Economics, financial forecasts and the “efficient market hypothesis”

“There is widespread disappointment with economists now because we did not forecast or prevent the financial crisis of 2008. The Economist's articles of July 18th on the state of economics ... caricatured [macroeconomists] as a lost generation educated in the use of valueless, even harmful, mathematical models, an education that made them incapable of conducting sensible economic policy. I think this caricature is nonsense ....

One thing we are not going to have, now or ever, is a set of models that forecast sudden falls in the value of financial assets, like the declines that followed the failure of Lehman Brothers in September. This is nothing new. It has been known for more than 40 years and is one of the main implications of Eugene Fama's "efficient-market hypothesis" (EMH), which states that the price of a financial asset reflects all relevant, generally available information.

If an economist had a formula that could reliably forecast crises a week in advance, say, then that formula would become part of generally available information and prices would fall a week earlier. (The term "efficient" as used here means that individuals use information in their own private interest. It has nothing to do with socially desirable pricing; people often confuse the two.)”

Robert Lucas, "In defence of the dismal science", The Economist (8 August 2009).

www.economist.com/businessfinance/displaystory.cfm?story_id=14165405

University of Chicago economist Robert Lucas (1937-), one of the most influential economists in the world, received the Nobel Prize in 1995. His ex-wife had a clause placed in their 1988 divorce settlement that she would receive half of any Nobel Prize won by Lucas in the next seven years. To her delight, Lucas won the prize just within the time limit.

In this article, Lucas defends economics -- and economists -- against criticisms that the financial crisis represents a failure of 'the dismal science'.

Comments of other prominent economists -- Robert J. Barro, Mark Thoma, Tyler Cowen, Markus Brunnermeier and Brad DeLong -- are posted at www.economist.com/blogs/freeexchange/lucas_roundtable/, along with a reply by Lucas to what he considers to be an inaccurate statement of DeLong regarding Lucas' opinion of Fed Chairman Ben Bernanke.

Needless to say, the failure of the economics profession in general and macroeconomists in particular to foresee the depth and severity of the current downturn has generated much debate in the profession itself. This debate is all the more heated because not just because different points of view and political positions are at stake, but reputations as well. Egos have been bruised, and it will take some time for passions to subside.

There will also have to be a dispassionate reassessment of macroeconomic theory and its usefulness for policy purposes. That, however, will take some time and must involve people who have not been at the center of the development of current theory and policy. They will also have to work step-by-step from the ground up, assessing the usefulness of elements such as the “efficient-market-hypothesis” (the assertion that prices on financial markets, e.g., stocks, bonds, property, already reflect all known information and instantly change to reflect new information) and the degree to which “sticky prices” (the assertion that microeconomic prices and wages are resistant to change), as another example, hinder the macroeconomic adjustment process. We will have to move beyond simple ideas like these that underlie the controversies about contemporary macroeconomic theory and policy.

While I am in sympathy with much of what Professor Lucas has to say, I do think macroeconomic theory is now in shambles. That does not mean we will stop teaching it in our classes. We macroeconomists do, after all, have to say something about how the macroeconomy operates to earn our pay. But the confidence in our theories has been eroded and our assurance that the deep recessions and horrible depressions of the past are history is now questionable. I think it is fair to say that economists have been wounded more by this crisis than the economy.

Thought du jour has returned from vacation and these missives will be sent once or twice a week until the new semester begins, when its full schedule will resume.

Thanks to Larry Willmore for much of today’s Tdj.

Will the U.S. economy see an upturn later this year?

The economy is now more than a year and a half into what is becoming its deepest and most prolonged recession in half a century. Output has fallen steeply the last year, with two recent quarters registering a sharp contraction averaging 6 per cent of GDP at an annual rate. Measured per person, even if the decline were to be halted today, the income of the average American will have dropped well over 7 per cent compared to the level enjoyed only a few years ago.

The Administration now points to some signs of recovery. Unemployment reports have recorded smaller monthly losses in jobs, some financial institutions have reversed their unsustainable losses and generated huge profits, some banks have begun to re-pay bailout loans and eliminate toxic assets from their balance sheets, fears of a sudden jump in interest rates and inflation or a precipitous drop in the dollar have receded, and there are signs economic activity may be stabilizing in some parts of the country. The sense of a "free fall" of the economy that pervaded the past year has been replaced by a hope that a revival may be on the horizon.

In some superficial sense, it may be true that conditions have improved. Statistically, the GDP includes government spending, and the massive but unsustainable deficits now being accumulated into huge increases in the national debt no doubt have had some positive effect on the economy. This effect may well intensify in the months ahead. Some increase in consumer spending and a rundown of inventories may also encourage businesses to increase their current production somewhat in response. The negative growth of the past year may well be replaced by some minor uptick reflecting improvements in a few sectors of the economy.

It is not unusual for there to be a positive quarter in the middle of a recession, especially when measured in terms of the aggregate volume of activity rather than in output per person. However, measures of overall GDP mask what is going on underneath this total, where industrial production, unemployment, capacity utilization, tax receipts, and other indicators of economic health continue to deteriorate. Moreover, average incomes can continue to decline noticeably even when the economy appears to be on the mend.

Nowhere is this clearer than in the job market, where the economy-wide unemployment rate of 9½ per cent hides rising distress in the lives of workers. More and more firms have been asking employees to work part-time, the work-week is being cut in the private and public sectors, and the average length of unemployment is rising. Even when a recovery begins, employers will first restore longer working hours to their present employees before they hire more workers. When an upturn begins, it will be a long, slow, painful and jobless recovery.

Adding to the dim prospects for a strong recovery and boost in job creation are the proposed higher business and energy taxes. Massively raising taxes on the economy in the best of times can be expected to lower its performance and discourage employment. Raising taxes in the middle of a recession, as the Administration is now advocating, can only be regarded as lunacy which will postpone any recovery.

The United States remains in the grip of a major downturn rooted in mammoth economic, financial, and trade imbalances that have taken years to become entrenched and will take years to overcome. The Administration is doing nothing to deal with these fundamental problems; indeed, its policies are only making them worse. Until these problems are addressed, the foundations for sustained and rapid growth cannot be restored. For this reason, if there is an upturn later this year, it will be weak and halting and temporary and by no means an indication the recession is over and we are on our way to recovery.

Lenin on the best way to destroy Capitalism

“Hundreds of thousands of rouble notes are being issued daily by our treasury. This is done, not in order to fill the coffers of the State with practically worthless paper, but with the deliberate intention of destroying the value of money as a means of payment. There is no justification for the existence of money in the Bolshevik state, where the necessities of life shall be paid for by work alone. Experience has taught us it is impossible to root out the evils of capitalism merely by confiscation and expropriation, for however ruthlessly such measures may be applied, astute speculators and obstinate survivors of the capitalist classes will always manage to evade them and continue to corrupt the life of the community.

The simplest way to exterminate the very spirit of capitalism is therefore to flood the country with notes of a high face-value without financial guarantees of any sort. Already even a hundred-rouble note is almost valueless in Russia. Soon even the simplest peasant will realise that it is only a scrap of paper, not worth more than the rags from which it is manufactured. Men will cease to covet and hoard it so soon as they discover it will not buy anything, and the great illusion of the value and power of money, on which the capitalist state is based will have been definitely destroyed. This is the real reason why our presses are printing rouble bills day and night, without rest.”

Quote attributed to Vladimir Ulianoff Lenin (1870-1924) during an interview with a London newspaper and subsequently referred to in the New York Times (~1919). This quote is notable because it is the basis of comments made by John Maynard Keynes in Chapter 6 of his Economic Consequences of the Peace (1919), where Keynes says:

“Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and it does it in a manner which not one man in a million is able to diagnose.”

“Lenin” was the alias of the Marxist revolutionary Vladimir Ulianoff (also spelled Ulyanov), the Communist politician, principal leader of Russia’s October Revolution of 1917, and first head of the Soviet Union.

In the midst of the national catastrophe that overwhelmed Russia in 1917 the Bolsheviks had been able to grasp power and begin to destroy the existing economic and political order in preparation of introducing a socialist society. Among the steps they took were the nationalization of the banks, confiscation of private bank accounts, assumption of control over factories, seizure of the properties of the Church, repudiation of foreign debts, and takeover of land by peasants. Needless to say, these actions in the economic area were complemented by the arrest of leaders of opposition parties and even members of the Menshevik faction of the Congress of Soviets of Workers’ and Soldiers’ Deputies, as the revolutionaries called themselves at the time.

Lenin’s determination to destroy the private economy and the general political chaos he promoted resulted in the Russian Civil War (1917-1923) and a period of upheaval and terror associated with what was called “War Communism” (1918-1921), a strict socialist economic policy of nationalization, state monopolies, obligatory labor, and rationing, confiscation and distribution of commodities in a centralized way, with severe penalties imposed on those who do not comply.

Some commentators such as the historian Richard Pipes argue that War Communism was an attempt to impose Communist economics on Russia, and Lenin and others expected an immediate and large increase in output and employment once their program of central commands and state control was introduced. The quote by Lenin above provides some idea of the naivety of Communists when it comes to economic affairs. Destroying the value of money and expecting that people can be somehow paid in kind on the basis of their “work” is delusional. No economy, however structured, can allocate resources and distribute goods and services without the means of exchange and unit of account we call “money”. That the Russian economy collapsed, famine killed millions and the hardships of the times multiplied under the rigors of the completely dysfunctional economic and political system introduced under Lenin is not surprising.

If Lenin’s understanding of the role of money in an economy was wanting, his appreciation of the destructive power of inflation is right on. As Keynes was well aware, although a general rise in the price level appears to be benign and associated with an equal percentage increase in the cost of all goods and services offset by an equal percentage increase in sources of income such as wages and salaries, interest and rents, in fact it can considerably distort these relationships in ways that are unpredictable. Here is how Keynes described its effects:

“By this method [inflation] they [governments] not only confiscate, but they confiscate arbitrarily; and while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the existing distribution of wealth. Those to whom the system brings windfalls, beyond their deserts and even beyond their expectations or desires, become ‘profiteers’, who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than of the proletariat. As the inflation proceeds and the value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery.” Keynes, Economic Consequences of the Peace (Chapter 6)

What is ominous about the present state of the world economy in general and the United States in particular is the increasingly reckless way economic policy is being conducted, here and abroad. In the U.S., the Federal Reserve is buying vast quantities of newly-minted bonds and has greatly expanded the monetary base of the economy this past year. It is by no means clear it has the power to control the potential inflationary forces that could be unleashed by such actions.

Fiscal policy has been dominated by two stimulus packages -- the first of $168 billion in February of last year and a second of $787 billion in January of this year. Both of these packages (and a potential third now being raised as a possibility) have resulted in an explosion in the budget deficit, a deficit that will impose continual pressure on the Fed to follow a monetary policy accommodating to the needs of the Treasury for finance. Neither stimulus program has resulted in a significant improvement in the economy.

The monetary lesson of Lenin we should learn is the tremendous importance of money for the proper functioning of the economy and the terrible consequences that will arise if we follow policies that result in the debauchment of the currency.

Thanks to Michael White and Kurt Schuler for their article on Keynes and Lenin in the Spring 2009 issue of The Journal of Economic Perspectives and the topic of this Tdj.

The sad state of the Swedish welfare state

“Sweden still sets hearts racing across Europe. The "Swedish model" might bring up thoughts of a nubile blonde rather than a strong social state, but it is in the latter incarnation that my home country stirs the passions of left-leaning Europeans. Whatever Sweden does must be right, or so reason progressive politicians and Guardian journalists – not to mention scores of Swedes. But beyond this blue-eyed vision lurks a darker reality. …

Swedes were roused from this dream with the 1986 assassination of prime minister Olof Palme. Palme might have left behind "a country where no one was poor and no one had room for optimism" as Andrew Brown puts it, but it was Sweden's homemade financial meltdown of the 1990s that finally killed off the dream. Poverty was added to the pessimism. Savage cuts hit schools, unemployment rocketed, the krona sank – leaving the social system in a disarray from which it has not recovered. …

Take healthcare. Swedes do not enjoy free public care: it costs to see a GP. That is, if you manage to see one. Queues are long and scandals rack the system. Psychiatric care, the source of many such scandals, has a near-medieval penchant for authoritarianism with few European equivalents. People are locked up for months for not taking medicine, given no therapy, and spat out of the system into despair and destitution. The mentally ill die in wards and in outpatient isolation. And they do not even have charities to turn to because state-run healthcare is supposed to work: this is Sweden, after all.

Those who do enjoy Sweden's second-rate public services are lucky. Undocumented migrants, who lack a "personal number", are barred from day-to-day healthcare. Foreigners do not fit easily into a social system built on the postwar notion of the folkhem, or people's home, whose rightful inhabitants are the native Swedes. … This is Sweden, after all.

Even being in the system is less rewarding than it was. Unemployment benefits are falling behind those of other countries, and access to social security involves Big Brother-style controls most Europeans would abhor. … Norwegian lawyers have sued over privacy infringement, leaving the prime minister perplexed – because in Sweden, the state is there to help us.
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Admittedly, Sweden might seem a haven of tranquillity compared with other European states. But in the hunt for a humane social model, Sweden no longer provides the blueprint. Europe's progressives will have to construct something new. But to do that, those who let their minds drift northwards for inspiration first have to wake up: the Swedish dream is over.”

Ruben Andersson, “Death of the super model”, The Guardian (29 June 2009).

http://www.guardian.co.uk/commentisfree/2009/jun/29/swedish-economy-social-state


Ruben Andersson is an anthropologist, writer and journalist based in London.

Government-run health care is more or less the same over the world in one respect: Compared to care available in the private sector, it involves longer-waits for care, rationing of procedures by bureaucratic formula, low capital investment and hence fewer and lower quality medical equipment, little to no personal attention, limited choice in physicians and care givers, and very high taxes to support what is called “free health care”.

Granted that private markets do not work well in the delivery of health care. And it is certainly true that private health delivery systems are less than perfect, especially as the relate to the quality of care available to different segments of the population. But it is even truer that public health delivery systems are sub-standard compared to the private system. Yet despite this we here in the U.S. seem determined to replace a less than perfect private system with an even more inferior government-run system.

I for one find this strange.

Thanks to Marginal Revolution for the pointer to the article.

Why the health care “Public Option” will destroy private health insurance

“An important question about any public provider of health insurance is whether it would have access to taxpayer funds. If not, the public plan would have to stand on its own financially, as private plans do, covering all expenses with premiums from those who signed up for it.

But if such a plan were desirable and feasible, nothing would stop someone from setting it up right now. In essence, a public plan without taxpayer support would be yet another nonprofit company offering health insurance. The fundamental viability of the enterprise does not depend on whether the employees are called “nonprofit administrators” or “civil servants.”

In practice, however, if a public option is available, it will probably enjoy taxpayer subsidies.
...
Such explicit or implicit subsidies would prevent a public plan from providing honest competition for private suppliers of health insurance. Instead, the public plan would likely undercut private firms and get an undue share of the market.
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A dominant government insurer, however, could potentially keep costs down by squeezing the suppliers of health care. This cost control works not by fostering honest competition but by thwarting it.

Recall a basic lesson of economics: A market participant with a dominant position can influence prices in a way that a small, competitive player cannot. A monopoly — a seller without competitors — can profitably raise the price of its product above the competitive level by reducing the quantity it supplies to the market. Similarly, a monopsony — a buyer without competitors — can reduce the price it pays below the competitive level by reducing the quantity it demands.

This lesson applies directly to the market for health care. If the government has a dominant role in buying the services of doctors and other health care providers, it can force prices down. Once the government is virtually the only game in town, health care providers will have little choice but to take whatever they can get. It is no wonder that the American Medical Association opposes the public option.”

By N. Gregory Mankiw, “The Pitfalls of the Public Option”, The New York Times (27 June 2009).

http://www.nytimes.com/2009/06/28/business/economy/28view.html?_r=1&ref=business

N. Gregory Mankiw is a professor of economics at Harvard. He was an adviser to President George W. Bush.

As Professor Mankiw points out, there is no purpose in having a public health care insurance option if all it is going to do is provide the same services as a regular provider in the market. Currently there are hundreds of health care insurance providers and adding one more competing under the same terms as the others will do nothing to affect the market in any fundamental way. If the “public option” were to have any influence, it would have to be subsidized and in the end it would undermine current providers.

One can conclude from this that the real intention of the government is to slowly but surely crowd out private health care insurers and move the country toward a “single payer” government monopoly of health care services in the U.S. It can’t introduce a single payer system instantly but over time as the infrastructure for a government monopoly is put in place, the proposed health care insurance cartel now under discussion will morph into a single-payer, universal health care delivery system.

If it is to work, a single payer system must be at once both a monopoly provider of health care and a monopsony purchaser of health care resources. There can be no middle ground for the forces at work necessitate an eventual government monopoly of services supplied and monopsony of resources demand.

In the beginning the reforms now under discussion will encompass only a fraction of the population, but it is the expensive fraction of households and individuals with pre-existing conditions and poorer health status. In order to control costs effectively it will be necessary for the government’s health care cartel to pay fees as low as possible to health care providers such as doctors, nurses and other medical practitioners and limit the provision of services and the quality of care provided. If it does not, it will not be able to compete with other health insurance providers, who serve healthier segments of the population such as those who are employed. But lower fees will only buy inferior resources and cost-cutting will lower the quality of care.

In response, a two-tier system can be expected to develop, with higher income households opting for private health care insurance and private health care delivery. Initially, these households will pay the extra taxes on the private plans and on top of that pay higher fees to obtain the quality of care they desire, much the same way that “free” but lower quality public schools can exist side-by-side with expensive, higher quality private schools. But this situation cannot continue over the longer-term.

One problem for the government’s cartel is that the very existence of a private health care market raises the wages and salaries of health care professionals, both those in the private market and those working for the cartel. There are all sorts of ways this can occur. The best physicians will take advantage of their superior skills by serving high-paying households in a private health care market and earn income far higher than those available to doctors working for the cartel. This will put upward pressure on the cartel salaries. Even physicians in government service or willing to accept the cartel’s reimbursement rates will attempt to “top off” their salaries with (hidden or otherwise) payments for extra or better service. The existence of a private market in health care and accepting more than the standard reimbursement rate not only undermines cost controls but defeats the very idea of equal health care for all. In the long-run, it cannot be tolerated and is the reason why private provision and private health care insurance is forbidden in many countries with universal health care.

Hence, eventually prohibitions against doctors taking private patients becomes necessary to maintain control of the health care market. Only if the government has a monopsony on the hiring of physicians and other health care workers can a lid be kept on the wages and salaries they are paid, which is a key element of health care costs. Similarly, the monopsonistic position of the cartel will allow it to control all resources entering the health care sector, from drugs to ambulances to bandages to hospital beds.

In sum, without all these controls a single payer system becomes a two-tier system of markedly unequal health care, exactly what critics of the present system say they dislike the most about it. On the other hand, with the controls a single payer system sinks into rationed and arbitrary care, abysmal quality and long waits even for simple procedures.

Much better would be a free private health care insurance market, focused on catastrophic coverage, supplemented by efforts of local governments and charities and churches to ensure adequate health care for those not covered by any insurance.

Baseball teams, umpires, and government control of companies

“If you knew that baseball teams with winning records tended to be more profitable for their owners than those with losing records - and if you learned that the Baltimore Orioles had just been purchased by the major league umpire's union, would you expect the Orioles to win more or fewer games?

Almost everyone implicitly understands why the umpires should not be allowed to own teams they referee.

In a free-market economic system, the government is supposed to be the referee and not a player. Its job is to set and enforce the rules, but if it is allowed to also become a player, by owning and managing business enterprises, it is unlikely to treat the competing companies fairly, and there will be little check on its own misbehavior.

Congress is now debating whether the U.S. government will create its own national health provider. The government is now the majority owner of the nation's biggest automobile manufacturer (General Motors Corp.), the biggest bank (Citigroup Inc.), and the biggest insurance company (American International Group Inc.). The record of government ownership and/or control of companies in the United States and elsewhere has been one long disaster.

Look at the past year alone. The nation's largest man-made environmental disaster (according to the New York Times) was the coal-ash spill in Tennessee on Dec. 28, 2008, caused by negligence at the Tennessee Valley Authority (a federal-government-owned enterprise). By volume, this spill was 48 times bigger than the Exxon Valdez spill. This September, the government formally took over mortgage giants Fannie Mae and Freddie Mac, whose financial holes were many times larger than those of Lehman Brothers Holdings Inc., WorldCom, Enron Corp. or GM. Fannie and Freddie were both U.S. government-sponsored and -regulated companies that had the implicit guarantee of the U.S. taxpayer.

Yet the companies not only failed, but between them have also left the U.S. taxpayer liable for more than $1 trillion. …
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The American Founding Fathers well understood human nature, and that is why they developed the system of checks and balances for the new republic.
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When government fails to limit its role to being the referee, and also begins to field a team in competition with private parties, the system of checks and balances breaks down. The result - more incompetence, less efficiency, fewer innovations, poorer service and more corruption!”

Richard W. Rahn, “Government grinds the gears”, Washington Times (18 June 2009).

http://www.washingtontimes.com/news/2009/jun/18/government-grinds-the-gears/


Richard W. Rahn is a senior fellow at the Cato Institute and chairman of the Institute for Global Economic Growth.

Senator Dodd on the Affordable Health Care Choices Act now before Congress

“Today is an historic day. No issue affects more Americans. In fact, there is not a single American who doesn’t have a stake in the success of our work. No issue is more of a moral imperative. In the richest country in the world, you shouldn’t have to be well-off to get well,” said Dodd. “With this bill, the Affordable Health Care Choices Act, we will protect people’s choice of doctors, hospitals, and insurance plans; reduce costs for families and businesses; and assure affordable, high-quality healthcare for every American.”
…
If there’s no other message out of today’s hearing it is this: we will act to cut the skyrocketing costs of our health care system. And we will at long last make quality, affordable health insurance available to every man, woman and child in America.

Our goal is to protect people’s choice of doctors, hospitals, and insurance plans; reduce costs for families, businesses, and government; and assure affordable, high-quality healthcare for every American. Our goal is also to strengthen what works and fix what doesn’t.

If you like the insurance you have today, you can keep it. If you don’t like what you have today, we’ll give you better choices, including a public option for health care. No longer will a pre-existing condition such as a heart attack, cancer, or even being the victim of domestic violence prevent you from obtaining insurance. No longer will cost be a barrier to coverage. Our approach will offer affordable options for Americans struggling under the skyrocketing cost of health care.

We have proposed a bill that would accomplish this great purpose.”

Quote from Senator Dodd’s web site, “Dodd Leads HELP Committee Mark-Up of Health Care Reform Bill” (19 June 2009).

http://dodd.senate.gov/?q=node/5028


Christopher Dodd (1944-) is an American lawyer and Democratic politician currently serving as the senior U.S. Senator from Connecticut. Senator Dodd and his wife sit on the board of many health care companies.

Hyuk hyuk hyuk, what the Senator says is just so funny! Without question, Senator Dodd is one of the best clowns in the circus we call the Senate. To say the government can actually provide people with something in a way that will cut costs! Great joke! And to say it will do it without adversely affecting people who already have what the government wants to provide to others free! And it’s going to expand coverage to the most health care costly segments of the population! And it’s going to do all this while reducing costs for families and businesses! What side-splitters!

Next he's going to say that members of Congress will be covered by and subject to the same requirements with regard to health care insurance they impose on other Americans! Ha! That’ll be the day! And that the government won’t be imprisoning folks who won’t join the proposed government-run health care insurance cartel! And the cartel isn’t going to restrict choice in any way! All this, while it reduces the long-term budget deficit! Oh, what a riot this guy is! I’m rolling on the floor with laughter!

I used to avoid listening to Senator Dodd. Now I realize like many other members of Congress, he is really a comedian out to entertain us with his whoppers about the legislation he supports. Sometimes I think the President also enjoys telling amusing stories that can’t possibly be true. Great fun!

But somehow I still have this nagging feeling that the jokes they tell are not for us, but on us.

Why we should spend more on health care

“Is increased health spending optimal?

President Barack Obama, speaking yesterday, says the answer is no:

“If we do nothing, within a decade we will be spending one out of every $5 we earn on health care. And in 30 years, we'll be spending one out of every $3 we earn on health care. And that's untenable. It's unacceptable. I will not allow it as President of the United States.”

Economists Robert Hall and Chad Jones, writing in the QJE [Quarterly Journal of Economics] a couple years ago, say the answer is yes:

“Over the past half century, Americans spent a rising share of total economic resources on health and enjoyed substantially longer lives as a result. Debate on health policy often focuses on limiting the growth of health spending. We investigate an issue central to this debate: Is the growth of health spending a rational response to changing economic conditions—notably the growth of income per person?

We develop a model based on standard economic assumptions and argue that this is indeed the case. Standard preferences—of the kind used widely in economics to study consumption, asset pricing, and labor supply—imply that health spending is a superior good with an income elasticity well above one. As people get richer and consumption rises, the marginal utility of consumption falls rapidly. Spending on health to extend life allows individuals to purchase additional periods of utility. The marginal utility of life extension does not decline. As a result, the optimal composition of total spending shifts toward health, and the health share grows along with income. In projections based on the quantitative analysis of our model, the optimal health share of spending seems likely to exceed 30 percent by the middle of the century.””

Greg Mankiw, “Is increased health spending optimal?”, Greg Mankiw's Blog (12 June 2009).

http://gregmankiw.blogspot.com/


N. Gregory Mankiw is professor of economics at Harvard University and a former
Chairman of President George W. Bush’s Council of Economic Advisors. His textbook is
used in Regent’s survey of economics course. He is a Republican policy advisor.

Robert E. Hall is Robert and Carole McNeil Hoover Senior Fellow and Professor of Economics at Stanford University. He is President-elect of the American Economic Association. Charles Jones was recently promoted to Professor of Economics, Graduate School of Business, Stanford University.

It is of course common sense that as consumers’ incomes rise over time the quantity demanded of different kinds of goods and services changes, a relationship formalized in economics under the term “Engel curves”, named after the 19th century German statistician Ernst Engel. Broadly, three relationships between income and changes in demand are recognized: For normal goods, as income increases, the quantity demanded increases. The share of the product in a typical consumer’s budget remains about the same over time. For inferior goods, as incomes increases, the quantity demanded decreases as consumers stop buying the good because they can now able to purchase better goods than before. Its share in a consumer’s budget tends to fall steadily as spending on more desired goods and services crowds out spending on the inferior good. In the case of superior goods, as income rises spending on these goods and services rises faster than income, and they make up a larger and larger proportion of consumption than in the past. Health care is a superior good, and its share in the national economy of the United States has risen over time because it is a more desirable kind of spending than other kinds of consumption.

It is perfectly sensible that people want to spend more and more of their rising income on health care. They certainly have the added income to do so. A tremendous increase in material wealth and living standards has taken place in the United States in recent decades. The real per capita income of the average American has risen by 70 per cent since 1980, for example, and many Americans have chosen to take much of that increase in purchasing power in the form of increased benefits, such as better health care insurance and services, rather than in other kinds of goods and services. Hence, the share of health care in the U.S. economy has risen greatly. As it did so, it created well-paying jobs for millions of workers and improved the lives of hundreds of millions of Americans.

For reasons beyond my comprehension, President Obama and his allies in Congress see this perfectly natural process of income growth and structural change as a problem that must be somehow “solved” immediately by government interference in the health care industry. They have embarked on a crusade to “reform” one-sixth of the U.S. economy by October of this year in an attempt to suppress people from spending their income on a superior good consumers regard as more desirable than the other things they might buy with their money (or, more to the point, giving their money to the government in taxes to spend on things they don’t want). It boggles the mind why the Administration and Congress want to put a cap on the benefits that come from this kind of spending.

Now, restructuring a large part of any economy is a process that takes decades, not months, and involves tremendous complexities and hidden interrelationships that no one understands or could understand. That is why it must be done slowly and with great care. Even in a tightly planned economy such as the former Soviet Union many years would be spent preparing for a task of this magnitude. What is frightening is that the Administration is not only proceeding blindly and hastily but that it clearly has not the slighted idea of what it is doing. Other than vague words and statements of pious intentions, the Administration has put forward no concrete ideas as to how it proposes to reform this huge sector of the economy. Instead, a small group of Congressional aides (mainly from Senator Kennedy’s office) and a few people from the Office of the White House are at this very moment yelling and screaming at each other as they try and hash out a plan in secret for Congress to vote on. In the end, the same thing will happen that happened with the Stimulus Plan: At the very last moment, a bill hundreds of pages in length and understood by no one, will be pulled out of a hat for a up or down vote in Congress before anyone has had a chance to read and seriously consider it.

The process by which legislation is draw up and passed in Congress has become a farce. It is unworthy of the American people and the American people should object to it.

Allan Meltzer on the independence of the Fed and the coming inflation

“Paul Volcker is … the head of President Obama’s Economic Recovery Advisory Board. Mr. Volcker and the administration’s many economic advisers are all fully aware of the inflationary dangers ahead. So is the current Fed chairman, Ben Bernanake. And yet the interest rate the Fed controls is nearly zero; and the enormous increase in bank reserves — caused by the Fed’s purchases of bonds and mortgages — will surely bring on severe inflation if allowed to remain. Still, they all reassure us that they can reduce reserves enough to prevent inflation and they are committed to doing so.

I do not doubt their knowledge or technical ability. What I doubt is the commitment of the administration and the autonomy of the Federal Reserve. Mr. Volcker was a very independent chairman. But under Mr. Bernanke, the Fed has sacrificed its independence and become the monetary arm of the Treasury: bailing out A.I.G., taking on illiquid securities from Bear Stearns and promising to provide as much as $700 billion of reserves to buy mortgages.

Independent central banks don’t do what this Fed has done. They leave such fiscal action to the legislative branch. By that same token, Mr. Volcker’s Fed had to avoid financing the large (for that time) Reagan budget deficits to be able to bring down inflation. The central bank was made independent expressly so that it could refuse to finance deficits. …
…
Some of my fellow economists, including many at the Fed, say that the big monetary goal is to avoid deflation. They point to the less than 1 percent decline in the consumer price index for the year ending in March as evidence that deflation is a threat. But this statistic is misleading: unstable food and energy prices may lower the price index for a few months, but deflation (or inflation) refers to the sustained rate of change of prices, not the price level. We should look instead at a less volatile price index, the gross domestic product deflator. In this year’s first quarter, it rose 2.9 percent — a sure sign of inflation.

Besides, no country facing enormous budget deficits, rapid growth in the money supply and the prospect of a sustained currency devaluation as we are has ever experienced deflation. These factors are harbingers of inflation.

When will it come? Surely not right away. But sooner or later, we will see the Fed, under pressure from Congress, the administration and business, try to prevent interest rates from increasing. …

Milton Friedman often said that “inflation was always and everywhere a monetary phenomenon.” The members of the Federal Reserve seem to dismiss this theory because they concentrate excessively on the near term and almost never discuss the medium- and long-term consequences of their actions. That’s a big error. They need to think past current political pressures and unemployment rates. For the next few years, they cannot neglect rising inflation.”

Allan H. Meltzer , “Inflation Nation”, The New York Times (3 May 2009).

http://www.nytimes.com/2009/05/04/opinion/04meltzer.html


Allan H. Meltzer, a professor of political economy at Carnegie Mellon University, is the author of “A History of the Federal Reserve.” He is considered one of the world's foremost experts on the development and applications of monetary policy.

Because of the great harm inflation can do to the economy and the fear that interest rates could be manipulated for political ends, the nation’s central bank has been placed beyond the direct control of democratic politics to an unusual degree. Its mandate, as stated in the Federal Reserve Act of 1913, as amended in section 2a, is to achieve three objectives:

“The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates”.

In order to carry out this responsibility the Fed has been granted great independence. It has been given both Target independence (that is, it is able to choose its own fundamental objectives) and Operational independence (that is, it is able to pursue its objectives as it sees fit, without interference or pressure from third parties). In this regard, it is recognized that it must have political independence from the government, technical independence in the sense of full control over the policy instruments it uses to attain its objectives, financial independence in the form of a secure capital base, and security of tenure of its key officials.

There is no question but that the Fed is a powerful institution. I tell my students that the Fed’s Open Market Committee, which sets American monetary policy, is the second most powerful committee in the world, trailing only the Joint Chiefs of Staff in its ability to affect developments across the globe. It can on its own and without limit or restraint reduce short-term interest rates by buying government securities, pumping cash into the economy and encouraging economic activity. Or it can raise short-term interest rates by selling government securities, taking cash out of the economy and dampening economic activity. Its demand and supply of Treasuries in the financial markets affects the entire term structure of U.S. interest rates and, given the key currency role of the U.S. dollar, interest rates in all other countries.

The threat to the independence of the Fed comes from the scale of the Fed’s interventions in credit markets in support of the Administration’s bailout and spending programs and its willingness to publically endorse measures undertaken by the Treasury.

During the past year the Fed has expanded the money supply by more than a trillion dollars and engaged in a wide range of activities which had the effect of lowering credit standards and loading its balance sheet with assets that that will be hard to unwind if it decides to change its policy stance. There is a growing concern that the Fed will refuse to withdraw the staggering quantity of liquidity it injected into the financial system once a revival in activity occurs for fear of prematurely ending any recovery. Any failure to raise interest rates and “take away the punchbowl just as the party gets going,” as a former Chairman of the Fed put it, would mean that rampant inflation could set in and the dollar could collapse on foreign exchange markets. Loss of control over inflation, the Fed’s single most important objective, would call into question its very independence.

Similarly, the Fed should avoid any appearance of supporting or not supporting actions taken by fiscal authorities, except in the most general and gentle way. It should never suggest anything that implies it is picking or choosing among companies or industries or financial concerns. To do so allows questions of favoritism and partiality to arise which are damaging to the central bank’s reputation. But to some degree it has done precisely this, supporting the Treasury’s decisions regarding macroeconomic policy. It has also joined with the Treasury in the financial realm in support of its policies. However, many feel it has overstepped its bounds by pressuring Bank of America and others in ways that reflect favoritism and in limiting the transparency of its operations.

Professor Meltzer is right to have expressed concerns about the Fed and how it has responded to the crisis. Some of us see a frightful storm of virulent inflation gathering on the horizon. While it will not be upon us any time soon, when it comes we believe it will come swiftly and it will be unstoppable except at great cost.

And we will blame the Fed for not only allowing this disaster to happen but for weakening the independence the central bank needs to sustain its reputation and keep political operatives at bay.

A New Classical Economist takes on a New Keynesian

“[Historian Niall] Ferguson and [economist] Paul Krugman ... locked horns at a public symposium in New York on April 30. The historian ... asserted that large fiscal deficits would push up long-term interest rates. This implied they would have a zero stimulatory effect: public spending would simply "crowd out" private spending. An enraged Mr Krugman responded ... that Keynes had proved that such crowding-out could occur only at full employment: if there were unemployed resources, fiscal deficits would not drive up interest rates without also expanding the economy. Prof Ferguson's ignorant remarks only confirmed that "we're living in a Dark Age of macroeconomics, in which hard-won knowledge has simply been forgotten".

However, this is not a debate between economists and historians. It is a battle within the economic profession – between the New Classical Economists and the New Keynesians. What is fascinating is that it is an almost exact rerun of the debate between Keynes and the British Treasury in 1929-30. The Treasury view was that bond-financed public spending was bound to diminish private spending by an equal amount. Keynes replied that if this were true it would apply to any new act of private spending. "In short, the fatalistic belief that there can never be more employment than there is is altogether baseless". ....

Are we doomed to rehearse the same arguments time and again? In this particular debate, I am on Prof Krugman's side, but I do not agree that Prof Ferguson's position represents a retreat to a phlogiston state of economics. This is to take economics to be like a natural science, which Keynes never believed it was ....

Ultimately, the Keynesian revolution was a triumph not of good science over bad science, but of good judgment over bad judgment.”

Robert Skidelsky, "Economists clash on shifting sands", Financial Times (10 June 2009).

www.ft.com/cms/s/0/31e89136-5511-11de-b5d4-00144feabdc0.html

www.skidelskyr.com/site/article/economists-clash-on-shifting-sands/

Historian Robert Skidelsky (1939-) is a member of the British House of Lords and author of a prize-winning biography of the economist John Maynard Keynes. Niall Ferguson (1964-), a British citizen from Scotland, is the Laurence A. Tisch Professor of History at Harvard University and the William Ziegler Professor of Business Administration at Harvard Business School. His specialty is financial and economic history and the history of empire. Paul Krugman (1953-) is a professor of economics and international affairs at Princeton University, a centenary professor at the London School of Economics, and an op-ed columnist for The New York Times.

As background, let me mention that the New Classical Economics emerged as a school of thought during the 1970s. It views macroeconomics from the perspective of neo-classical economic theory, rather than Keynesian theory, and stresses the importance of rooting macroeconomics in the behavior of microeconomic agents that are utility-maximizing and possess rational expectations. In a New Classical Economics framework, the economy is seen as having an equilibrium at full employment and maximum potential output, which can be achieved through market-clearing adjustments to prices and wages. Niall Ferguson is seen as in the classroom of this school of economic thought, which captured much of the intellectual momentum of the past few decades, with its adherents winning several Nobel Prizes in Economics. The tenets of New Classical Economics underlies much “conservative” economic thought today.

New Keynesian Economics was developed in reaction to the New Classical Economics. It strives to provide microfoundations for Keynesian economic analysis. The New Classicals called into question many of the precepts of the Keynesian revolution, especially as they relate to the “stickiness” of prices and wages. New Keynesians, in contrast, maintain that the market clearing approach of the New Classicals cannot explain short-term economic fluctuations, and they say the failure of prices and wages to adjust quickly to new conditions leads to involuntary unemployment and recurrent declines in economic activity. Add to this failures of coordination among economic actors and imperfect labor markets and in the view of New Keynesians you have the possibility of deep and prolonged downturns in economic activity. Paul Krugman can be seen as a member of this school of thought, which is shared by many economists in the Obama Administration.

Now, no one economist actually adheres completely to the tenets of any school of thought and these two competing sets of ideas are not the only ones in circulation today. They can in some sense, however, be seen as a continuation of the old non-Keynesian vs. Keynesian debates of the past. The debate between these two contemporary schools goes way back, and today’s debates are merely the latest incarnation of a long intellectual fight. If you want to think of it in the simplest terms possible, New Classicals think that economies adjust to the constant changes introduced by new technologies, different consumer preferences and investor opportunities, exogenous shocks from abroad and stupid government policies at home mainly by changes in (relative) prices and wages, with some (but not much) change in output and employment levels. New Keynesians, on the other hand, think the opposite, namely, that all the changes occurring in the economy lead mainly to ups and downs in employment and economic activity, and only secondarily to changes in (relative) prices and wages. Exaggerating, but with much truth, the fights about fiscal policy you see in Washington today are between these two groups and their different views on the nature of the economic adjustment process underlying economic change.

Let me quickly add that politicians know little or nothing about this debate and could not care less about it. They are not thinkers and are often blind to the forces that shape the present and the future. But whether they realize it or not they are dependent very much upon advisors who are rabid participators in the debate, with strong view that they are right and the other camp is wrong. The success of Barack Obama’s terms in office, whether he realizes it or not, will depend critically on whether the New Keynesians advising his Administration are right or wrong in their assessment as to exactly how the economy adjusts to the problems it confronts.

While the spat between Ferguson and Krugman appears to be about bond yields and the inflationary pressures of large deficits, it is really about the adjustment process and the role of government. If, as Ferguson and conservatives insist, the macroeconomic adjustment process plays out mainly through the price system and the changes that take place to relative prices and wages, as New Classicals insist, the Administration’s policies will aggravate the difficulties before the economy and delay any recovery. Interfering with prices and wages, they will argue, is interfering with adjustment process.

If, as Krugman and liberals insist, the macroeconomic adjustment process works mainly through large changes in incomes and employment because prices and wages refuse to adjust, policy must both mitigate the adverse impact that job losses have on welfare and directly counter the decline in aggregate demand. Hence, the Administration’s stimulus package and Krugman’s argument that public spending cannot crowd out private spending. Sticky prices and wages mean government spending affects quantities (output and employment), not prices (and hence, not the price adjustment process).

To conservatives, prices and wages are not that sticky and government policy cannot help an adjustment process guided by changes taking place simultaneously in millions of different prices and wages, although it might be helpful mitigating the negative effects of any downturn on individuals who are particularly hard hit. To liberals, government policy can control the adjustment process, indeed, the entire economy, because it can set the level of aggregate demand and in doing so determine quantities produced and jobs provided. Prevailing prices, in their view they are sticky, are divorced from cost and demand considerations anyway. One sees the economy best guided by a flexible price system; the other sees the economy as one that can be shaped by mandates and commands to perform better.

Skidelsky sides with Krugman. I side with Ferguson, both on the narrow question of the impact of large deficits causing rising bond yields and, ultimately, inflation and on the broader question of the nature of economic change and the adjustment process. I also fear the power of government as corrupting and threatening to freedom.

A Tdj by Doug Walker with thanks to Larry Willmore for the pointer.