The Dismal Economist

Paul Krugman seems to be visiting Japan these days, at least he has published his second Japan-related column within a few days. Although, contrary to what the title suggests, it is really more about his pet topic, Chinese undervaluation of the yuan and how it hurts US growth. But he takes the concerns about China’s recent sharp increase in purchases of Japanese government bonds (which contribute to a strengthening yen) that Japanese finance minister Yoshihiko Noda expressed a few days ago as a starting point to complain about Chinese currency manipulation and a US government that is lacking the guts to sanction China for this:

Last week Japan’s minister of finance declared that he and his colleagues wanted a discussion with China about the latter’s purchases of Japanese bonds, to “examine its intention” — diplomat-speak for “Stop it right now.” The news made me want to bang my head against the wall in frustration.

You see, senior American policy figures have repeatedly balked at doing anything about Chinese currency manipulation, at least in part out of fear that the Chinese would stop buying our bonds. Yet in the current environment, Chinese purchases of our bonds don’t help us — they hurt us. The Japanese understand that. Why don’t we?

Some background: If discussion of Chinese currency policy seems confusing, it’s only because many people don’t want to face up to the stark, simple reality — namely, that China is deliberately keeping its currency artificially weak.

With a sluggish recovery in the US and continuing high unemployment, chances for the imposition of a temporary tariff on Chinese imports — as demanded by Krugman — are rising in the US. In the meantime, it will be interesting to see whether or not the Japanese will finally start intervening in the foreign exchange market. As I argued previously, I think they should.

Tim Hartford wrote a defense of Economists (“Models tell us more than hindsight“), responding to his FT colleague Gideon Rachman‘s demand to “Sweep economists off their throne“. A few days ago, Rachman wrote in the FT:

When Paul Krugman, a Nobel prize-winning economist, clashed with Niall Ferguson, a famous historian (and FT contributing editor), over how best to respond to the economic crisis, Prof Ferguson’s response was humorously humble. “A cat may look at a king,” he wrote, “and sometimes a historian can challenge an economist.”

As the proud owner of a huge grey Chartreux cat, and a history graduate, I believe that it is time to overturn this implicit intellectual hierarchy. The cats must unsheath their claws and lacerate the kings, ripping away their regal pretensions. The vanity of economists needs to be challenged. Above all, their claim to scientific rigour – buttressed by models and equations – must be treated much more sceptically.

Hartford responds:

I know as little about history as Gideon knows about economics, but no doubt he is right to suggest that an important role of the historian is to emphasise the knotty particularity of time and place, and the difficulty of producing sweeping scientific laws that accurately describe a complex social world. Economists, sociologists, psychologists and anthropologists should appreciate this just as keenly. The best do. Many do not and, sadly, they are over-represented in the media. Perhaps this is the reason Gideon misunderstands the task and the methods of economics.

He argues that while economic edifices are always collapsing, “buildings constructed according to the laws of physics seem to stand”. This is an odd statement. Buildings constructed according to the laws of physics have a habit of falling down. Henry Petroski, engineer and author of Success through Failure, observes that structural engineers tend to learn by constructing ever more ambitious structures. When one of them falls down or wobbles, engineers figure out what was wrong with their models. Sometimes the results are tragic: when the innovative Malpasset dam cracked thanks to inadequate geological modelling, nearly 400 people died. Sometimes they are delicious: the award-winning Kemper Arena collapsed, with no loss of life, just 24 hours after hosting the American Institute of Architects Convention. From his riverside eyrie, I think Gideon can just see the famous wobbly bridge across the Thames. Is this really a damning indictment of the laws of physics?

But, of course, our grasp of the laws of physics is not to blame. The trouble is the difficulty of modelling them in a world with snowdrifts, clay seams and error-prone contractors. In short, buildings, like economic institutions, stand up not because of our grasp of the laws governing them, but because they have survived a process of trial and error in a complex world.

Economic institutions are more complicated and unique than any building. No wonder that progress is so difficult. But Gideon is too quick to dismiss “models and equations”. I agree that macroeconomic models have proved fairly useless. I also agree that economists, like historians, sociologists, political scientists and newspaper columnists, make terrible forecasters. But few academic economists bother to try, and forecasting models represent a small slice of the mathematics deployed by economists.

Paul Krugman’s recent NY Times column reviews the Japanese woes of the past two decades and draws conclusions for US economic policymaking:

In the 1990s, Japan conducted a dress rehearsal for the crisis that struck much of the world in 2008. Runaway banks fueled a bubble in land prices; when the bubble burst, these banks were severely weakened, as were the balance sheets of everyone who had borrowed in the belief that land prices would stay high. The result was protracted economic weakness.

And the policy response was too little, too late. The Bank of Japan cut interest rates and took other steps to pump up spending, but it was always behind the curve and persistent deflation took hold. The government propped up employment with public works programs, but its efforts were never focused enough to start a self-sustaining recovery. Banks were kept afloat, but were slow to face up to bad debts and resume lending. The result of inadequate policy was an economy that remains depressed to this day.

Yet the picture is grayish rather than pitch black. Japan’s economy may be depressed, but it’s not in a depression. The employment picture has been troubled, with a growing number of “freeters” living from temporary job to temporary job. But thanks to those government job-creation plans, the country isn’t suffering mass unemployment. Debt has risen, but despite constant warnings of imminent crisis — and even downgrades from rating agencies back in 2002 — the government is still able to borrow, long term, at an interest rate of only 1.1 percent.

In short, Japan’s performance has been disappointing but not disastrous. And given the policy agenda of America’s right, that’s a performance we may wish we’d managed to match.

In today’s FT Martin Wolf tries to persuade my fellow countrymen that the introduction of the euro was actually benefical for Germany (Germans are wrong: the eurozone is good for them). According to a recent public-opinion poll, half of the German population would like to change the euro back into deutschmark. Albeit I have doubts any of these euro-sceptics will be convinced by Wolf’s arguments, they are to the point nonetheless:

…why […] should Germans accept that they have an overwhelming interest in the success of the eurozone? The immediate answer is that the economy is hugely dependent on exports for demand […]. From 2000 to 2008 external demand generated as much as two-thirds of the growth in overall demand for German output. Germany needs both captive markets and a competitive exchange rate. The eurozone has delivered both, to an inordinate degree: the crisis in the periphery has dragged down the value of the euro; and many of Germany’s eurozone partners (who absorb two-fifths of its exports – nine times as much as China) are uncompetitive, after a decade of rising relative costs.

More important, imagine what would have happened, in the absence of the euro. The exchange rate of the D-Mark would have exploded upwards, as currency crises savaged the European economy, as happened in the 1990s. In peripheral Europe, currency depreciations would have been at least as big as, if not bigger than, sterling’s. The absence of such shocks has greatly enhanced the prospects for the German recovery. The creation of the eurozone was, for this reason alone, much more than a favour Germany did for its partners. It was also a big economic (not to mention political) gain for Germany. German industrialists are clear on this, as is the government.

Wolf concludes that “Germany was (and is) a big beneficiary of the existence of the eurozone. It is in Germany’s interests to push for a future in which the eurozone survives and peripheral countries adjust successfully.” I couldn’t agree more. The same applies to his concluding paragraph:

Germany has an enormous political and economic interest in making the eurozone work, however unpopular that view may be. The euro has been a stable currency: indeed, the rate of inflation has been lower than it was under the Bundesbank. The euro has also shielded the German economy from what would have been still bigger shocks. The challenge is to change the workings of the eurozone and reform its institutions in a way that makes the economy work for everybody. Change is painful. But Germany has no sane alternative.

The New York Review of Books recently published an interesting piece, The Slump Goes On: Why?, by Paul Krugman and Robin Wells. Krugman and Wells discuss the origins of the 2008 crisis and the ongoing policy debates about the response to the crisis and its aftermath.

In their article they refer to three recently published books, namely by Raghuram G. Rajan (Fault Lines: How Hidden Fractures Still Threaten the World Economy, Princeton University Press, 260 pp., $26.95), Nouriel Roubini and Stephen Mihm (Crisis Economics: A Crash Course in the Future of Finance, Penguin, 353 pp., $27.95), and Richard C. Koo (The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession, Wiley, 296 pp., $45.00). It is apparent that they are no big fans of Rajan’s analysis. First, they disagree with his judgement of the “prolonged period of low rates [after the burst of the dotcom bubble] as a terrible policy mistake, setting the stage for the housing bubble”. Second, they oppose Rajan’s view that moral hazard created by government programmes was a major cause of the crisis:

The idea that the government did it—that government-sponsored loans, government mandates, and explicit or implicit government guarantees led to irresponsible home purchases—is an article of faith on the political right. It’s also a central theme, though not the only one, of Raghuram Rajan’s Fault Lines.

They clearly side with Roubini and Mihm’s (“Roubini and Mihm, by contrast, get it right”), which they cite in this context:

The huge growth in the subprime market was primarily underwritten not by Fannie Mae and Freddie Mac but by private mortgage lenders like Countrywide. Moreover, the Community Reinvestment Act long predates the housing bubble…. Overblown claims that Fannie Mae and Freddie Mac single-handedly caused the subprime crisis are just plain wrong.

They also endorse Koo’s argument that the biggest problem facing economies in the aftermath of the burst of a financial bubble lies not in the financial sector but in nonfinancial sectors with too much debt on their balance sheets:

These broader problems of debt and deleveraging arguably explain why the successful stabilization of the financial industry has done no more than pull the economy back from the brink, without producing a strong recovery. The economy is hamstrung—still crippled by a debt overhang. That is, the simultaneous efforts of so many people to pay down debt at the same time are keeping the economy depressed.

To those familiar with Krugman’s thinking it will be hardly surprising that that the article concludes with an endoresement of fiscal stimului:

So what’s the answer? In the short run, the only way to avoid a deep slump when almost everyone in the private sector is trying to pay down debt simultaneously is for the government to move in the opposite direction—to become, in effect, the borrower of last resort, issuing debt and continuing to spend as the private sector pulls back. In the heat of a Minsky moment, budget deficits are not only good, they are necessary. Indeed, the surge in budget deficits around the world between 2007 and 2009 was arguably even more important than the financial rescue in keeping the real estate bust from triggering a full replay of the Great Depression.

Whether or not further fiscal stimulus will help the economy recover remains fiercly debated. In ending the article, Krugman and Wells announce a sequel. I wouldn’t expect any great surpises…

Last week I had a post arguing that the time was ripe for the Bank of Japan (BOJ) to intervene in the foreign exchange market to halt the appreciation of the yen. Today, the FT writes:

The Japanese yen hit another 15-year high on Wednesday despite fresh comments from the Japanese finance minister about the possibility of currency intervention. Yoshihiko Noda told lawmakers on Wednesday that Japan was ready to take “bold measures when necessary” which “naturally… includes intervention.” However, his comments did little to appease the risk aversion that is driving investors to snap up Japan’s currency, fuelled by concerns about the US economy. The yen reached a peak of Y83.35 against the US dollar in Tokyo, surpassing the Y83.52 it hit overnight. It was trading at Y83.48 against the greenback early afternoon in Tokyo. It rose as far as Y106.03 against the euro as the European currency was knocked by renewed concerns about Eurozone financial system.

Concerns are rising about the impact of the strong yen on company profits and the broader economy, which is also putting downward pressure on the stock market. The FT observes that “[w]orries are growing that a persistent rise in the Japanese currency will force companies to shift even more production overseas, further hollowing-out domestic manufacturing and potentially having a negative knock-on effect on unemployment.”

BOJ governor Masaaki Shirakawa is quoted in the FT as repeating “earlier comments that the central bank would take “additional measures” if necessary.” It is clear that the markets have not responded to any verbal intervention of the past months, be it by the goverment or the BOJ. Any further attempts to talk the yen down will be a waste of time. The time has come to let deeds match the words.

While the BOJ and the Japanese government are waffling, China continues to build up her yen portfolio, effectively driving up the yen:

The yen’s strength has also spurred some central banks to add to their yen exposure as they balance their foreign exchange reserves, traders have said, with China being the most recently purchaser. Japanese balance of payments data for July released on Wednesday showed that Chinese direct net buying of Japanese bonds reached a total of Y2,316.1bn for the first seven months of the year. The vast majority of that buying is in bills with a maturity of one year or less. It is not clear exactly how much buying China is doing as trades are recorded from the jurisdiction in which they are executed. So if China buys Japanese bills through a New York-based broker, for example, that transaction is recorded as being from the UK. Net purchases of Japanese bonds from the UK were Y3,095bn in July.

As I argued earlier, it would be wise for Japan to seek a co-operative approach and discuss foreign exchange intervention with the US, China and the Eurozone. If that doesn’t go anywhere, Japan should just go ahead and do it. China, after all, shows that unilateral currency intervention to avoid appreciation of one’s currency is pretty effective.

Yesterday, the Bank of Japan (BOJ), Japan’s central bank, called in an ad hoc policy board meeting where it decided to further extend last December’s special liquidity programme by an additional Y10,000bn ($118bn) six-month credit facility. The effect on the markets, however, was negligible (the yen even strengthen against the dollar). The move was widely expected, and it failed to impress. Indeed, it was symptomatic of the BOJ’s lack of a clear strategy to address the problems the Japanese economy is facing. And problems there are: deflation, a anaemic recovery and – on top of this – a surging yen, which last week hit a 15-year high of Y83.57 against the dollar.

The strong yen is hurting Japanese exports, which are also suffering from the global slowdown. The Japanese government has been trying to talk the currency down. Japanese Finance Minister Yoshihiko Noda, for instance, recently said that “[e]xcessive and disorderly currency moves are harmful for the stability of the economy” and that the government “will keep a close watch on the market and pay closer attention to it.” However, action has been missing, as has been a clear monetary strategy. As noted by the FT, “[t]o cynics among analysts and investors, the flurry of action by Japanese economic authorities […] was more about politics than substance, a somewhat desperate show intended to ensure they are not blamed for a badly faltering recovery.”

In my view, the time is ripe for currency intervention. As I argued a while ago elsewhere, the BOJ could do like most of its East Asian neighbours and intervene in the foreign exchange market to reduce the yen’s value. This would not only ease pressure for the country’s exporter industry, it would also help to address Japan’s deflation problem: whereas continued forex intervention to keep the yuan pegged to the dollar has caused unwanted monetary expansion and inflationary pressure in China, this would exactly be the desired effect of the Japanese intervention. Of course, exchange intervention Chinese style would be a radical measure that would almost certainly trigger complaints from abroad. The ministry of finance, which is in charge of the yen’s exchange rate policy, should thus seek to find a cooperative solution with the Chinese, American and European partners to reduce the yen’s value – a move that might also deflect attention from the bilateral Sino-American currency dispute. (As an aside: itsn’t it somewhat ironic that the continuous purchase of Japanese government bonds by the Chinese authorities is pushing the yen up?)

Given that fears of a double-dip recession in Japan are growing, the Japanese government and the BOJ should not stand idle and watch the yen rise further. I am not arguing that the BOJ should imitate Chinese monetary policy; however, it could operate a “leaning against the wind” policy that it has followed in the past. Moreover, the BOJ should not only start on developing a convincing strategy to combat deflation, it should also think about a better communication strategy.

The Economist published an interesting table with the world’s largest container ports in 1989 and in 2009:

THE changes in distribution and cargo-handling capabilities of the world’s biggest container ports show the shifts that the world economy has undergone over the past two decades. The volume of cargo traded through the world’s biggest container ports has increased nearly sixfold in the past 20 years as globalisation has taken hold. Singapore has now nabbed the top spot and every other big port in 1989 has moved down the list. Twenty years ago more than half of the top 20 container ports were in America or Europe reflecting imports into both regions from around the globe. Now, Asia’s strength as an exporter is more in evidence. Fourteen of the top 20 container ports are in that region, with eight in China.

Today, Tim Besley gave the EEA’s Presidential Address, a lecture on “Fragile States and Development Policy”.  The lecture was a tour de force through his work with Torsten Persson on the causes of fragility and its consequences for development. For instance, in a recent paper called State Capacity, Conflict and Development, they highlight the absence of state capacities to raise revenue and to support markets as a key factor for the persistence of weak states. In The Logic of Political Violence they explain the emergence of political violence with a model where an incumbent or opposition can choose to use violence as a means of acquiring or maintaining power. Interesting stuff. He said they are making a book out of this, which I suppose will be a worthwhile read.

This week, I’ve been attending the Annual Congress of the European Economic Association at the University of Glasgow (a four-day overdose of economics). Last night, Joseph Stiglitz gave the Adam Smith lecture, in which he called for new approaches in macroeconomics. The criticism he raises — of the belief in market efficiency, ignorance of information asymmetries and bubbles, use of representative agent modles, money models without banks and so on — isn’t exactly new, but he certainly has a point, and it ain’t a bad idea of raising this in front of several hundred representatives of the dismal science. His critique of macroeconomics somewhat reminds of Paul Krugman‘s much-cited dictum last year that much of the past 30 years of macroeconomics was “spectacularly useless at best, and positively harmful at worst”, as well as Willem Buiter‘s description of “the typical graduate macroeconomics and monetary economics training received at Anglo-American universities during the past 30 years or so” as “a privately and socially costly waste of time and other resources”. An article Stiglitz wrote in the FT a few days ago gives a brief outline of his arguments. (The lecture itself is not online.) If you missed it, it is also worth reading Krugman’s February 2007 criticism of free-market orthodoxy in the New York Review of Books and The Economist’s cover story from July 2009 on “What Went Wrong in Economics”.