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Saturday, May 26, 2012

A Tale of Two Memos to Two President-Elects

Today the Wall Street Journal dedicated more than three-fourths of a page to publishing large excerpts from a 1980 memo to president-elect Ronald Reagan from George Shultz and other economists who had advised Reagan in the presidential campaign. In my view, that memo represents a watershed in the history of economics with great relevance today, and that is why I focused on it in my new book First Principles, where I explain why the economy prospers when policy adheres to the basic principles of economic freedom, but falters when policy deviates from those principles, as it is doing now. That original fifteen page 1980 memo was an important reason why policy veered back to the principles of economic freedom the 1980s and the 1990s. Here is how I describe the memo in First Principles:

Less than two weeks [after the 1980 election], on November 16, 1980, many of the economists who had worked together in the campaign wrote an extraordinary memo to Reagan entitled ‘Economic Strategy for the Reagan Administration.’ It began with a call for action: “Sharp change in present economic policy is an absolute necessity. The problems . . . an almost endless litany of economic ills, large and small, are severe. But they are not intractable. Having been produced by government policy, they can be redressed by a change in policy.”

The memo then outlined a set of reforms for tax policy, regulatory policy, the budget, and monetary policy. There were no temporary tax rebates, short-term public works projects, or other so-called stimulus packages. Rather there were sentences like “The need for a long-term point of view is essential to allow for the time, the coherence and the predictability so necessary for success.”

I believe it is instructive to compare the full 15-page 1980 memo to President-elect Reagan with a similarly-timed fifty-seven page 2008 memo to President-elect Obama. The 2008 memo from Larry Summers was recently posted by Ryan Lizza on the New Yorker web page generating much political and economic debate. Both were written in times of great economic difficulties, but the contrast between the overall approaches to economic policy is striking. Most important, unlike the 1980 memo to Reagan, the 2008 memo focused mainly on short-term interventions and so-called stimulus packages. The recent debate in the press has been over whether the short-term stimulus package should have been larger. In contrast the 1980 memo did not even mention such short term stimulus packages, but rather focused on more permanent long-term strategies and policy predictability.

Tuesday, May 22, 2012

Big Mac and Big Macro

One of the most important things for students to learn in introductory economics is that differences in productivity are the main reason for differences in real wages over time and across countries.

In his presidential address this year before the American Economic Association, Princeton economist Orley Ashenfelter provides an interesting and novel way to calculate and compare real wages over time and across countries. He divides the nominal wage rate of McDonald’s workers ($/hour) by the price of a Big Mac ($/Big Mac) to get an estimate of Big Macs Per Hour (BMPH) which ranges from 3.09 in Japan to .35 in India. In other words it takes about 19 minutes of work at a McDonalds to earn enough buy a Big Mac in Japan and about 3 hours in India. As Ashenfelter puts it, the advantage of this approach is that “international comparisons of wages of McDonald’s crew members are free of interpretation problems stemming from differences in skill content or compensating wage differentials.” And by dividing the sample period in two--from 2000 to 2007 and from 2007 to 2011--he delves into macroeconomics and shows how devastating the financial crisis and the big recession have been to the economic prosperity of most people around the world.

Here is a terrific Big Macro video of an interview with Ashenfelter on Canadian public TV on the subject of his Big Mac studies.  He explains in simple, candid, and interesting terms what is going on and why productivity makes such a difference.

Sunday, May 13, 2012

More Evidence on What Is Holding the Economy Back

Milton Friedman’s “plucking model” should be back in fashion now because it reminds us of the historical fact that throughout American history—until now—the deeper the recession, the faster the recovery. I like to bring a guitar to talks and lectures to illustrate this: Like a guitar string, when the economy is “plucked” down or pulled down, the “string” or the economy always springs back up. The more the economy is “plucked” down, the faster it springs back up. This has been true throughout recorded American history, and it holds whether or not there has been a financial crisis. Here is a link where you can find Hoover Institution Working Paper E-88-48 in which Friedman described the model. (He also envisioned a board on top of the guitar string to prevent a reverse action on the upside, which he argued was not in the data).

Of course something is now interfering with the usual economic response, because our current recovery is certainly not springing back to normal. I have argued that economic policy is holding the economy back, and I think recent research by Ellen McGrattan and Ed Prescott (on increased regulations) and by Scott Baker, Nick Bloom, and Steve Davis (on policy uncertainty) supports this view. Their work is part of a forthcoming book (Government Policy and the Delayed Economic Recovery) edited by Lee Ohanian, Ian Wright and me.

Here are two charts which show why both increased regulation and policy uncertainty are very significant. The first chart uses data from research by Susan Dudley and Melinda Warren. It takes their series on the number of “full time equivalent” federal employees in regulatory activities and subtracts out the number of Transportation Safety Administration (TSA) workers. (I interpolated the years 2002 and 2003 when TSA was expanding and moving from DOT to DHS). There has been a 25 percent increase just since 2007. And these data barely reflect the increased regulations from the health care and financial reform legislation.

The second chart shows the number of provisions in the tax code that are expiring each year. This is part of an index used by Baker, Bloom, and Davis. It shows a substantial increase in the past few years in policy uncertainty.

Monday, May 7, 2012

A Diverse and Wide Open Hearing on Fed Reforms

The House Domestic Monetary Policy subcommittee, with Ron Paul in the chair, is holding hearings tomorrow (May 8) on six proposed bills to reform the Fed. The bills are remarkably diverse ranging from Ron Paul’s Federal Reserve Board Abolition Act to Barney Frank’s bill to remove the Fed district bank presidents as voting members on the FOMC and replace them with appointees of the president of the United States.

Two of the bills (Kevin Brady’s and Mike Pence’s) would refrom the Fed’s dual mandate, which in my view would help the Fed get back to more a rules-based policy with fewer of the recent discretionary interventions which have proved so harmful. The Brady bill would go further and restrict the degree to which the Fed can purchase large quantities of mortgages and other non-Treasury securities. Kevin Brady and Barney Frank will be there to defend their own bills, and Ron Paul will be able to do so as the chair.

The witnesses for this hearing also have very diverse views: two economists from the Austrian school: Jeffrey Herbener and Peter Klein, as well as Jamie Galbraith, Alice Rivlin and me. All the written testimonies are posted on the House Financial Services Committee website.

Regardless of the disagreements one might have with specific proposals or individual witnesses, the subcommittee should be thanked for placing monetary policy reform issues in a prominent place in the public debate and for endeavoring to keep the debate wide open.

Thursday, May 3, 2012

Talk about Economic Successes and Follies

Russ Robert’s latest EconTalk is about my new book First Principles. As with so many of Russ’s EconTalk interviews, he quickly gets to the heart of the matter and spends a good part of interview on the “naming names” sections of the book including the chapter “Who Gets Us In and Out of These Messes?”

This part of the book is based on my personal experiences in Washington with policymakers such Alan Greenspan, Paul O’Neill, Charlie Schultze, or on long discussions with current or former colleagues such as George Shultz and Milton Friedman who were involved in making decisions in earlier times.

As Russ brings out in the interview, it's important to try to identify policymakers who stuck to, or ignored, or compromised on the principles and then draw lessons from successes and mistakes. The history shows that neither political party wholly owns the successes or the mistakes.

The issues are quite relevant to the current situation as Gene Epstein brings out in this recent Barron's interview with me, appropriately titled Fiscal Follies and Monetary Mischief.

Wednesday, May 2, 2012

Debate and Evidence on the Weak Recovery

Last week’s GDP release is yet more evidence that this recovery has been remarkably weak, and has been so from the start—averaging only 2.4 percent in the 11 quarters since the recovery began. See my updated charts below with a comparison with the 1983-85 recovery. Debate about the causes of the weak recovery continues, however, with some still blaming the severity of the downturn and the financial crisis and others blaming economic policy. Indeed this was a big part of the recent debate at Stanford between me and Larry Summers which is now available on video.

Economic historian Mike Bordo, who is visiting at Hoover and Stanford this year sheds new light on the subject in a recent working paper with Joseph Haubrich of the Federal Reserve Bank of Cleveland. In a study of U.S. business cycles they find that deep recessions have always been followed by strong rather than weak recoveries and that this is also the case when there are severe financial crises. So history is not on the side of those who blame the preceeding deep recession and financial crisis. Other factors have likely been at work.