free website/app used to track individual finances), the authors find that consumption dropped sharply among government workers. This spending drop occurred even though the shutdown would have little if any impact on their lifetime earnings because they knew they would be paid later for the time they did not work. The reaction of the workers, then, is at odds with commonly used versions of the permanent income hypothesis.
The authors did find that some of the drop in consumption was because people delayed paying certain bills, such as their mortgage bill or some credit card debt. While this allowed some of the workers to partially smooth their spending over time, there still was a real drop in consumption by most of the government workers impacted by the shutdown. Thus, the majority of these workers did not smooth out their earnings over time based on their expected long-term earnings but rather immediately reacted to the situation at hand.
This finding is important because it provides real insight into how people respond to income shocks, which has implications for how we think about credit constraints, unemployment, and other economic issues. Because people respond to short-term shocks in their income by dramatically cutting back on their spending, programs such as unemployment insurance that replace income immediately for displaced workers could be much more effective at smoothing consumption than temporary tax cuts that are not seen until April 15. Currently, strong interpretations of the permanent income hypothesis predict the unemployment policies and tax cuts deliver equivalent outcomes.
This new work by Gelman, Kariv, Shapiro, Silverman, and Tadelis is important because it pushes back against a set of flawed but long-held beliefs about how the economy works that can lead to bad policy. By bringing data to the debate, these authors are helping to advance the science of economics.
Things to Read at Nighttime on March 18, 2015
Must- and Should-Reads:
- Morning Must-Read: : Survival of the Fittest Might Have Actually Been Survival of the Richest
- Nighttime Must-Read: : The Disappointing Unseriousness of the House GOP’s Budget
- : Strong Currents Keep Interest Rates Down
- Afternoon Must-Read: : Are recoveries from Financial Crises Always Slow?
- Today’s Must-Must Read: : Thoughts about monetary and fiscal policy in a post-inflation world
- : The Worldwide Deficit of High-Quality Debt
- Lunchtime Must-Read: : On Paul Krugman’s: ‘John and Maynard’s Excellent Adventure’
- Morning Must-Read: : Are Retirees Falling Short?
- : “Currency appreciation will be a drag; this implies a policy of slower monetary tightening is in order…”
- : “Safety net programs cut poverty nearly in half in 2013, lifting 39 million people out of poverty… rebut[ting] claims that government programs do little to reduce poverty…”
Might Like to Be Aware of:
Nighttime Must-Read: James Pethokoukis: The Disappointing Unseriousness of the House GOP’s Budget
…This new plan just assumes tax revenue as a share of GDP stays steady. Seems unlikely…. But the biggest problem with the House budget isn’t faulty math but a faulty premise. House Republicans apparently believe the federal debt is at unsustainable levels, needs to be reduced ASAP, and eventually eliminated… that the federal debt is America’s biggest problem. But where’s the evidence? Low interest rates are hardly signaling investor alarm. And… our currency is the world’s reserve…. The big economic danger… is chronic slow growth from having to sharply raise taxes if we don’t restructure entitlements in a way that promotes savings and work… along with trimming tax breaks for the wealthy. If there is a good economic reason for actually paying off the national debt–much less making it a key goal–I am unaware of it.
What Game Is the Federal Reserve Playing?
The Federal Reserve:
- Now expects to be more patient in their plans of when and how far they will raise interest rates than they were last December.
- Just removed the sentence in which they said they would be patient from their post-meeting statement.
Afternoon Must-Read: Nick Bunker: Are recoveries from Financial Crises Always Slow?
Scooped by Nick Bunker! Well, that post can now go in the trash!
…When economies go through major systemic failures of their financial systems the ensuing economic recoveries will invariably be tepid and prolonged. This view is based primarily on research by economists Carmen Reinhart and Kenneth Rogoff…. Christina D. Romer and David H. Romer… is a refinement of those analyses… focused specifically on financial crises in rich economies in the latter half of the 20th century…. Very large financial crises… Sometimes, as in the case of Japan, the crisis leads to significant recessions and slow recoveries. And sometimes, such as with Norway in the early 1990s, the effect was pretty much non-existent…. A large financial crisis doesn’t necessarily mean a large economic downturn has to happen. Economic events aren’t forces that sweep over us, but things that we can react to and very possibly control.
…There’s every reason to think that the same thing will happen this time…. The 1990-91 recession was brought on by a credit crunch, the 2001 recession by overinvestment; this time we’ve got both. I guess we’ll see. In any case, whatever happens will probably last quite a while.
…based on assessments of the health of countries’ financial systems from a consistent, real-time narrative source…. We find that output declines following financial crises in modern advanced countries are highly variable, on average only moderate, and often temporary. One important driver of the variation in outcomes across crises appears to be the severity and persistence of the financial distress itself.
…Five to six years after the onset of the current crisis only Germany and the United States… have reached their 2007–2008 peaks in per capita income…. The sub-prime crisis is not an anomaly in the context of the pre-WWII era. Postwar business cycles are not the right comparator for the severe crises that have swept advanced economies in recent years….
Even after one of the most severe multi-year crises on record in the advanced economies, the received wisdom in policy circles clings to the notion that high-income countries are completely different from their emerging-market counterparts… growth, financial stability, and debt sustainability can be achieved through a mix of austerity and forbearance (and some reform). The claim is that advanced countries do not need to resort to the more eclectic policies of… debt restructurings and con- versions, higher inflation, capital controls, and other forms of financial repression.
Now entering the sixth or seventh year (depending on the country) of crisis, output remains well below its pre-crisis peak in ten of the twelve crisis countries. The gap with potential output is even greater. Delays in accepting that desperate times call for desperate measures keeps raising the odds that, as documented here, this crisis may in the end surpass in severity the depression of the 1930s in a large number of countries.
…Financial stability risks have been increasingly linked to real estate lending booms which are typically followed by deeper recessions and slower recoveries.” |
Sovereigns versus Banks: Credit, Crises, and Consequences: In advanced countries since 1870… significant financial stability risks have mostly come from private sector credit booms rather than from the expansion of public debt. However… high levels of public debt have tended to exacerbate the effects of private sector deleveraging after crises…. (i) In a normal recession and recovery real GDP per capita falls by 1.5 percent and takes only 2 years to regain its previous peak, but in a financial crisis recession the drop is typically 5 percent and it takes over 5 years to regain the previous peak; (ii) the output drop is even worse and recovery even slower when the crisis is preceded by a credit boom; and (iii) the path of recovery is worse still when a credit-fueled crisis coincides with elevated public debt levels…. Fiscal space appears to be a constraint in the aftermath of a crisis, then and now.”
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Betting the House: “loose monetary conditions, credit growth, house price booms, and financial instability? This paper analyzes the role of interest rates and credit in driving house price booms and busts with data spanning 140 years of modern economic history in the advanced economies. We exploit the implications of the macroeconomic policy trilemma to identify exogenous variation in monetary conditions: countries with fixed exchange regimes often see fluctuations in short-term interest rates unrelated to home economic conditions. We use novel instrumental variable local projection methods to demonstrate that loose monetary conditions lead to booms in real estate lending and house prices bubbles; these, in turn, materially heighten the risk of financial crises. Both effects have become stronger in the postwar era.
Today’s Must-Must-Read: Alice Rivlin: Thoughts about Monetary and Fiscal Policy in a Post-Inflation World
…When politicians and financial journalists ask me earnestly, as they do, whether the Federal Reserve isn’t risking devastating ‘run-away’ inflation by buying all those bonds, I suspect cultural lag. What Inflation? We should be so lucky! Central banks have amply proved that they know how to stop inflation—Paul Volcker showed that. They have been much less successful in getting little inflation going…. The last time the core PCE hit 3.0 percent was 1992….
Yet many economists worry about that elusive animal, the NAIRU. The rhetoric of many politicians and much the financial press implies that we face a dangerous inflation-prone world…. In this new world the top-of the-list threats to prosperity in large advance economies are financial instability, slow growth with tendencies to deflation, and the concentration of income, wealth and political power in the hands of a small number of people….
I see four major challenges to current thinking: (1) We have to recognize that the main job of central banks is avoiding financial crisis. (2) We will have to get used to central banks operating at quite low interest rates much of the time and managing big balance sheets without apologies. (3) We have to rehabilitate [expansionary] budget policy to make it useable again and move to a sustainable debt track at the same time. (4) We have to find constitutional ways of reducing the power of big money in politics and economic policy—or change the Constitution…
Lunchtime Must-Read: Mark Thoma: On Paul Krugman’s: ‘John and Maynard’s Excellent Adventure’
Ah. But, Mark, what real-world questions were DSGE models built to answer? I cannot think of any…
…IS-LM models were built to answer exactly the kinds of questions we encountered during the Great Recession and… provided good answers…. DSGE models were built to address other issues, and it’s not surprising they didn’t do very well when they were pushed to address questions they weren’t designed to answer…
Morning Must-Read: Danielle Paquette: Survival of the Fittest Might Have Actually Been Survival of the Richest
…And wealthy men apparently fathered way more babies, according to a new study… a sharp decline in genetic diversity in male lineages across the world during the Stone Age…. 456 men living in seven regions across Africa, Asia and Europe… Y chromosome… passed down through the male lineage, and the mitochondria… from an offspring’s genetic mother…. Two ancient ‘bottlenecks’…. Migration from Africa drove the first…. The rise of agriculture… likely drove the second. For every 17 women who passed on their DNA, researchers could find genetic evidence of only one male whose lineage stretched to modern times.
Morning Must-Read: Alicia Munnell et al.: Are Retirees Falling Short?
…Researchers using a life-cycle model… conclude that most pre-retirees have an optimal level of wealth…. The comforting results of the optimal savings research depend crucially on two as- sumptions–that households’ consumption declines when the kids leave home and that households plan on declining consumption in retirement…. The target replacement rate analysis assumes that consumption does not decline when the kids leave
home and that retirees plan on level consumption in retirement. The question is which view best reflects the real world.