Supply-side vs. demand-side recessions

Tyler Cowen links to an interesting post about the deflationary impact of the internet. This is interesting not just because it illustrates how technological change impacts the economy, but because it tells us something about recessions. Namely, it tells us that our current recession - like all of the other ones in recent memory - was caused by deficiencies in demand, not in supply. 

Does output falter because people don't want to buy as much stuff, or because we become unable to make as much stuff as we used to? This is a debate that has gripped the macroeconomics profession for many decades. Which is kind of surprising to me, because it is so obvious that demand shocks are the culprit.

The reason is prices. If recessions are caused by negative supply shocks, then we should see falling output accompanied by rising prices (inflation). If recessions are caused by negative demand shocks, we should see falling output accompanied by falling prices (disinflation or deflation).

Draw a supply-demand curve for the whole economy, and it looks like this:

A negative shock to supply - for example, a resource shortage or an increase in harmful government regulation or a "negative technology shock" - will shift either the long-run aggregate supply curve or the short-run aggregate supply curve (or both) to the left. The new equilibrium will have lower output and higher prices. However, a negative shock to demand - for example, an increase in the demand for money - will shift the aggregate demand curve to the left; the new equilibrium will have lower output and lower prices.

In all of the recent recessions, faltering output has been accompanied by lower, or even negative, inflation. This means that demand shocks must have been the culprit. If "uncertainty about government policy" were really the cause of the recession, as many conservatives claim, then we would have seen prices rise - as companies grew less willing to make the stuff that people wanted, stuff would become more scarce, and people would bid up the prices (dipping into their savings to do so). I.e, we would have seen inflation. But we didn't see inflation.

So it seems that the stories that conservatives tell about the recession - "policy uncertainty," "recalculation," or even a "negative shock to financial technology" - are not true. The stories that everyone else tells about the recession - "a flight to quality," "increased demand for safe assets," etc. - look much more like what basic introductory macroeconomics would predict.

Of course, conservatives don't necessarily believe in the graph I included above. They may dismiss the idea of a downward-sloping AD curve (and an upward-sloping SRAS curve), and imagine that the AD curve is just a flat line (or maybe even an upward-sloping line?). In that world, supply changes, and only supply changes, determine the level of output, and demand changes, and only demand changes, determine the price level.

That's where the blog post that Cowen linked to comes in. In a world in which deflationary recessions (such as our current one) are caused by negative supply shocks, then positive supply shocks should also leave prices unchanged. In particular, an improvement in technology would cause us to produce more stuff at the same price, rather than more stuff at lower prices. However, if the internet is deflationary, it shows that positive supply shocks do, in fact, decrease prices. The AD curve slopes down, as it should.

The basic point here is about the dangers of doing what Larry Summers calls "price-free analysis". If you ignore prices, it is possible to convince yourself that recessions are caused by technology getting worse, or by people taking a spontaneous vacation, or by Barack Obama being a scary socialist. If you pay attention to prices - as all economists should - it becomes harder to believe in these things.

So the question is: Do conservative-leaning economists push these stories because they believe that we live in a world that is vastly more complicated than anything that can be described in Econ 102? Or is it just because they choose to ignore Econ 102 completely?

Nationalism, the U.S. debt, and the "party of business"

I've been avoiding writing anything about the whole debt ceiling situation, because it just depresses me too much...not just because a U.S. default/downgrade will have a seriously negative impact on my upcoming job search, but because it represents the final nail in the coffin of American exceptionalism, and I am a very strong nationalist.

At this point, it matters a bit, but only a bit, whether a deal is cobbled together, whether Obama uses the constitutional option, or whether we mint a bunch of huge platinum coins. Much of the real damage has, it seems to me, already been done. The interest rates at which a nation can borrow are an inverse function of the strength of bond investors' belief that the nation will pay the money back. And the events of this debt ceiling crisis have brought new information to light that will deeply shake investors' belief in the creditworthiness of the U.S. government.

In particular, one piece of information is crucial above all others. This is the fact that the Republican Party is willing to seriously entertain the option of a sovereign default.

Before this crisis, it seems to me that most people believed the Republican Party to be the "party of business" - that is, that corporations and businesspeople held ultimate sway over the party's decisions. Whatever happens with the debt ceiling, it is now clear, as Brad DeLong points out, that the GOP is not the "party of business." They are the party of Someone Else (more on this later).

This fact is not precisely "new information." There were many, many warning signs. Most recently, there was the rebellion of the House Republicans against the TARP bailout. Before that, there were the massive deficits run up by the Bush 2 and Reagan administrations - deficits that the Nixon or Eisenhower (or Coolidge, or Harding, or Hoover) administrations would never have contemplated. Yet despite these troubling signs, a bedrock belief in the "party of business" label persisted. Conservatives and liberals alike believed that Republican tax cuts were rewarding today's rich people rather than penalizing tomorrow's rich people.

Now that people are finally starting to question the political priorities of the Republican Party, the U.S. Treasury market, and a bunch of other markets that use the Treasury as the risk-free benchmark, are going to be disrupted, platinum coins or no platinum coins. Whether we default this week or in five or ten years, the bond markets now know that it will be the GOP that pulls the trigger.

Without patting myself on the back, I have to say that I always strongly suspected that the Republicans were not the "party of business." This is not because of any knowledge of political theory on my part, but because I grew up in College Station, Texas, one of America's most conservative towns (and the home of Texas A&M, which is sort of a feeder school for the Republican Party). College Station has a few businesspeople, but they tend to be pretty moderate. The real movers and shakers in local politics are "social conservatives."

This has national-level implications. Social conservatives dominate the South, and the South dominates the GOP. Since 1992, the Republicans have won 21 percent of the electoral votes outside of the South. You heard that right: one fifth. The GOP lives and dies not by the campaign contributions of CEOs and investment bankers, but by the votes of Southern white middle- and working-class social conservatives. This is a fact that the world, and bond markets, are just now beginning to understand.

I haven't looked at the names of the House Republican rebels who are blocking John Boehner's attempts to cut a deal on the debt ceiling, but I:m willing to bet dinner that they are even more Southern than the GOP as a whole. I have some evidence to this effect, so you probably shouldn't take the bet.

And this is why we have a debt crisis.

Which leaves one big question: Why are Southern white middle- and working-class social conservatives so eager to embrace a debt default? The effects on the real economy of a U.S. debt downgrade would hit every Southerner in the pocketbook. I suppose this is generally the case in debt default situations - the same working-class populists who think a default represents "free money" end up being the people who lose their jobs. But usually this only happens in poor countries with sclerotic political systems - Latin America, etc.

It seems to me - and this part is a guess and a supposition - that white Southern conservatives just don't have a lot of nationalism - at least, not for the nation they currently inhabit. They seem to feel, instinctively, that the United States of America is only "their country" when one of their own is in power. As soon as a liberal takes office, off come the U.S. flag bumper stickers, and on go the Confederate flag bumper stickers. When Southern white conservatives talk about the "real America," or cry "I want my America back!", my instinct says that they are talking about an America that the United States has never been - a white racial nation. That America did exist, briefly, before it got stomped by the United States. But its flag still flies, and now it is getting its revenge.

Like I said...just a hunch. But do you have a better explanation why 60 house Republicans are dead-set on ending America's status as the center of the global economy?

Special Limits in Your Homeowner Policy

Your homeowners insurance policy places limits on certain types of property. In your policy there is a section titled “Special Limits on Certain Property.” This section will list various items and place a dollar limit on each type of property- such as jewelry, fine arts, guns or money.

Why do insurance policies contain such provisions? The homeowners insurance policy is written to provide coverage for the average policy holder. Most of us do not own collections or keep large amounts of cash at our homes. While the policy provides some limited coverage for special types of property, it in no way serves the needs of the unique collector.

There is, however, a solution for the collector or owner of unusual property items. It is possible to amend your homeowners policy, by endorsement, to provide special coverage for unique collection items such as coins or stamps. By asking your agent to include a schedule property floater in your coverage, you can specifically insure items of special interest. The personal property floater also expands coverage for perils not included in the homeowner policy.

Our 100th Blog Post!

We have now reached 100 posts on the Fey Insurance Services blog. Over the past few years we have posted about a variety of insurance and risk management topics. We have helped to educate businesses and individuals on how to best protect their hard earned assets such as their home, cars, and businesses. We have also give tips on how to stay safe in an ever changing world including tips on online identity safety and how to best prepare your home for the winter months.

Our hope is that you have enjoyed the 99 other posts and found some information that was helpful in each one. For the years to come we will continue to add helpful content so that our clients and readers can enjoy a safe and protected life.

Why Japanese government bond yields are so low

 

 Paul Krugman poses a puzzle:

A question (to which I don’t have the full answer): why are the interest rates on Italian and Japanese debt so different? As of right now, 10-year Japanese bonds are yielding 1.09%; 10-year Italian bonds 5.76%.

I ask this because in a number of ways the two countries look similar. Both have high debt levels, although Japan’s is higher. Both have awful demography. In other respects, the numbers if anything favor Italy, which has a much smaller current deficit as a percentage of GDP.

I don't really know anything about Italy, but I do know a bit about Japan, and today I asked several Japanese economists why Japanese government bond yields are so low when Japanese government debt is so high. Their answers were pretty much in agreement.

It comes down to three things: 1) financial repression, 2) home bias, and 3) dysfunctional equity markets.

Although many of Japan's legendary bureaucratic ministries have dramatically weakened in power and prestige since the 1980s, the Ministry of Finance (MOF) is still extremely powerful. Japan's financial system, like many financial systems in Asia, is dominated by large banks. In order to finance the government's huge deficits, the MOF puts pressure on the big banks to buy lots and lots and lots of Japanese government bonds (JGBs). 

This holds JGB interest rates down to very low levels. It also reduces deposit rates on Japanese households' savings accounts to zero, since the big banks need to maintain their spreads. So households see JGBs as fairly attractive investments compared to savings accounts. This is less of a factor these days, since Japanese net household saving is actually quite low now, but one professor I spoke with told me that households have apparently been shifting money from savings accounts to bonds.  

This is the same kind of financial repression that Michael Pettis has talked about with regards to China. Ultra-low interest rates on household savings act as a stealth tax on households. In China this stealth tax has apparently been used to pay off non-performing loans at big banks; in Japan, it is going to fund government spending. 

Of course, in China, the government can dictate the return on household savings because China has capital controls. Japan does not. So why don't Japanese households (and pension funds, another big purchaser of JGBs) simply defect and purchase foreign assets? Apparently, home bias is a big part of it. Japanese investors are scared of exchange rate risk; only recently have companies began offering households global index funds matched with currency swaps in order to limit this risk. Also, xenophobia appears to play a role as well; Japanese investors still tend to see foreign assets as inherently risky, ignoring the fact that diversification can dramatically lower that risk.

What about the Japanese domestic stock market? The experience since the bubble and crash in the 80s have convinced many Japanese investors that stocks go down in the long run, not up (as Americans tend to believe). And though no one I talked to mentioned this, I suspect that continued prevalence of cross-shareholdings and all-insider boards of directors have convinced investors that Japanese stock markets are institutionally dysfunctional, and hence a bad bet. I can't say I really disagree.

So I think that solves the Japan part of the puzzle. Bureaucratic power over a bank-centric financial system, enabled by home bias, allows the government to hold down its borrowing costs at the expense of households. As for Italy, though I don't know anything about it, I suspect that it has a far more "normal" financial system.

As a final note, it seems to me that the Japanese government's success in holding down its borrowing costs has probably had big negative effects on the economy. Banks that are forced to buy JGBs can't lend as much to firms, which seems like it would depresses economic activity, holds down growth, and probably contribute to deflation via suppressed wages. Households have been squeezed and squeezed by falling incomes until their savings rates have gone negative, yet they are still earning nothing on their savings. As a result, households are dead set against tax hikes to close the budget deficit, but politically powerful farmers and construction companies won't allow spending to fall either. It's hard to see how this vicious cycle will be broken, until Japan is forced to default from the sheer weight of interest payments. That would be the biggest and most catastrophic sovereign default in world history, unless of course the U.S. manages to pull one off first.

Update: A friend at the Ministry of Finance points out that much of the pressure on banks to buy JGBs is regulatory rather than informal. Banks are required by law to keep a certain amount of their capital in "safe assets," which in practice means JGBs only. Foreign-country bonds do not count, even if exchange rate risk is hedged via currency swaps. He also told me that much of the demand for JGBs is expected to come from small and regional banks in the near future, while big banks are hedging their bets by shifting into shorter-term JGBs.

Business Income

Calculating the appropriate business income limit does not have to be a mind-numbing process. To understand business income coverage limits, you must simply understand that the coverage is almost entirely based on time. The amount of coverage and the correct coinsurance amount can be calculated once a reasonable estimation of the time necessary to return to full operational capability is determined.

Four Key Objectives must be accomplished as quickly as reasonably possible:

1) Rebuild the building, or find a move to an alternate permanent location.
2) Find, purchase, and have operational, replacement machinery and equipment.
3) Replace and/or replenish stock (raw materials for manufacturing operations).
4) Return operations to the same level existing just prior to the loss.

Business Income’s Necessity

According to the Federal Emergency Management Agency (FEMA), there is a structure fire ever 4.5 minutes. Approximately 25 percent of businesses never reopen after a shutdown of just 30 or more days, according to the insurance industry. When you include the number of business failures within five years that are directly traceable to the same kind of claim, the number could approach 40 percent.

Business closings as a result of natural disasters also reach 25percent. The U.S. Small Business Administration reports that more than 90 percent of small businesses fail within two years after being struck by a disaster. Combining these two pieces of statistical data, losses can lead to the closure of thousands of business in any given year due to an interruption in operations.

The Calculation

Once total revenues and the total amount of non-continuing expenses (production-related expenses that do not continue during the interruption) is known and applied to an honest worst-case scenario estimate of the time necessary to resume operations, the correct coinsurance percentage can be calculated. Coinsurance percentages, in 10 percent increments, can be from 50 percent to 100 percent- each representing a proportion of one year (50 percent equals six months; 60 percent equals 7.2 months; 100 percent equals 12 months). It is also sometimes possible to obtain a 15-month business-interruption period at a corresponding coinsurance limit of 125 percent.

The Reality

Most businesses that close and never reopen after a catastrophic closure (30 days or more), don’t close because of the lack of building and business personal property coverage. They close because there is no money coming in the door. Few businesses can remain viable without a source of income. Many business expenses continue even during the period of temporary closing.

Obviously, the optimal goal is to have the building, contents and business income all properly insured. Ultimately, only the business can provide these figures, but this simple approach can make this exercise much easier. Once you accept the reality that loss of income is as important to the insure as insuring your property, we can help guide you to the proper coverage to further protect your business.

A real Laffer

One more short note on John Cochrane's paper. In my last post I talked a bit about "dynamic Laffer effects," and claimed that they didn't make sense in a historical context. But I wanted to point out that they make even less sense in a theoretical context.

A "dynamic Laffer effect" is a permanent effect of tax rates on growth rates. John Cochrane illustrates the idea with this equation:

PV is tax revenues, Y is GDP, g is the long-term growth rate of GDP, t is the tax rate, and r is the interest rate.

The third term on the right hand side represents the permanent effect on growth rates of a change in tax rates. Cochrane asserts that this term is negative, and suggests a value of "only" -0.02 for the derivative dg/dlog(t).

Sounds small and insignificant, right? It makes sense that taxes have some negative effect, however small, on the rate of growth, right?

Except it doesn't make sense. If taxes change the long-term growth rate, then tiny differences in tax rates between countries will, over a long enough time scale, cause countries' incomes to diverge. A country with a 10.01% tax rate will eventually become infinitely richer than a country with a 10% tax rate.

But you don't need to invoke infinity to see how silly this is. Here's a numerical example. The United States takes in about 27% of our GDP in tax revenue. Using Cochrane's numbers, a country that took in only 6% of its GDP in tax revenue would - all else being equal - grow about 3% per year faster than us, year after year. In a mere 24 years, that country would be twice as rich as us. After a century, they would be 19 times as rich as us. That's about the same as the current disparity between us and sub-Saharan Africa.

In other words, dynamic Laffer effects can't exist, because, as a physics prof of mine liked to say, "then the Universe would explode." Tiny differences in tax rates among rich nations would eventually add up to massive differences in wealth, and we'd see exponential divergence instead of the convergence that we see in the real world. The nonexistence of dynamic Laffer effects is a stability condition of growth theory.

And yet the existence of these Universe-exploding effects is absolutely central and crucial to conservative policy ideas.