Alien Employers or: How I Learned to Stop Worrying and let the World Run a Current Account Surplus

Meet your new boss.

Back when the Greek crisis was just breaking, I remember having my morning coffee, still half asleep, TV turned on in the background, when I heard a news reporter ask an interesting question. I put my coffee down and turned to the TV. The Parthenon was in the background, communist banners were draped about, and small smokey fires burning here and there. And the reporter, standing excitedly in the middle of all this, rather earnestly asked what I thought was a very good question: Why should Germany even consider bailing out Greece? 

Then, with hardly a pause, he breathlessly began to explain why. His answer went something like this...

"Why?! Let me tell you why, people..." [turns head to the left] "As I look over here, I see and Audi and a BMW..." [turns head to the right] "...and as I look over there, I see a Mercedes and a Volkswagen!" [turns to camera--big light bulb flashing over his head] "Greece is an extremely important export market for Germany!"

Well, as the following diagram shows, this certainly does appear to be the case (source):

So as far as I can gather, what the fellow is trying to tell us is this. The Germans should forgive Greeks their debts because, well, how else will the Greeks continue to afford importing German-made cars? After all, it is the Greek consumer that is selflessly keeping the German autoworker employed. Moreover, it has been a fine recipe for keeping German unemployment low, and growing German wealth. Yes, that's right...wealth in the form of...well, you know...grade A assets, like Greek government bonds.

Now where on earth might a fellow get an idea so bizarre as this? Well, how about here: Germans and Aliens (Paul Krugman):

But the Germans believe that their own experience shows that austerity works: they went through some tough times a decade ago, but they tightened their belts, and all was well in the end. Not that it will do any good, but it's worth emphasizing that Germany's experience can only be generalized if we find some space aliens to trade with, fast. Why? Because the key to German economic affairs this past decade has been a truly massive shift from current account deficit to surplus. 

Now, other countries within Europe could emulate Germany's past if Germany herself were willing to let its current account surplus vanish. But it isn't, of course. So the German demand is that everyone run a current account surplus, just like they do -- something that would only be possible if we can find someone or something else to buy our exports. It remains remarkable to see with how little wisdom the world is governed.

Now, I'm not sure whether any German really has made an explicit demand for all countries to run current account surpluses. But if anyone did, it would clearly be silly. The current accounts of all countries must necessarily sum to zero; at least, in the absence intergalactic trade.

But then, that sort of gave me an idea. Why not a world current account surplus?  What is an account, anyway? It's just a book-entry object. Let's give the account owner a proper name. And what's in a name? May as well call the account holder "Space Alien," with a "local" delivery address, say, the Pacific Ocean.

Next step. Contract some agency to print up Space Alien bonds, rate them AAA, then use them to acquire goods from all over the world, including ocean vessels. That should lower world unemployment. Then load the vessels with the newly purchased cargo, sail them out to their delivery point (the mid Pacific, say), and sink them all. (This last step is absolutely necessary, as sending the goods to any country on earth will mean job-killing imports for that country, jeopardizing their current account surplus).  Alas, the Space Aliens will ultimately have to default on its debt but, you know, who really cares? Just means more work is needed to replenish our lost wealth.

Now, if you think this sounds a little loopy, let me direct you to this: Fake Alien Invasion Would End Economic Slump.

Of course, this is all just a variation of the old Keynesian prescription of employing people to dig up holes and fill them up again. And, contrary to what you may be thinking, the purpose of this post is not to argue against the ability of such a program to increase net employment. What I want to question instead is why running a current account surplus is necessary for all this hocus pocus to work? 

Here's an idea. Instead of exporting vehicles to Greece, why don't German car manufacturers ship their cars to domestic German residents instead? The domestic purchasers could pay for the cars by issuing fake paper, just like their foreign counterparts. And when the time comes to default, well, at least all the BMWs, Audis, Mercedes, and Volkswagens will be residing on German soil. 

The regional dispersion in U.S. vacancy and unemployment rates

Since I happen to have handy some regional data on the help-wanted index (HWI) for the U.S., I thought it might be interesting to see whether U.S. vacancy and unemployment dynamics in a cross-section display any interesting patterns. (I would like to thank Kyle Herkenhoff for suggesting this exercise to me).

The regional HWI data is from the Conference Board. I explain here how the data was corrected for the recent substitution from print to electronic media in job advertising activities. That data was constructed for 36 U.S. cities.  I construct a "vacancy rate" measure by dividing the HWI by the labor force and normalizing to 10  in 1990:1. Here is what the aggregate data looks like:

As one would expect, there is a strong negative correlation between vacancies and unemployment; this is the so-called Beveridge Curve.

Labor economists sometimes like to gauge labor market conditions by constructing a "labor market tightness" variable--the ratio of vacancies to unemployment, or the v/u ratio. The v/u ratio plays a prominent role equilibrium unemployment theory; see Diamond, Mortensen and Pissarides. As the following diagram shows, labor-market-tightness is highly procyclical.

Regional Patterns

The following diagram plots the unemployment rates for 36 metropolitan areas in the U.S. The solid black line is a population-weighted average (it corresponds to the national unemployment rate).

The figure shows that there is significant disparity in regional unemployment rates at all points in the business cycle. As the U.S. economy emerged from the recession in the early 1990s, regional variation in unemployment rates seems to have declined for the rest of that decade. Nothing much changed until the most recent recession, where we see a dramatic increase in both the average unemployment rate and its in its dispersion across regions.

Next, let's take a look at regional "vacancy rates" (the city-based HWI divided by regional labor force).

The dispersion in regional vacancy rates appears to be very, very large (measurement error?). Using my eyeball metric, it appears that the dispersion in vacancy rates is somewhat procyclical. In particular, look at how the dispersion appears to increase throughout the 1990s expansion--at the same time, the dispersion in unemployment rates is declining. This suggests that the dispersion in labor-market-tightness is procyclical; and indeed, the following diagram shows this to be the case.

It would be interesting to know what might be behind these regional differences in labor market tightness, and why this regional dispersion varies over the business cycle.

First, what accounts for the dispersion? In a basic Mortensen-Pissarides labor market search model, extended to incorporate regions, I think that the labor-market-tightness variable is likely to equate across regions (at least, allowing for factor mobility). Regional differences in tax rates, etc., might account for some of the disparity. But the measured disparity is huge.

Second, what accounts for the cyclical properties of the dispersion? Is it simply the case that some regions are populated by industries that are more cyclically sensitive to aggregate shocks? Or is it the case that the shocks themselves are concentrated in certain regions, with the effects propagating to other regions of the country?

If anyone would like to see this data plotted in a different way, or see some statistics reported, feel free to let me know. (Thanks to Constanza Liborio for preparing these graphs.)

The China Factor

The sovereign debt crisis in Europe has garnered most of our attention as of late. But should Europe really be our main concern? For several months now, many economists (including myself) have been casting a nervous eye over to China. Paul Krugman summarizes these concerns nicely in his NYT article today: Will China Break? Mark Gongloff earlier asked the million dollar question here: China's Shadow Banking System: The Next Subprime?  Hmm...

P.S. And what's with these stories I keep hearing about China's missing bosses? (e.g., China's Vanishing Factory Bosses). Sounds ominous, if true. We truly do live in interesting times. 

Beveridge Curves for 36 U.S. Cities (updated)

On October 9, 2010, I posted some regional vacancy-unemployment data for the United States; see: Beveridge Curves for 36 U.S. Cities.

My measure of vacancies was the Conference Board's help-wanted index (HWI).  A colleague of  mine (Silvio Contessi) pointed me to a paper by Regis Barnichon (EL 2010) that identifies a major flaw in this data series. Barnichon summarizes the problem here:

The traditional measure of vacancy posting is the Conference Board Help-Wanted Index (HWI) that measures the number of help-wanted advertisements in 51 major newspapers. However, since the mid-1990s, this “print” measure of vacancy posting has become increasingly unrepresentative as advertising over the internet has become more prevalent. Instead, economists increasingly rely on the Job Openings and Labor Turnover Survey (JOLTS) measure of job openings. However, this measure is only available since December 2000 and cannot be used to contrast current labor market situations with past experiences.

In this paper, I build a vacancy posting index that captures the behavior of total—“print” and “online”—help-wanted advertising, by combining the print HWI with the online Help-Wanted Index published by the Conference Board since 2005. 

Here is how Barnichon's correction looks for the aggregate data.

That is, the secular decline (blue line) in the original HWI series is estimated to be entirely the consequence of a substitution away from print to electronic forms of job advertising.

With this in mind, I asked my tireless research assistant (Constanza Liborio) to recalculate our regional Beveridge curves using Barnichon's correction (for those interested, I can email you a file describing the exact procedure employed).

The regional vacancy data was purchased from the Conference Board (their Help Wanted Online data series), so unfortunately, I cannot make it available to you without their permission. I have permission to display the data, however. Here is what we get.

Addendum: Dec. 13, 2011

As I have stressed in an earlier post, one should be careful in using these raw correlations to identify the source of disturbance; see: Interpreting the Beveridge Curve.

A reader points out that the Monster Employment Index (available since 2004) might be of some use for measuring regional employment opportunities. 

On Bagehot's Penalty Rate

What principles should govern the way a lender-of-last-resort (LLR) operates during a financial crisis? On this question, one is frequently referred to two key principles, attributed to Walter Bagehot in his book Lombard Street. The two principles are usually summarized as "lend freely and at a penalty rate." What does this mean?

In "normal times," firms regularly borrow cash on a short-term basis (say, to meet payroll). These loans are usually collateralized with a host of assets (e.g., accounts receivable, property, securities). The dictum "lend freely" in this context means to extend cash loans freely against the collateral that is normally put up to secure short-term lending arrangements.

The rationale commonly offered for the LLR is that during a crisis, "perfectly good" collateral assets are either no longer accepted as security for short term loans, or that if they are, they are heavily discounted (e.g., a creditor will only lend 75 cents for every dollar in collateral, instead of the usual 99 cents). Whatever the ultimate cause, this type of "liquidity crisis" creates havoc in the payments system. This havoc can be avoided, or at least mitigated, by a LLR that stands ready to replace the "missing" lending activity. (Or so the story goes.)

Let's say that the normal discount rate on high grade collateral is 0 < d < 1. So if a creditor offers to lend $99 for every $100 in collateral, d = 0.01 (one percent discount). Let's suppose that during a crisis, the discount rate rises to c > d. (If c = 0.5, then there is a 50% discount or "haircut" on collateral.) One issue that the LLR must address is the discount rate it should offer on an emergency loan. Let me call this discount rate p.

Now, if the LLR sets p = c, then what is the point of having an LLR? So clearly, if the LLR is to influence lending activity in any manner, it must  set p < c. Opponents of LLR activity like to label p < c a "bailout." (This term is rarely defined precisely; it appears to be a label to attach to programs that one does not like.)

At the other extreme, the LLR could set p = d. In this case, the LLR is discounting collateral in the same way that the market does during "normal" times. If the LLR instead set p > d, it is charging a "penalty rate." (Note: I do not think that Bagehot ever used this term.) How should the LLR set this penalty rate and why? Here is Bagehot:

First. That these loans should only be made at a very high rate of interest. This will operate as a heavy fine on unreasonable timidity, and will prevent the greatest number of applications by persons who did not require it. The rate should be raised early in the panic, so that the fine may be paid early; that no one may borrow out of idle precaution without paying well for it; that the Banking reserve may be protected as far as possible. (emphasis, my own)

Well, O.K., so he does not appear to answer the question of what discount rate to apply; only that it should be "very high." But I am less interested here in the precise penalty rate as to the rationale for why a penalty rate is necessary. A colleague of mine (who appears to have done a great deal of reading in the area) suggests that the rationale was primarily to ensure that the Bank of England did not run out of reserves (an event that would have led to its failure, and the subsequent end of civilization in the minds of many at the time).

Of course, the Federal Reserve Bank of the United States does not face the prospect of running out of cash reserves, the way that the Bank of England did back then. This is because "cash" back then took the form of specie (gold and silver coin). "Cash" today takes the form of small denomination paper notes (and electronic digits in reserve accounts) that the Fed can issue "out of thin air." In light of our modern institutional structure, I wonder whether Bagehot, living in today's world, might not have dropped his "penalty rate" dictum?

Is there any good reason left for the penalty rate? Perhaps there is. But it is clearly of second-order importance during a financial crisis. First, lend freely. It is probably not the time to worry about this penalty rate or that penalty rate in the depths of a liquidity crisis. If an institution is deemed, after the fact, to have benefited "unfairly" at the expense of society during an emergency lending episode, then a "fee for service" (i.e., tax) could be applied after the crisis has passed.

P.S. Would be interested to hear from historians on this subject.

Postcript: January 30, 2012
I would like to thank Josh Hendrickson for sending me the link to this paper:

Turning Bagehot on his Head.
Abstract: Ever since Bagehot’s (1873) pioneering work, it is a widely accepted wisdom that in order to alleviate (ex ante) bank moral hazard, a lender of last resort should lend at penalty rates only. In a model in which banks are subject to shocks but can exert effort to affect the likelihood of these shocks, we show that the validity of this argument crucially relies on banks always remaining solvent. The reason is that when banks become insolvent, Bagehot’s prescription dictates to let them fail. Penalty rates charged when banks are illiquid (but solvent) then reduce banks’ incentives to avoid insolvency ex ante and thus increase bank moral hazard. We derive a condition which shows precisely when this effect on ex ante incentives outweighs the traditional one and show that it is fulfilled under plausible scenarios.

A bridge over the macroeconomic divide

No one can deny that Paul Krugman is a gifted expositor of economic ideas. His column today, "Death by Hawkery," constitutes a fine example of this skill in action.

What I found most interesting in this column is something that would have almost surely escaped his average reader. In particular, I noticed that in telling his basic story, he appealed to a mathematically explicit model of credit cycles written by Nobu Kiyotaki and John Moore (JPE 1997).

Why do I find this interesting?

Well, first of all, I notice that at the time, Kiyotaki was affiliated with that great "freshwater macro" department at the University of Minnesota. You will also notice that the arch-devil Ed Prescott is thanked (among others) for his "thoughtful comments and help" on the paper.

I mention this because I think that Krugman has in the past overemphasized the disagreement that exists among the newer cohorts of macroeconomists (one could make the case that disagreement was much greater in the past); see, for example, here: Disagreement Among Economists. On this matter, I side with Steve Williamson, who I think has rightly taken Krugman to task on this issue; see here and here.

Secondly, I find it interesting that the mechanism highlighted by Kiyotaki and Moore in no way relies on nominal or real price rigidities. It is, in fact, a real business cycle model. Yes, you heard me correctly: Paul Krugman is appealing to an RBC model to help him account for recent events. (Granted, it is an RBC model that incorporates limited commitment, a friction that plays a prominent role in all modern macro theory; see my post here: Asset Shortages and Price Bubbles: A New Monetarist Perspective).

I think this constitutes evidence that the great macroeconomic divide is not as great as it is sometimes portrayed. Most of the disagreement I am aware of is of the gentlemanly "let us agree to disagree" type. But there is no fundamental disagreement in basic macroeconomic methodology among most academic macroeconomists. (There are, of course, healthy and welcome challenges from the fringes of the profession.)

Now for some comments on the economic ideas.

As you may have gathered from my previous post, I am generally sympathetic to the idea of expanding the supply of U.S. treasury debt at this time (with a commitment to unwind in the future, if and when economic conditions improve). Of course, a big question is what to do with the funds acquired in this manner. I'm with Krugman in that heck, we may as well use it to build physical capital (public infrastructure). Financing a corporate tax cut to stimulate domestic private capital spending might be a good idea too (not so politically popular though).

These provisional policy recommendations suggest themselves to me by way of a class of "new monetarist" models that I like to use to organize my thinking about things. But I should say, however, that I'm still not sure just how seriously to take these models (at least, their current incarnations). I'm still a little sketchy about how one might plausibly generate negative real rates of interest in these models; that is, models that take seriously the intertemporal production capabilities of actual economies (you will note that Krugman abstracts from physical capital in telling his little story).

I can't help but note that this same class of models might be used instead to support "conservative" policies. In particular, one force that can potentially drive the expected marginal product of capital (real interest rate) lower is the rational (or irrational) expectation of a future regulatory/tax burden paid for by capital accumulators of all types (including human capital).

If (and I emphasize the if) this is the (or a significant part of the) fundamental problem (and how do we really know that it is not?), then it is hard to see how treasury debt expansion and/or inflationary policy is going to solve it. Fixing the problem in this case means providing an environment that rewards private investment. Death by Dovery is also a possibility. 

Not enough U.S. debt?

One way to measure the ability to service debt is to compute a debt-to-income ratio. Suppose, for example, that your income is $50K per year, that your home is worth $200K, and that you have a $150K mortgage. Then your debt-to-income ratio is 150/50 = 3; or 300%.

Similarly, one way to measure the ability of a country to service its national debt is to compute debt-to-GDP (a measure of domestic income) ratio. The ratio of U.S. federal debt to GDP is currently close to 100%.

Of course, what has a lot of people worried is not the level, but the trajectory, of this ratio. Clearly, the debt-to-GDP ratio cannot rise forever.

No, but on the other hand, there is some evidence to suggest that it can feasibly go much higher. (Whether it should be permitted to do so is a different question, of course.)

Before I go on, I want to clear up a misguided analogy that I frequently hear repeated. The misguided analogy is the idea of the government behaving like a household running up a massive amount of credit card debt.

If this is the way you like to think about things, let me ask you this: Which of your credit cards charge you 0% interest? I ask because that is the interest rate creditors around the world are willing to lend to the U.S. federal government. And what sort of credit card company starts to reduce the interest it charges on your debt as you become progressively more indebted (see the figure above)?

In fact, the terms are even much better than 0%. The real cost of borrowing is measured by the real (inflation adjusted) interest rate. As the figure above shows, the real cost of borrowing has plummeted over the last decade for the U.S. government. As the following figure shows, the U.S. government can now borrow funds for 10 years at close to zero real interest. It can borrow funds for 5 years at a negative real interest.

Now, a negative real rate of interest is a pretty cool deal. Imagine importing 100 bottles of beer from China today, and having to return only 99 bottles next year. If the interest rate remains unchanged one year from now, you can rollover your debt and make a profit. For example, you could borrow another 100 bottles of beer from China, use 99 of these bottles to pay off your maturing obligation, and then drink the remaining beer for free. (Of course, domestic beer brewers would become upset at the lack of demand for their own product, but maybe they can be bribed with free Chinese beer?)

Before we get too carried away, however, I explain here why these very low real rates constitute bad news.

Why are real rates so low?

My own view is that this phenomenon, at its root, has little to do with Federal Reserve or Treasury policy. I believe that the decline in real rates on U.S. treasuries reflects a steady change in how agents and agencies around the world want to structure their wealth portfolios. There has been a massive substitution away from many asset classes into U.S. treasuries; and it is this fundamental market force that is driving real interest rates lower.

The phenomenon began in the early 1990s, with the collapse of the Japanese stock market. Then Mexico in 1994, the Asian crisis 1997-98, Russia in 1998, and Brazil in 1999; see Bernanke (2005). Investors became rationally pessimistic about the returns to investing in these countries, as well as similar countries that had not yet experienced crisis. The natural effect of this would be capital outflows from these countries into relative safe havens, like the United States.

The basic thesis here is very much related to what Ricardo Caballero calls a "global asset shortage." See his discussion here and here; and my own discussion here and here.

The global investment collapse associated with the recent recession has pushed already low real rates lower still. There has been a flight to U.S. treasuries not only by foreigners, but this time by Americans too. Evidently, the perceived return to domestic capital spending remains low. (Some basic theory available here.)

Policy 

Given this pessimistic outlook, it seems unclear what monetary policy can do (the Fed is largely limited to swapping low interest currency for low interest treasuries).

I do, however, believe that there may be a role for the U.S. treasury (in principle, at least). In particular, given the huge worldwide appetite for U.S. treasury debt (as reflected by absurdly low yields), this is the time to start accommodating this demand. Failure to do so at this time will only drive real rates lower. For a world economy that is reasonably expected to grow, negative real interest rates imply a dynamic inefficiency. In short, this is the time to start raising real rates, not lowering them (real rates theoretically rise when new debt crowds out private capital, but note that new debt can also be used to finance corporate tax cuts to stimulate investment, if so desired).

Of course, what theory also tells us is that the government should also be prepared to reverse this recommended debt expansion (assuming that tax rates remain unchanged) once the domestic and world economy return to normal. One may legitimately question whether the government can be expected to make these cuts at the appropriate time. If the government lacks credibility along this dimension (or if future governments cannot be expected to abide by policies put in place by previous governments), then political forces may emerge to block an otherwise socially desirable debt expansion. Perhaps this is one way to interpret recent events.