The rate of decline in employment moderated substantially in May, according to the BLS figures released June 5, to about half the monthly rate of job loss recorded over the preceding six months (345,000 vs. 642,000). The news was received in a variety of ways.

First, the cynics. They tend to wax sarcastic at the idea of “things are not getting worse quite as fast as they were” as a good-news proposition. But a wide variety of recent data indicate that the economy is no longer in the state of free-fall that it entered last September, and this is indeed good news. To begin to level off is the first step toward the start of the recovery.

Second, the academics note (correctly) that there is little information in each individual monthly statistical fluctuation that is measured, because the data are inevitably noisy. Still, the public wants to know, in real time, what is the best we can glean from the information we have.

Third, the financial press, in particular, had been asking whether this quarter could turn out to be the bottom of the recession. The May employment report encouraged speculation that the answer was “yes.” The stock market reacted positively.

The members of the NBER Business Cycle Dating Committee (of which I am one) will be responsible for calling the trough when the time is right. We have a range of views regarding the proper place of employment numbers in such deliberations. But one can say, on the one hand, that a decline in economic activity is a decline in economic activity, and therefore still a state of recession, even if the rate of decline has moderated a lot. One can also say, on the other hand, that employment is usually a lagging indicator of economic activity. (For example, the economy continued to lose jobs long after the ends of the 1991 and 2001 recessions. Hence the “jobless recoveries.”)

Speaking entirely for myself, I like to look at the rate of change of total hours worked in the economy. Total hours worked is equal to the total number of workers employed multiplied by the average length of the workweek for the average worker. The length of the workweek tends to respond at turning points faster than does the number of jobs. When demand is slowing, firms tend to cut back on overtime, and then switch to part-time workers or in some cases cut workers back to partial workweeks, before they lay them off. Conversely, when demand is rising, firms tend to end furloughs, and if necessary ask workers to work overtime, before they hire new workers. (The hours worked measure improved in April 1991 and November 2001 which on other grounds were eventually declared to mark the ends of their respective recessions.) The phenomenon is called “labor hoarding” and it is attributable to the costs of finding, hiring and training new workers and the costs in terms of severance pay and morale when firing workers.

Unfortunately, as reported by Forbes, pursuing this logic leads to second thoughts about whether the most recent BLS announcement was really good news after all. The length of the average work week fell to its lowest since 1964 ! The graph below shows that, not only did total hours worked decline in May, but the rate of decline (0.7%) was very much in line with the rate of contraction that workers have experienced since September. Hours worked suggests that the hope-inspiring May moderation in the job loss series may have been a monthly aberration. If firms were really gearing up to start hiring workers once again, why would they now be cutting back as strongly as ever on the hours that they ask their existing employees to work? If one factors in falling wages, to compute total weekly earnings, the picture looks still worse. My bottom line: the labor market does not quite yet suggest that the economy has hit bottom.

[Any readers wishing to post comments are referred to the versions on RGE Monitor or Seeking Alpha .]

The current visit of Secretary Tim Geithner to Beijing once again shines the spotlight on the Renminbi (RMB) and on demands by US politicians that the People’s Bank of China (the country’s central bank) abandon the peg to the dollar.

Throughout the period 2003-2008, I, as some others, have thought that demands from American politicians of both parties that China loosen the dollar link have been misguided in a number of particulars. They were misguided in thinking that an appreciation of the RMB would, alone, do much to boost US output or employment. The demands were especially misguided in putting such high priority on the entire exchange rate issue, given that we need China’s help on more important things, such as preventing a nuclear-armed North Korea. But my arguments during this period might reasonably have been viewed by non-wonks as quibbles. After all, I did agree, along with a majority of other economists, that an increase in the flexibility of China’s exchange rate would be a good thing.

Now, in 2009, the situation has changed in some important ways. Continued demands from American congressmen that China should stop intervening in foreign exchange market to keep the RMB fixed against the dollar have become especially foolish. This is because of two developments over the last year.

The first development: in mid-2008, the top leaders in China decided to abandon the policy they had followed in 2007 — which had consisted of the long-desired abandonment of the dollar peg and the placing of a substantial weight on the euro. They changed horses in mid-stream: After mid-2008 they returned to their old policy (e.g., 2005-06) of a fairly close peg to the dollar. Evidently the motivation for the return to the dollar was complaints from Chinese exporters who had lost competitiveness in 2007 as the euro and therefore the new basket appreciated against the dollar. (Barry Naughton, 2008, gives a glimpse inside politburo politics.)

Why, then, are American congressmen wrong to complain that the return of the dollar link has given American firms an additional price disadvantage in world markets? The first reason on the list is that over the last year, the euro (surprisingly) depreciated against the dollar. In other words, at precisely the moment when the RMB jumped back on the dollar horse, the dollar horse and the euro horse changed directions vis-á-vis each other. If the Chinese authorities had kept the (loose) basket policy of 2007 instead of switching back to the dollar peg in 2008, the value of the RMB would be lower today, not higher, and dollar-based producers would be at a greater competitive disadvantage, not lower.

The second development is that, in 2009, the stratospheric rate of rise of China’s foreign exchange reserves has fallen abruptly. In some months earlier this year, the PBoC actually lost reserves. This means that an increase in exchange rate flexibility — in the extreme case, a move to floating — under current conditions might not result in an appreciation of the RMB, and might even result in a depreciation. Again, that does not correspond to what the congressmen actually want, nor to the public opinion that they represent.

In the near future, we could see a return of substantial surpluses on China’s overall balance of payments and a return of the 38-year trend dollar depreciation. In that case, non-intervention would once again imply RMB appreciation against the dollar. But that leads us to the third point.

The third development, this spring, is the appearance in the dollar’s garden of the first “red shoots.” Red as in deficits and red as in China. For decades, the United States has been able to count on foreigner investors, and in a pinch foreign central banks more specifically, to buy dollars to finance US current account deficits. In recent years, the PBoC has been the lead facilitator, piling up $2 trillion in reserves, most of it in dollars. Many argued that this “exorbitant privilege” could continue indefinitely. But during the past two months we have seen the first signals that this might not continue forever. The possibility that rating agencies might eventually downgrade US debt is in the air, and US longer-term interest rates have finally begun to rise over the last month.

The most telling warning shots have come from Chinese officials. Premier Wen in April expressed worry that US Treasury securities would lose value in the future; that required an unprecedented public assurance from President Obama. Then PBoC Governor Zhou in May proposed replacing the dollar as an international currency, with the SDR. Another official told Americans that his countrymen “hate” having to hold a currency that they believe will lose value in the future as it has in the past. Interpreted separately and literally, each of these statements raises interesting economic questions worthy of extended discussion. Taken together, they constitute a simple wake-up call for oblivious Americans. The message is that at a time when big budget deficits lie deep in America’s past (the big debt that Obama inherited from George W. Bush), America’s present (the record budget deficits caused by the current recession), and America’s future (rising medical costs and the retirement of the baby boomers), we are heavily and increasingly dependent on China to buy our treasury securities. If they and other Asian and commodity-exporting countries stop buying our treasuries, the result would almost certainly be a hard landing for the dollar. I define a dollar hard landing as the combination of a big fall in its value together with a big increase in US interest rates. The outcome might be stagflation.

As a general proposition, it is somewhat obtuse to make strident demands on one’s biggest creditor without taking any consideration of the change in the power relationship that debtor status entails. It is astoundingly obtuse to make the demand that the Chinese stop buying dollars, at the same time as we depend on them continuing to buy dollars to finance our deficits. But demanding that they stop buying dollars is precisely what we have been doing for six years, every time we respond to trade concerns by demanding that they stop intervening to prevent the RMB from rising.

Fortunately, Secretary Geithner’s April decision not to declare China guilty of unfair currency manipulation, in Treasury’s semi-annual report, suggests that he understands the subtleties of the situation. Now if those congressmen would just learn some economics…

[Any readers wishing to post comments are referred to the RGE Monitor version or Seeking Alpha version of this post.]

The Commerce Department this morning announced its advance estimate of last quarter’s real GDP. As expected, the estimate shows that GDP fell in the first quarter of 2009 — by a hefty 6.1 per cent at an annual rate. An implication is that the recession has just tied the post-war record for longevity.

The previous record-holders were the recessions of 1973-75 and 1981-82, each of them four quarters in length according to the official NBER chronology. In the current downturn, the NBER’s Business Cycle Data Committee determined that the economy peaked in the 4th quarter of 2007. Although the Committee won’t declare the trough of the recession until well after the fact, and the trough could well be a ways off, a negative 1st quarter of 2009 almost certainly means that the four-quarter benchmark has now been attained. (The Commerce Department often revises its GDP figures substantially between the advance estimate and the final number, and we are due for major backward-looking revisions in July. Indeed that is one reason why the NBER always waits so long to issue its findings. In the past, the size of the average revision has been just over 1 percentage point, whether up or down. It is highly unlikely that future revisions will change this morning’s negative number into a positive one.)

The NBER also keeps a more precise monthly chronology. The postwar record is 16 months, again shared by the 1973-75 and 1981-82 recessions. To match this monthly benchmark, the current downturn would have to have continued into April. Our best single indicator as to whether it did so will be the employment number to be released by the Bureau of Labor Statistics next Friday, May 8. It almost certainly will show that there were further job losses in April. If so, it will further confirm the dismal conclusion: one would have to go back 80 years, to the disaster of 1929-1933, to find a longer recession.

Most international summit meetings are long on photo-opportunities and short on substance.   There was a great danger that last Thursday’s G-20 meeting in London would be merit comparison to the failed World Economic Conference of 1933, which was also held in London.   This one, however, did have genuine substance.   

Nobody reads the communiques, or listens to the press conferences of leaders or finance ministers. But here is the substance:

Top of the list of accomplishments was expansion of IMF resources. The new SDR allocation was perhaps the most noteworthy and unexpected decision: those observers who have proposed such a step in the current international crisis, or in past international crises, have usually been dismissed as pipe-dreamers (John Williamson, Dani Rodrik, George Soros, Joe Stiglitz…). In addition, there seems to have been some forward movement on international regulation of the financial sector, as the Europeans wanted. Although President Obama acquitted himself well overall, the failure to achieve agreement for coordinated additional fiscal stimulus, as the Americans wanted, was probably the greatest shortcoming of the meeting.

I believe the G-20 meeting will be remembered historically, but not primarily for the above reasons. It will be remembered as the occasion on which primary emphasis shifted from the G-7, the global steering group that until now has had a monopoly on real economic decision-making power, to the G-20. Of the various substantive ways in which developing countries could and should have been given more representation in recent years, the shift to the G-20 is the first one to have actually taken place.

It is ironic that the dollar has strengthened rather than weakened over the last year.

• The sub-prime mortgage crisis originated in the United States;
• The crisis has severely undermined the credibility of American financial institutions -- both in the narrower sense that leading investment banks have now disappeared and in the broader sense that American modes of corporate governance have lost value as role models (rating agencies, accounting systems, executive compensation, and so on)
• The response in Washington has included further acceleration in the already-rising national debt plus an expansion of the US money supply and reduction in policy interest rates that, though appropriate, are unprecedented.

Under normal conditions, any country on the receiving end of three such bullet-points would see its currency go down in flames. Yet the dollar has appreciated.

The explanation is not a mystery. The world’s investors have in two years gone from inordinately low perceptions of (and aversion to) risk and illiquidity, to inordinately higher perceptions of (and aversion to) risk and illiquidity. Virtually all assets other than US Treasury bills look risky and illiquid. That there has been a flight to quality is not surprising. What is perhaps surprising is that US Treasury bills continue to be perceived as the safest of safe havens and the US dollar continues to be the preferred international currency. The flight to the dollar shows up in both the strength of the dollar and the low level of US interest rates. For those of us who warned that the unsustainable current account deficit could eventually lead to a decline in the international role of the dollar at the hands of the euro... that day is not today.

The most noteworthy flows into the dollar and into US treasury securities come in the form of purchases by foreign central banks. The People’s Bank of China recently reached $ 2 trillion in international reserves, which it continues to hold predominantly in dollars. Other central banks among Asian exporters of manufactures and Gulf exporters of oil have been behaving similarly. Even the American public is increasingly being made aware that the United States has grown dependent on the Chinese authorities for its funding.

(The accompanying cartoon says it all… except that China’s reserves have increased by half again since then, and that, as Shang-Jin Wei points out, the sign should really say “Float the Yuan” instead of “Fix the Yuan.”)

[Source: KAL's cartoon From The Economist print edition - Aug 9th 2007 - Illustration by Kevin Kallaugher: http://media.economist.com/images/20070811/D3207WW0.jpg]

There is another irony, however. Even while the US has grown increasingly dependent on purchases of dollars by the People’s Bank of China, US politicians maintain their demands that the People’s Bank of China abandon its purchases of dollars. They don’t usually phrase it this way, because the logical contradiction would be too glaring. Instead the US policy has been, and apparently still is, that China should allow its currency to appreciate. But it is elementary economics that PBoC purchases of dollars over the last six years are the force that has prevented the Renminbi from appreciating. The American insistence that the RMB appreciate is an insistence that the PBoC should stop buying dollars.

The authorities in Beijing have in various ways taken some steps in the direction that Americans have demanded. I have written in the past on the details of what exchange rate policy the Chinese have actually followed over the last four years, and I plan to update that analysis in a successor post tomorrow.

My position on what policy the Chinese should follow regarding the Renminbi has been roughly in the middle of a contentious range of commentators over the last few years:

On the one hand, I have argued:

1. that it is foolish for American politicians to place so much emphasis on this issue in our bilateral relations
2. that it is dangerous to ignore the flip-side implications for funding of US deficits, and
3. that it is unwise to use language such as "unfair manipulation" or "violation of international rules."

On the other hand, I have argued that an appreciation was both

1. in the interest of China, for a number of reasons, and
2. in the interest of the world, to help address the global imbalances problem.

The balance of arguments has now shifted. Overheating is no longer the problem for the Chinese economy that it was as recently as a year ago, having been pushed aside by an abrupt fall in exports. Global imbalances are no longer the most important problem for the world macroeconomy, having been supplanted by the inadequacy of demand. If American politicians are still inclined to make demands on China, it should be for increased fiscal stimulus. Given that China often reacts adversely to foreign pressure, however, perhaps it is just as well that American politicians have been asking for the wrong thing.

[If you wish to post a comment, please go to the versions at Seeking Alpha or RGE Monitor.]

Now I am a believer.

Few readers of my blog will be surprised to hear that I voted Barack Obama in the election. But I was always skeptical that he would be able to achieve fully his promises to bring candor, responsibility, and bipartisanship to Washington. Experience had convinced me it wasn't practical. OK, I am still dubious whether it is possible to achieve bipartisanship -- even for Obama. The evidence was his failure a week ago to get a single Republican vote for his fiscal stimulus in the House (and only three votes in the Senate) despite his substantial election mandate, 63% approval rating, the severity of the current recession, and the concessions he made to the other side.

When it comes to honesty and responsibility, however, what Obama did at his Fiscal Responsibility Summit today was breathtaking. The President didn't just promise to cut the budget deficit in half over the next four years. Both his predecessors promised to do that. He and OMB Director Orszag provided enough details to make me believe that they actually might be able to do it, despite the remarkably adverse circumstances that he has inherited. (This assumes that recovery begins within a year, as most forecasters assume.)

Before I elaborate on how he apparently plans to bring fiscal sanity back to Washington, let me explain what to us policy wonks is the most amazing thing of all: With a few bold waves of his hand, Obama has brought down all the cobwebs of misleading and dishonest budget math that have hopelessly obscured and encumbered the making of fiscal policy at the White House. This is a risk: it means admitting that the budget situation is far worse than the Republicans have been claiming. They could try to blame the appearance of worse numbers on him. But he is doing the right thing. And this is the right time to do it.

To get more specific, here are three kinds of tricks that his predecessor used in order to pretend to be on a path back to fiscal solvency. They sound childish, but they fooled most of the country. (I am skipping the wilder claims, that didn’t fool as many people.) Obama and his team are voluntarily giving up these tricks, even though he probably won't get much credit for it:

• Trick #1: Omitting from future budget estimates the cost of the wars in Iraq and Afghanistan. Every year, for the past 5 years, the expensive wars have continued; and every year the White House and its allies in Congress pretended that this was a surprise. Obama is putting the estimated future costs of the wars into the forecasts right now.
• Trick #2: Pretending in every succeeding budget forecast that you will allow temporary tax cuts such as the “AMT patch” to expire in a few years, thereby bringing in more tax revenue, even though everyone knows you will renew them when the time comes and this is in fact your declared policy. The White House forecasts will now include honest forecasts of future taxes. Gone also will be the similar trick of pretending in the budget forecasts that the government will in the future cut Medicare payments to doctors even though you have no intention of doing so (because it would result in the doctors dropping out of Medicare).
• Trick #3: Using as the base line for a promise to “cut the budget deficit in half” an artificially high budget deficit that you yourself proposed. This is what Bush did in the fine print of his promise in the 2004 campaign. (Not that he cut the budget deficit at all, in the end. But we will get to actual policies below. Right now we are just talking about ways to fool the press into reporting misleading claims with a straight face.) Obama has explicitly said that he plans to cut the deficit in half relative to the $1.3 trillion deficit he inherited, not relative to the much higher deficit that will occur in the coming fiscal year as a result of the recession….that is, as a result both of inevitably lost tax receipts and of the fiscal stimulus that Obama correctly deemed necessary to moderate the recession's severity. This choice of benchmark was brave. After all, he would have been within his rights to say that because he inherited the recession from his predecessor, the corresponding rise in the deficit in 2010 should not count as his responsibility.

Turning from word to deed, how will Obama move the country back toward fiscal responsibility? It won't be easy, so deep is the current hole we are in. But I perceive four categories of initiatives, each of them encompassing further breaths of fresh air: (1) limiting spending growth, (2) increasing tax revenue, (3) making new initiatives more cost-effective, and (4) long-term entitlements reform.

(1) Limiting spending growth

Three examples of measures that Obama mentioned in his speech today that I particularly like:

• Cut unneeded federal payments to agribusiness. This one is high on the wish list of virtually every economist.
• Eliminate expensive weapons systems that are of no help meeting today's national security challenges and which the Pentagon does not want.
• Withdraw combat troops from Iraq. Enough said.
• Reinstate PAYGO (Pay as You Go). This provision means that if some Congressman proposes a new outlay, they have to show how to pay for it by proposing someplace else to cut. The provision was originally adopted by the first President Bush in 1990 (as part of a courageous budget agreement with congressional Democrats, which probably cost him re-election); it was extended by President Clinton in 1993 (without a single Republican vote); it helped a lot to deliver fiscal surpluses by the latter part of the decade (1998-2000); and it was allowed to expire by the second President Bush in 2001 (with the result that the rate of spending growth tripled thereafter).

(2) Increasing tax revenue

Two examples (among other possibilties):

• Let Bush's tax cuts on income for those earning above $250,000 expire as scheduled after 2010.
• Tax investment income earned by hedge fund partners at the same ordinary income tax rates that the rest of us pay. It's about time.

(3) Seeking cost-effectiveness when addressing priorities that the Democrats consider neglected, such as health care and global climate change.

Two examples:

• Increase the efficiency with which health care is delivered.
• By 2012, require that companies buy permits for Greenhouse Gas Emissions, rather than giving them all the permits for free. Free allocation would be a big windfall to utilities and others because they will in any case pass on much of the increased cost of energy to consumers.

(4) Long-term entitlements reform.

The overwhelming problem in the longer term is the coming deficits of Social Security (big) and Medicare (much bigger). The easy thing for Obama to do would have been to put off any attempt to deal with them until after he had put behind him the financial crisis, recession, and first steps toward budget responsibility. But he has indicated that he wants to put in place during his first year in office the process to deal with the future entitlements problems.

Everybody familiar with the facts has always known how to fix Social Security. The solution is not all that hard, but is politically painful to enact. The answer is some combination of three changes:

(i) progressive indexation of benefits. (Current retirees would not have their benefits cut, not even relative to what they otherwise would have been. Really);

(ii) raising the retirement age. (Just a little. Really. And let’s exempt workers who do heavy manual labor); and

(iii) making upper-income workers pay higher payroll taxes than those earning $107,000.

One could add that in the past it was always considered necessary to add a fourth component in order to bring Republicans on board: privatization of some part of Social Security, which would be invested by workers in the stock market. Predictably, the clamor for this provision died down when the stock market crashed.

I have no inside knowledge if this is what Obama is planning. The game in the past has always been that no politician would propose any combination of the three components, because if he or she did, members of the opposite party would promptly attack him. So the thing to do is to form a study group comprising knowledgeable members of both parties in the Congress, have them meet for one year, and then come out holding hands and simultaneously declaring their support for a precise package of this sort.

This was the strategy Bill Clinton chose to address Social Security, after having successfully delivered on his earlier promises to cut the budget deficit in half in his first term and then to eliminate it entirely. (”Save Social Security First,” State of the Union speech, January 1998.) But before the year was up, the Republicans decided they would rather impeach him than solve the Social Security problem. In this sense Obama is taking up where Clinton left off eight years ago. Too bad the country sank $5 trillion in the hole in the meantime.

[For any readers wishing to post a comment, I suggest you go the version of this post at SeekingAlpha.]

          We often hear the question “isn’t this economic crisis becoming as bad as the Great Depression?” Economists can offer a variety of reassurances, but each of them is quite circumscribed:

1. First reassurance:   So far, the downturn is at worst competing with 1981-82 for the title of worst post-war recession.  True, it is too late for the large monetary and fiscal stimulus applied from Washington to prevent a major recession.   In April the current episode is all but certain to surpass the 1981-82 recession in length. It is still quite possible, however, that with the help of the stimulus package the current recession could fall short of the 1981-82 in depth.   Unemployment peaked at 11.4%  in January 1983, whereas so far we are “only” up to 8.5% (in January 2008).

But the situation is clearly going to get worse before it gets better.

2. Second reassurance: The standard forecasts currently call for the US and other economies to begin to recover by 2010.  Even if the situation continues its recent rapid deterioration and the current recession in a year or so attains the prize for most severe of the post-war recessions, it still has a long way to go before it rivals the Great Depression in either length or severity. In the Depression unemployment peaked at 25% in 1933; as late as 1941 it was still as high as 9.9%, far above normal levels (e.g., the levels before the 1929 stock market crash).

But how do we really know for sure that this recession won’t reach the league of the economic disaster that was the 1930s? After all, Japan in the 1990s endured a period of essentially zero growth that lasted as long as the Great Depression. Over the last year, forecasters have already marked down their growth forecasts over and over again, both in the U.S. and globally. When the sub-prime mortgage crisis first hit, in the summer of 2007, the Fed and White House said it was “contained.” When instead it spread, freezing up liquidity throughout the financial system, they said that Wall Street was not Main Street. When it became increasingly evident that the entire U.S. economy was in recession, most emphatically including Main Street, many talked of “decoupling:” under which other major economies would remain centers of global growth. Yet this optimistic hope, like the others, soon crumbled away to nothing.

3. Third reassurance: Even if the worst were to happen, and we turned out to be at the beginning of a decade of high unemployment and stagnation analogous to the Great Depression, standards of living in absolute terms would remain far higher than in the 1930s. This fact is worth noting.

But it does not offer much solace. There is a reason why the focus is always on the growth rate of income, rather than the level. People tend to form expectations based on their parents’ lifestyle and a trend expectation of continued economic improvement, and to grow accustomed to their recent standard of living. At least after human beings get past subsistence, their happiness is related more strongly to the rate of change of their standard of living than to the absolute level. A five per cent loss of income from current levels probably leaves people more miserable than a five per cent increase from 1930s levels of income. And loss of a job or house is, needless to say, enormously disruptive to a family, often traumatic.

4. So the important question, then, is: how do we know that the recession that began in December 2007 will not turn out to be analogous to the downturn that began in 1929: the beginning of what could turn out to be a very severe loss of income and a decade of high unemployment? There are plenty of analogies between now and then:
(i) a crisis in the US financial sector that had its roots in long excessive booms in real estate and the stock market;
(ii) the spreading of the crisis from the financial sector to the real economy and throughout the world; and even
(iii) popular American disillusionment with a Republican president perceived as too passive and too beholden to the rich, which then helps elect a charismatic and activist new Democrat.

          The usual reason that is given not to fear a repeat of the Great Depression is that we have learned from the mistakes of that era, and won’t repeat them this time.    What exactly is it that we learned?   How can we be sure of doing it right this time?    There are four big lessons for economic policy from the 1930s:

(Lesson I) Monetary policy — The Fed should respond to a severe loss of demand by aggressive monetary expansion, not by allowing the money supply to contract as happened in the 1930s (most famously pointed out by Milton Friedman and Anna Schwartz, in the Great Contraction chapter of a Monetary History of the United States). It happens that the Chairman of the Federal Reserve, Ben Bernanke, and the Chair of the President’s Council of Economic Advisers, Christie Romer, are two of the very top experts in the monetary history of the 1930s. The lessons of this period have been well absorbed, and the Fed has already given us an appropriately aggressive response. But that can only take us so far.

(Lesson II) Regulation of the financial sector — In times of financial crisis, many banks and especially their depositors will have to be bailed out; this recognition in turn requires a corresponding degree of regulation in normal times. The 1930s left us with institutions such as deposit insurance and minimum requirements for banks’ reserves and capital. The existence of these safeguards is another reason why it is indeed unlikely that we will experience anything as bad as the Great Depression. The origins of the financial crisis of 2007 was not that de-regulation fervor had led to a dismantling of the important safeguards from the 1930s. (It’s true that Glass Steagall and prohibitions on inter-state banking were dismantled in the 1990s. But that did not cause the crisis.) The problem was rather that regulation did not keep up with new innovations in non-bank financial institutions. Reform in this area is more easily said than done, and more easily done wrong than done right; but will nevertheless have to be attempted as soon as we get past the current crisis.

(Lesson III) Fiscal policy — When a deficiency of aggregate demand leads to a serious and prolonged recession, the government should respond with intelligently designed fiscal easing, in the form of both spending increases and tax cuts.  To the extent that Franklin Roosevelt tried Keynesian stimulus in 1933, it worked, though only World War II spending years later finished the job.   There are several critical qualifiers to note before we generalize to the post-war era.  First, the budget process must not be so encumbered by political machinations or corruption as to delay disbursements until it is too late, on the one hand, or to divert them to projects with miserable cost/benefit ratios, on the other hand. Second, the budget plans must also pay due attention to the constraints of long-run fiscal sustainability. Absent these conditions, a fiscal expansion could well make things worse rather than better. The good news is that the fiscal stimulus package that President Obama signed into law last Tuesday was better designed than those enacted in many past American recessions, let alone those enacted in other countries. The efforts to block it, by those in the Congress who do not understand the lessons of the past, were unsuccessful (though they did succeed in slightly reducing bang for the buck). The bad news is that Obama has taken office with a handicap that Franklin Roosevelt did not have: a trillion-dollar deficit and a $11 trillion national debt, both of which are already guaranteed to reach alarming levels as a share of GDP in the coming year. This negative inheritance constrains the extent of fiscal expansion that is feasible.

(Lesson IV) Trade policy — The lesson that economists have long thought had been most clearly demonstrated by the 1930s is the lesson to which today’s Congress has paid the least heed. Senator Smoot (R) and Congressman Hawley (R) in 1929 proposed legislation to raise US tariffs sharply. Warnings of the damage that such protectionism would cause were ignored, including a petition organized by the leading economists of the day and signed by 1,028 of the profession. President Hoover (R) signed the infamous Smoot-Hawley bill in 1930. The consequences are well-known. Other countries instantly retaliated, and emulated this aggressive act of protectionism. Over the subsequent years world trade collapsed (down 60% by 1932), helping to put the “Great” into Great Depression and facilitating the rise of rabid nationalism in Germany and Japan.

The Buy America provisions in the original House version of the current stimulus bill risked a repetition of the mistake of Smoot-Hawley. These provisions have received far more attention in the media in every foreign country than inside the United States. President Obama insisted that the legislation abide by our international treaty commitments. It would have been better if this statement had come earlier, but it was music to the ears of us free traders. The final stimulus bill that the President signed this week was somewhat better from a trade perspective than the original. In his short time in office, Obama is already doing a better job of respecting international commitments than did his predecessor, who imposed WTO-illegal steel tariffs in 2002.

We are assured that:
(i) the government will apply the remaining Buy America provisions in a judicious manner (we are only talking about government procurement here, not interference with private-sector imports); that
(ii) in particular, the legal commitments to open markets vis-à-vis Canada and Mexico will continue, and that
(iii) the import content to the stimulus package would have been low in any case (just some iron and steel in bridges). I still worry. The part of the Smoot-Hawley lesson that even a mercantilist can appreciate is foreign retaliation: the initial reduction in imports is more than offset by a reduction in exports. If the Buy America provision was heard internationally as the firing of a starting gun in a new race toward protectionism, then the preceding three reassurances are not very reassuring.

To say that the 1930s hold important lessons for policy makers today is not to underestimate the other important lessons from subsequent history, especially the excessive fiscal and monetary expansions of 1964-2005. President Obama will turn to the issue of long-run fiscal sustainability tomorrow.

[To any readers wishing to post a comment:  I suggest you go to the versions of this post at RGE or SeekingAlpha.]

Everyone asks for tips: Where can I put my money?   Stocks or bonds have done very badly over the last  year, needless to say, and one cannot be confident that they have hit bottom.  Should one just leave everything in banks and money market funds?   Surely there must be something else worth buying?

Inflation-indexed bonds (TIPS in particular, the acronym for Treasury Inflation-Protected securities) seem an undervalued asset. Using the conventional break-even approach, TIPs have lately implied an implausibly low long-term US inflation rate: 1% at the 10-year horizon and less than zero at the 5-year horizon.    Is the explanation that people fear deflation?    It is hard to see that we could have negative inflation for many years.   I suspect the standard calculation of the implicit TIPS premium for expected inflation doesn’t even take into account the asymmetric form of their indexation, which makes them something of a one-way bet:   When the security matures, the U.S. Treasury pays the original or adjusted principal, whichever is greater.   Surely the market is not correctly pricing TIPS.   One implication is that they cannot be relied upon as an indicator of expected inflation.

Another implication is that we should all buy them.   Because the inflation-indexed component is taxable, I recommend holding them in a non-taxable retirement account, such as a 401k.

Of course I am not the first one to have noticed this:   quite a few others have pointed it out in recent weeks and months.    Indeed the prices of TIPs have begun to recover a bit since the beginning of the year.   But I think they have further to go.

Perhaps the Fed should buy TIPs, alongside all the other assets it is buying. Or the Treasury should swap them for conventional long-term Treasury bonds, now that investors are pushing the price of the latter down in response to huge increases in supply (i.e., are finally demanding higher returns on long-term Treasuries).   Either strategy should help a bit improve the country’s endangered long-term fiscal situation.

[To any readers wishing to post a comment:  I suggest you go to the version of this post at SeekingAlpha.]

Congress has finally agreed on a $790 billion stimulus package. Is it too small, as many Democrats claim (such as Paul Krugman), or too big, as many Republicans claim (such as the minority party leadership in Congress)? The answer is yes. It is too big and too small.

If the criterion is how much annual stimulus to demand is needed to bring the economy back up to the level of potential output in 2010 and beyond, and to bring the unemployment rate back down to the natural rate of unemployment, then $800 billion is to small. The Congressional Budget Office has estimated that the economy will fall short of potential output by about 7 per cent of GDP, in both 2009 and 2010. (The source is testimony on January 27 by the new Director of CBO, Doug Elmendorf – an outstanding choice to run that agency, by the way. The news on jobs and other economic indicators in the two weeks since that testimony was written has continued to show rapid deterioration of the economy.) The $800 billion is to be spread over several years; the peak is to be about $356 billion in 2010, which is about 2 ½ per cent of GDP. The most optimistic estimate of the "Keynesian multiplier" that anyone has is 2, which would imply a 5 per cent boost to GDP. That is less than the 7 per cent gap, and so not enough to return the economy to full employment.

In practice, even if interest rates were to stay very low, the actual multiplier effect would almost certainly be substantially less than this. For one thing, much of the stimulus takes the form of tax cuts, and the part of the tax cut that households save will not contribute to demand and therefore will not enter the stream of spending and income. (Of course a shortage of national saving is part of how we got into this problem, so that an increase in private saving is welcome in the longer run. But the question here is how to stimulate spending that has been depressed by the current crisis.) And another part of the tax cuts, a one-year AMT patch — while again desirable — will have no effect on spending because the beneficiaries, along with the forecasters and everyone else, were already assuming that they would not be paying the AMT tax. If we are lucky, the American Recovery and Reconstruction Act will close half of the gap, relative to the magnitude of the recession we would have otherwise had. So, no, it is not enough.

But in another sense, $800 billion is too much. The 2009 fiscal-year deficit is already expected to exceed $1.2 trillion, so we are talking about deficits thereafter that could surpass 10 per cent of GDP. The ratio of government debt to GDP is forecast to surpass 85% already in fiscal year 2009.

These numbers are far above the levels that are considered danger signals when they come from any other country. Until now, the US has not been "any other country;" The rest of the world has been willing to finance American profligacy cheerfully. But there have already been signs in the last few weeks that the prospect of this much Treasury debt coming onto the markets is already beginning to push bond prices down and long-term interest rates up. My feeling is that if the current stimulus package were to break the $1 trillion mark, it might truly alarm international investors, who would in that case stop acquiring dollar assets, thus precipitating the hard landing of the dollar that so many of us have feared for so long. In those circumstances, the Fed would lose the ability to keep interest rates low, and we could be in even worse trouble than today.

Everything would be different if we had spent the last 8 years preserving the budget surpluses that Bill Clinton bequeathed to George Bush. Then we would have paid down a big share of the national debt by now, instead of doubling it. We would be in a strong enough fiscal position to undertake the expansion today that we really need.

In that light it is ironic, to say the least, that the politicians who are warning against the size of the stimulus bill (”generational theft”), particularly the Congressmen who are voting against it, are mostly the same Republicans who supported the original fiscal policies that gave us the doubling of the national debt: the huge long-term tax cuts of 2001 and 2003 and the greatly accelerated rate of government spending. What we need now is a fiscal policy that maximizes short-run demand stimulus relative to long-run damage to the national debt. Lots of bang for the buck. The Republicans supported fiscal policies that did the opposite. Lots of buck for the bang. They are still doing it today when they argue that tax cuts give stimulus and spending does not. One doesn't even hear them give an economic argument in support of this proposition. They just close their eyes and endlessly repeat their "tax cut" mantra, like a religious cult that can't even remember why.

Admittedly it would be hard for the congressional naysayers to give an economic argument for their position. Not only have the more extreme theories of the supply siders been discredited, but Martin Feldstein, the father of respectable pro-saving tax-cut thinking, has recently been in the vanguard of those warning that the current economic downturn requires increased spending rather than more tax cuts, and pointing out that 2008's tax rebates didn't work because such a large share of them was saved.

[If you wish to post a comment, I suggest you go to the version of this blog at RGE or SeekingAlpha.]

Some observations on the plan announced by Treasury Secretary Tim Geithner yesterday:

Clearly we need to hear more details. I sympathize with Geithner, who has only been in office a couple of weeks. He has had to take over in the middle of the worst financial crisis in 77 years, at the same time that he must personally fill out the reams of forms that it takes to get confirmed by the Senate (like all such new appointees) and to fill lots of positions throughout the upper levels of the Treasury. But the American public will demand further elaboration on his plan soon.

For now, one must guess what is going to be the precise shape of the new Private Public Investment Fund (PPIF). I would bet that the plan will do a better job of preventing taxpayers from being fleeced by bankers than did the preceding incarnations of TARP or would some of the alternate proposals that are out there. In this regard, the caps on executive pay for those banks taking advantage of government money will draw the most attention. But even more important is that, whereas the original TARP paid the banks more for their damaged assets than the market was willing to pay, I hope and expect that the PPIF will have mechanisms to guard against paying more than these assets are worth.

The valuation will come from other private investors who put their own money on the line to buy these assets at discount, in the open, not from some Treasury official making some impossibly wild guess as to the assets' value. But we still don't know, for example, whether the form of Treasury assistance will be a commitment to help cover any future losses if these assets were to decline further in value relative to what the investors pay for them (”insurance guarantees”) or some other form of joint participation with private investors (”coinvestment”). Something is needed to get private equity and distressed-debt specialists to get in the game now.

Much has been made of the sharp negative reaction of the stock market, as on Inauguration Day. Clearly markets were disappointed in what Geithner had to say. But I haven't seen anyone point out an implication of the fact that the losses have been heavily concentrated among prices of banks and other finance stocks: This need not necessarily be an entirely negative signal on the Administration's plan. What is in the interest of bank shareholders is not the same as what is in the interest of the rest of us. Bank shareholders are still hoping that, with government budgetary outlays, they will recoup much of the value of their shares. But the rest of us are, loosely speaking, hoping for the opposite – at least in the case of banks where the big losses can be attributed to mistakes on their part. To my way of thinking, it is actually a good sign if what is making shareholders unhappy is the Geithner plan’s measures to prevent banks that ask for government money from then paying dividends or acquiring other banks (unless asked to do so), until they have repaid the government.

The goal of any Treasury plan should be, and I believe is currently, to recognize (write down) the losses of the banks and near-banks, putting these losses in the past so that the banks can resume lending, and to do it without incurring further huge costs for taxpayers beyond what is absolutely necessary to get the economy going again (taxpayer protection). Knowing how to price unpriceable bank assets (price discovery) has been the big stumbling block. We don't want to repeat the original Paulson plan of paying more for these assets than they were worth.

The lesson from Japan in the 1990s (and the US Saving and Loan crisis before that), is that if the government is too timid politically to move quickly, by spending some money and wiping out some bank shareholders, it will end up later on by spending a lot more money. And in the meantime, a lot more people will be wiped out.

Increasingly, observers like Nouriel Roubini are saying that the best way to accomplish these goals is simply to nationalize the worst of the banks, wiping out the shareholders' equity, and then re-privatizing them or selling off their assets in the near future. This is the famous Swedish model. Secretary Geithner points out that government officials are not good at running banks (though Paul Krugman points out that neither are their current managers). Perhaps the most important point is that, given the huge national debt that was run up by the previous team and the huge additional budget deficit that we will run this year due to the recession, the Treasury is constrained in how much money it can lay out in its financial repair plan. Finally, everyone recognizes that most Americans are allergic to the idea of nationalization, which admittedly would be a radical step if judged in the context of the pre-2008 world. (At a minimum, a euphemism for nationalization is needed. I suggest the simple label “bankruptcy” to make clear to the public that the bank shareholders and managers are not being bailed out.)

Coinvestment then. Or insurance guarantees. In any case let's hope Geithner and team come up with their more complete answer soon.