conversableeconomist

Longer Global Supply Chains

The Strategy, Policy, and Review Department of the IMF published a paper on \”Changing Patterns of Global Trade\” on June 15. I think students of economics often get a good sense of how international trade can benefit all nations participating, but at least at the intro level, they often get a less good sense of the actual patterns of international trade. One emphasis of the report is on longer global supply chains. Here are a few patterns and facts.

 1) The share of foreign content embedded in gross exports is rising. 
A country can import certain goods or services, use them in production, and then export them again. The share of foreign value-added in exports measures this process, and it has been steadily rising since the 1970s. Here\’s a table combining several studies, showing a rise in foreign value-added in exports from 18% in 1970 to 24% in 1990, 27% in 1995, and 33% by 2005.  This is a sign of longer global supply chains and rising global interconnectedness.

2) For some countries, gross exports can be less useful as a measure of what the country produces for export than the domestic value-added content of exports.
This figure shows gross exports as the dark line for each country, and domestic value added as the shaded line–the difference between the two is foreign value-added that is re-exported. For a number of countries like Singapore, Malaysia, and Thailand, there\’s a big gap between the two. 

3) The rise in foreign value-added in exports varies across countries and across industries. 
Here\’s a table I compiled out of statistics in the report. In China and Japan, the share of foreign-value added almost doubled from 1995 to 2005–which is a signal of the Asian regional economy becoming much more integrated, with inputs often crossing borders several times at different stages of production. The rise in foreign value-added as a share of total exports is noticeable but lower in the U.S. and Germany. If one looks just at the rise in foreign value-added as a share of exports in the high technology sector, these patterns are even more pronounced.

4) World trade has tripled since the 1950s. 
\”World trade has grown steadily since World War II, with the expansion accelerating over the past decade. Despite a post-crisis dip, the current level of world gross exports is almost three times that prevailing in the 1950s (Figure 1). With the exception of commodity-price booms in the 1970s and more recently in 2004-2008, commodity trade accounted for a declining share of this growth, with the share of noncommodity
trade rising to more than 20 percent of global GDP in 2008.\”

Although the growth in world trade over time looks bumpy but more-or-less continual, the type of trade is changing. The growth in trade in the 1950s and 1960s was often a result of lower tariffs, for example. But in recent years, the growth in trade stems from an increasingly interconnected web of countries, who often are producing increasingly similar products.


5) Trade in higher technology goods has led the rise in international trade.
\”The structure of trade has been characterized by a rising share of higher technology goods (Figure 4). The contribution of high-technology and medium-high-technology exports such as machinery and transport equipment increased, whereas that of lower technology products such as textiles declined. Technology
intensive export structures generally offer better prospects for future economic growth. Trade in high-technology products tends to grow faster than average, and has larger spillover effects on skills and knowledge-intensive activities. The process of technological absorption is not passive but rather “capability” driven and depends more on the national ability to harness and adapt technologies rather than on factor endowments.\”

conversableeconomist

High Food Prices and Political Unrest

Marco Lagi, Karla Z. Bertrand and Yaneer Bar-Yam of the New England Complex Systems Institute have a working paper up about \”The Food Crises and Political Instability in North Africa and the Middle East.\” This figure tells the heart of the story. The black line shows the two recent spikes in global food prices, one in 2008 and one in 2011. The vertical red lines show the dates of various food riots and/or civil disruptions, with the number of deaths shown in parentheses.Of course, food prices aren\’t the only factor in causing such disruptions, but the fact that such riots and disruptions essentially vanished in 2009 and 2010, in the time period between the two price spikes, is nonetheless striking.

Thanks to the Instapundit website for the pointer to this study. I\’ve posted a couple of times recently on the subject of the global spike in food prices in 2008 and again in 2011 (see here and here). I\’ve also posted a couple of times in the last few months on how unemployment and poor economic conditions have contributed to political unrest in the Middle East (for example, here and here).

conversableeconomist

Where Did S&P Get Its Power? The Federal Government (Of Course)

When Standard & Poor\’s downgraded the credit rating of the U.S. government on August 5, and the global economy trembled, a natural question is: \”Who gave them all this power, anyway?\” The same question arises when Fitch announced earlier this week that it would not issue a similar downgrade. The answer to who made the credit rating agencies so powerful is: The federal government. Lawrence White encapsulates the history in the Spring 2010 issue of my own Journal of Economic Perspectives, in an article on \”The Credit Rating Agencies.\” Larry writes: 

\”However, a major change in the relationship between the credit rating agencies and the U.S. bond markets occurred in the 1930s. Bank regulators were eager to encourage banks to invest only in safe bonds. They issued a set of regulations that culminated in a 1936 decree that prohibited banks from investing in “speculative investment securities” as determined by “recognized rating manuals.” “Speculative” securities (which nowadays would be called “ junk bonds”) were below “investment grade.” Thus, banks were restricted to holding only bonds that were “investment grade”—in modern ratings, this would be equivalent to bonds that were rated BBB– or better on the Standard & Poor’s scale. With these regulations in place, banks were no longer free to act on information about bonds from any source that they deemed reliable (albeit within oversight by bank regulators). They were instead forced to use the judgments of the publishers of the “recognized rating manuals”—which were only Moody’s, Poor’s, Standard, and Fitch. Essentially, the creditworthiness judgments of these third-party raters had attained the force of law.\”

\”In the following decades, the insurance regulators of the 48 (and eventually 50) states followed a similar path. State insurance regulators established minimum capital requirements that were geared to the ratings on the bonds in which the insurance companies invested—the ratings, of course, coming from the same small group of rating agencies. Once again, an important set of regulators had delegated their safety decisions to the credit rating agencies. In the 1970s, federal pension regulators pursued a similar strategy.\”

\”The Securities and Exchange Commission crystallized the centrality of the three rating agencies in 1975, when it decided to modify its minimum capital requirements for broker-dealers, who include major investment banks and securities firms. Following the pattern of the other financial regulators, the SEC wanted those capital requirements to be sensitive to the riskiness of the broker-dealers’ asset portfolios and hence wanted to use bond ratings as the indicators of risk. But it worried that references to “recognized rating manuals” were too vague and that a bogus rating fifi rm might arise that would promise AAA ratings to those companies that would suitably reward it and “DDD” ratings to those that would not.\”

\”To deal with this potential problem, the Securities and Exchange Commission created a new category—“nationally recognized statistical rating organization” (NRSRO)—and immediately grandfathered Moody’s, Standard & Poor’s, and Fitch into the category. The SEC declared that only the ratings of NRSROs were
valid for the determination of the broker-dealers’ capital requirements. Other financial regulators soon adopted the NRSRO category and the rating agencies within it. In the early 1990s, the SEC again made use of the NRSROs’ ratings when it established safety requirements for the commercial paper (short-term debt) held by money market mutual funds.\”

\”Taken together, these regulatory rules meant that the judgments of credit rating agencies became of central importance in bond markets. Banks and many other financial institutions could satisfy the safety requirements of their regulators by just heeding the ratings, rather than their own evaluations of the risks of the bonds.\”

White goes on to discuss how the NRSRO category has evolved over time, and how Congress more-or-less bludgeoned the Securities and Exchange Commission into allowing some additional NRSROs in the last decade. His article, written in 2010, also points out that one reason why the housing bubble spread through mortgage-backed securities and into the banking system was that the NRSRO\’s like Standard & Poor\’s gave some of that debt a tremendously misguided AAA rating. Far too many banks and bank regulators just accepted that rating, although S&P and the other credit rating agencies had no particular history or expertise in evaluating these somewhat complex financial instruments based on subprime mortgage debts. White and others have long argued that while it\’s perfectly fine to have firms which sell their expertise and opinions about the riskiness of bonds, there\’s no reason to anoint some of them in such a way that banks and bank regulators legally outsource judgment and prudence to them.

Maybe S&P is wrong to downgrade the U.S. credit rating. But after it whiffed so spectacularly and totally missed the riskiness of the subprime-related mortgage backed securities, it\’s seems a bit unsporting to turn around and criticize them for being too vigilant now. And if the U.S. government doesn\’t like the power wielded by S&P–well, it has only itself to blame for bestowing so much of that power in the first place.

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Can Bernanke Unwind the Fed\’s Policies?

The Federal Reserve has taken five main policy steps since the financial crisis started to become apparent in late 2007. I supported each of those five steps when they were taken, given the economic situation at the time. But the recession and financial crisis were largely over in June 2009, even if what followed has been an unpleasantly stagnant recovery. The Fed needs to be clear that as conditions warrant, it will be willing to unwind its earlier policies. Thus, when the Fed Open Market Committee announced last week on a 7-3 vote that it would extend its near-zero federal funds interest rates for the next two years, it seemed to me a misstep.  Narayana Kocherlakota, who moved from a position as professor of economics at the University of Minnesota to become President of the Minneapolis Federal Reserve, took the unusual step of explaining publicly why he dissented, and even recording a short video clip of his explanation, which is posted at the Minneapolis Fed website.

But I\’m getting ahead of the story. Here are the Fed\’s five main policy steps since 2007.

1) From May 2006 through September 2007, the federal funds interest rate was about 5%. As the financial crisis began to become apparent in fall 2007 and as the recession started in December 2007, the Fed cut the federal funds rate to 2% by April 2008, where it remained until September 2008. This change can be thought of as the standard Fed reaction to a recession. As Rick Mishkin, who was a member of the Fed Board of Governors at the time, notes an article in the Winter 2011 issue of my own Journal of Economic Perspectives, even in late summer 2008 mainstream forecasters like the Congressional Budget Office were predicting only a short, shallow recession. Rick wrote: \” In summer of 2008, when I was serving on the Federal Reserve Board of Governors, there was even talk that the Fed might need to raise interest rates to keep inflation under control.\”

2) When the financial crisis hit with hurricane force in September 2008, the Fed then took the federal funds target rate down to near-zero. As noted earlier, at its August 9 meeting last week, the Open Market Committee voted to keep this interest rate target for two more years, at which time the policy of a near-zero federal funds rate would have lasted about five years. 

3) Starting in late 2007, the Fed created a veritable alphabet soup of lending agencies to provide short-term credit lines to banks, other financial institutions, and players in key credit markets. These include: the Term Auction Facility (TAF); the Term Securities Lending Facility (TSLF); the Primary Dealer Credit Facility (PDCF); the Asset-Backed Commercial Paper Money; the Market Mutual Fund Liquidity Facility (AMLF);
the Commercial Paper Funding Facility (CPFF); the Money Market Investor Funding Facility (MMIFF); the and Term Asset-Backed Securities Loan Facility (TALF). For a readable overview of these efforts aimed at teachers of economics,  this is a good starting point. From my point of view, the key fact about all these agencies is that they have all been closed down. Thus, I consider them a success. They helped to assure that short-term credit was available during a financial crisis, and then they went away.

4) The Fed started buying mortgage-backed securities early in 2009. At this time, in the depths of the financial crisis, the high level of uncertainty over what these securities were truly worth was in danger of making the market for these securities illiquid, which in turn could have made the financial crisis even worse. As the New York Fed explains: \”The FOMC directed the Desk to purchase $1.25 trillion of agency MBS [mortgage-backed securities]. Actual purchases by the program effectively reached this target. The purchase activity began on January 5, 2009 and continued through March 31, 2010. … On August 10, 2010, the FOMC directed the Desk to keep constant the Federal Reserve’s holdings of securities at their current level by reinvesting principal payments from agency debt and agency MBS in longer-term Treasury securities. As a result, agency MBS holdings will decline over time.\”

5) The Fed started buying and holding new Treasury debt. The Fed has always held some Treasury debt as part of its normal operations, and in particular as part of carrying out its open market operations and buying and selling bonds. But that amount swelled from about $480 billion back in summer 2008 to about $1.6 trillion now. The Federal Reserve now holds more in U.S. Treasury debt than the China and Japan combined. While the plan to purchase more Treasury debt known as QE2 (that is, \”quantitative easing part 2\”) officially stopped at the end of June, as noted a moment ago, the Fed is now moving from holding mortgage-backed securities to holding Treasury debt, in such a way that its overall holdings of financial securities does not decline.  

Overall, here\’s where the Fed stands in unwinding the crisis-driven policies enacted since 2007. The many short-term lending facilities have been phased out. The ownership of mortgage-backed securities is being phased down. What is not yet being phased down are the ultra-low interest rates and buying Treasury securities. I\’m not brash enough to say just when these policies should be reversed, but I do know this: A central bank can\’t just keep pumping out money and credit until  unemployment is back to normal levels and hearty growth has resumed. At that point, the central bank has overreacted, potentially by a lot. When the Fed decides that it is time to change these policies, the U.S. probably won\’t be at full employment and resurgent growth–and so its decision is certain to be controversial.

Here\’s a graph showing the effective federal funds interest rate since the 1950s, using the ever-helpful FRED website at the St. Louis Fed. Notice that when recessions (the shaded bars) occur, the Fed typically cuts this interest rate, but then when recovery has begun, it raises the rate again. But now the federal funds rate has been at a rock-bottom near zero for more than two years, and in its August 9 meeting, the Federal Open Market Committee voted to leave the rate near-zero until summer 2013. Kocherlakota of the Minneapolis Fed explained his dissent from the policy this way: \”I believe that in November [2010], the Committee judiciously chose a level of accommodation that was well calibrated for the prevailing economic conditions. Since November, inflation has risen and unemployment has fallen. I do not believe that providing more accommodation—easing monetary policy—is the appropriate response to these changes in the economy.\”

From an outsider\’s point of view, it sure looks as if the Federal Reserve action at its August 9 meeting was a response to headlines from the week before: headlines about the difficulties in hashing out an agreement to raise the federal borrowing ceiling, headlines about Standard & Poor\’s downgrading the credit rating of the federal government, headlines about the stock market falling.  But monetary policy decisions setting expectations for the next couple of years shouldn\’t be responding to yesterday\’s headlines.

As one looks at the federal funds interest rate over time, other troubling issues become apparent. One is that the federal funds interest rate has been gradually moving downward, a step at a time, since it was raised sky-high to stop the inflation of the 1970s. With the federal funds rate at near-zero, this process of stepping interest rates lower and lower has now stopped. Another concern is that the Bank of Japan has run a near-zero interest rate for more than a decade, while failing to stimulate its economy. There is a possible theoretical argument–far from proven, but still a concern–that an economy can get stuck in a situation with near-zero interest rates and stagnant growth. In this kind of model, explained for example by James Bullard of the St. Louis Fed, \”Seven Faces of `The Peril\’\”,  a central bank can\’t wait for a full recovery before raising interest rates, because the hyper-low near-zero interest rates are part of what\’s blocking the economy from resuming growth.


I wouldn\’t advocate a sharp or immediate rise in the federal funds interest rate. But I would have voted with Kocherlakota against committing to two more years of near-zero rates. After all, part of what encouraged so much overborrowing in the years leading up to the financial crisis was that the Fed kept interest rates so low for a couple of years after the end of the 2001 recession. The answer to a financial crisis rooted in overborrowing is not to encourage the next wave of overborrowing! The Fed should be thinking about when and how it could get the federal funds target rate up into the 1-2% range–which after all seemed a reasonable interest rate when the economy was in an actual recession back in 2008.

The Federal Reserve buying Treasury bonds is another tough issue. Officially, the Fed\’s QE2 program of purchasing Treasury securities finished at the end of June, although as noted earlier, the Fed is still using money freed up by winding down its mortgage-backed securities to buy Treasury bonds. Back during World War II, which was fought largely with borrowed money, the mission of the Fed was to keep interest rates low so that federal borrowing costs could stay low. But in 1951, the Fed announced that it was done with that mission, and would instead focus on growth and low inflation. After a battle of bureaucracies, the Fed won its independence. (For an overview and discussion of what happened in the 1951 agreement, one useful starting point is this issue from the Richmond Fed in 2001.)

Having the Fed buy Treasury debt starting in 2009 during the worst of the financial crisis and its aftermath was a fully defensible decision. I sometimes say that it\’s generally a bad idea to shoot torrents of water at high speed through an office building–but if there\’s a fire, it\’s a policy that can make sense. During an emergency, steps that wouldn\’t make sense at other times sometimes need to be taken. But the recession has now been over for a couple of years. If the U.S. government wishes to run continuing large deficits, it needs to start facing the economic consequences of doing so. The Fed is already helping the federal government to borrow this money by holding interest rates so low, and in time will probably help the federal government further by creating some inflation to reduce the real value of what has been borrowed. It\’s time for the Fed to back away from being the actual default buyer for new federal debt. This step doesn\’t require any big announcement, only that the Fed refrain for now from announcing a QE3 program for buying more Treasury debt. If another financial crisis surfaces, after all, the Fed should try to hold something in reserve.

conversableeconomist

Economic Growth: Why We Need It, What We\’re Not Doing

Michael Greenstone and Adam Looney put together a background paper for a Hamilton Project conference called \”A Dozen Economic Facts About Innovation.\”

Why is innovation and increased productivity important? Two of the main measurable reasons are how it increases incomes and life expectancy. It may be that the worst economic event to befall the U.S. economy in the last 40 years is not relatively recent shock of the Great Recession, terrible though that has been, but the productivity slowdown that hit in the early 1970s. Greenstone and Looney write: \”If TFP [total factor productivity] had continued growing at the pre-1973 trend and that productivity gain were reflected in workers’ compensation, compensation could be 51 percent higher, or about $18 per hour more than today’s average of $35.44 per hour. This calculation highlights that small changes in innovation and annual TFP growth lead to large differences in long-run standards of living.\”

Economic growth and innovation have also helped to generate longer life expectancies, partly through reductions in  infectious disease, but also through better diets and cleaner water and sanitation. The gains in health have huge value. Kevin Murphy and Robert Topel estimated the long-term value of gains in health in a 2006 article in the Journal of Political Economy (pp. 871-904).From their abstract: \”Cumulative gains in life expectancy after 1900 were worth over $1.2 million to the representative American in 2000, whereas post-1970 gains added about $3.2 trillion per year to national wealth, equal to about half of GDP. Potential gains from future health improvements are also large; for example, a 1 percent reduction in cancer mortality would be worth $500 billion.\” Here\’s a Greenstone-Looney figure on gains in life expectancy and reductions in infectious disease.

One of the most striking areas of innovation in recent years, of course, is the electronics industry. Here\’s a graph showing what it would have cost to buy the computing power of an iPad 2 over recent decades. Notice that the vertical scale is a logarithmic graph: that is, it is descending by powers of ten as the price of computing power halves and halves and halves over and over again.

What\’s to be done to improve the prospects for innovation and economic growth for the future? There is a broad productivity agenda of improving human capital, investing in plant and equipment, and getting America\’s financial and budgetary problems under control. But there is also a more narrow technology-focused agenda. For example, every politician in the U.S. talks has been talking about the importance of technology for decades–but government spending on research and development has actually been sinking. Corporate spending on R&D has taken up some of the slack, but government R&D is far more likely to be focused on the basic research that generates new industries, not the tightly-focused process companies often use to update their products.

Another issue is to have America\’s higher education system focus more heavily on the so-called STEM fields: that is, science, technology, engineering, and mathematics. The share of total U.S. degrees being granted in these fields has fallen since the mid-1980s, and compared to other countries, the U.S. higher education system grants a lower proportion of its degrees in STEM fields.

A final issue is to improve the U.S. patent system. There are lots of subtle issues about what kind of innovation deserves a patent, or what doesn\’t, and how much a patent is really worth in an intellectual property showdown. But at a more basic level, a slow patent system is less useful for everyone–and the time to get a decision from the U.S. Patent Office has been rising.

conversableeconomist

Feeling Dumped by the Economy

Here are the opening paragraphs of article I wrote for the Opinion section of the Minneapolis Star Tribune on Sunday, August 14. The complete article is at the link, and also below the fold:

\”Not that many years ago, a lot of middle-class Americans felt as if they had built a close and personal relationship with Mr. or Ms. Economy (depending on your gender preference).

The rules of the relationship were clear: Get skills and training, and after spending young adulthood sampling jobs, buckle down to a long-term career choice. Borrow heavily to buy a house early in life, and then benefit from rising house prices. Save for the long term by putting money in the stock market.

Do these things, the understanding was, and the Economy would reciprocate — with rising income, reasonable job security and a comfortable retirement.

Of course, no long-term relationship is perfect. The Economy might occasionally lash out: perhaps with a dot-com boom, followed by a stock market crash, a recession and higher unemployment. Many of us misbehaved in this relationship, too. Sometimes we ran bloated credit cards bills and didn\’t save the way we should have. Yet even in the hard times, this relationship was supposed to be long-term.

But in this grim and prolonged aftermath of the Great Recession of 2007-2009 — some economists are calling it the Long Slump — millions of Americans are feeling that they have been dumped by the economy.\”

The economy is like a bad marriage
  • Article by: TIMOTHY TAYLOR

Not that many years ago, a lot of middle-class Americans felt as if they had built a close and personal relationship with Mr. or Ms. Economy (depending on your gender preference).

The rules of the relationship were clear: Get skills and training, and after spending young adulthood sampling jobs, buckle down to a long-term career choice. Borrow heavily to buy a house early in life, and then benefit from rising house prices. Save for the long term by putting money in the stock market. Do these things, the understanding was, and the Economy would reciprocate — with rising income, reasonable job security and a comfortable retirement.

Of course, no long-term relationship is perfect. The Economy might occasionally lash out: perhaps with a dot-com boom, followed by a stock market crash, a recession and higher unemployment. Many of us misbehaved in this relationship, too. Sometimes we ran bloated credit cards bills and didn\’t save the way we should have.

Yet even in the hard times, this relationship was supposed to be long-term. But in this grim and prolonged aftermath of the Great Recession of 2007-2009 — some economists are calling it the Long Slump — millions of Americans are feeling that they have been dumped by the economy.

A national CNBC survey in late June found that 63 percent of Americans are pessimistic about both the current and future state of the economy and its future, while only 6 percent are optimistic about both. The stock market swoon of that began in late July, fueled by grim economic signs and the floundering attempts of our political system to head off a national debt crisis, have further shaken many Americans\’ confidence in their long-term prospects.

Getting dumped — whether by the Economy or an actual person — brings a sad parade of disappointed expectations. After it has happened, it doesn\’t mend a broken heart when you recognize that you never should have believed some of the promises you thought you heard.

As housing prices skyrocketed in the mid-2000s, rising by more than 10 percent per year for several years, no one actually promised the trend would last forever. Still, it has been stunning to watch as the total value of real estate owned by U.S. households dropped by $6.3 trillion over the last five years — from $22.7 trillion in 2006 to $16.4 trillion by the end of 2010, according to Federal Reserve data. Even worse, back in 2006, 56 percent of the value of real estate was owners\’ equity; by the end of 2010, only 39 percent was owner\’s equity.

No one actually promised that unemployment would stay low forever. But the spikes in the unemployment rate from recessions had been falling, from 10 percent in the recession of 1982, to not quite 8 percent after the recession of 1991, to 6.3 percent after the recession of 2001. This time, unemployment went over 8 percent in February 2009 and probably won\’t get back below that level until 2012. In 2010, 43 percent of the unemployed had been without jobs for more than 26 weeks — by far the highest level since the Great Depression.

Those who trusted their long-term retirement savings to the stock market have been running in mud. The Standard and Poor\’s 500 index, for example, was 1,427 in 2000 but recently has been hovering around 1,200. All the economic news sounds grim. Gas prices, though moderating lately, recently flirted with $4 per gallon. Food prices are up: A ton of hard red winter wheat was selling for $182 in May 2010 and $354 in May 2011.

Since early 2009, the Federal Reserve created money to buy $1.1 trillion in U.S. Treasury securities and another $900 billion in mortgage-backed securities, presumably because it was concerned that no one else was going to buy them. Many pension funds don\’t have enough money to cover the promises they have made; neither do Social Security or Medicare.

After being dumped, mood swings follow. This relationship is actually a love/hate triangle — us, the Economy and Government. For some, Economy is the deceiver who trifled with our affections and betrayed us, and Government is the new love. Others see Government as the troublemaker, and dear old Economy as a victim like the rest of us.

But we have met the Economy, and the Government, and it\’s all us. We all need this three-way relationship to work.

In the short term, the economy is struggling because too many households, companies and financial institutions borrowed far too much, and it takes years for an economy to work through the aftermath of a severe financial crisis. Forecasters like the Congressional Budget Office predict that unemployment rates won\’t fall back to the 5 percent range until 2016.

In the long term, the formula for economic growth is straightforward: It\’s an economy that invests in human capital, physical capital and innovation — and which does so in the context of a decentralized, market-oriented environment that provides incentives and rewards for these activities. The U.S. economy faces severe challenges in all of these areas.

We aren\’t improving the skills of workers. A review of the education statistics by Nobel laureate economist James Heckman found that U.S. high school graduation rates peaked at about 80 percent in the late 1960s and have declined 4 to 5 percentage points since then. Too many undergraduate and graduate students are running up enormous debts without the career prospects to justify it. High unemployment means that many workers aren\’t building skills.

We aren\’t saving enough. The personal savings rate was about 10 percent of income in the 1970s and into the early 1980s, but over the last decade, despite a recent upward blip, it\’s typically been less than 5 percent of income. Meanwhile, Congressional Budget Office projections show total federal debt on a path to exceed 180 percent of GDP by 2035. That won\’t happen, because wary investors will stop buying government bonds before that level is reached.

Thus, when America\’s private sector firms look for financial capital to invest in plant and equipment, it\’s harder to find. With low private saving and high public borrowing, the U.S. economy is relying heavily on inflows of foreign financial capital, which won\’t continue forever. America\’s technological advantage remains substantial, but expertise of all kinds is going global.

In the end, economic growth can\’t be legislated or dictated; if it could be, the world would be a much richer place. A wise economist named Arnold Harberger once gave a speech asking whether economic growth was more like yeast or mushrooms. He answered \”mushrooms.\” Harberger wrote: \”[Y]east causes bread to expand very evenly, like a balloon being filled with air, while mushrooms have the habit of popping up, almost overnight, in a fashion that is not easy to predict.\”

Thus, the most important advice to the economically lovelorn is to work hard on fundamentals — build education and skills, get our personal and government finances in order, focus on knowledge and innovation — and then get out of the way and give those economic mushrooms a chance to sprout. As the quintessential noneconomist Kahlil Gibran famously wrote: \”If you love somebody, let them go …\”

It\’s hard to watch an intimate partner like Economy going through such dreadful times. I feel especially for those near or just entering retirement, whose houses and retirement accounts are worth so much less than they\’d expected, and for young people trying to start their careers in such a dismal labor market.

But with Economy, a true breakup is unthinkable. There\’s no realistic alternative to working patiently on the relationship.

Timothy Taylor is managing editor of the Journal of Economic Perspectives, based at Macalester College in St. Paul. He blogs at conversableeconomist.blogspot.com.

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Can Later Retirement Ages Save Social Security and Medicare?

Social Security and Medicare have both made promises about future benefits that their current sources of financing won\’t allow them to keep. If we moved back the retirement age, would it fix these programs? Short answer: moving back the retirement age could have a large effect in addressing the financial problems of Social Security, but would have a much smaller effect in helping Medicare.

For Social Security, the website of the Office of the Chief Actuary has estimates of the cost savings from a wide variety of proposals. Proposal C2.6, for example, reads: \”Increase the normal retirement age (NRA) 3 months per year starting in 2017 until reaching 70 for those attaining age 62 in 2032. Then increase the NRA 1 month every 2 years thereafter. Note that the NRA would increase from 66 to 67 faster than under current law. Increase the earliest eligibility age (EEA) from 62 to 64 at the same time the NRA would increase from 67 to 69; that is, for those attaining age 62 in 2021 through 2028. Keep EEA at 64 thereafter.\”

Those who will be 62 in 2032 are currently about 41 years old. Telling them now that early retirement will be 64 for them, instead of 62, and that normal retirement will be 70 for them, instead of the 67 years for this group in current law, seems to me completely reasonable. This change alone doesn\’t fix Social Security completely, but it would close about 70% of the projected funding gap for the program over the next 75 years.

For Medicare, in contrast, a higher eligibility age does a lot less. The Kaiser Family Foundation put out a report earlier this summer called Raising the Age of Medicare Eligibility: A Fresh Look Following Implementation of Health Reform.  The study assumes that the age of Medicare eligibility is raised from 65 to 67 as of 2014. Most policy proposals, of course, would have a slower phase-in. But the point here is not to analyze a policy proposal, but to get a handle on the changes that would arise when such a change in age was fully phased in. Here are some of the forecasts:

  • For federal spending, the older age of eligibility saves $31.1 billion for Medicare. However, a number 65 and 66 year-olds who were not eligible for Medicare would lack health insurance, and thus would be eligible for either Medicaid or for subsidized insurance under the new \”health exchanges\” in the health care legislation that President Obama signed into law in 2010. In addition, those 65 and 66 year-olds wouldn\’t be paying premiums into the Medicare system. After these offsets are taken into account, overall federal spending would be reduced by only $5.7 billion.
  • \”In addition, costs to employers are projected to increase by $4.5 billion in 2014 and costs to states are expected to increase by $0.7 billion. In the aggregate, raising the age of eligibility to 67 in 2014 is projected to result in an estimated net increase of $3.7 billion in out-of-pocket costs for those ages 65 and 66 who would otherwise have been covered by Medicare.\”
  • \”Medicare Part B premiums would increase by three percent in 2014, as the deferred enrollment of relatively healthy, lower-cost beneficiaries would raise the average cost across remaining beneficiaries.\”

A key underlying issue here, of course, is that health care spending tends to rise with age. Pushing back the age of Medicare eligibility affects the relatively health group a little above age 65, but it doesn\’t affect the health care bills of the more aged, and so it offers relatively small cost savings for the Medicare program. In a study from last year, Gerald F. Riley and James D. Lubitz report on \”\”Long-term trends in Medicare payments in the last year of life\” (Health Services Research, April 2010, 45(2):565-76). They point out that Medicare spending on those who die in a given year is much higher than on those who survive the year: in 2006, Medicare spending in 2006 on those who died in that year was $38,975, while Medicare spending in 2006 on those who survived the year was $5,993. Their estimates show that 25-30% of all Medicare spending is on patients in their last year of life, and that this number hasn\’t changed much over time, and isn\’t much affected by adjusting for changes in age or gender of the elderly over the last 30 years. 

conversableeconomist

The Committee on World Food Security Hates Biofuels

A few weeks back, I noted that a report of 10 international organizations offered a strong recommendation that countries drop their biofuel subsidies. Now the Committee on World Food Security, which is \”the United Nations’ forum for reviewing and following up on policies concerning world food security\” has published \”Price volatility and food security: A report by The High Level Panel of Experts on Food Security and Nutrition.\”  The committee looks at recent high levels of food prices and extreme volatility, and puts a substantial share of the blame on policies to mandate and subsidize biofuels.

Prices of basic agricultural goods have doubled or tripled in the last few years, as shown in the table. The figure shows that there has been extreme volatility: a price spike in 2007-08, then a sharp drop, and now another price spike.

The report summarizes the problems caused by these trends in this way: \”Food price volatility over the last four years has hurt millions of people, undermining nutritional status and food security. The level of price volatility in commodity markets has also undermined the prospects of developing countries for economic growth and poverty reduction. … In the international markets, consumers with very different income levels compete for access to food. Consumers in poor countries are much more sensitive to price changes than consumers in rich countries. This is true of richer and poorer consumers within countries as well. It also
means that, when supplies are short, the poorest consumers must absorb the largest part of the quantitative adjustment necessary to restore equilibrium to the market. While a spike in food prices forces the poorest consumers to reduce their consumption, richer consumers can maintain more or less the same level of
consumption, increasing inequity in the overall distribution of food. Biofuel support policies tend to reinforce this uneven division of the quantitative adjustment because they make the biofuel industry less sensitive to higher commodity input prices.\”

To be sure, there are a variety of causes for high and volatile food prices. Earlier this week, I posted about some economists at the St. Louis Fed who argued that poor weather conditions played a role. Rising demand for basic grain products as incomes rise in emerging countries and people increase how much grain-fed meat they eat probably plays a role. Countries that reacted to the high food prices by limiting or banning food exports probably contributed to price volatility. Stocks of grains have been relatively low during the last decade or so, which has surely contributed to making the price spikes more severe.

But along with these other factors, and potential policies to deal with them, biofuel subsidies stand out as a potent and reversible cause of high and volatile food prices. Along with the report\’s other analysis and policy suggestions, it states: \”Biofuel support policies in the United States and the European Union have created a demand shock that is widely considered to be one of the major causes of the international food price rise of 2007/08 … Given the major roles played by biofuels in diverting food to energy use, the CFS [Committee on Food Security] should demand of governments the abolition of targets on biofuels and the removal of subsidies and tariffs on biofuel production and processing.\”

conversableeconomist

America\’s Infrastructure Problem: Engineering vs. Economic Perspectives

Once every four years, the American Society of Civil Engineers publishes a \”Report Card for America’s
Infrastructure,\” which gives typically low letter grades to various categories of U.S. infrastructure–and thus helps make the case for hiring more members of the American Society of Civil Engineers. Now ASCE has published a study of the economic costs of underinvestment in infrastructure (available here with free registration), called Failure to Act: The Economic Impact of Current Investment Trends in Surface Transportation Infrastructure.

My quick summary of the ASCE work in this area: Love the engineering approach to putting costs on U.S. infrastructure issues, but suspicious about the economic analysis.

Here are some examples of what I mean by the engineering approach of putting costs on infrastructure, from the report: \”Investment of roughly $220 billion annually (2010 dollars) is needed from 2010 to 2040, based on unit costs, minimum tolerable conditions,  and data sources consistent with current application of federal highway, bridge, and transit investment models. This breaks down to an average investment of approximately $196 billion per year for highway pavements and bridges, including $161 billion for congestion mitigation and $35 billion for preservation of existing facilities. In addition, $25 billion per year in transit capital infrastructure investment (including rolling stock as well as trackage, terminals, and roadways for access) is needed. Approximately 37% of this highway and bridge investment and 25% of this transit investment will be needed simply to resolve existing deficiencies of almost $74 billion that are already affecting the U .S. economy. The remainder is needed to prevent deficiencies from recurring or getting worse over time….If present trends continue, the funding gap for rail and bus transit, seen as 41% in 2010, is expected to increase to 55% by 2040. The expected gap in highway funding, 48% in 2010, is expected to increase to 54% by 2040.\”

The report has useful estimates of what share of American surface travel happens on unimproved roads, or the costs for bridges that need repairing. \” The United States carries a backlog of $3 trillion in unfunded
surface transportation needs, including a $2.2 trillion backlog for highways and bridges and $86 billion in unfunded transit capital infrastructure needs. This backlog does not include the cost of providing access to transit to the significant number of Americans who do not currently have access to fixed route transit
and/or demand response transit. Approximately 15% of transit revenue miles occurring in 2010 are on vehicles with a state of good repair of “fair” or “poor.” In addition, 31% of passenger car vehicle miles of travel occurred on roadways with less than minimum tolerable pavement conditions and 18% of passenger
car trips occurred on congested roads. By 2040, the proportion of transit revenue miles occurring on less than “good” vehicles will rise to 33%, and the 18% of passenger car VMT traveled in congested conditions will rise to 36%.\”

There are also estimates of some of the costs of infrastructure underinvestment: \”In 2010, it was estimated that deficiencies in America’s surface transportation systems cost households and businesses nearly $130 billion. This included approximately $97 billion in vehicle operating costs, $32 billion in travel time delays, $1.2 billion in safety costs and $590 million in environmental costs. … If present trends continue, by 2020 the annual costs imposed on the U.S. economy by deteriorating infrastructure will increase by 82% to $210 billion, and by 2040 the costs will have increased by 351% to $520 billion.\”

So far, so good. I don\’t know the underlying calculations or data sources here in any detail, but these are roughly the kinds of numbers one sees in various reports. But when the ASCE turns to longer-term economic projections, things get a little odd. Here are three examples:

1) A few days after I\’d downloaded my copy of the report, I got a follow-up e-mail, which read in part: \”The original report dramatically underreported the negative effect of Americans\’ personal income due to failing transportation infrastructure. … Our original release projected that Americans\’ personal income would drop by $930 billion by 2020 but recover slightly in 2040.  The data clearly show that the effects will be dramatically more negative, with $3.1 trillion in personal income losses by 2040.  The negative effects on American GDP will also expand dramatically over time, with a near-term loss of $897 billion and a near-tripling of that loss to $2.6 trillion by 2040.\” I know nothing about what might have gone on behind the scenes here. Maybe someone just made an enormous error in calculations and no one else caught it. But my quick cynical reaction is that someone wasn\’t happy that the report didn\’t show big enough losses by 2040, and so the numbers got tweaked.

2) The report estimates that better infrastructure will add 400,000 jobs to the total level of U.S. employment in 2040. Every credible model I know of unemployment in the very long-term suggests that the economy, in one way or another, rebounds back to a \”natural\” level of unemployment. One can make a solid case that appropriate infrastructure investment helps productivity and thus wages. But I don\’t know of any theory which suggests that infrastructure makes the total number of jobs higher in the long-run.

3) The report has some weirdly detailed aspects, like how about 150,000 new jobs could be created in the entertainment industry by 2040 with better infrastructure, or how poor infrastructure by 2040 could reduce exports of meat products by $1.2 billion. Nobody has a crystal ball for predictions 30 years in the future, of course, but this kind of odd detail feels artificial and untrustworthy.

But the biggest problem I have with the economics of these ASCE reports is that the \”costs\” they estimate mostly seem to assume, as you might expect from a group of civil engineers, that the answer to infrastructure problems is always a matter of pouring more concrete. For example, consider the estimate above that we  need to spend $161 billion per year on infrastructure for \”congestion mitigation.\” To an economist, the immediate reaction is to think about congestion pricing or tolls as at least a partial solution to this issue. Or consider the costs of environmental pollution from transportation. To an economist, an obvious answer is to impose pollution fees or some kind of cap-and-trade structure as a tool for reducing that pollution. Or on the issue of road wear-and-tear, an obvious answer for economists is to point out that heavy trucks and buses impose by far the most of the wear-and-tear costs, and charging taxes based on axle weights would be a natural way to provide incentives to spread out these loads while raising money for road repair.

Thus, I agree with the need for substantially greater investment in infrastructure. I live near Minneapolis, where the most-travelled bridge in the state collapsed just four years ago in 2007. For example, I would favor a major effort to improve right-of-ways for freight rail, with depots outside major metro areas for transshipping to trucks. I favor infrastructure spending targeted at the worst bottleneck sites for traffic jams, to clear up those local messes. But I would start my infrastructure planning by using congestion charges, pollution charges, and axle-weight charges, along with getting freight out of trucks and on to rail, and then see what else is needed. I suspect that the level and shape of infrastructure spending that comes out of this approach could turn out to be substantially different than the ASCE approach.
 

For some alternative takes on the economics of infrastructure issues, often complementary to the ASCE approach, here are some starting points:

conversableeconomist

Disability Insurance: One More Trust Fund Going Broke

Sometime when you\’re exhausted by worrying over when the Social Security and Medicare trust funds will go broke, spend a little time worrying about the Disability Insurance trust fund. Here\’s a figure from the 2011 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Federal Disability Insurance Trust Funds. The figure shows low-cost, high-cost, and intermediate options for Old Age and Survivors Insurance, which is what most people mean by Social Security, and for Disability Insurance, up through 2020. The DI trust fund drops below the safe reserve level by around 2013, and in the intermediate scenario the trust fund has disappeared by 2018.

David Autor and Mark Duggan have a suggested reform for disability insurance.  Basically, their proposal is to stop making disability insurance such a bimodal choice. Under current law, disability is defined as \”inability\” to work, and is thought of typically being a permanent condition. Those who go on disability tend to stay there, and not to work again. Their hope is to make disability a partial condition, so that the disabled would benefit from going back to work while still receiving some support. There\’s a nice readable version of the reform in the Summer 2011 issue of the Milken Institute Review (downloadable with free registration by going here) and a more detailed version in a December 2010 paper written for the Hamilton Project and the Center for American Progress. (Full disclosure: David Autor is my boss: He\’s Editor of the Journal of Economic Perspectives, where I am managing editor. Also, Autor and Duggan have written about disability insurance in the Summer 2006 issue, before Autor became editor of the journal.)  

To set the stage for their proposal, here are some illustrative figures from their Hamilton Project report. \”Between 1989 and 2009, the share of adults receiving SSDI benefits doubled, rising from 2.3 to 4.6 percent of Americans ages twenty-five to sixty-four (Figure 1). In the same interval, real annual cash transfer payments to SSDI recipients rose from $40 to $121 billion, and Medicare expenditures for SSDI recipients rose from $18 to $69 billion (Figure 2). Due to its rapid growth, SSDI has come to encompass an ever-larger share of the Social Security system budget. In 1989, approximately one in ten Social Security dollars was spent on SSDI. By 2009, this number had risen to almost one in five Social Security dollars (18 percent), as shown in Figure 3.\”

The usual approach to dealing with rising costs of disability insurance have been to try to tighten standards for who will be treated as disabled, or in some cases to revoke disability status. There are reasons to suspect that in some cases, \”disability\” may be a way of providing income support to low-skilled workers who lack job opportunities, but aren\’t yet old enough to retire. In contrast, the Autor and Duggan proposal would cover all workers with a private disability insurance policy, purchased through employers (as many employers do already for their workers), which would cover disabilities in the short term. Private disability insurance can be partial, and can include rehabilitation and incentives to get back to work. After a couple of years, individuals who couldn\’t return to work would enter the current disability insurance system.

Autor and Duggan describe it this way: \”We propose modifying PDI [private disability insurance] to support
workers from 90 days to 27 months after the onset of disability, with the goal of providing partial income replacement and support geared toward helping individuals maximize work readiness and self-sufficiency. After receiving PDI benefits for 24 months, individuals still unable to work would transfer to the
regular SSDI system. The screening criteria for SSDI wouldn’t change.\”

It\’s not clear to me that this policy is sufficient to save Disability Insurance as we know it. Autor and Duggan offer as a conservative guess-timate that this plan might be able over time to reduce the number of those receiving disability insurance by 6-10%. But they point out that a similar plan in the Netherlands has saved money and trimmed the disability rolls. A policy doesn\’t have to be perfect to be well worth trying.

They write in the Milken Institute Review: \”\”In the half century since the introduction of SSDI, technologies for treating and accommodating work-limiting disabilities have advanced, the physical demands of the workplace have been reduced, and the societal consensus on the proper objective for treatment of disabled workers has greatly evolved. The SSDI program was designed to provide income support (and, after 1972, health insurance) to workers transitioning from employment to early retirement and, in many cases, death. This goal was progressive for its time, but no more.\”