TVHE – Page 166 – The Visible Hand in Economics

Thinking about the US output gap

February 10, 2012/in Macroeconomics, US economics /by Matt Nolan

Via Marginal Revolution I noticed the argument that a drop in lifetime wealth may have reduced potential output, thereby implying that there is a smaller output gap (permanent loss in productive capacity).

Now, I share Scott Sumners concern about this view. It is true that a negative permanent wealth shock will in turn lead to lower consumption – but in of itself this does not imply that it leads to lower output, which is what GDP and potential GDP are measures of.

Tyler Cowen put up the best defence of it when he stated “Simplest response to Sumner and Yglesias is that we may have had a biased estimate of the previous trend, for bubble and TGS-related reasons.” [note, he improved the defence further in response to Krugman here], but I think we need to go a step further and ask “how could we have been past some long term potential output before”? In truth we need an explanation that works for why potential rose and why it fell that uses the idea of wealth.

In order to understand why potential may have risen then fallen we need to ask what factors were influencing the expectations of individuals so that they supplied too much labour/invested in too much capital. We can’t just say “they consumed more” because without the ability to produce we consume more by borrowing and importing – which leads to the increase in consumption and imports canceling out in GDP. We need a reason why production, output, GDP, was higher.

For this we need to rely on expectations. Start with the drop. Suddenly wealth is lower – wealth is the stream of returns on an asset, in the aggregate sense it is the discounted sum of expected income/output that is expected in the economy. A drop in wealth here suggests that peoples expectations of future potential output have fallen – for better or worse. As a result, your expected return on investing is lower – whether that be in skills for work, or whether it be capital in your job.

On the other side, suddenly wealth expectations are higher. Income now has a greater expected rate of return in the future, you are more willing to invest now.

There is a case to be made that, if the rate of return is higher now, you will be willing to invest in order to reap the benefit. Furthermore, you would be willing to supply more labour in order to achieve the capital gain (a return) associated with those “higher house prices” in the future.

If your wealth expectations suddenly fall, you are not willing to invest as much in the future, as the expected real rate of return is lower. You are not willing to work as much given that the return on savings will be lower. As a result, “potential output” would have declined.

Note: You could in turn read these the other way around, it depends on the magnitude of “income” and “substitution” effects from the change in the expected real rate of return in the economy.

Note 2: This is an entirely supply based argument, as it is about potential output. Potential output is the “supply” notion of the economy, while many of the other cyclical issues we discuss are “demand” based.

Sidenote

These shocks exist for any view of “potential output”. And this doesn’t mean potential isn’t a useless concept – it just means that maybe there is a more solid variable we can use to tell us the same thing without the confusion.

Conveniently we measure the UNEMPLOYMENT RATE, and we have a relatively clear and fixed idea of what the natural rate of unemployment is. As a result, the gap between these two is a lot more useful to look at when trying to ascertain whether we are below or above potential IMHO.

Update: Scott Sumner discusses why this doesn’t make sense for the US. However, I think it is a partially workable argument for NZ given the inflationary pressures we were experiencing, the high participation rate, and the amazingly low unemployment rate all prior to the crisis.

Australia and New Zealand in monetary policy

Sorry for my lack of posting recently, my high level of disorganisation is taking its toll at what is quite a busy time for some reason.

As a result, I will post today with a comment I wrote somewhere else – hopefully, one day I can do a real post on this issue 😉

Over at Money Illusion Marcus Nunes links to an interesting post comparing monetary policy outcomes during the GFC between Aussie and NZ. One conclusion is that, during the GFC both central banks did some good work – but Aussie was better (from the market monetarist standpoint).

I stab down a reply stating that I think this is unfair on the RBNZ. I list some reasons why and discuss. Key points are:

I think that the potential output gap suggested are wrongish,
In per capita terms the divergence is much weaker,
Australia had more of a TOT boost – which needs to be taken into account in this framework,
New Zealand suffered a myriad of other “supply side shocks”, which even in the market monetarist framework are expected to lead to an ex-post deviation from trend even with an optimal central bank,
If we stretch things out for the latest data, and look in per capita terms, the RBNZ appears to have got us back to this “trend” once we were finally free of the effects of drought, earthquakes, and regulatory changes.

The one argument I can see pulled out against the RBNZ is the same one being pulled out about the BOE – that they changed the structural framework in banking without compensating for any current drop in money supply indirectly linked to this change. However, even this is a bit rough – given the high level of uncertainty about the impact of those structural changes … in essence “ex-ante” they will have been taking this into account (they were saying it), the impact may have just been larger than they reasonably expected.

A society of Entrepreneurs?

February 8, 2012/5 Comments/in International economics, Labour economics /by Matt Nolan

Is that the future of the labour market, a myriad of “self-employed” entrepreneurs offering services in order to gain income – income that creates a claim on resources that are largely created by capital/machines.

This is what the “three laws of future employment” at new geography suggests to me. (ht Marginal Revolution) .

The laws are:

Law #1: People will get jobs doing things that computers can’t do.
Law #2: A global market place will result in lower pay and fewer opportunities for many careers. (But also in cheaper and better products and a higher standard of living for American consumers.)
Law #3: Professional people will more likely be freelancers and less likely to have a steady job.

Where does this come from? Say that a lot of the fundamental things we consume, both in terms of manufacturing and primary goods, can be mechanized extremely cheaply – with virtually no labour input. In that case, investment in the machines and their maintenance is extremely valuable – and owners will as a result be willing to pay a significant sum (in terms of resources) to those who in turn look after the machines.

If only a very small number of people are required to look after and build the machines, then the rest of society has to move into roles where they do one of two things:

Serve a secondary market of people without access to capital – say making food for their own small group of people, or making clothing.
Offer a service to the owners of capital and the group of people who are looking after it.

In that case, there is likely to be a very very large service sector with a small base of labour manufacturing and primary production that is very productive/capital intensive.

Now why would we expect entrepreneurs, why wouldn’t we see massive scale in the service industry like we have in the other sectors? Well, generally, services don’t fit the “scale” model – economies of scale do not exist in service industries, and as given the value of heterogeniety in the service industry the flexibility of small firms/entrepreneurs would be vital. Lets not forget the internet either, which has reduced the cost of entry into service industries and increased competition.

In a situation where capital is very heavily concentrated (both in terms of physical and human capital – given that a small number of people in the service industry will also have significant talent and be able to extract far more rent than others), I see a role for significant redistribution and a minimum income in this type of environment. As the constraint of scarcity is loosened, the idea of having a government to help ensure a minimum standard of living really becomes more important. The question is, how far along that road are we now?

Wages and costs in December

February 7, 2012/in New Zealand Economics /by Matt Nolan

So the latest labour market statistics are out … and since the “quality-adjusted wage increase” (what is actually just inflation expectations) exceeded “inflation” (proxied by annual growth in the CPI) I thought people might say something about it.

I mean hell, when it was the other way around we didn’t hear the end of it – even when we pointed out why the comparison was weird, and why there were specific one off factors behind the shift.

Now the data is out, its been 30 minutes, and all I see is this and this. Nothing wrong with what they’ve said per see (although it would be nice to point out that the wage increase is for a fixed quality and quantity of worker) – but if they were so keen to make it sound like New Zealander’s were getting poorer before, why not say they are getting richer now. At least be consistent right … 😉

Update: Ahh but this happens everywhere right.

Prices provide a signal, not a cause

January 27, 2012/in Economic theory /by Matt Nolan

Over at the always awesome Stumbling and Mumbling blog (seriously, I could write a post about every single post this guy has done) the question is asked regarding whether society should set a “maximum wage”. While he says that such a policy can be justified in theory he states the following:

My point here is that high CEO pay is not the disease, but the symptom – of the fact that CEOs have too much power. Treating the symptom is not sufficient, and might even be counter-productive.

I would note that, in terms of thinking about “excessive power” we need to ask ourselves about the framework that business works within. Large businesses will be subject to waste, empire building, asymmetric information, and organisational issues – but just because there are issues does not mean that anything can be done to improve them, it may just be the way things are.

The key point is that an “excessive wage” just like a “price” that is “out of whack” is a signal, a symptom, of some underlying issue. It should be a call to try and understand how the allocation of resources is working in the market, and whether any issues exist, not a call to arbitrarily mess around with prices.

Why fear labour market globalisation?

January 26, 2012/13 Comments/in International economics /by Matt Nolan

While reading Rates Blog today I came across the following statement:

7. Training your replacements – The next wave of globalisation is going to hit service sectors in developed economies that have previously been immune to outsourcing to the likes of China or India.

First the manufacturing sectors in America, New Zealand and Australia (Toyota laid off 350 workers there yesterday) were gutted. Now the services sectors face being cleaned out.

The first batttleground we are seeing across the Tasman is in financial services. The media there is up in arms about layoffs in banking as some of the big banks outsource IT services and accounting to India.

This could come here too. It has already happened in chunks of Telecommunications (tried ringing Telecom’s Philippino O18 staff lately?) and will eventually spread to the likes of IT, banking, medical services, media, insurance and legal services. The growth of the Internet is accelerating this shift.

My response? So, in the same way that they’ve lowered the cost of manufactured goods, subsidised them, and done all the work making them – they are now threatening to do the same with the service sector. So they are offering to do all the work for us? Sweet deal!

There are two things to keep in mind with all this:

There may a concern that if they make everything we will make nothing!!! But this is a false dichotomy – in truth, if they can do these things at a truly lower cost, and decide to do it in an environment of free trade they have a comparative advantage and so prices will adjust to ensure that both they and us (with whatever we have a comparative advantage in) are better off. Now, if they are intervening to do this through subsidies it does not mean we are worse off – as their choice to subsidise is implicitly a transfer to consumers (us). The people who truly pay are the tax payers in these other countries.
It is possible that, as globalisation in labour markets gets underway, we experience stagnant or even lower wages in the Western world. However, this is because people who are currently STARVING are now getting the opportunity to pull out of abject poverty and consumer some resources. Globalisation of labour markets will reduce global income inequality, improve the lifestyles of the worlds most poor, and increase the size of the “economic pie” – this is a great thing. As a result of this we may see a hollowing out of the middle class in developed countries in the near term – so what. We could make the argument that the middle class that was artificially holding up their claim on resources by restricting the ability of the very poor to get themselves out of poverty – when we frame it that way does your opinion about what is “morally right” change 😉 [Good post on this sort of issue on Money Illusion]

While reading Rates Blog today I came across the following statement:

7. Training your replacements – The next wave of globalisation is going to hit service sectors in developed economies that have previously been immune to outsourcing to the likes of China or India.
First the manufacturing sectors in America, New Zealand and Australia (Toyota laid off 350 workers there yesterday) were gutted. Now the services sectors face being cleaned out.
The first batttleground we are seeing across the Tasman is in financial services. The media there is up in arms about layoffs in banking as some of the big banks outsource IT services and accounting to India.
This could come here too. It has already happened in chunks of Telecommunications (tried ringing Telecom’s Philippino O18 staff lately?) and will eventually spread to the likes of IT, banking, medical services, media, insurance and legal services. The growth of the Internet is accelerating this shift.

My response? So, in the same way that they’ve lowered the cost of manufactured goods using outsourced companies including Mexico manufacturing, subsidized them, and done all the work making them – they are now threatening to do the same with the service sector. So they are offering to do all the work for us? Sweet deal!