Will the disaster in Japan lead to a double dip recession?

Here is a possible scenario I have been thinking about.

It appears likely that the disaster in Japan will cause shortages of a lot of components needed for manufacturing various products, and this will quickly lead to reduced output of a lot of products in plants all over the world because most manufacturing operations use "just in time" inventory management and therefore don't keep a big supply on hand of the components they need to make their products.

The reduced supply of a number of products will then cause a rise in the prices of those products under the laws of supply and demand.

The rising prices of a number of products, especially when coupled with rising energy prices due to the disruption in the Middle East, will lead many people to conclude that inflation is picking up.   This will lead to increased pressure on the Fed to tighten.

If the Fed does indeed tighten monetary policy in the face of these supply-shock rising prices it could trigger a second recession.

The key point is that rising prices due to supply shocks are *not* an indication of an overheating economy that needs to be reined in using monetary policy.  They are just an indication of real shortages of real goods.

Trying to fight price increases caused by real shortages by tightening monetary policy is not a smart choice.  If the Fed lets shortage induced price increases run their natural course the rising prices will reduce demand for the particular goods in short supply until equilibrium is reached, and other industries will not be directly affected.  If the Fed tries to fight shortage induced price increases by tightening monetary policy the demand for all goods, even those not in short supply, will be reduced, and all industries will see a reduction in demand, i.e. a recession.


Discouraged by the focus on deficit cutting

The recent enthusiasm for reducing the deficit has me extremely discouraged.

Job creation is at a pace where we will be back at full employment (say in the 5% unemployment range) in . . . well, never.  We still haven't seen job creation that will significantly reduce unemployment in a reasonable number of years.  A drop in consumer spending caused this recession, so a rise in consumer spending will be required to fix it, but consumer spending, while it has been growing, has not been growing at a pace that would bring down unemployment at a reasonable pace.  There is no particular reason to think that the rate of increase in consumer spending will accelerate any time soon.  Housing prices are continuing to fall, and households are still carrying a lot of debt, so it's hard to see a reason for consumers to start spending substantially more of each paycheck.  In short, there is no reason to expect strong economic growth for the next few years.

In this context, any reduction in government spending, or even any reduction in the rate of growth of government spending, will slow economic growth at a time when we can't afford to be slowing economic growth.  Every $40,000 or so reduction in government spending will be around one more unemployed person.  Since the population is steadily growing, even holding government spending stable will tend to help keep unemployment high. So when politicians of both parties talk about reducing government spending and the deficit, what I hear is politicians advocating for increasing unemployment.

Of course the Conservatives argue that reduced government spending will somehow stimulate private job creation, but I just don't see how.  The only plausible mechanism by which government deficit spending holds back private job creation is by driving up interest rates which in turn reduces real investment.  However, interest rates are at near record lows, so its hard to see how additional reductions in the interest rate would spark much more investment.

In any event, here is what the next few years look like to me at this point.   Congress slows the growth of government spending, or even reduces it, over the next year.  As a result unemployment falls only a percent or two over the next two years at best, and at worst it stays above 9% or even breaks into double digits.  Economic stagnation going into the 2012 election results in Republicans taking the Presidency and possibly the Senate and increasing their numbers in the house.   Then after 2012 government spending is cut at an increasing rate with the government under solid Republican control, resulting in high unemployment continuing and maybe getting worse.

What will 3-10 years of unemployment above 7% mean for America?


Maybe big deficits are the solution, and not the problem

I originally posted this as a comment on On Deficit Proposals, a Failure of Will and Not Ideas on the New York Times Economix blog.  In that blog post it was argued that the deficit has never been controlled because of lack of political willpower to do the right thing.

Maybe the reason that the deficit has not yet been reduced is because reducing the deficit would be harmful to America. Maybe the invisible hand of the political marketplace is arriving at the correct solution (ever increasing deficits) and fending off attempts to undermine the economy via deficit reduction.  Maybe it is not a coincidence that the governments of all wealthy nations run large deficits. Maybe running a large deficit is a necessary element for sustained economic growth.

In order for the economy to not shrink total spending (consumption + investment) has to equal total income. In other words, every dollar earned must be spent one way or another. If less is spent than is earned in a period then in the next period someone is going to have less income because of that reduced spending.

As long as there are adequate profitable investment opportunities available (i.e. every additional dollar spent on real capital yields an acceptable profit) then any income that is saved instead of spent on consumption can be loaned (at interest) to entrepeneurs who will then spend it on capital investment and keep overall spending equal to income.

However, if the supply of savings exceeds the supply of profitable investment opportunities you will see (1) interest rates fall as the supply saved money exceeds the demand for investment spending, and (2) economic growth stagnate or go negative as total spending falls short of total income.

When the economy stagnates the government can rescue the situation by reducing the excess supply of saved income by (1) raising taxes and/or (2) borrowing more and then spending the proceeds.  This keeps the economy growing when it would otherwise stagnate or shrink because savings exceeds spending.  Although nobody talks about it in these terms, maybe the invisible hand of political economy has been making it happen for decades via the mechanism of the government borrowing more and spending more to avert "short term pain" whenever the economic growth starts to go soft.

Maybe exercising political will to reduce the deficit in the face of a stagnant economy would be the worst possible thing to do right now.

People with high income tend to save more of their income.  Policies that shift more of total income to high earners will tend to increase savings, which will in turn make it more likely that the economy will stagnate because savings exceeds profitable investment opportunities.


Why I don't think QE2 will trigger any significant and persistant inflation

I originally posted a version of this as a comment to this blog post:

Why is the Fed doing this? on Econbrowser.com

I wouldn't worry too much about QE2. I don't think the Fed could cause inflation right now with any reasonable amount of QE. Here is my reasoning.

1. In an economy that is 70% consumer spending inflation cannot get very far without corresponding increases in nominal household income. If prices rise without corresponding increases in household income aggregate real demand will fall in proportion to price increases and quickly snuff inflation.

2. Thus, for QE2 to cause significant inflation there has to be some mechanism by which the additional money pouring out of the Fed turns into an increase in household income.

3. One possible mechanism would be that freshly printed money is used for real investment, that creates jobs and thereby creates increases in household income. However, interest rates are already at near record lows and companies are still not embracing real investment, so it seems unlikely that a few more tenths of a percent drop in the interest rate will stimulate significant increases in real investment.  Companies make the decision to invest based on the spread between probable profit from the investment and the cost of borrowing the money to make the investment and if an investment isn't already attractive its still not going to be very attractive after rates fall a bit more.

4. The additional money being used to bid up commodity prices is not likely to result in increases in household income as long as there is excess capacity and high unemployment. Commodity sellers will simply tend to pocket the extra profits from the higher prices and choose not to share those extra profits with their workers (what pressure is there to share with workers with unemployment so high?).

5. Higher commodity prices could result in increased commodity production, which could result in increases in household income. However, the increased commodity supply from increased production will tend to moderate the price increases at the same time that the higher household income is providing income to pay higher prices, so once again inflation will tend to be blunted over time.


Maybe bubbles are not the problem

The other day I was reading another Dean Baker post about how the Fed should have prevented the real estate bubble because the popping of the bubble caused of the recession (The Washington Post Praises Baby Sitter Who Burned Down the House: the Kids Survived).

As I commented on that blog post, Keynes didn't think preventing booms was the right answer. From The General Theory of Employment, Interest, and Money, Chapter 21 - Trade Cycle - Section III:
Thus the remedy for the boom is not a higher rate of interest but a lower rate of interest! For that may enable the so-called boom to last. The right remedy for the trade cycle is not to be found in abolishing booms and thus keeping us permanently in a semi-slump; but in abolishing slumps and thus keeping us permanently in a quasi-boom.
Read all of Chap 21, Section III, for the complete reasoning. Instead of preventing bubbles Keynes thought the key to managing the business cycle was to redistribute income to people who would spend it on consumption:
"Furthermore, even if we were to suppose that contemporary booms are apt to be associated with a momentary condition of full investment or over-investment in the strict sense, it would still be absurd to regard a higher rate of interest as the appropriate remedy. For in this event the case of those who attribute the disease to under-consumption would be wholly established. The remedy would lie in various measures designed to increase the propensity to consume by the redistribution of incomes or otherwise; so that a given level of employment would require a smaller volume of current investment to support it."
From The General Theory of Employment, Interest, and Money: Chapter 21 - Trade Cycle - Section III. In other words, the problem with a boom is that eventually over-investment results in over-supply of the popular assets at which point investors reduce investment spending, which reduces overall demand, which triggers a recession. However, the recession can be avoided if we shift income to consumers when the investors start reducing their investment spending so that overall demand (investment + consumption) doesn't fall.

Reading these arguments from Keynes reminded me of a recent post by Robert Reich who argued that no amount of monetary or fiscal stimulus would fix the recession because the problem is that the middle class has run out of ways to increase their consumption spending:
Ultimately, even if fiscal and monetary policy weren’t deadlocked, we’d still face the same conundrum. Say the White House and Ben Bernanke got everything they wanted to boost the economy. At some point these boosts would have to end. The economy would have to be able to run on its own.

But it can’t run on its own because consumers have reached the end of their ropes.
After three decades of flat wages during which almost all the gains of growth have gone to the very top, the middle class no longer has the buying power to keep the economy going. It can’t send more spouses into paid work, can’t work more hours, can’t borrow any more. All the coping mechanisms are exhausted.

Anyone who thinks China will get us out of this fix and make up for the shortfall in demand is blind to reality.

So what’s the answer? Reorganizing the economy to make sure the vast middle class has a larger share of its benefits. Remaking the basic bargain linking pay to per-capita productivity.
This in turn got me thinking: what if the current recession was a natural and inevitable consequence of the upward redistribution of income America has seen over the last few decades? If the middle class spends every extra dollar of income it receives, but the upper class saves most of every extra dollar it receives, then having most of GDP growth go to the upper classes will result in savings and investment steadily growing while consumer demand grows at a slower rate. Eventually this will result in a situation where the upper classes have fully invested in every existing profitable investment opportunity available at that level of consumer demand and there are few new opportunities for profitable investment because underlying consumer demand is not growing fast enough. At this point the upper classes will cut back their investment spending, triggering a recession unless some other sector (government, consumers, or exports) increases its spending by an equal amount.

You can look at the recent housing boom and bust through this paradigm. As the point of exhaustion of profitable opportunities was reached the financial system started shifting more and more of the excess savings of the upper classes to the middle class through mortgages that were easier and easier to obtain (read sub-prime). This resulted in growing middle class demand for housing which in turn resulted in full employment through growing construction employment. The problem was that because the excess savings were shifted to the middle classes through the mechanism of loans the process could not continue indefinitely. When the middle class could no longer afford to increase their debt service the flow of money from the upper classes to the middle classes abruptly stopped and the recession started.

How to avoid this cycle? It seems to me that the key for steady economic growth is to ensure that every dollar of GDP growth gets more or less distributed evenly on a per capita basis, i.e. if GDP grows by $100 the top 10% income bracket should receive only $10, and the bottom 90% should receive $90. This way consumer demand will steadily grow as GDP grows and the reduced income of the upper brackets will mean that there is a healthy shortage of capital for investment so that every additional dollar of upper bracket income will get spent on profitable investments.

But how to do this? One obvious way would be to make taxes more progressive (raise taxes on the upper brackets and reduce taxes on the middle class) so that middle class disposable incomes and upper class disposable incomes grow at equal rates. Another way would be raise taxes on the upper brackets and increase government spending. Or we could keep taxes low and have the government borrow the excess savings of the upper brackets and then use deficit spending to support demand. Or we could devalue the dollar to make our industries competitive in the global market and increase demand for exports. Of course it is easy to find flaws with each of these approaches, but doing nothing will result in a perpetually stagnant economy.


Genetic mapping and diseases

Today the New York Times ran this article:

A Decade Later, Gene Map Yeilds Few New Cures

This article talks about the fact that scientists have largely been unable to "ferret out the genetic roots of common diseases like cancer and Alzheimer's" using the map of the human genome. Here is a typical example of what has been happening:
A medical team . . . collected 101 genetic variants that had been statistically linked to heart disease in various genome-scanning studies. But the variants turned out to have no value in forecasting disease among 19,000 women who had been followed for 12 years.
This news was not very surprising to me because I have been skeptical about theories linking diseases to genetics for a long time.

There are some diseases that are obviously genetic in origin because they follow straight Mendelian rules (Huntington's Disease, Tay-Sachs, etc.) in being passed from parents to children.  However, it never made sense to me to assume a genetic component to a diseases that didn't strictly follow Mendelian rules.  For example, to my way of thinking if heart disease had a significant genetic component we would expect to see clear statistically patterns of heart disease among the children of two parents who have heart disease, just like we do with Huntington's disease (and we would also expect identical twins to always both get the disease).  Also, I have never heard an evidence-based explanation for why would should expect common diseases to have a genetic link.  Most of the explanations I have heard have been basically "just-so" stories, along the lines of "we don't know what causes this disease so it must have a genetic origin" and/or "children of people with this disease have an increased risk for it, so it must be genetic."  Neither of these arguments have ever seemed very compelling to me.  Maybe diseases just happen.  Maybe children are exposed to the same environmental factors as parents.  Maybe there is a behavioral causes that gets passed down by parents teaching their children.

What seems odd to me is that scientists seem to be doubling down on the genetic theory of disease rather than using the recent failures of gene mapping as a wake up call that they need to be investigating new theories for the causes of these diseases:
But with most diseases, the common [genetic] variants have turned out to explain just a fraction of the genetic risk. It now seems more likely that each common disease is mostly caused by large numbers of rare variants, ones too rare to have been cataloged by the HapMap.
The underlying assumption here is that diseases must have a genetic cause, so when studies fail to find a few genetic variants causing the diseases then the theory automatically becomes that each disease must be caused by a large number of different genetic variations. But what about the possibility that these common diseases are not linked to any flavor of genetic variation? What if these diseases are exclusively caused by environmental or behavioral factors? Why discount that possibility?

I think two factors favor researchers pursuing genetic theories of disease. One is pretty obvious: if a disease is caused by genetics then it increases the probability that it can be treated with a drug, and drugs are very profitable.  The other factor is that a genetic origin of disease relieves people of guilt and/or pressure to change their behavior.  If a disease is caused by behavior then people with the disease tend to feel guilty about inflicting the disease on themselves, and they feel pressure to change their habits, neither of which is emotionally comfortable.  The same emotional discomfort holds for diseases with environmental causes (avoiding environmental factors requires changes in behavior).  Finding a genetic cause for a disease takes the social and emotional pressure off people.

Another quote from the article that I think illustrates narrow-mindedness in the scientific community:
At this point, some 850 sites on the genome, most of them near genes, have been implicated in common diseases, said Eric S. Lander, director of the Broad Institute in Cambridge, Mass., and a leader of the HapMap project. “So I feel strongly that the hypothesis has been vindicated,” he said. But most of the sites linked with diseases are not in genes — the stretches of DNA that tell the cell to make proteins — and have no known biological function, leading some geneticists to suspect that the associations are spurious.
 What about the possibility that these stretches of DNA with no known biological function are controlling stuff using mechanisms we haven't even conceived of yet?  What if the protein coding genes are just one small part of a vastly more complex biological control system that we haven't even imagined yet?

Towards the end the article provides support of my theory that there are complex things going on in the genome, and biology, that we haven't even begun to imagine:
But while 10 years of the genome may have produced little for medicine, the story for basic science has been quite different. Research on the genome has transformed biology, producing a steady string of surprises. First was the discovery that the number of human genes is astonishingly small compared with those of lower animals like the laboratory roundworm and fruit fly. The barely visible roundworm needs 20,000 genes that make proteins, the working parts of cells, whereas humans, apparently so much higher on the evolutionary scale, seem to have only 21,000 protein-coding genes.
The slowly emerging explanation is that humans and other animals have much the same set of protein-coding genes, but the human set is regulated in a much more complicated way, through elaborate use of DNA’s companion molecule, RNA.
If roundworms and humans have approximately the same number of genes doesn't that scream that genes are not where the interesting stuff is happening? Is anyone looking to find out what that something else is that makes the difference between humans and roundworms?

I have no idea what the answers are, but it seems to me that there are all kinds of red flags that our basic paradigm about genes, the genome, biology, and diseases are fundamentally unsound on some level and a major paradigm shifting discovery is out there waiting to be made.


It feels to me like we are drifting towards a double-dip recession

This morning I read a piece by Robert Reich that made me think to myself "exactly! this is what is going on":

Why We're Falling into a Double-Dip Recession

The past few months I have felt that we were at risk for a double-dip recession, primarily because I don't see anything that would spark and sustain strong growth in consumer spending and without that the economy is going to be very fragile. The past few days I have been getting the feeling that the double-dip may start soon. First there was the various European debt crises. Then there was Dean Baker pointing out that mortgage applications have dropped to very low levels, which to me points to very soft housing sales in the next few months which in turn could trigger another collapse in housing prices. Then there was the stock market getting into a pattern of wild daily swings of over 1%, which to me is always a sign that a new major trend is struggling to come out of its shell (I think these daily wild swings happen when the market as a whole no longer has clear vision of what the future holds and without stable expectations for the future the market reacts strongly to daily events). Then there was the news that in April consumer income rose at a healthy pace, but consumer spending did not. And then there was the horrible jobs report yesterday showing almost no growth in employment once you net out temporary census jobs.

And then there are people like David Leonhardt at the NY Times who think the prospects for the economy are looking so rosy that it's time to start cutting government spending:

Jobs Bill vs. Deficit, a Showdown in the Senate

When I read stuff where people saying the future looks bright for the economy the arguments just seem weak. For example, let's look at each of the arguments made in this piece. Argument number 1:

Since the recession’s nadir, in January 2009, the job market has improved at the most rapid pace since 1983. On Friday, forecasters expect the Labor Department to report that job growth continued to accelerate in May.
He makes it sound like jobs have been growing steadily since January 2009, but if you look at this graph of total nonfarm payrolls it sure looks like jobs have only been growing since January 2010:

Couple that with Friday's report showing dismal growth outside of temporary census jobs and I don't see this as a sure sign that happy days are here again. Next argument:
Corporate executives are becoming more upbeat, surveys show. Business travel has picked up. Silicon Valley firms are doing more deals. Nissan broke ground last week on a car battery plant in Tennessee, and Chrysler is adding 1,100 jobs at a Jeep plant in Michigan.
Those are all good signs, but not really a slam dunk case for optimism. And that is it for Mr. Leonhardt's arguments for why we can stop worrying about economy and start worrying about the deficit. Convinced?