Dr. Doom: Macroeconomic Policy Is Limited

Nouriel Roubini says the U.S. is facing similar macroeconomic policy constraints as Japan did after its real estate and equity bubble crashed in 1989:

First, monetary policy – however aggressive – is like pushing on a string when you have a glut of capacity and credit/insolvency rather than just illiquidity problems. Second, fiscal policy has its limits in a worlds where you are already the biggest net debtor and net borrower in the world and where you need to borrow this year $2 trillion net ($2.5 trillion gross) to finance your fiscal deficit while every other country (including your traditional lenders/creditors) are now running large fiscal deficits with the risk of a sharp back-up in long-term interest rates once the tsunami of new US Treasuries hits the market (see the back-up in Treas yields in the last 10 days and the scary signal it sends about coming dislocations in the US Treasuries market). Third, the US is taking an approach to bank recap and clean-up that looks more like Japan (convoy system and delayed true clean-up as the necessary pain to shareholders and unsecured creditors of banks is avoided/delayed) than the successful Swedish outright takeover/nationalization process. Fourth, the market friendly approach case-by-case approach to the necessary debt reduction of insolvent private non-financial agents (corporate for Japan, households for the US) will be too slow as working out one household at the time the debt overhang of 15 million insolvent households will take years when a systemic debt overhang requires an across the board debt reduction (as in Mexico and Argentina) that is not politically feasible – so far – in the US.

Thus, even if the US were to do everything right and fast enough (on the monetary, fiscal, bank cleanup and household debt reduction) we would still have a severe two year U-shaped recession until early 2010 with a weak recovery of growth (1% or so that feels like a recession even if you are technically out of it) in 2010-2011. But if the US does not do it right this severe U-shaped US and global recession may turn into a nasty multi-year L-shaped near depression like the one experienced by Japan. We don’t have to go back to the Great Depression (when output fell over 20% and unemployment peaked over 25%); even a stag-deflation and Near-Depression like the Japanese one would be most severe for the US and the global economy. And while six months ago I was putting the odds of this L-shaped near-depression at 10% or so such odds have now risen to one third...

No wonder he is called Dr. Doom.

No, Greenspan Was Not Right

Nick Rowe asks an interesting question:

In 2003, Alan Greenspan argued that the Fed needed to set low interest rates to prevent falling into a liquidity trap and deflationary spiral... In 2008, Greenspan's critics argue that those same low interest rates caused an asset bubble, which burst, causing the economy to fall into a liquidity trap and deflationary spiral. Is it possible that Greenspan and his critics were both right? Was the US economy doomed either way?

My answer is no. A deflationary spiral of the kind Nick describes is the result of a collapse in aggregate demand that creates expectations of further declines in nominal spending and ultimately the price level. Along the way the policy interest rate hits its lower bound of zero, real debt burdens increase, and financial intermediation gets disrupted. These conditions better describes today than 2003. The deflation scare of that time was simply a panicked misreading of deflationary pressures arising from robust productivity gains. To make my case I have re-posted with some editing portions of a previous post:

These next three figures make my case. The first figure shows productivity--as measured by non-farm business labor productivity--did see an acceleration in its year-on-year (Y/Y) growth rate around 2003:


The figure also shows the ex-post real federal funds rate (ffr) relative to the Y/Y productivity growth rate. Assuming there were no significant changes in intertemporal preferences and population growth rates, this first figure suggests the Fed was pushing its policy rate down as the natural rate--which is a function of intertemporal preferences, population growth rate, and productivity growth rate--was increasing.

The next figure shows the Y/Y growth rate of nominal spending--measured by final nominal sales to domestic purchasers--against the nominal ffr. The year in question, 2003, is highlighted by the two dashed lines. This figure indicates nominal spending or aggregate demand was not collapsing but rather growing throughout 2003. The ffr, on the other hand was being pushed to down to 1%.


So productivity was increasing and aggregate demand was not collapsing. What about the weak labor market? One story is that the "jobless recovery" was simply the consequence of the above productivity gains. Another story is that the existing low ffr was pushing the cost of capital down and encouraging an inordinate substitution of capital for labor by 2003. In either case, there is no justification for further lowering of the ffr in 2003. The figure below sheds some light on this view. It graphs real non-residential fixed investment against total nonfarm employment with the year 2003 again delineated.

This figure shows that non-residential fixed investment was recovering in 2003 while employment remained flat. Firms, therefore, were investing in their capital stock while avoiding new additions to labor. I suspect monetary policy played some role in this development.

So Greenspan may have thought a deflationary spiral was around the corner in 2003, but the data indicates there was none in sight.

Industries Losing the Most Jobs

So we learned today that U.S. employment plunged by 598,000 in January, the largest monthly decline since December 1974. Although one should be careful to normalize such numbers--there is a much larger workforce today than in 1974--these numbers are striking. The table below shows which sectors are losing the most jobs: (Click on figure to enlarge.)

The Latest State Employment Numbers

I noted earlier that the state of Texas--where I am employed--had seen hardly any of the employment losses taking place throughout the rest of the United States. I now can no longer make that claim. Nonfarm payroll employment numbers for December showed that Texas lost 37,000 jobs during past two months. Still, Texas did gain 153,700 jobs overall in 2008. Here is the figure for employment in Texas: (Click on figure to enlarge.)

By way of comparison, here is employment in California and Florida:



Below is a table for employment changes over 2008 for all states:

The Latest Installment in the New Deal Debate

The latest installment in the ongoing New Deal debate comes from Harold Cole and Lee Ohanian. Writing in today's WSJ they move beyond the unemployment numbers discussion and present data on hours worked, consumption per capita, and nonresidential investment:

The goal of the New Deal was to get Americans back to work. But the New Deal didn't restore employment. In fact, there was even less work on average during the New Deal than before FDR took office. Total hours worked per adult, including government employees, were 18% below their 1929 level between 1930-32, but were 23% lower on average during the New Deal (1933-39). Private hours worked were even lower after FDR took office, averaging 27% below their 1929 level, compared to 18% lower between in 1930-32.

Even comparing hours worked at the end of 1930s to those at the beginning of FDR's presidency doesn't paint a picture of recovery. Total hours worked per adult in 1939 remained about 21% below their 1929 level, compared to a decline of 27% in 1933. And it wasn't just work that remained scarce during the New Deal. Per capita consumption did not recover at all, remaining 25% below its trend level throughout the New Deal, and per-capita nonresidential investment averaged about 60% below trend. The Great Depression clearly continued long after FDR took office.

The rest of their article explains how the New Deal created the above numbers. There is nothing new in their story, but their numbers certainly are interesting. I am looking forward to reading what Eric Rauchway, Brad DeLong, Paul Krugman and others have to say in response to this piece. Please guys, don't dissapoint me.

If you are interested, the Ohanian and Lee data can be found here.

Update: Eric Rauchway replies here. Among other things, he notes Ohanian and Lee's critique is narrowly focused on the NRA and ignores New Deal policies that did work (e.g. devaluing the dollar, not sterilizing gold inflows, and shoring up banks).

Update II: Brad DeLong provides a great response here.

Samuel Brittan on Deflation

Samuel Brittan writes in the Financial Times:

Too much that passes for financial comment is preoccupied with the bogey of deflation when it ought to be concerned with the reality of slump.

If I read Brittan correctly, he is saying we should focus on the source of the problem--the slump--not the symptom of it. Sounds like Brittan would be sympathetic to a nominal income target for monetary policy. Brittan also makes this interesting comment:

Some of the same short-fused commentators who now blame Alan Greenspan, the former Federal Reserve chairman, for overstimulating the US economy [in the early-to-mid 2000s] were then screaming for him to do more to offset the threat of deflation.

Brittan goes on to talk more about deflation, including the mention of an article I really enjoyed reading.

The Incredible Collapse of U.S. Domestic Demand

I believe macroeconomic stability is best achieved by having macroeconomic policy aim to stabilize nominal spending. This approach, rather than stabilizing inflation or the price level, gets at the source of macroeconomic volatility rather than the symptom. Given this understanding--see my previous posts here, here, and here for more on targeting nominal spending--I was alarmed to see in Friday's GDP numbers that nominal spending or domestic demand in the United States crashed in the 2008:Q4. The BEA release showed that final sales to domestic purchasers--GDP minus private inventory change minus exports plus imports--declined at an annual rate of about 10%. This rate is the sharpest quarterly decline for the entire post World War II era as can be seen below: (Click on figure to enlarge.)


Excluding government spending, domestic demand declined even more at a rate of approximately 11% in 2008:Q4. Given the nominal rigidities--sticky prices--that exist in the U.S. economy, this incredible collapse of U.S. domestic demand does not bode well for the economy moving forward. Maybe I missed it, but it seems this development should be getting more attention.

Update: The above graph is in nominal terms. On a real basis the collapse in domestic demand is still large but no longer the biggest one since WWII.