The sum of all heresies

Tim Duy weighs in on the industrial policy discussion touched off by Andy Grove's article in Business Week. His post is telling, because it gives voice, all at once, to all the nagging suspicions that are gnawing away at the guts of so many observers of current events. He writes:

Only one word describes the American labor market outcome of the last decade - abysmal. Not only is job growth well below trend, but the quality of jobs is in question. The jobs deficit is even more striking considering the supposed gains in productivity over the past 15 years. Job growth should not stagnate. Resources - including labor - released via higher productivity are supposed to be channeled into expanding sectors. Moreover, productivity growth is supposed to yield improved economic outcomes via higher real wages. Yet as spencer famously shows, labor's share of output has been steadily decreasing since the early 1980s...

Why has the American jobs machine failed so spectacularly? This should be the most pressing issue facing economists and policymakers. Are either up to the task?

Yves Smith directs us to an intriguing piece by Andy Grove, former CEO of Intel. Rajiv Sethi follows up and summarizes...I think the Yves-Sethi conversation is remarkably important, and should lead one to reexamine the importance of the manufacturing sector. I admit that in past years I tended to dismiss the manufacturing sector, seeing its relative decline as simply a transition to more productive knowledge-based work...

The loss of manufacturing capacity in the Groves scenario critically impacts the potential growth of the nation...

Note that a number of trends all begin in the 1980s. Absolute manufacturing declines, the rise of persistent trade deficits, the decline in labor's share of output, growing income inequality, and the Great Moderation. That the combination of these trends is coincidental seems unlikely...

If manufacturing is critically important to driving trends of national well being, an exploration of the decline of that sector is crucial. But that exploration almost always leads back to a very difficult place - international trade. And every right minded economist and policymaker knows unequivocally that free trade is good, and to even question that assumption makes one an ignorant heretic who has never heard of Smoot-Hawley. Therefore, the examination ends. Manufacturing's decline simply cannot be a problem if it is consequence of international trade because everyone knows international trade is good.

[The modern pro-free-trade orthodoxy] fails to acknowledge that while free trade produces net positive effects, that process can certainly be upset by the deliberate manipulation of currency values. And make no mistake, those values have been manipulated. There can be no other excuse for the massive buildup of official reserve assets in global central banks.

I don't think it is a coincidence that the absolute decline in manufacturing accelerated in the wake of the US strong Dollar policy, which provided the freedom for China to pursue an aggressively mercantilist economic strategy, perfecting what Japan's policymakers began in the 1980s. Thus I don't think the pernicious hollowing out of America's industrial base is simply the result of comparative advantage. I grow increasingly convinced that the disappointing economic outcomes of the last decade are the culmination of decades of industrial neglect...And I am increasingly convinced that these trends have been largely dismissed by the economics community because acknowledging them would cast doubt on value of free trade, failing to recognize that currency manipulation was turning free trade into a zero-sum game.

In short, I have become a heretic.

But what then is the appropriate policy response? Unfortunately, we are held captive by fears of a debilitating trade war...

Bottom Line: Something more than cyclical forces is weighing on the American jobs machine. Here I have tried to extend the Grove/Smith/Sethi discourse with additional focus on absolute declines in manufacturing jobs and distressing declines in capacity growth rates. These trends may be critically important in understanding the dismal performance of US labor markets. If they are in fact critical, they raise serious questions about US trade policy - questions that few in Washington want to address. Given the extent to which manufacturing capacity has already been offshored, those questions go far beyond the recently announced tiny shift in Chinese currency policy. Simply put, accepting the importance of manufacturing capacity and the possibility that offshoring has had a much more deleterious impact on the US economy than commonly accepted would requrie a significant paradigm shift in the thinking of US policymakers. If you scream "protectionist fool" in response, then you need to have a viable policy alternative that goes beyond the empty rhetoric of "we need to teach better creative thinking skills in schools." That answer is simply too little too late.

Tim Duy's post is not an economics paper, and it does not prove his case. But it tells a story (which is all most econ papers do anyway) that weaves together a number of disturbing threads - the decline of American manufacturing, Chinese mercantilism, rising inequality, stagnant real wages, and job insecurity. This is a story that is not supported by any economic model that I know of...but, given economists' ability to write down a model that supports any conclusion, and given the tendency of models that defy the free-trade orthodoxy to languish unread in third-rate journals, I'm inclined to give Duy a pass for now.

The fact is, many people instinctively believe that mercantilism can work if your trade partners don't fight back; that the export (or import-substituting) manufacturing sector is especially important for job growth and living standards; and that it is no coincidence that our inequality, stagnant living standards, and insecurity have worsened as our trade balance with China (and with the other Asian nations in China's supply chain) has worsened. These beliefs are considered heretical, but they just refuse to go away.

Now, many instinctive, heretical beliefs are actually totally false: for example, "young-Earth" theories, global warming denial, or disbelief in quantum mechanics. But in the case of the free trade orthodoxy, there is no hard evidence that free trade is always and everywhere the optimum policy. There is no fossil record, no climate record, no electron double-slit experiment that free-traders can hold up and say "Look, unbelievers! HERE'S THE PROOF YOU ARE WRONG!" Instead, economists have a bunch of models, all of which assume that free trade is good and proceed from there.

So instead or arguing from evidence, the free-trade orthodoxy relies on shouting down and insulting any who deny its precepts. I myself have participated in this, in the Introductory Macroeconomics course I TA for at the University of Michigan. We always include a lecture that pits pro-free-trade arguments against anti-free-trade arguments, and we make sure that the former always come out the "winner" at the end of the day. We use the very simplest models of trade, and we never mention industrial policy or the manufacturing sector or mercantilism. And another four hundred students tramps off to be America's next generation of businesspeople, lawyers, journalists, professors, and voters...

And yet the nagging little voice in the backs of our heads continues to whisper the things Tim Duy has dared to say in the light of day. It continues to tug and worry at the corners of our faith in free trade, crying "E pur, non e libero!"

Andy Grove comes out in favor of industrial policy

Andy Grove, the famous Intel boss who built the company into the world's leading semiconductor manufacturer, has come out in favor of old-fashioned industrial policy. His arguments are twofold: 1) that industrial policy creates more middle-class jobs than our current approach, and 2) that industrial policy creates "network effects" among industries that give advantages tomorrow's technology startups. Some excerpts from his article:

On job creation:

You could say, as many do, that shipping jobs overseas is no big deal because the high-value work—and much of the profits—remain in the U.S. That may well be so. But what kind of a society are we going to have if it consists of highly paid people doing high-value-added work—and masses of unemployed?

Since the early days of Silicon Valley, the money invested in companies has increased dramatically, only to produce fewer jobs. Simply put, the U.S. has become wildly inefficient at creating American tech jobs.

On industrial network effects:

There's more at stake than exported jobs. With some technologies, both scaling and innovation take place overseas.

Such is the case with advanced batteries. It has taken years and many false starts, but finally we are about to witness mass-produced electric cars and trucks. They all rely on lithium-ion batteries. What microprocessors are to computing, batteries are to electric vehicles. Unlike with microprocessors, the U.S. share of lithium-ion battery production is tiny (figure-E).

That's a problem. A new industry needs an effective ecosystem in which technology knowhow accumulates, experience builds on experience, and close relationships develop between supplier and customer. The U.S. lost its lead in batteries 30 years ago when it stopped making consumer electronics devices. Whoever made batteries then gained the exposure and relationships needed to learn to supply batteries for the more demanding laptop PC market, and after that, for the even more demanding automobile market. U.S. companies did not participate in the first phase and consequently were not in the running for all that followed. I doubt they will ever catch up...

[In the U.S. there is] a general undervaluing of manufacturing—the idea that as long as "knowledge work" stays in the U.S., it doesn't matter what happens to factory jobs. It's not just newspaper commentators who spread this idea. Consider this passage by Princeton University economist Alan S. Blinder: "The TV manufacturing industry really started here, and at one point employed many workers. But as TV sets became 'just a commodity,' their production moved offshore to locations with much lower wages. And nowadays the number of television sets manufactured in the U.S. is zero. A failure? No, a success."

I disagree. Not only did we lose an untold number of jobs, we broke the chain of experience that is so important in technological evolution. As happened with batteries, abandoning today's "commodity" manufacturing can lock you out of tomorrow's emerging industry.

And on what to do about it:

The first task is to rebuild our industrial commons. We should develop a system of financial incentives: Levy an extra tax on the product of offshored labor. (If the result is a trade war, treat it like other wars—fight to win.) Keep that money separate. Deposit it in the coffers of what we might call the Scaling Bank of the U.S. and make these sums available to companies that will scale their American operations. Such a system would be a daily reminder that while pursuing our company goals, all of us in business have a responsibility to maintain the industrial base on which we depend and the society whose adaptability—and stability—we may have taken for granted.

Now, in many intellectual circles in America it has come to be regarded as an article of faith that "protectionism" and "industrial policy" are the road to ruin (just as in Asia the exact opposite has become an article of faith). Just the other day, for example, a friend of mine - a very smart lawyer - suggested that Washington Post columnist Steven Pearlstein be "flayed" for arguing that only the threat of tariffs can get China to change its currency policy.

But after actually reading some trade theory and development theory at the highest academic level, I have to say that the only thing I'm more sure of is how little I ought to be sure of when it comes to this topic. Sure, trade in general is awesome. But to let the light of that basic truth blind us to the subtler questions of industrial policy, strategic trade interactions, etc. is as absurd as to let the fact that communism failed blind us to the efficiency of some kinds of government intervention in the economy.

The bottom line: I am not sure whether Andy Grove is right about industrial policy. But I am reasonably sure that no one else is sure whether he's right, especially the vast commentariat that shrieks "trade war" and "protectionism" whenever anybody suggests anything like what Grove is suggesting. And I am sure that Andy Grove, though old, is a very smart guy. And when very smart guys - like Grove, or like Paul Samuelson, the greatest economist of our age - start saying things that contradict our conventional wisdom, we should at the very least pay close attention.

Update: Yves Smith and Rajiv Sethi respond to Grove's article. Smith is broadly supportive. Sethi is skeptical, but, like me, recognize economists' fundamental ignorance in these sort of matters and are made uneasy by the possibility that Grove is onto something. Tyler Cowen, meanwhile, goes for an off-the-cuff defense of the conventional wisdom. Mark Thoma agrees with me and Sethi, and points out (correctly, in my opinion) that the social inequality case for industrial policy is stronger (so far) than the innovation-and-efficiency case.

More Athreya smackdown

Just to add to the list of bloggers smacking down Kartik Athreya for his assertion that bloggers shouldn't talk about economics, we have great posts by Tyler Cowen, David Merkel, Jeffrey Harding, and Ambrose Evans-Evans-Pritchard, and a more-than-slightly unfair (but funny) one from Barry Ritzholtz. The money quote, IMHO, is this from Tyler Cowen:

I would say that economics is really, really, really, really, really, really, really hard. And that's leaving out a few of the "reallys."

It's so hard that experts don't always do it well. The experts are constantly prone to correction by non-experts, by practitioners, by people who are self-educated economic experts but not professional economists, and by people who know some economics and a lot about some other field(s). It is very often that we -- at least some of us -- are wrong and at least some of those other people are right.

Earthquake Insurance In Ohio?!

The big question going around on June 23rd was, “Did you feel the earthquake”. Many thought people were joking, but when they checked their Facebook page and saw that many of their friends in the Ohio area had felt the earth move, they knew the question was legit. The reason Ohioans felt the earth move was just north of us, Canada had a 5.0 magnitude earthquake.

Though we are not California or anywhere near California, Ohio still has their fair share of earthquakes. On average Ohio has 5 to 6 earthquakes a year. Year to date in 2010 we have already had 6, so the question that has to be asked of this insurance blog is should people in Ohio carry earthquake insurance? We at Fey Insurance Services feel that it is a good idea to have this coverage. It is something we always quote to our customers. For an average valued house the premium can range from $50 to $80 a year. Though we only have little earthquakes the potential for a large scale quake is there and if that happened the affects would be devastating to a home.

Feel free to get in touch with us to inquire about earthquake insurance.

Jobless recoveries - mystery solved!!!

Bill Gavin and Menzie Chinn solve the mystery of the "jobless recoveries" we've been having since the early 90s:

In the earlier postwar recessions, the unemployment rate began to fall very quickly once the expansion began. By contrast, the unemployment rate continued to climb even after the recovery had begun for the 1990-91 and 2001 recessions. No one is predicting a rapid drop in the unemployment rate this time around, either...

Bill called my attention to the contribution of temporary layoffs to this changing behavior in the unemployment rate. He noted that the Social Security Amendments of 1958 explicitly exempted unemployment insurance from income taxation, and recalled a 1976 paper by Martin Feldstein which proposed that this gave firms a strong incentive to use temporary layoffs in response to a business downturn. By temporarily laying workers off rather than asking them to work shorter hours, the firm could deliver maximal after-tax compensation to its labor force, intending to hire those same workers back as soon as business improved. Temporary layoffs accounted for up to a quarter of those unemployed at the worst of the 1973-75 recession.

Bill believes that the key developments that changed this dynamic were the Revenue Act of 1978, which subjected unemployment benefits to partial taxation under the income tax law, and the Tax Reform Act of 1986, which made unemployment benefits taxable as ordinary income. Since the mid-1980s, the above graph shows that temporary layoffs have become a much less important feature of recessions...

If you subtract temporary layoffs from the number of unemployed, here's what the adjusted unemployment rate would look like. The earlier recessions look much more like the recent jobless recoveries.

Now THAT is good economics work. Simple, empirical, and predictive.

Perhaps we should consider once again exempting unemployment benefits from taxation.

Economics would be hard...if it worked.

Wow. Kartik Athreya, researcher at the Richmond Fed, set off a blogging conflagration the likes of which I haven't seen since George Will lied about global cooling. What Athreya said was this:

In this essay, I argue that neither non-economist bloggers, nor economists who portray economics —especially macroeconomic policy— as a simple enterprise with clear conclusions, are likely to contibute any insight to discussion of economics and, as a result, should be ignored by an open-minded lay public...

In the wake of the recent financial crisis, bloggers seem unable to resist commentating routinely about economic events...Examples include Matt Yglesias, John Stossel, Robert Samuelson, and Robert Reich....I will argue that it is exceedingly unlikely that these authors have anything interesting to say about economic policy.

On the face of it, this seems like a reasonable complaint. Athreya is a PhD economist; these others he named (and many other "economics bloggers" like Megan McArdle and Will Wilkinson) have no advanced economics degree. He's saying "Listen to the experts, ignore the laymen."

Is that such a crazy statement? If an epidemiologist told us not to listen to bloggers who denied AIDS was caused by HIV, or if an evolutionary biologist told us to ignore bloggers' arguments against human evolution, or if a geologist told us to ignore writers who advocated for a "young Earth," or if climatologists told us to ignore George Will's or Steven Levitt's armchair theorizing about climate change, part of their argument would certainly be that the bloggers in question simply didn't have the technical expertise to make an important contribution. And we would buy that argument. But when Athreya tries to use this line in reference to economics, he receives an epic smackdown!

Brad Delong:

[S]omeone who has taken a year of Ph.D. coursework in a decent economics department (and passed their Ph.D. qualifying exams) is unlikely to be able to say anything coherent about our current macroeconomic policy dilemmas[.]

Matt Yglesias:

Now in the natural sciences [you would] try to conduct some experiments...Economists, however, can’t run controlled experiments on macroeconomic phenemona. That’s a big part of what makes these questions so hard. But that’s also why it’s foolish to view them as akin to questions in the natural sciences where laymen have nothing to contribute. If economic policy questions were easier, you’d just “ask an economist” what to do about sky-high unemployment. But...there’s no consensus and relatively little prospect for forging a consensus [on economic issues] through standard scientific methods.

Will Wilkinson:

[Athreya's] argument for why [economics] is so hard –economics is full of phenomena ”pathologically riddled by dynamic considerations and feedback effects”– sounds to my ear like an argument for the unreliability of pathologically oversimplified economic models, and for the proposition that economists will more often than not fail to converge on a consensus position on which the rest of us can rely.

Mike Konczal:

I’m actually going to take the critique one step further and be critical of economics. Never, and I mean never, during the financial crisis, where we’d leave work on Friday and wonder whether or not the world would collapse during that weekend or what kind of market we’d walk into on Monday, did I think “man I wish there were more academic economists around.” Academic economists had very little language with which to describe the crisis. Most of our narratives come straight from journalism or sociology. There are no “toxic assets” in economics, that evocative description comes to us from business world and journalism. Same with the culture and pitfalls of high mathematical finance, math predicated on the efficient markets hypothesis...

I think [Athreya] took down the essay, but he mentioned how bloggers who haven’t taken the first year of Economics PhD coursework, and passed the prelim exam, shouldn’t be writing...My very first economics class ever was auditing a graduate macroeconomics class where we went through the Lucas/Stokey “Recursive Methods in Economic Dynamics” and Ljungqvist and Sargent “Recursive Macroeconomic Theory.” I still remember asking my classmates “no seriously, this isn’t what macroeconomics is, is it?” It was like they were training to be electrical engineers, but could do no actual engineering. I still am terrified of what macro graduate students are cooking.

John Chandley:

[T]hose economists who were in charge got it mostly wrong, probably because of their particular PhD training in economics.

The grownups in charge back then claimed they knew what they were doing, even though they couldn’t see an $8 trillion housing bubble, didn’t think it was a problem, didn’t think the Federal Reserve or anyone else should do anything about it, didn’t want states enforcing laws against lending fraud, didn’t think the shadow banking system and its fraudulent CDO/CDS trading were a systemic threat that required intervention, didn’t realize major banks/investment banks had become too big to fail/reform/control, and believed deep in their souls despite all evidence to the contrary that financial markets were self correcting . . . and then watched helplessly as the financial system collapsed and took the economy and millions of people, their homes, their jobs, their savings down with it.

Economics can seem hard to non-economists, but it doesn’t take a PhD economist to recognize the last 30 years of ruling economic advisers and their apologists should never be trusted again.

Richard Green:

[I]n the end, we should be respecting evidence more than clever theoretical edifices. And yes, Kartik, while I am not an expert in macro, I did have to slog through lots of OLG models and rational expectation models and real business cycle stuff in graduate school, and pass prelim questions on them, so I have at least some idea of what it is that I find intellectually unsatisfying. [George] Akerlof's view, expressed before we had the financial meltdown, that we really need to start over with modern macro, has, I think, largely been vindicated.

And finally, Matt Yglesias again with the epic smackdown:

To oversimplify a bit for the sake of polemic, a lot of economics work seems to put more emphasis on “doing work that superficially resembles physics and therefore counts as science-like” rather than on doing work that actually resembles scientific endeavor in the sense of leading to useful predictions or technologies or what have you. You get the sense that some practitioners of economics would pick up The Origin of Species and dismiss it as too narrative to count as real science. This guy’s just arguing from a bunch of anecdotes!

The consensus response to Kartik Athreya is: Macroeconomics sucks so hard right now that anyone with half a brain has useful things to add to the discourse. And the sad thing, and the amazing thing, is that this response is completely correct.

Macroeconomics started out in the 30s with Keynesianism, which was mostly (but not completely) wrong science, but at least it was science. The discipline was then gutted by Robert Lucas, Edward Prescott, and their followers in the 70s, who asserted a number of ridiculous things (I will not launch into a list and explanation of these ridiculous things, but you can read me ranting about them here, here, here, and here); these ridiculous things were heavily promoted by businessmen and Republican politicians eager to stop government from intervening in the economy, and because of this - and with more than a little help from the Nobel Prize committee - Lucas, Prescott, et al. turned macroeconomics from wrong science into nonscience.

And here we are today. Macroeconomics doesn't work because it was designed not to work. And so bloggers with philosophy degrees often have just as much valuable stuff to say as PhD macroeconomists. Someday, if serious scientifically-minded folks can fix macro, Athreya's admonition to "listen to the experts" will be right. But that day is a long way off. As of now, there are no experts.

Health Care and the Debt-pocalypse

More and more, one single truth about America's national debt is becoming clear: If we don't want an unsustainable increase in our debt level, we must cut federal health care spending. A lot.

Brad DeLong reiterates this point:

In short, if we want to do as much harm to the long-term budget picture as we did good by passing [Obama's health care bill], we would have to spend $8 trillion on additional stimulus. The effects of fiscal stimulus spending now on our long-term budget position are lost in the rounding error.

The reason, of course, is that the big drivers of the long-term deficit are the excess above GDP projexted growth rates of Medicare and Medicaid. Put in place institutions that slow the long-term growth of Medicare and Medicaid--as the CBO believes the [Obama's health care bill] does--and you do infinitely more to improve the long-term budget picture than any stimulus program could possibly do to harm it.

As you can see, except for the brief bump caused by the stimulus, federal discretionary spending has held steady or shrunk as a percent of GDP. It is also apparent that Social Security is not in trouble; payments are headed for only a modest rise as the Baby Boomers retire, a rise that could be completely counteracted by ending the income cap on payroll taxes and raising the retirement age by a year or so.

So basically all of the huge projected growth in federal spending comes from Medicare and Medicaid. We have two choices to avoid a sovereign default: raise taxes enormously to cover this cost, or enact deep cuts in Medicare and Medicaid.

I strongly dislike the first option. Though in general I support taxing the public to pay for public goods, I don't think most of this health care spending qualifies. First of all, health care is mostly a private good, meaning that the benefits of health care spending mostly accrue to the person the money gets spent on. That reduces the economic rationale for having the government pay. But even more importantly, health care is a sector with low and decreasing productivity; most of that new money we're spending isn't giving us better health. Why distort our economy with higher taxes just to throw the money at unnecessary treatments, procedures, and fees?

I supported Obama's health care bill because it came up with a bunch of ways to control costs (some of which could be expanded in the future if they work), and by making health care universal it enabled the broad political coalition that will be necessary to cut health spending in the future. But the reality is, health spending needs to be cut, and cut big. If we do this now, we can call it "restraining the growth of Medicare and Medicaid spending." If we wait, we'll have massive government and social breakdown as old people pull out all the stops to save their health care from the draconian slashing that will by then be necessary.

So we had better start slowing Medicare and Medicaid down right now. This may sound like a political non-starter for the Obama administration, but I think it could actually be a good move; if Obama shows all the austerity-freaks and deficit hawks out there that he is serious about long-term deficit cutting, they'll be more inclined to accept short-term measures like the recently defeated jobs bill.

But, one way or another, Medicare and Medicaid must be cut, and cut big. We have no other option for averting the Debt-pocalypse. None.