A slow-growth America can't lead the world

This somewhat obvious point is made by John Taylor in the Wall Street Journal. Taylor argues that after World War II, the U.S. promoted international economic growth through reliance on the market and the incentives it provides. Times have changed. Taylor writes,

At the most recent meeting a year ago in Seoul, the G-20 rejected the president's [Obama] pleas for a deficit-increasing Keynesian stimulus and instead urged credible budget-deficit reduction and a return to sound fiscal policy. And on that trip he had to defend the activist monetary policy of the Federal Reserve against widespread criticism that its easy money was damaging to emerging-market countries, causing volatile capital flows and inflationary pressures.

With a weak recovery—retarded by new health-care legislation and financial regulations, an exploding debt, and threats of higher taxes—the U.S. is in no position to lead as it has in the past.

By contrast, in the years after World War II, the U.S. led the world in promoting economic growth through reliance on the market and the incentives it provides, the rule of law, limited government, and more predictable fiscal and monetary policy. It created a rules-based, open trading system by helping to found the General Agreement on Tariffs and Trade, which slashed tariffs multilaterally. The miraculous postwar European and Japanese recoveries came from greater adherence to these principles of economic freedom and direct support from the U.S.

After getting off track with interventionist policies in the 1970s, the U.S. put its economic house in order in the 1980s, adopting pro-growth policies and creating a long boom that lasted through the 1990s. Again its economic ideas were contagious, not just in Britain under Margaret Thatcher but in the developing world. Seeing the advantages of American-style economic liberty over state intervention and control, Deng Xiaoping expanded his initial and tentative market-based reforms in China and created an economic renaissance. The U.S. helped the countries in Central and Eastern Europe implement market-based reforms, and it encouraged other countries and the international financial institutions to do the same in Africa and Latin America.

As the U.S. has moved away from the principles of economic freedom—instead promoting short-term fiscal and monetary interventionism with more federal government regulations—its leadership has declined. Some, even in the U.S., may cheer the decline, but it is not good for the world or for the U.S.

It could rightly be argued that American economic policy post WW2 was not perfect given its over use of regulation and high marginal tax rates, but comparatively speaking the American model was better than that being used in large areas of the world which were not free either economically or politically. Just compare it with post WW2 Britain with its even greater controls over the economy. John Jewkes summed up the situation in the title of this book "The new ordeal by planning: the experience of the Forties and the Sixties". And it was often better than much of the policy we see today.

Taylor is right when he says,

If [...] the U.S. starts to return to the principles of economic freedom—the best route to improving its own economy—then perhaps it will be able to reassert its economic leadership, benefit the world economy, and in turn create an even more prosperous American economy in a grand virtuous circle.

John Taylor on policy in face of the financial crisis

At his blog Economics One John Taylor writes about his testimony before the US Senate Budget Committee. He writes,

My testimony summarized the results of studies conducted at Stanford during the past three years examining the empirical impact of the policies (the studies are described in the appendix).

One simple fact which I reported received considerable attention in the senators’ discussion. It was that only $2.4 billion of the $862 billion in the 2009 stimulus package (ARRA) has been spent on federal infrastructure—three-tenths of a percent. More may have resulted at the state and local level but there is no clear connection between the federal grants and such spending.

More generally I reported that on balance the federal policy responses to the crisis have not been effective. Three years after the crisis began the recovery is weak and unemployment is high. A direct examination of the fiscal stimulus packages shows that they had little effect and have left a harmful legacy of higher debt. The impact of the extraordinary monetary actions has been mixed: while some actions were helpful during the panic stage of the crisis, others brought the panic on in the first place and have had little or no impact since the panic. The monetary actions have also left a legacy of a large monetary overhang which must eventually be unwound.

I am frequently asked what I would have done differently. It turns out that I testified before the same Senate Budget Committee two years ago in November 2008 and recommended a specific four part fiscal policy response to the crisis. The response was based on certain established economic principles, which I summarized by saying that policy should be predictable, permanent and pervasive affecting incentives throughout the economy.

But this is not the policy we got. Rather than predictable, the policy has created uncertainty about the debt, growing federal spending, future tax rate increases, new regulations, and the exit from the unorthodox monetary policy. Rather than permanent, it has been temporary and thereby has not created a lasting economic recovery. And rather than pervasive, it has targeted certain sectors or groups such as automobiles, first time home buyers, large financial firms and not others. It is not surprising, therefore, that the policy response has left us with high unemployment and low growth. Given these facts, the best that one can say about the policy response is that things could have been even worse, a claim that I disagree with and see no evidence to support.

So the stimulus has not stimulated. It has created regime uncertainty however. Again this shows that New Zealand's somewhat low-key approach to the crisis may have been the right one.

Measuring economic welfare (updated)

John Taylor at the Economics One blog draws our attention to a new measure of economic welfare. The measure combines consumption, leisure, mortality, and even inequality. Interestingly, if not surprisingly, the new measure is positively correlated with GDP per capita. But as Taylor points out there are differences.

For example, income per capita in France is only 70 percent of that in the United States, while the new welfare measure for France is 97 percent of that in the United States. The difference is mainly due to more leisure and less income inequality in France.

One point that I'm sure that many people will not like is

[t]he gains and losses of utility from different levels of income inequality are based on the Rawls abstract concept of the veil of ignorance in which each person enters a lottery each year determining what country he or she will live in--one with less or more income inequality.

This idea has been criticized by a number of welfare economists.

The last point Taylor makes may be the most important,

Chad and Pete have a whole section on “caveats” in their interesting paper.

but you can bet they will be ignored.

Update: Tim Worstall comments here.

The efficiencies of central planning

John Taylor writes at this blog Economics One:

That’s why I was so interested in Paul Gregory's recent blog about this summer’s grain export ban in Russia. It’s a current event well worth telling students about. After the damage from the heat to Russia’s grain crop, Prime Minister Putin imposed a ban on grain exports. But as Paul Gregory shows the reason the story is worth telling is that Russia is now an exporter of grain. In contrast the Soviet Union actually had to import grain from the United States and other countries, because of the inefficiency of the collective farms and misallocation of resources under central planning. Recall that President Carter put an embargo on U.S. exports of grain to the Soviet Union, using it as a lever to get the Soviet’s to leave Afghanistan.

In the years before the Russian Revolution, Russia was an exporter of grains. Ukraine was considered the breadbasket of Europe. Now after the collapse of the Soviet Union, Russia and the Ukraine are exporting again. So this fall the inefficiencies of central planning in the Soviet Union can be explained with a current event after all.

Before central planning, a grain exporter, during central planning grain importer, after central planning grain exporter again. I'm sure there is a message here somewhere .................

Math in econ

At his blog Economics One John Taylor writes, with respect to the use of maths in economics,

People are always surprised by the amount of math used in teaching economics in graduate school, and some think it is used too much. In an interview with Milton Friedman I published several years ago, he said “I go back to what Alfred Marshall said about economics: Translate your results into English and then burn the mathematics. I think there’s too much emphasis on mathematics as such and not on mathematics as a tool in understanding economic relationships.” While I agree about the need to explain the mathematical results in simple terms, I do not agree about burning the math once translated. Mathematical methods are now used in practice in economics and finance in both the public and private sector, from auctioning the spectrum to matching medical students and residence programs. People need to have an intuitive understanding of the methods, but you also need the math (and the computer programs) to make them work.

I would say that Marshall, who was trained as a mathematician, is basically right about the maths, you should burn it in as many cases as you can. However there are some situations where you can't and thus you have to live with it. I would also say that Friedman is right when he says "I think there’s too much emphasis on mathematics as such and not on mathematics as a tool in understanding economic relationships." Maths should be the handmaiden to the economics and not the other way round.

The IMF on the multiplier

Matt Nolan has been talking about Fiscal policy camps over at TVHE. Given this discussion let me add this from John Taylor's blog Economics One:

In a soon to be published paper, several economists at the International Monetary Fund report estimates of government spending multipliers which are much smaller than those previously reported by the U.S. Administration. In order to obtain the estimates the IMF economists use a very large complex model called the Global Integrated Monetary and Fiscal (GIMF) Model developed by Douglas Laxton and his colleagues at the IMF . The paper is quite technical, but the bottom line summary is that a one percent increase in government purchases (as a share of GDP) increases GDP by a maximum of 0.7 percent and then fades out rapidly. This means that government spending crowds out other components of GDP (investment, consumption, net exports) immediately and by a large amount.

This doesn't make government spending look good or all that useful. Something that supporters of increased government spending in face of the financial crises will have trouble explaining. After all their whole argument was based on a large government multiplier.

Latest data continue to show little impact of government stimulus on GDP

John Taylor writes on his blog Economics One that

The 3.2 percent growth rate of real GDP in the first quarter (released by BEA yesterday) confirms that the recovery is looking more U-shaped than V-shaped. But it also provides further evidence that the stimulus package of 2009 has had a small contribution to the recovery. Most of the recovery has been due to investment—including inventory investment, which was positive in the first quarter after declining for all of last year—and has little to do with discretionary stimulus packages.

So thus far the stimulus package seems to be having little effect on recovery. Taylor gives two charts that show the percentage contribution of investment and government purchases to real GDP growth in the first quarter and in the preceding quarters since 2007. The charts clearly indicate that the changes in real GDP growth have been mostly due to changes in investment and little to changes in government purchases. This makes New Zealand's not doing much response to the crisis look more like a good policy.

Schools of thought and influence on policy making

Relying on the interpretations of opinions of people is one way to characterise a school of thought and measure its influence. But John Taylor at Economics One asks if there is a less inherently subjective way to characterise a school of thought or to measure the extent of its influence on policy making. He writes

Are there more objective, perhaps quantitative, ways? Consider, for example, measuring influence by the representation of members of a school in top economic positions in government where there is an opportunity to influence policy. And consider as a measure of an economist’s school, the university where he or she received the PhD. The data in the chart follows this approach. It shows the university PhD percentages of appointees to the President’s Council of Economics Advisers (CEA).

The blue line shows the percentage of presidential appointees to the CEA who have a PhD from Chicago. The red line shows the same for MIT or Harvard (Cambridge), one possible definition of an alternative to the Chicago school. The years from the creation of the CEA in 1946 until 1980 are shown along with each presidential term thereafter. Observe that the peak of the Chicago school influence was in the Reagan administration; it then dropped off markedly. In contrast Cambridge reached a low point of zero appointees to the CEA during the Reagan administration and then rose slightly to 20 percent in Bush 41, to 82 percent in Clinton, and to 100 percent in both Bush 43 and in Obama.

Blaming the financial crisis on the free-market influence of the Chicago school is certainly not consistent with these data. There were no Chicago PhDs on the President’s CEA leading up to or during the financial crisis. In contrast there was a great influx and then dominance of PhDs from Cambridge. And also notice that there were plenty of Chicago PhDs on the CEA at the time of the start of the Great Moderation—20 plus years of excellent economic performance. These data are more consistent with the view that the waning of the free-market Chicago school and the rise of interventionist alternatives was largely responsible for the crisis. But the main point is that there is no evidence here for blaming the influence of Chicago.

Taylor goes on to note,

The data are robust when you look beyond the CEA to other top posts normally held by PhD economists. All assistant secretaries of Treasury for Economic Policy appointed during the Bush 43 and Obama Administrations had PhDs from Harvard. During the same period, all chief economists appointed to the IMF had PhDs from MIT, and, except for Don Kohn, who was promoted from within and Susan Bies who was appointed as a banker, all PhD economists appointed to the Federal Reserve Board were from Cambridge MA.

So do free market supporters really have influence on policy making these days?

Macroeconomists do it with models

John Taylor has an interesting post - Measuring the Impact of the Stimulus Package with Economic Models - at his Economics One blog on the problems of evaluating the effects of the stimulus package of 2009 in the US. Taylor writes,

It's been nearly a year since the stimulus package of 2009 was passed. Unfortunately most attempts to answer the question “What was the size of the impact?” are still based on economic models in which the answer is built-in, and was built-in well before the stimulus. Frequently the same economic models that said, a year ago, the impact would be large are now trotted out to show that the impact is large. In other words these assessments are not based on the actual experience with the stimulus. I think this has confused public discourse.

In other words, should we be surprised that we see the rabbit come out of the hat given we saw it carefully put it there in the first place? Taylor continues,

An example is a November 21 news story in the New York Times with the headline “New Consensus Sees Stimulus Package as a Worthy Step.” Authors Jackie Calmes and Michael Cooper write that “the accumulation of hard data and real-life experience has allowed more dispassionate analysts to reach a consensus that the stimulus package, messy as it is, is working. The legislation, a variety of economists say, is helping an economy in free fall a year ago to grow again and shed fewer jobs than it otherwise would.”

As evidence the article includes three graphs, which are reproduced on the left of the chart below. Each of the three graphs on the left corresponds to a Keynesian model maintined by the group shown above the graph. All three graphs show that without the stimulus the recovery would be considerably weaker. The difference between the black line and the gray line is their estimated impact of the stimulus. But this difference was built-in to these models before the stimulus saw the light of day. So there are no new hard data or real life experiences here.

Taylor then makes the point that if the rabbit isn't put in the hat, it doesn't come out.

In fact, a number of other economic models predicted that the stimulus would not be very effective, and, using the same approach, those models now say that it is not very effective. To illustrate this I have added two other graphs on the right-hand side of the chart which did not appear in the New York Times article. The first one is based an a popular and well-regarded new Keynesian model estimated by Frank Smets, Director of Research at the European Central Bank, and his colleague Raf Wouters. Focus again on the difference between the black and the gray lines, which is what is predicted by that model, as shown in research by John Cogan, Volker Wieland, Tobias Cwik, and me. Note that the impact is very small. The second additional graph on the right is based on the research of Professor Robert Barro of Harvard University. As he explained last January, “when I attempted to estimate directly the multiplier associated with peacetime government purchases, I got a number insignificantly different from zero.” So according to that research, the difference between the black and the gray line should be about zero, which is what that graph shows. So there is no consensus.

There seems to be at least two basic messages that follow from this: one, when using models to evaluate policy outcomes it is important to go beyond the use of just a few select models, and check to see if the outcome is robust across a number of different models. Second, it is now time to start looking at the direct impacts of the stimulus by looking at the hard data.