February 2005 Archives

UPDATE: Posted the wrong version but caught my error a few minutes later. This is the correct version.

There was clearly a slowdown in 2003, but the rate of increase appears to be back on track somewhat. The last couple months look like it's trying to decide which way to go. This Friday, the payroll numbers for February will be released. I will be posting an update to this chart which for better or for worse, might be just as interesting as the raw numbers.

UPDATE: I just crunched a few numbers that you might want to chew on this week. Since May, the percentage rate increases have been 1.2, 1.3, 1.3, 1.5, 1.5, 1.6, 1.6, 1.7, 1.7. Growth is steady but slow. To really look like we're back on track, we would probably want (at least) 1.8% growth for the previous 12 months. That would require over 200,000 jobs (depending on how you prefer to round your figures, I'm being generous). We only saw that kind of growth 4 times last year, but we need to see more of it. 150,000 this month (like we had in January), would put us further behind where we should be at this point in a recovery.

Greg Ip of the Wall St. Journal reports on the possibility.

Some analysts believe the Fed's openness has contributed to the low level of stock-market volatility and the narrow spread between yields on Treasurys and riskier corporate bonds. "The low price of risk is a pervasive feature of financial markets," says Tom Gallagher of ISI Group, an economic research firm. "Much of this could be due to monetary policy." He says that volatility in the stock market began to decline about the time Mr. Greenspan first used the words "considerable period" to signal a long period of low interest rates.

And later in the article,

But the Fed's willingness to forecast its interest-rate plans reflected an unusual confidence in those plans resulting from unique, and likely temporary, circumstances. Interest rates were exceptionally low, so they obviously had to rise. But the risk of inflation also was low, so the pace could be leisurely. "The crucial difference between now and in the past is an extraordinary productivity acceleration," Mr. Greenspan said last April. "That means that the price pressures are not anywhere near where they would be under normal circumstances. ... It means that you can go in a much more measured pace."

Since then, a lot has changed. The federal-funds rate, at 2.5%, is approaching a range in which Fed officials believe it will no longer be "accommodative," that is stimulating spending. Meanwhile, the economy's spare capacity has diminished, productivity growth has slowed, and the dollar has dropped, so inflation risks have risen.

See macroblog for more.

And then there's this news (Reuters) from today...

The benchmark 10-year note slid 29/32 in price, driving yields up to 4.38 percent from 4.27 percent on Friday. The break of 4.30 percent took yields to the highest level since early December and triggered a wave of technical selling.

Just another thing to keep an eye on.

The leader to The Economist's article on the Fed and inflation this week ends with the following:

During the past century, every monetary rule has eventually broken down: the gold standard, the Bretton Woods system of fixed exchange rates, and monetary targeting. Now it seems that strict inflation targeting may not be a panacea either. It would be foolish for the Fed to sign up for crude inflation targeting just as it goes out of fashion.

Fair enough. Inflation targeting has pros and cons, and I haven't been convinced yet that the pros outweigh the cons. In a perfect world, it would be easier to convince me, but... I don't have to finish that sentence, do I? That paragraph could be the end of a nice article explaining the pros and cons of rules vs. discretion and the Fed's dual (and somewhat contradictory) objectives.

But it wasn't. For instance, they say,

Some central bankers in Britain, continental Europe, Australia and New Zealand have said publicly that monetary policy needs to take more account of asset prices and that sometimes interest rates may need to rise by more than if the sole objective were to keep consumer-price inflation within target.

In a recent article, Otmar Issing, the chief economist of the European Central Bank (ECB), threw down the gauntlet to the Fed. He argued that it is hard, but not impossible, to identify when asset prices are overshooting; there are benchmarks against which valuations can be judged. If prices look frothy, central banks should signal their concern. And they should certainly avoid contributing to “unsustainable collective euphoria”. Central banks should also look out for the surge in money and credit which often accompanies a bubble.

The accompanying article says much the same thing.

Back in 2001, the president of the St. Louis Fed, William Poole, gave a talk at my campus that makes a number of important points on this issue. There's a lot of information in asset prices, but the Fed should not target them directly. One of Poole's more salient points is this,

A widely known result from control theory states that, with one instrument, the policymaker can at best achieve one policy objective. That objective, in my view, ought to be a low and stable rate of inflation. As a matter of logic, therefore, pursuing a separate stock market objective means compromises of some sort on the inflation objective. Clearly, targeting the stock market might come at a high price. Once the Federal Reserve compromises on its price stability goal, inflation and inflation expectations build up. Experience shows that inflation expectations are persistent, and inflation fighting tends to entail recessions. Because permitting the economy to run off track has negative consequences for the stock market, any effort to target the stock market is likely to be self-defeating.

Or, to extend that point to the present discussion, what do you do when asset prices and the CPI diverge, as The Economist suggests is the case, this time for housing values instead of the stock market? And that brings up an even more troubling question of what do when the stock market is flat, the CPI rising moderately, and housing going through the roof?

I don't know either. I suppose you can use the usual array of blunt policy instruments, but that means that sometimes the CPI growth could go dangerously low (or negative). Again, The Economist:

Given the elusiveness of a perfect price index, central banks should keep using conventional, narrow inflation targets, but be prepared to undershoot them temporarily if house or share prices soar.

Not a good idea. Brad DeLong agrees. Seems like they are asking the Fed to target relative prices AND nominal prices. I don't think they have enough policy instruments to do that without there being some rather serious consequences.

Still no specifics on when this will happen or how soon it will lead to any actual move on the exchange rate. However, China did announce that they will allow insurance companies to invest overseas, providing a relief valve for currency to leave the country. This as a part of generally increasing the amount that can be traded in the capital account.

Read the Reuters article.

To refresh your memory, here is my post from a month ago when the advance numbers came out. Note the chart at the bottom.

Here's today's news release. Real GDP was up 3.8% (annual rate) for the 4th quarter of 2004. That's considerably higher than the advance number of 3.1% and even higher than the 3.5% that was expected by analysts a month ago. It's even a little bit higher than what analysts were expecting earlier in 2004. If the economy can maintain this rate for a few quarters, I think a lot of people would be happy. Whether that is likely is a post for another day.

Where did the increase come from? Well, a good part of it undoubtedly came from the undercounting of exports to Canada in the advance figures. Ooops! The rest, according to the BEA is due to increases in inventory investment as well as the category for equipment and software.

Angry Bear has a nice chart which shows that while residential investment is growing more slowly, nonresidential investment is increasing at a pretty good pace, with only a minor hiccup in early 2004.

Phil Luciano, a Peoria columnist, thinks he knows, and he may have touched a nerve. Responses to a recent column came from journalists around the country. Today he shares some of those e-mails. Here's a sample:

Fast-food journalism: I spent more than 20 years in the business, at the Los Angeles Times, Newsday, and smaller dailies and weeklies. You still have good newspapers and reporters out there. But you run a bank, you get bankers and tellers. You run a fast-food joint, you get people flipping frozen burgers. You run a newspaper where the priority is raking in high profit margins for shareholders, where the stuff of life becomes the "daily product," where stories and layouts all look and read more or less the same, then you get a boring newspaper staffed by unimaginative, bank-tellers-turned-journalists. - Mark

Yuck: These days, the more controversial the fact, the more likely it will be rewritten by a gun-shy copy editor until it resembles nothing more exciting than yesterday's oatmeal. - The Morning Call, Allentown, Penn.

Indeed. Remember, these are journalists saying these things.

Apple is again giving away free iTunes in 1 out of 3 Pepsi bottles. They did this last year, and I raked in quite a few of the winning bottle caps. I already have three from the latest promotion, and I hope that this becomes an annual event.

Here's an article on the iPod (which I do not yet have--I just listen on my computer).

John M. Berry, columnist for Bloomberg weighs in.

Today's best Social Security analysis is by Arnold Kling. By the way, if you don't read his blog, you should.

The memorandum to which he refers is can be found at the SSA website.

He gets it right. At issue is the rate at which a worker trades off benefits when he or she contributes to a private account. If I'm reading it as he does, it appears that this proposal shaves the benefits by 3%, which means the private accounts have to return at least that much for the worker to break even. His problem with that is that 3% is too high. Alas, it looks like this is, as he says, "dictated by the Social Security actuaries."

I have to agree with Kling that 3% makes the system look more solvent, but might bias people against private accounts (or lead to inflated claims about the returns on those accounts--something which also appears to be happening).

Kling says,

"Actuarial scoring" of Social Security and the reform proposals is a menace. The assumptions used in scoring are rigid and misleading. If you want to be in a position to evaluate Social Security reform objectively and accurately, the first thing you have to do is throw out the actuarial analysis. Pay no attention to the "trust fund," the "solvency" of the system, or other noise generated by the actuaries.

They certainly are rigid. And it's true that the solvency or lack thereof depends on those rigid assumptions. I'd be more comfortable with a lower number, but that means that private accounts would have to be introduced much more gradually (to satisfy anyone's definition of actuarially sound). Of course, that wouldn't bother me one bit.

Oh, and one more thing. The proposal in the memo, which apparently is now going by the name of H.R. 530, lets anyone under age 55 start a private account. Read it!

I give you David Altig and Jagadeesh Gokhale's idea from back in 1996, nine years ago. (Yes, the David Altig of macroblog.)

Calculations using the current distributions of Social Security benefits by age and sex (assuming a 1.8 percent internal rate of return on the contributions of those included in the present system, and an 8 percent return on investments in private capital markets) suggest that 42 is the appropriate cutoff age. With this as the dividing line, 18 percent of the contributions of those age 42 and younger would be sufficient to provide those age 43 and older with benefits at least equal to those received under the current system. For younger workers, future benefits may be greater than those offered by the current system, because their contributions will reap the higher private rate of return for an even longer period.

Having dithered for nine years, I'd say the appropriate cutoff is at a younger age now. And this paragraph from the same 1996 article is delicious in its irony.

For an individual starting from scratch, the rate of return from a funded system will clearly exceed that of the unfunded scheme. However, if the cutoff age below which individuals are shifted to the privatized system is too high (say, 55), some workers would not have enough remaining years to exploit the increased private returns, leaving them worse off than before.

I don't know whether to laugh or cry.

Via the Club for Growth:

U.S. Rep. Martin Sabo (D-MN) announced this week that he will introduce a bill in Congress that he says will "guarantee Social Security solvency through 2080" by increasing the interest rate on Treasury bonds in the Social Security trust fund.

PGL at Angry Bear responds first. I'm going to take a different approach though. Rather than make this another post about what I think the trust fund is or is not (I've been pretty clear about that in the last few weeks), I'm just going to explain why I think this idea is not a good one.

My complaint is simple. Even if we keep the current Social Security system, I would just ask that the system's income and outgo be balanced in the long run. Right now, that's where the infamous 2018 and 2042 dates come into play. The plus side of the ledger wins until 2018, then the negative side of the ledger wins for many years into the future--hitting a zero balance in 2042. PGL often comments that the Republicans want to raid the trust fund or that Reagan lied in 1983. I respond as follows. If we raise taxes (or borrow less!) from 2018 to 2042 to pay back the bonds in the trust fund, then David Ricardo, for one, would not call Reagan a liar.

(The fact that many people reading this will find the previous sentence unrealistic is a political issue, not an economic one.)

The problem is that the world does not end in 2042. Beyond that year, the system goes negative and would probably stay negative for a long time, forcing the general fund to subsidize Social Security, perhaps indefinitely (unless there is another baby boom). I think we can all agree that the pay-as-you-go system is not in long run balance when the long run is taken to be past 2042. That would bother me. At that point, I would want us to raise the retirement age, raise payroll taxes, or cut benefits. Of course, I really would prefer that we never get to that point in the first place. That's why I support doing something now, while there is a lot of time to do something gradually.

Anyway, back to Rep. Sabo's plan. His plan would simply shift the financing from the pay-as-you-go Social Security system to the general fund... until (at least) 2080. He's talking about doing exactly what I would try to avoid... for 40 years. This is more than just a counterpoint to the "raiding the trust fund" argument. This would institutionalize a long run imbalance in the pay-as-you-go Social Security system--a long period of deficit without a corresponding surplus. In my rank ordering of approaches to the Social Security issue, this ranks right below doing nothing.

Harvey Rosen is the new CEA chair. Rosen is already a member of the CEA, so someone will need to be appointed to take his spot as he moves up.

BLS News Release

Angry Bear and macroblog provide today's commentary.

The market cheered a little bit anyway.

Oh, and what's this? I almost forgot. From the Reuters article linked above:

Markets will look for the release at 2 p.m. (1900 GMT) of the Federal Open Market Committee's minutes from its Feb. 1-2 meeting for clues about future rate hikes.

I'm going to read the minutes. Expect an update to this post within an hour or two.

UPDATE: After the procedural part of the minutes:

At this meeting the Committee engaged in a broad-ranging discussion of the pros and cons of formulating a numerical definition of the price-stability objective of monetary policy. A staff presentation on the topic included a review of the potential costs and benefits of introducing such a definition as well as of other countries’ experiences. In the subsequent discussion, meeting participants uniformly agreed that price stability provided the best environment for maximizing sustainable economic growth in the long run, but expressed a range of views on whether it would be helpful for the Committee to articulate a specific numerical definition for the Federal Reserve's price-stability objective––either a single figure or a range. Those who believed such a move would be on balance beneficial cited, for example, its usefulness as an anchor for long-term inflation expectations, as a vehicle for enhanced clarity of Committee deliberations, and as an additional tool for communications. Several of those who saw greater potential drawbacks were concerned that such a shift might appear to be inconsistent with the Committee’s dual mandate of fostering maximum employment as well as price stability or that it might inappropriately bias or constrain policy at times; in any case, with inflation expectations well-contained over recent years, the benefits of announcing a specific inflation objective were not likely to be large. The Committee decided to defer further discussion.

Too bad we have to wait 5 years for the transcripts.

The committee also seems to feel that inflation is being held in check for now.

Core consumer prices decelerated over the past few months, while overall consumer prices were buffeted by movements in energy prices. The rate of increase in core prices in the twelve months ending in December was somewhat higher than the very low rate that prevailed during the year-earlier period; the overall index also accelerated, with about half of its advance accounted for by a sharp rise in energy prices. Measures of inflation expectations were little changed over the intermeeting period. With regard to labor costs, the employment cost index decelerated in the fourth quarter; the slowdown was attributable to wages, which gained only slightly, while benefit costs rose a bit faster than in the third quarter.

And you knew that they would mention this...

The Committee’s decision at its December meeting to increase the federal funds rate had been fully anticipated in financial markets, and reaction to the attendant statement was muted. The release of the minutes of the December meeting on January 4, however, triggered a significant upward revision in the anticipated path of monetary policy: Investors apparently read them as expressing more widespread concern among Committee members about inflation pressures than had been the case previously. Market participants viewed the generally favorable incoming data on economic activity as consistent with their expectations of firmer policy. Interest rates on intermediate-term Treasury securities rose in response to the revision to policy expectations, but longer-term yields were little changed over the intermeeting period.

The forecast for '05 and '06:

As part of its continuing effort to improve its communications, the Committee had earlier decided to add one year to the forecast period so as to make the projections more useful to the public. The forecasts of the rate of expansion in real GDP were concentrated in the upper part of a 3½ to 4 percent range for 2005; for 2006 the forecasts were in a slightly lower range of 3¼ to 3¾ percent, with a central tendency at 3½ percent. These rates of growth were associated with a civilian unemployment rate in the range of 5 to 5½ percent and a central tendency of 5¼ percent in the fourth quarter of 2005 and 5 to 5¼ percent in the fourth quarter of 2006. The rate of inflation, as measured by the core PCE price index, was expected to remain fairly stable, with forecasts concentrated in the lower portion of a 1½ to 2 percent range for both this year and next.

This is the only thing I could find that expressed any concern about inflation. It's near the end, and makes me wonder if the regional banks are more hawkish than the board at the moment.

However, several participants suggested the possibility of an upward skew to the distribution of inflation outcomes, especially if there were appreciable further declines in the foreign exchange value of the dollar or in structural productivity growth; already some participants were hearing anecdotal reports from firms of an increased ability to pass cost increases through to product prices, perhaps because of increasing confidence in the outlook for the economic expansion.

I would think that the participants who are hearing anecdotal evidence from firms are the bank presidents.

This sums it up:

All members judged that a further quarter-point firming in the target federal funds rate was appropriate in light of current overall accommodative financial conditions and the continuing outlook for solid economic growth and diminished slack in resource utilization. A higher nominal federal funds rate was seen as needed to contain risks of increased cost and price pressures, but even with this action, the real federal funds rate was generally seen as remaining below levels that might reasonably be associated with maintaining a stable inflation rate over the medium run. The pace of policy moves at upcoming meetings, however, would depend on incoming data.

Most of this we knew already.

UPDATE: The status quo is apparently good. A market strategist quoted in the article says,

There's nothing in here when I read these things that jumps out at me and strikes me as something different or new.

Yeah.

UPDATE: Yet another article, here the writer feels that the minutes indicate more tightening, which would be good for the dollar. Maybe, but this is not "news." The minutes say clearly that

The pace of policy moves at upcoming meetings, however, would depend on incoming data.

In other words, expect 1/4 point at each of the next three meetings unless we get some signals to quicken or slow that pace. Today's CPI numbers did not contain such a signal, in my opinion. The current pace of rate hikes seems consistent with the amount of inflation pressure evident in today's data.

Read here. Brad Setser has been posting a lot about the dollar, and in the last 24 hours about the news out of Korea that I mentioned yesterday. For a minute, I toyed with the idea of giving that post a clever title like, "It begins," but I thought that would be a little too dramatic. I wonder what Setser would have thought of such a title.

Let me be clear about where I stand. I don't think this should be over dramatized, which is why in the end I opted for a less clever, more boring title for that post. However, it does give one pause. And though Setser is not bashful about showing concern:

News about what any of these four central banks [Taiwan, Korea, Russia and India] intend to do is hardly marginal news in my book. Three of the four -- Russia, India and Korea -- have now indicated a desire to either diversify their reserves or to spend their reserves on "infrastructure." Some say Taiwan has made similar noises as well, though Taiwan's central bank officially denies any such intent.

But he ends with a ray of, well, I'll call it hope.

To my knowledge, at this stage, we have no real way of knowing whether Asian central banks are purchasing fewer dollar assets (relative to the increase in their reserves), or just purchasing fewer Treasuries. In one scenario, Asian central banks are buying euros and other currencies. In the other scenario, they are just buying a broader range of (higher-yielding) dollar-denominated assets, and doing their purchases in ways that the US data does not pick up as cleanly.

I'll call it hope because if they are simply diversifying their purchases of dollar assets, the news is far less troubling. We'll know eventually. Such things show up in the balance of payments in time. Of course, if they're not picking up other dollar assets, we'll see the signs.

My gut feeling? Foreign demand for dollar assets shifted dramatically from private assets to Treasury securities beginning in 2001. (I'll try to find a data link later.) This might be the pendulum swinging back, but like I (and Setser) said, we won't know with certainty for a while.

David Altig and Alex Tabarrok are in the Wall Street Journal Online's Econoblog today. (Subscription required)

David links to this post of mine, making this my first inbound link from the Wall Street Journal. Pretty cool stuff for an assistant professor from Peoria who started blogging just a few months ago.

Anyway, the post he links to is where I observed that the Retirement Savings Accounts proposed by the President would apparently replace the Traditional and Roth IRAs presumably simplifying the tax treatment of savings and encouraging the same. I haven't seen anyone else mention this (though I'm sure by now word must be getting out--certainly after today it will), and I think it deserves some discussion. In principle, I have nothing against the idea if it simplifies and encourages saving. Of course some details would have to be worked out concerning how to deal with existing IRAs, but I'm pretty sure that's doable. The issue I have with it is that it's hard to imagine anything simpler than a Roth IRA. Maybe the best thing to do is to simply expand on that concept. Absent anything else on the table, that would be the first thing I would suggest.

If you're here for the first time via the Wall Street Journal site, welcome!

25 years ago today, a bunch of kids mostly from Minnesota and Massachussetts up-ended the world of Olympic hockey and became a piece of American history. Read here.

The Bank of Korea (home of the world's fourth largest reserves) signals a desire to diversify. UPDATE: Brad Setser has more.

Tomorrow brings the release of the January CPI, so it will probably be a quiet day for the dollar as traders await tomorrow's news. This will give us more of a clue as to which way the Fed might be heading at the next two or three meetings.

Read here.

The discussion that started at Angry Bear and macroblog (not to mention the others that have piled on) got me thinking.

We use this word "default" a lot in these debates over the appropriate way to pay for war, pay to restructure Social Security, and otherwise finance our debts. When most people hear the word "default," they probably think of firms which have gone out of business without paying off its debts. Bonds from companies that face this kind of risk carry the adjective "junk" due to the fact that you may not see any return if the firm goes under. Perhaps some people relate default to third-world debt crises. But are the third-world debt crises or the kind of default that results from a firm going out of business appropriate models for the U.S. economy?

I don't think so.

(*I can hear the shuffling of feet and clearing of throats out there in blogland*)

Let me explain. The part of Krauthammer's piece that had everyone in an uproar was the part about the IOUs in the trust fund being worthless. OK, he doesn't say "worthless," he says,

These pieces of paper might be useful for rolling cigars. They will not fund your retirement.

Whatever. This is the rhetoric of default. This is the (overly) dramatic statement of how bad things are. This is the heart of the "worthless IOU" argument.

But it doesn't fly. Krauthammer himself follows with,

To cover retiree benefits, the government will have to exhaust all of its FICA tax revenue and come up with the rest -- by borrowing on the world market, raising taxes or cutting other government programs. (emphasis mine)

And in so doing, he reveals that this is a General Fund problem. The worthless IOU argument was just a distraction. Whether he meant it to be a distraction or not, I can't say. It's an easy trap to fall into, but I'm sure that some writers have set the trap deliberately.

The real problem is not some theoretical point in the future when the U.S. repudiates its debt. Not likely to happen. What we need to be on guard against is the prospect of the insidious default that is caused by inflation (if the Fed becomes complicit in the borrowing and becomes the buyer of last resort for the IOUs). Another version of default was pointed out by Dave and I will repeat the two paragraphs that make the point extremely well.

Suppose I hold a Treasury security. That, of course, is a payment the government owes to me, and I have every expectation that it will be made. But if, for some reason, there has been a miscalculation, a change in economic circumstances, a change in policy, the government may find that it has to raise my taxes to obtain the revenues to honor those payments. In doing so, it has effectively reduced the return on that security. Distortionary price effects aside -- granted, a major qualification -- why should it matter to me how it happens? Lower my social security benefits, raise my income taxes, whatever. It all amounts to a haircut on that Treasury payment to me.

Because the distributional aspects of these things can matter, blanket haircuts are probably a pretty bad idea -- foreigners, for example, finance a good chunk of our collective borrowing, and they aren't likely to appreciate the opportunity to finance our fiscal imbalances on an ongoing basis. Changes in tax and transfer policies are the way we go because they can be targeted (which gets us to positive versus normative questions, which I'll address below.) But the basic economic distinction is one without a difference.

Precisely.

Bottom line: We need to be careful about what we mean when we discuss (or imply the possibility of) default lest we fall into rhetorical traps. The "worthless IOU" argument is itself worthless. There are undoubtedly other cases where it has been used to get the attention of the reader and then been cast aside when it has served its purpose. Better to be upfront about the more likely (and just as troubling) consequences of too much spending, if that's the point you would like to make.

Krauthammer's argument does not require the "worthless IOU" concept and would be better off without it. And I think we should keep the discussion of Social Security reform honest by refraining from using that argument unless you are willing to apply it to the General Fund problem as well. I am not. I'm more inclined towards Dave's comments noted above.

Looking for a newspaper feed? Check this out. There's more on the site than just the feed links, very interesting stuff.

Inflation pressures appear to be easing. I just hope they don't become complacent. The road ahead is long and winding. Read here.

PGL at Angry Bear critiqued a recent Charles Krauthammer article for essentially calling the IOUs in the Social Security trustfund worthless. Specifically, Krauthammer says,

Let's start with basics. The Social Security system has no trust fund. No lock box. When you pay your payroll tax every year, the money is not converted into gold bars and shipped to some desert island, ready for retrieval when you turn 65. The system is pay-as-you-go. The money goes to support that year's Social Security recipients. What's left over is "loaned" to the federal Treasury. And gets entirely spent. It vanishes. In return, a piece of paper gets deposited in a vault in West Virginia saying that the left hand of the government owes money to the right hand of the government.

These pieces of paper might be useful for rolling cigars. They will not fund your retirement. Your Leisure World greens fees will be coming from the payroll taxes of young people during the years you grow old.

And PGL replies,

If you really believe piece of paper called financial assets are worth nothing, I’ll gladly take all of your cash, funds in your bank accounts, and other financial assets. In turn, I’ll even buy a week’s worth of groceries.

Dave at macroblog posts a detailed response that defends Krauthammer's essential point while pointing out the comingling of positive and normative analysis in Krauthammer's article.

I'll go one step further. Krauthammer is setting up a straw man with the "worthless IOU" argument. But really folks, we've been over this before. This is a variation on the topic that Dave, PGL, and I addressed a couple weeks ago. Click here for my post which has links to the others.

Dave appears to remember that discussion since he correctly points out the positive/normative distinction. Here's what I said back then,

The trust fund is a social contract. In that sense, it's fully funded politically and morally. But I see nothing in the accounting structure of Social Security to suggest that it is fully funded in the strict economic sense.

The meaning of a default here is a breakdown of that social contract. That has real political/economic implications just like a default through the financial markets.

I also called the trust fund a "useful fiction." It's clearly not worthless, but it's just not fully funded in an economic (or accounting) sense. And I can say that with a perfectly straight face while refusing to accept Krauthammer's straw man the way he clearly intends it. Actually, I just read the whole article again leaving out those two paragraphs. It's much better that way. He actually makes a good point about the need to enact reform now, before the outgo exceeds the income in 2018. He doesn't say so in so many words, but I think his argument fits quite well with the view that the Social Security problem is really a general fund problem. (That's a view that I think PGL could accept.)

Dave's explanation of the distinction between Treasury securities and Federal Reserve notes is an interesting way of lifting the discussion to a more abstract level.

But if, for some reason, there has been a miscalculation, a change in economic circumstances, a change in policy, the government may find that it has to raise my taxes to obtain the revenues to honor those payments. In doing so, it has effectively reduced the return on that security. Distortionary price effects aside -- granted, a major qualification -- why should it matter to me how it happens? Lower my social security benefits, raise my income taxes, whatever. It all amounts to a haircut on that Treasury payment to me.

PGL still doesn't totally buy it (see the update at his post), but Dave responds directly to PGL in this comment to his own post.

The thing is, it is seemingly much easier to find your road to collapse by trying to finance imbalances with inflation than it is from explicit taxation or spending reductions. So we appear willing to countenance more "little defaults" with Treasury securities than we are with money. And I'll repeat myself -- if the government raises taxes and reduces the return to the debt I hold in the process, they default. We put up with it (a) because we can verify the state of the world and identify cause and effect; and (b) we can throw the rascals out of office for getting us into the situation if we want to (an idea I know you can embrace).

I think that captures the essential idea. Allow me to just add this point (saying the same thing in different language). PGL asks,

So if the Federal government defaults on its IOUs, what does the Federal Reserve rely on to honor its commitments?

If the Fed is really independent, it can honor its commitment without regard to the Federal government defaulting on its IOUs. The Fed would "simply" have to refuse to be complicit and maintain the value of the dollar (perhaps by allowing interest rates to rise--not pretty, but then refusing to be complicit in a default entails sacrifice). The reverse is the real problem. If the Fed is not independent, that's when its commitment to price stability goes out the window. If the government defaults on its commitments, the Fed is either complicit or not. If it is complicit, we've got all the problems PGL is worried about and then some. If not, then we're ok. I would further state that if the executive and legislative branches believed in the independence of the Fed, they will be less likely to default (in Dave's sense of many "little defaults") because they know they will bear the political cost (part b of Dave's comment).

Thoughts?

...but it does get reflected in the implied probabilities on fed funds futures.

If you haven't seen them at macroblog yet, go there now. If a picture is worth a thousand words, this is worth three grand.

Quick interpretation: We're looking at the next three FOMC meetings here. The market believes that a 25 basis point move is almost certain at the next one (March). By the May meeting, the market considers it most likely that the rate will be 50 basis points higher than it is now. Most likely, two 25 b.p. moves. However, the probability of a 75 b.p. move by that time increased from about 10% to about 15%.

But by July, more uncertainty creeps in. Until very recently, a lot of people might have thought that one of the next three meetings would bring a break in the action--a momentary pause in the rate increases. That probability has taken a hit in the last few days (blue line on his 3rd chart). It is looking very likely that the rate will be 75 b.p. higher in July than it is now. The probability of a full point hike between now and then is over 20% according to the futures market. That could be accomplished by a 50 b.p. hike in one of those three meetings, most likely May or July.

The PPI data macroblog cites would be seen to be the proximate cause, but it's been building in my mind for a while.

We'll keep an eye on this.

Brad Setser points us to an interesting tidbit from the LA Times:

During the transition, less money would be paid into the system even as it paid out at current benefit levels. Bush said earlier this week that he would not rule out paying those transition costs by raising the current wage cap of $90,000 that can be taxed for retirement.

On Thursday, a number of conservatives said that directly contradicts Bush's earlier promise that he would refuse to raise taxes.

At least he waited until after the election--something his Dad didn't do.

But seriously, it's not necessarily a bad idea. You probably wouldn't have to raise it much to have a pretty good bump in revenue (Club for Growth arguments notwithstanding). There are many good reasons to keep the growth of the "cap" small and gradual, but it shouldn't be treated as a sacred cow that arbitrarily cannot be touched.

After all, the benefit structure of Social Security is meant to be progressive. The payroll tax is not. I've never understood this. So, a small, gradual increase of the cap (in addition to the usual inflation adjustment) is not a deal breaker for me, as long as it is just that--small and gradual.

UPDATE: The NY Times has an editorial that makes one think of this as a dynamic bargaining problem. They even propose a solution.

Paul Krugman's latest NY Times piece gets it partly right. First, the not-so-good:

But privatization "as a general model," he said, "has in it the seeds of developing full funding by its very nature." Nice metaphor, but what does it mean? Clearly, he was trying to create the impression of links where none exist.

Swing and miss. Private accounts must be fully funded. (There are no credible proposals to the contrary.) Ergo, if fully funding Social Security is a goal, private accounts represent a means to achieving that goal. Granted, it's not the only way, but it is a way. Seems to me that's the link he [Greenspan] was going for, and it's correct as far as it goes, whether you agree with private accounts or not.

He does get a couple of hits though:

Privatizers claim that financial markets won't be disturbed by all that borrowing because the Bush plan prescribes offsetting cuts in guaranteed benefits for the workers who open private accounts. Mr. Greenspan, who does know a thing or two about markets, put his finger on the reason why those prospective future benefit cuts wouldn't offset current borrowing in the eyes of investors: "Well, the problem is that you cannot commit future Congresses to stay with that."

Valid point in general, so it's a hit. However, I think decision day on this is still many years in the future. The financial markets will not pull the trigger until and unless private accounts are unsuccessful to the point that Congress will be tempted to break the commitment to lower benefits. If you are confident about private accounts, you won't worry about this as much. If you don't think private accounts will deliever the goods, it's an entirely rational point to raise.

Yet the chairman managed to avoid admitting the obvious - that borrowing on the scale the Bush plan requires would substantially increase the risk of a financial crisis. And the headlines didn't emphasize his concession that crucial critiques of the Bush plan are right. As he surely intended, the headlines emphasized his support for privatization.

Two ideas in one paragraph. The first sentence belongs with the paragraph which preceeded it (above). The last part is correct. The headlines did emphasize his [Greenspan's] support for privatization. No doubt about that. Is it what he intended? Well, you could argue that he's been a central banker long enough to know what the headlines would be if he said certain things. The fact that he said them anyway is circumstantial evidence in Krugman's favor.

I can't really comment on the last part of his column directly, though I wish I could. I'll explain why and do the best I can.

One last point: a disturbing thing about Wednesday's hearing was the deference with which Democratic senators treated Mr. Greenspan. They acted as if he were still playing his proper role, acting as a nonpartisan source of economic advice. After the hearing, rather than challenging Mr. Greenspan's testimony, they tried to spin it in their favor.

But Mr. Greenspan is no longer entitled to such deference. By repeatedly shilling for whatever the Bush administration wants, he has betrayed the trust placed in Fed chairmen, and deserves to be treated as just another partisan hack.

I did not see the hearings. I was working on more pressing matters on Wednesday, and on Thursday I was teaching. C-Span sadly has not rebroadcast the hearings, at least not to my knowledge (and I have checked their website every day). Often they replay these in the evenings or later in the week, and I'm very disappointed that they haven't done so this time. I can say that from previous hearings that I have seen on C-Span, the treatment was anything but deferential (at least since the recession) from the Democrats. One of the reasons I watch them is for the entertaining way in which the Democrats verbally lash him and he responds in such a soft-spoken, even-handed way.

However, I did find this quote on Rueters:

"I do have to express skepticism that telling workers losing their jobs ... 'Do not despair. Private accounts are coming' will be less a morale booster than I think you implied," said Rep. Barney Frank, a Massachusetts Democrat.

I suppose you could deliver that line in a deferential manner. It could also be delivered with the implication that he's a partisan hack. Unfortunately, I did not see the delivery, just the words.

Alan Greenspan left out one little word in his testimony to Congress this week: "measured."

What does this mean? It's hard to say for certain right now. We aren't even totally sure what the word itself means for policy, much less what it means when the word is left out of the discussion.

Since the Fed started using the word "measured" in its press releases several months ago, I have interpreted it to mean the following. The fed funds rate will be raised 25 basis points at a time in a series of meetings over the next 18 to 24 months with occasional breaks in the increases. Since then, there has not been such a break. Every meeting since mid-summer has resulted in a 25 b.p. increase. If you would have asked me in June if we would have had a meeting between then and now that left rates unchanged, I would have said yes. I would have been wrong. And yet, in the days leading up to each meeting, I have correctly predicted that rates would go up. Clearly the preponderance of the news since June has been positive. Not enough to please everyone, but enough to render my June definition of "measured" a bit out of step with reality.

So count me as rather unsurprised that Greenspan ditched the word. Maybe it was the right word in June, but no longer. Or maybe the word doesn't mean the same thing anymore.

Today, the markets are expecting rate increases at the next three meetings. The IEM is only looking at the next two, and it agrees. Who am I to disagree? In the absence of any developments between now and then, I think the next two, and quite likely three, are almost a foregone conclusion. After that? Ask again later.

And yet, the long bonds show no fear. Yield on the 10 year is still below 4.2%. In June, I told our local media that such a result would be possible if the financial market believed the Fed was resolute in fighting inflation. After all, in June, there was some upward pressure building on yields as the markets started to turn bearish. I kept repeating that for the remainder of 2004 as I tried to explain the apparent paradox. I still think that my explanation was right for the 3rd and maybe the 4th quarter, but I told people that I would expect to see a little steam coming out of the bond market by the end of the year or early 2005. I'll give myself partial credit on this one. I wouldn't have predicted the yield to be this low in mid-Feburary.

Conventional wisdom would say that the 10 year yield has to start to move up by the time the Fed finally reaches a "neutral" policy stance, whatever that turns out to be. Is this odd situation we find ourselves in due to the fact that foreign central banks are soaking up any bonds we put out there? Brad Setser seems to think so, and it has him worried. However, I think the negative scenario he paints needs a catalyst to get it started. It's unclear precisely what that catalyst might be. (If it was clear, this post, as well as many others on my favorite econ blogs lately, would be unnecessary.) Setser has a rather general hypothesis that should provide us with a good amount of blog fodder.

The current system is delivering rapid growth in China. But that does not mean that the current system does not also impose substantial costs on China. Over the next two years, Nouriel and I suspect those costs will become increasingly apparent, and China's willingness to continue to "overfinance" the US will fall -- forcing the US to start to adjust ...

Obviously, that is a debatable proposition, but given its importance to the global economy, it also something worth debating!

Indeed.

And so, a post that began with the observation that Greenspan failed to say a certain word ends with the speculation that something very critical lies beneath the surface of that story. Interest rates may need to go higher to get foreign private investors to carry the load now being borne by foreign central banks. How high? What is "neutral"? Is neutral enough? These are questions that no one can answer right now, but as Setser indicates, this is an important debate.

For more, see Reuters and the Washington Post, just to name a couple of today's stories. This isn't going away.

I like what they've done with it. Well organized. Everything at your fingertips.

Lucas, Robert. "Making a Miracle" Econometrica 61(2), March 1993 pp.251-272.

Lucas, Robert. "Some Macroeconomics for the 21st Century" Journal of Economic Perspectives 14(1), Winter 2000 pp. 159-168.

With some of my lecture notes based on Parente and Prescott's Barriers to Riches.

"If you're going to move to private accounts, which I approve of, I think you have to do it in a cautious, gradual way."

--Alan Greenspan, Feb. 16, 2005

That is what I've been saying for weeks.

There's more from this NY Times article.

"Could we create the personal accounts without any substantial borrowing for the transition?" [Senator Shelby] asked. "And if so, how?"

"Well," Mr. Greenspan replied, "obviously if you raise taxes, you could."

"What about cutting benefits?" Mr. Shelby asked.

"You could certainly do it that way, too," the chairman said.

Now that's the Alan Greenspan we all know.

Anyway, more on this later. I'm still hoping that C-Span will run it tonight and post a link.

UPDATE: Nothing on C-Span. I am very, very disappointed. But take heart, macroblog has much more.

In the last day or so, speculation has increased that Greenspan may address Social Security privatization when he ascends the Hill today to meet with the Senate Banking Committee.

Will he give his opinion?

The latest Reuters story as of this post is here.

MSNBC story here.

Bloomberg lays it all out here. I especially like the ending:

"John and Jane out in Peoria aren't going to change their opinion on Social Security because of what Alan Greenspan says," he said.

Probably not. If I bump into John and Jane on the street, I will ask them. (I do know a few folks named John in Peoria, none named Jane.)Gotta love the gratuitous Peoria references.

This one, for example, doesn't cut it.

While Social Security reform cannot and must not include tax increases, there is an opportunity to increase economic growth and government revenues by cutting effective marginal tax rates. This is why there must be no “phase-ins” and no “caps” on the 4% of wages that workers should be able to put in their Personal Social Security Accounts. With Personal Accounts with no “phase-ins” and no “caps”, Social Security Reform will act as a 4 percentage-point cut in marginal tax rates on everyone making less than $90,000 per year. This would give a significant boost to economic growth and, over time, Federal revenues.

Anyone selling privatization as a means to growth is selling snake oil. If you want to sell it on other grounds, like participating in a growing economy or being a member of the "ownership society," that's one thing. And I'm sympathetic to privatization for a number of those reasons. But holding up Social Security privatization along with a Laffer curve and saying that it will "give a significant boost to economic growth and, over time, Federal revenues" is raising expectations a little higher than I'm comfortable with.

[Note: I was born and raised a Minnesotan with a gift for understatement. You are free to interpret the last sentence in light of that fact.]

Thanks to PGL at Angry Bear for the link.

Read here

Not enough time for deep analysis tonight, but suffice to say that The Economist is supportive of privatization. They also provide a counterpoint to the many critics who point to the British experience as a reason to avoid privatization. More here.

If you don't have a subscription to The Economist, get thee to a library once a week. Good stuff.

UPDATE: Brad DeLong is not amused. Now, I should clarify that while I still think The Economist is good reading, I clearly don't follow them blindly.

While DeLong makes some good points, he doesn't address this article or these comments specifically.

However, in both Sweden and Australia, as in Chile, the new accounts are mandatory, while in America they will be voluntary. To find out how voluntary accounts have worked, Americans need to look at Britain, where Margaret Thatcher introduced them in 1988.

That should be enough to put them off the idea for good, according to Mr Bush's critics. In their version of history, Britain's experience was a disaster, in which people who opted for individual accounts were made worse-off by pension mis-selling. Fortunately, the critics are wrong.

To be sure, pensions were mis-sold in the late 1980s and early 1990s: the bill for putting things right was £12 billion ($22 billion). But the mis-selling was out of employers' defined-benefit plans, not out of the state system. Many people were lured away from generous employers' plans into funded individual pensions when they would have been better off staying with their employers' schemes. “Mis-selling was not about people being sold private pensions when state pensions would have been better for them,” says Philip Booth, the editorial director of the Institute of Economic Affairs, a think-tank.

Britain's mis-selling scandal occurred within a distinctive pension system that had long allowed employers to provide part of the overall state benefit in return for rebates on part of their payroll taxes. In the late 1980s, this right to “contract out” was extended to individuals, who were also given the right to leave their employers' plans. In America, as Olivia Mitchell, a member of Mr Bush's pensions commission in 2001, points out, there is no “contracting out” for private workers in Social Security and the new individual accounts will form part of Social Security.

I haven't heard that argument in the American media. I do hear all kinds of talk about how we shouldn't let our system be like Britain's. I'd welcome more on this point from those in the know.

DeLong concludes, quite fairly,

To head off this moral hazard meltdown, a plan should--and the Bush plan appears to--very tightly constrain where the investments can go.

The moral hazard is the temptation to bail out the private accounts whose investments go bad.

I agree, and I did read some of the Bush plan tonight too. He's right. It does appear to offer some safeguards. I'm not completely sold on the Bush plan though. It seems different from the three proposals that had been discussed earlier (maybe just more detailed--I didn't sit with all of them side by side). I think we need to scrutinize it more carefully. And that's what I intend to do. I hope you will join me over the next few months.

I still learn more from one issue of The Economist than from (at least) two issues of American newsmagazines.

Because the madness of March is coming soon.

Enjoy!