The Ferg-beast attacks

I'm breaking my blogging hiatus to briefly respond to Niall Ferguson, not because I'm mad, but because it's fun. For those who haven't seen it, Ferguson has posted a massive three-part rant (part 1, part 2, part 3) in which he attempts to take Paul Krugman to task for making wrong predictions, for being a big meanie, etc. etc. The series is titled "Krugtron the Invincible", after my blog post of the same name. In fact, Ferguson references me in part 1 of his rant:

The resemblance between Krugman and Voltron was suggested by one of the gaggle of bloggers who are to Krugman what Egyptian plovers are to crocodiles.

...and again in part 3:

For too long, Paul Krugman has exploited his authority as an award-winning economist and his power as a New York Times columnist to heap opprobrium on anyone who ventures to disagree with him. Along the way, he has acquired a claque of like-minded bloggers who play a sinister game of tag with him, endorsing his attacks and adding vitriol of their own. I would like to name and shame in this context Dean Baker, Josh Barro, Brad DeLong, Matthew O'Brien, Noah Smith, Matthew Yglesias and Justin Wolfers. Krugman and his acolytes evidently relish the viciousness of their attacks, priding themselves on the crassness of their language.

Having been named, but not successfully shamed, I feel I ought to make a few points in response:

1. The Egyptian plover does not, in fact, eat meat out of the mouths of Nile crocodiles. That is a myth.

2. Ferguson attempts to peg me as a Krugman yes-man. This is lazy and uninformed on his part, since everyone who reads my blog or Twitter feed knows that I am a Brad DeLong yes-man, not a Krugman yes-man.

3. Some of Krugman's critics have good points. Others seem driven mainly by personal dislike for Krugman's polemical style or liberal politics. But a few seem to be motivated by a peculiar type of intellectual inferiority complex. They seem to believe that by catching a famous "smart guy" like Krugman making a mistake, they can prove themselves to be highly intelligent. Naturally, this doesn't actually work. Ferguson should worry about whether he falls into this latter category of Krugman detractors.

4. Of course, there is a fourth reason for criticizing a public intellectual: pure enjoyment. Ferguson seems too angry and bitter for his Krugman-bashing to be motivated by pure fun, but my own occasional Ferguson-bashing (see here and here) was motivated each time by the peculiar glee that comes from giving a really bad article the thorough point-by-point thrashing that it deserved.

5. My advice to Ferguson would be: Unless you're aiming for your legacy as a public intellectual to be "that British guy who constantly went after Paul Krugman", I'd suggest finding something else to write about. History, for example. I hear you're a very good historian.

6. To readers: If you really want to read more Ferguson-bashing, see Matt O'Brien and Josh Barro.

Borrowing from the Future — Except that We Aren't

This morning’s New York Times featured an utterly clueless op-ed by Stephen D. King (not the horror writer, at least not intentionally).  It would take too long to go through all the errors and misrepresentations he managed to pull together, but one in particular deserves mention, since it is a common meme: fiscal deficits mean that “we are borrowing from future generations”.

Let’s look at this calmly.  First, suppose we have a closed economy; there is no trade and no international flows of lending and debt service.  In this state of happy isolation, the government may choose to run a budget deficit.  If it does, it issues bonds.  People who want this kind of asset buy the bonds, and it is their purchase that funds government spending not covered by tax revenue.  These bonds have maturities, so what happens when their time is up?

One of three things.  First, the bonds could be redeemed with no new bonds issued.  This would reduce the amount of bonds in private portfolios, but it would give the ex-bondholders an equivalent amount of cash to spend on something else.  The cash comes from a budget surplus, which means that taxpayers have paid in extra.  Those who don’t own bonds are now net payers to those who do.  From an accounting standpoint, however, they also gain in the sense that they are no longer liable to pay a stream of interest on the bonds into the future.

Historically, this doesn’t happen very much.  The best example is the huge deficits that the US and Britain used to finance WWII.  Neither country ran equivalent surpluses later on to “pay off” the debt.  Their economies grew, inflation eroded debt claims, and over time the debt-to-GDP levels slid back down to more reasonable levels.  Specifically, when the war bonds came due these governments simply issued more bonds to finance their redemption; they rolled over the debt.  That’s what happens in 99% of the cases, and you can see this by looking at how small and infrequent fiscal surpluses actually are.  This refinancing through issuance of new debt is option number two.

The third possibility is default.  Banana republics and governments under the influence of suicide cults sometimes do this.  ‘Nuf said.

So where is “borrowing from the future”?  Well, all government is borrowing from some people to pay other people, and paying back these debts, should it ever happen, simply reverses that flow.  Either way, money is making its way from one group to another at the same point in time.  Note that interest on the debt has nothing to do with present vs future either: the current generation, which incurs the debt, begins paying interest immediately in exactly the same way their distant descendants will.

None of this means, of course, that deficits are innocent in every respect.  To run them, the government has to be able to sell its bonds or, if the central bank is going to monetize them, the economic environment has to permit this.  (It can’t be too inflationary.)  That can break down.  Past experience can guide us in assessing how close we are to the upper limit of our fiscal space.  (The struggling countries in the Eurozone are a special case, because they don’t borrow in their own currencies.)

Ah, but you say, we are not in a closed economy.  Some of our borrowing is from foreigners, and debt service transfers money from us to them.  Some responses:

1. This is not about present versus future, but our people and their people.  After all, international interest payments, like intranational ones, don’t wait to be paid; we begin paying them right away.

2. The world as a whole is a closed economy.  If “we” are everyone in the world (and in some senses we are), there is no outside, at least economically.

3. The amount of foreign borrowing to finance fiscal deficits is not directly a function of the size of the deficit but of whatever determines our international payments position—our current and capital accounts.  To make the case that government borrowing increases the current account deficit, you have to, well, make the case.  For instance, is there a historical relationship between the size of US fiscal deficits as a proportion of GDP and corresponding current account deficits?  Show this if you can.  (In general there isn't, although the current account and the sum of net domestic borrowing, both public and private, is an accounting identity.  If two things are an identity, one does not "cause" the other because they are both the same thing.)  On a theoretical level, the idea is that issuing more public debt raises domestic interest rates, which in turn raises exchange rates, which in turn increases trade deficits.  OK, try to show that.  (The US record doesn’t provide much support.)

So there you have it.  At an individual level, borrowing is truly borrowing from the future.  At a population level, borrowing is the creation of assets and liabilities across different people.  People like King are committing a fallacy of composition.

Incidentally, we are borrowing from the future.  We are shirking the investments we need to make so that our children and grandchildren can live in a habitable world with a well-educated population that enjoys a productive infrastructure.  No fallacy of composition there.

In Defense of the Constitution

Democracy is dead, and the Constituion is responsible. That, at any rate, seems to be the emerging consensus among some of America's smarter left of center bloggers. Last week, Dylan Matthews of Wonkblog laid the blame for the current government shutdown not on President Obama or Ted Cruz, but on James Madison: 

This week's shutdown is only the latest symptom of an underlying disease in our democracy whose origins lie in the Constitution and some supremely misguided ideas that made their way into it in 1787, and found their fullest exposition in Madison's Federalist no. 51.

Matthews' opinion was seconded by Matt Yglesias, who argued that ultimately "America was doomed" because of our presidential system of government. And this weekend Jonathan Chait argued that the current budget battles might have been "destined all along" due to our constitutional structure. 

Matthews, Yglesias, and Chait all based their claims on a 1990 essay by political scientist Juan Linz, The Perils of Presidentialism. Written during the wave of democratization that coincided with the end of the Cold War, Linz's essay lists a number of dangers arising from a strong presidency, and argues that newly democratic nations ought to consider adopting a parliamentary system of government (like that of Germany) rather than a presidential one (like we have here in the U.S.).  

It's a good essay, and if one were designing a system of government from scratch, particularly in a society without a long tradition of democratic self-government, Linz's concerns ought to be taken seriously. But there is something a little odd about seeing The Perils of Presidentialism being cited as an argument by those who wish that the House of Representatives would be more accommodating to the President. As the title suggests, The Perils of Presidentialism is chiefly concerned that come from the president having too much power. 

For example, Linz argues that because the president alone is elected by the whole nation, he and his supporters "may be tempted to define his policies as reflections of the popular will and those of his opponents as the selfish designs of narrow interests." This certainly is a temptation. In fact, it seems to be a strong temptation for Chait himself, who describes today's GOP as "a party large enough to control a chamber of Congress yet too small to win the presidency." Matthews likewise suggests that his personal favorite theory of democracy is summed up in a statement by Max Weber: "In a democracy the people choose a leader in whom they trust. Then the chosen leader says, 'Now shut up and obey me." 

It gets worse. According to Linz, there is also a danger that the president will "use ideological formulations to discredit his foes," perhaps, for example, by referring to them as nihilists, anarchists, terrorists, etc.

And then there is the timing factor. Linz' also argues that, because of presidential term limits, a president's 

awareness of the time limits facing him and the program to which his name is tied cannot help but affect his political style...  This exaggerated sense of urgency on the part of the president may lead to ill-conceived policy initiatives, overly hasty stabs at implementation, unwarranted anger at the lawful opposition, and a host of other evils. 

Ultimately, Linz fears, frustration with legislative unwillingness to go along with presidential policy might lead to a military coup, or other forms of violence. 

While it's fun to speculate about alternative systems of government, America is not at risk of devolving into a military dictatorship any time soon. For all our faults, the U.S. is in fact one of the most successful countries in the history of the planet, and our constitutional structure, with its system of divided power, is one of the reasons for that. If you want to attack the House Republicans, be my guest. But leave James Madison out of it.   

UPDATE: On Twitter, Adam Gurri directs me to a piece of his that sums up my thinking perfectly: 

Rather than judging institutions on the basis of theory, we ought to be looking at their resilience; how they stand the test of time. The electoral college is frequently a target of criticism and ridicule by people who feel it is outdated, but it is precisely because its life can be measured in centuries rather than decades that we should trust it by default. At least, we should trust it more than the simple stories proffered by pundits and scholars. 

The more I learn about the Swiss canton system, the crazier it seems to me. Yet there are some cantons that have been in continual existence for something like 700 years—and Switzerland is a very wealthy and very peaceful nation. We should not conclude from this that their system of government should be spread to every corner of the Earth, but it is clear that there is something about the system as it operates in Switzerland that works.  

Metaphysics and the Breaking Bad Finale

If we spirits have offended, think but this and all is mended

That you have but slumbered here, while these visions did appear

Last weekend was the series finale of Breaking Bad, the critically acclaimed drama about an Albuquerque chemistry teacher who becomes a meth dealer after being diagnosed with cancer. From what I can gather, most fans were satisfied by the show's resolution. There is a small but growing cadre of viewers, however, who found parts of the episode a bit unrealistic, and have responded by arguing that the ending was in fact all a dream. Here, for example, is Emily Nussbaum:

[H]alfway through, at around the time that Walt was gazing at Walt, Jr., I became fixated on the idea that what we were watching must be a dying fantasy on the part of Walter White, not something that was actually happening—at least not in the “real world” of the previous seasons. … I mean, wouldn’t this finale have made far more sense had the episode ended on a shot of Walter White dead, frozen to death, behind the wheel of a car he couldn’t start? Certainly, everything that came after that moment possessed an eerie, magical feeling—from the instant that key fell from the car’s sun visor, inside a car that was snowed in. Walt hit the window, the snow fell off, and we were off to the races. Even within this stylized series, there was a feeling of unreality—and a strikingly different tone from the episode that preceded this one. 

This isn’t the first time that a show or movie has inspired some creative theorizing. The end of The Sopranos sparked debates over whether Tony Soprano had or had not been killed at the moment after the episode ended. Fans and critics alike engaged in elaborate exegesis over whether Leonardo DeCaprio was awake or dreaming at the end of Inception. And the ending of Lost, well, what can you say.

These sorts of arguments come so naturally to people that it is easy to gloss over a certain strangeness underlying the whole debate. Breaking Bad, after all, is a work of fiction. Walter White does not exist. As such, it’s not entirely clear what it means to say make claims about what happened to him or other fictional characters outside explicit descriptions of what happened on the screen.

This sort of attitude is perhaps best expressed by the late novelist Douglas Adams (of Hitchhiker’s Guide to the Galaxy fame). Responding to a fan question about some detail of Arthur Dent’s life not mentioned in his books, Adams responded:

The book is a work of fiction. It’s a sequence of words arranged to unfold a story in a reader’s mind. There is no such actual, real person as Arthur Dent. He has no existence outside the sequence of words designed to create an idea of this imaginary person in people’s minds. There is no objective real world I am describing, or which I can enter, and pick up his computer, look at it and tell you what model it is, or turn it over and read off its serial number for you. It doesn’t exist.

 On one level, Adams is perfectly correct. Still, there is something unsatisfying about this point of view. It’s not clear that one could enjoy fiction were it to be held consistently. 

                                     You may say I'm a dreamer, but I'm not the only one.

An alternate perspective was offered by the philosopher David Lewis in his paper Truth in Fiction. Lewis is best known as an advocate of Modal Realism (the view that every possible world really exists). But while Truth in Fiction utilizes Lewis’ possible world semantics, I don’t think one need to accept Modal Realism in order to accept his basic argument.

According to Lewis: 

A sentence of the form 'In the fiction f, x is non-vacuously true iff, wherever w is one of the collective belief worlds of the community of origin f, then some world where f is told as known fact and f is true differs less from the world w, on balance, than does any world where f is told as known fact and x is not true. It is vacuously true iff there are no possible worlds where f is told as known fact.   

 Okay, so that's a bit of a mouthful, but basically Lewis is saying that the claim "Walter White froze to death at the end of Breaking Bad" is true if a world in which that happened is closer to the actual world than a world in which everything before that point depicted in the show happened and he did not die in that way (the bit about collective beliefs is to deal with a situation where a society might have factually wrong beliefs that are depicted in the story, e.g. the solution to the Sherlock Holmes story "Adventures of the Speckled-Band" is based on an error about snakes, but Lewis doesn't think we should therefore conclude that Holmes got the wrong man).

This, however, poses a bit of a problem. There are, after all, plenty of fictional tales containing elements that are implausible or even impossible in our world. A world in which everything past the first couple of scenes of Buffy the Vampire Slayer was a dream would be more similar to the actual world than a world in which it all really happened (and this isn’t simply because the viewers of Buffy mistakenly thought that vampires were real). On the other hand, it’s not clear that Lewis is entitled to rule out dream explanations per se. After all, there are works of fiction where large portions of the narrative turn out to be a dream (the ninth season of Dallas perhaps being the most famous example).

So while I don’t find the Breaking Bad dreamers’ arguments terribly plausible, their theories seem to have done something I would have thought even less plausible, namely, refute one of the Twentieth Century’s most capable philosophers.   

How important was the “structural balance” screw-up in driving European austerity?

I’m really glad to see that this European screw-up is, eventually, making headlines and that the European Commission is reconsidering the operational details of its production function method to estimate potential output and structural deficits (see WSJ).

As reported by the WSJ’s Real Time Brussels blog, the issue has become important, as the new European Fiscal Compact, which entered into force on 1 January 2013, requires that the structural deficit for euro-area Member States be less than 0.5%. So since “the European Commission uses [the structural balance] metric — the actual government budget balance adjusted for the strength of the economy – to determine how much austerity is needed; getting it wrong has big consequences.”

The question is whether “getting the structural balance wrong” in 2010 – the time at which Europe started to become obsessed with fiscal austerity – mattered in driving the amount of consolidation.

I first came across and pointed out the weakness of the structural balance calculations of the European Commission in 2010 in a series of Goldman Sachs publications that I then summarized with my co-author Natacha Valla on VoxEU. The basic storyline was and remains simple. The European Commission drastically revised downward its estimates of potential GDP as the crisis hit, which automatically increased its structural deficit measures for European countries.

This raised 2 questions?

1/ Did it make sense? 2/ And did the downward revisions to potential GDP matter for the size of consolidation packages?

First, did the downward revisions to potential GDP – that the European Commission introduced early in the crisis – make sense?

The European Commission uses a production function methodology for calculating potential growth rates and output gaps (see here). It features a simple Cobb Douglas specification where potential output depends on TFP and a combination of factor inputs (potential labor and capital). Importantly for what follows, potential labor input is calculated as:

Working age Population x Participation rate x Average hours worked x (1 - NAWRU)

It’s important to focus on potential labor input since the bulk of the revisions applied between 2008 and 2010 to potential GDP arose because of revisions to labor input.

Figure 1. Decomposition of the revisions (2010 vs. 2008 vintage) to potential GDP: Spain

Source: VoxEU. Note: The vertical axis is in percentage points.

And as you can guess from the drawing by Manu Cartoons, a large part of that decrease came from an increase in the Commission’s estimate of structural unemployment: the now infamous NAWRU. The European Commission uses the non-accelerating wage rate of unemployment (NAWRU) as an estimate for structural unemployment. We can discuss the pros and cons of NAWRU as a dynamic measure of structural unemployment in normal times, but the following graph should basically scream at you that this measure has failed at separating cyclical and structural unemployment during these extraordinary times.

Figure 2: Actual unemployment and NAWRU: Spain

Source: European Commission, 2013 spring forecast exercise

So although one can argue that a crisis can temporarily – as workers need time to adjust to the new sectoral and geographical composition of jobs – or permanently – because of hysteresis effects – decrease potential labor input, the size of the adjustments applied by the European Commission appears clearly inadequate.

Second, did it matter and was it more important than the fiscal multiplier screw-up in driving austerity?

As pointed out by Real Time Brussels, a reconsideration of the methods that the European Commission uses for estimating potential output could now cut the estimated structural deficits of the periphery countries and mean less austerity given the 0.5% rule of the Fiscal Compact. But I don’t think that, back in 2010, the structural deficit numbers played an important role for the countries that were under the heavy pressure of bond markets as they mostly focused on the nominal deficit and debt to GDP ratio metrics in designing their consolidation packages.

The structural balance screw-up may have mattered, however, for Germany (and for other core countries to the extent that their fiscal strategy mostly mimicked that of Germany) as it designed its consolidation plan for the 2011-2016 period based on the structural balance metric. In my VoxEU piece, you can see that the downward revision to potential GDP applied to core countries was not negligible. For Germany, the European Commission revised the potential GDP growth rate by about 0.5 percentage points.

I need to find the output gap and the cyclical-adjustment parameters used both in 2008 and 2010 by the European Commission to quantify by how much austerity would have decreased had Germany followed the same consolidation path (similar speed and end-points in terms of structural deficit) but used the 2008 vintage version of its potential output estimates rather the revised 2010 estimates. But my guess is that the consolidation efforts Germany planned for were to a significant extent unnecessary restrictive, even taking as given its objective of converging to a structural deficit of 0.35% by 2016.

Source: German Stability Program

Given the sheer size of core countries for the euro area, this operational mess-up may have been quite significant in delivering an inappropriate overall fiscal stance and hindering rebalancing. As a matter of fact, I wonder if this operational mess-up wasn’t more important than the fiscal multiplier screw-up in delivering this outcome. Granted, fiscal consolidation would have been less drastic in the periphery without the fiscal multiplier screw-up. But the biggest European fiscal policy failure wasn’t so much that of the periphery, which had pretty much no choice than drastically consolidate in the absence of a proper lender of last resort. The biggest fiscal policy mistake was the early consolidation efforts of the core, which started - and were amplified by the structural balance screw-up - in 2010 although “in the absence of default risk, debt adjustment should be very gradual”.

Jeremie Cohen-Setton (@JCSBruegel) is a PhD candidate in economics at UC Berkeley and an Affiliate Fellow at Bruegel. He specializes in Macroeconomic Policies and Macroeconomic History and worked previously as an economist at HM Treasury and at Goldman Sachs. Jeremie blogs at ecbwatchers.org and is the main author of the blogs review at bruegel.org.