Stuff that bores my wife

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

2011-03-18T06:42:00.000-07:00

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

2011-01-29T06:27:00.000-07:00

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

2010-11-16T05:08:00.000-07:00

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

2010-10-26T07:58:00.000-07:00

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

2010-10-02T05:04:00.001-07:00

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

2010-06-13T09:45:00.000-07:00

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

2010-06-05T05:56:00.001-07:00

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?

Bound and determined to shoot ourselves in the foot

2010-05-15T06:32:00.001-07:00

These days the media is filled with pundits declaring that government deficits and debts are out of control and austerity measures must be implemented to avert disaster. These pieces are all basically the same: governments can't borrow indefinitely! Austerity must be imposed! Here is a typical piece for Nouriel Roubini, the economist who famously predicted the financial crisis of 2008:

Return to the Abyss by Nouriel Roubini

And here is the point of the piece:

While such fiscal stimulus and bailouts may have been necessary to prevent the Great Recession from turning into Great Depression II, piling public debt on top of private debt carries a high cost. Eventually those large deficits and debts need to be reduced through higher taxes and lower spending, and such austerity – necessary to avoid a fiscal crisis – tends to slow economic recovery in the short run. If fiscal imbalances are not addressed through spending cuts and revenue increases, only two options remain: inflation for countries that borrow in their own currency and can monetize their deficits; or default for countries that borrow in a foreign currency or can’t print their own.

Notice that he assumes that austerity, inflation, or default are the only options for countries with "large deficits and debts." He assumes, without explanation, that dealing with a deficit by simply printing money must necessarily lead to inflation. But does it?

A simplistic description of a recession is that a significant portion of the work force is sitting idle because people, on average, are not spending enough money to keep everyone employed. A simplistic description of inflation is too much spending chasing too few goods. A simplistic description of why people think that deficits financed by printing money will lead to inflation is because they think the spending of freshly printed money will outstrip the supply of goods causing inflation.

Here is the question that pops into my head whenever someone talks about the horrors of printing money during a recession: If a significant portion of the population is sitting idle because there is not enough spending, how exactly will printing money to cover a deficit cause inflation?

To think this through, think about what it means for a government to borrow money to finance a deficit during a recession. During a recession people are, by definition, saving too much and spending too little. When the government runs a deficit because of increased spending to counter the recession, and they borrow it from the private sector, they are basically borrowing the money that the private sector should have been spending and spending it for them. Sure there would be a nice accounting balance in the process if the government borrowed this idle money from the private sector and then spent it. But logically, wouldn't the resultant deficit spending be the same whether the government borrowed the money or just printed it? The private sector money that the government otherwise would have borrowed will still be sitting idle because of the recession whether the government borrows it or not.

The only possible difference between a borrowing vs. printing situation is that in a borrowing situation the borrowing demand from the government will increase interest rates, attracting more saving at the expense of private spending, which would make the downturn in private spending worse. That doesn't seem like a good idea.

But isn't all the un-borrowed private money going to cause inflation once the economy turns around?

The savings left in private hands when the government prints instead of borrowing will only cause inflation if it is used for spending. And spending will only cause inflation if it exceeds the available supply of goods and services. Leaving money that otherwise would have been borrowed in the private sector will help accelerate the recovery once the economy starts growing. If and when inflation actually becomes a problem it is easy to choke it off by raising interest rates.

But what if the government keeps printing money even after the economy recovers, that will surely cause inflation!

Remember, the reason the government is running a deficit is because the recession has reduced tax revenues and increased spending on automatic stabilizers (unemployment benefits, etc). Once the economy returns to health the deficit will naturally dwindle as tax revenues increase and automatic stabilizer payments decrease. In short, the government won't have much need to print money once the economy is back to full capacity.

But what about the stagflation of the 70s? Doesn't that prove that you can have inflation during a recession?

The inflation of the 70s was triggered by a huge oil supply shock; there wasn't enough oil to meet even the reduced demand during the recession. We are not currently facing any sharp reduction in the supply of any commodities.

To me the solution to the deficit and debt problem is obvious. Governments should just start liberally printing the money (i.e. have their central banks buy government debt) to finance their deficits during the recession and simply stop adding to their debt burdens. If and when inflation actually starts to creep up above 2-5% have the central bank stop buying public debt, start selling the public debt they bought to soak up the excess money, and start raising interest rates. Easy peasy. No crisis required. No grinding years of austerity measures that throw the economy back into recession and lead to political unrest.

Speaking of austerity measures, whenever someone proposes solving deficit problems during a recession by imposing austerity measures I wonder how exactly triggering another recession through austerity measures can be expected to solve a deficit caused by a recession. Isn't austerity going to lead to a downward spiral of austerity, reduced tax revenues, increased deficit, more austerity, etc.?

To me the fear of printing money to ameliorate a recession seems like ignorant superstition. And the fact that people are advocating prolonging high unemployment and reduced benefits for people in need on the basis of this superstition seems tragic and bizarre. Real people are really suffering right now, and many would have that continue indefinitely rather than run a hypothetical risk of inflation for which there is little or no empirical evidence.

A sensible analysis

2010-02-24T06:37:00.003-07:00

This analysis of the current world economic situation by Martin Wolf seems sensible to me:

The world economy has no easy way out of the mire

As long as private savings remains high on a global level, and profitable private investment opportunities are limited by stagnant aggregate private demand, the global economy is going to be weak. Here are some possibilities I see:

Governments can borrow the excess private savings and invest it in stuff that will help generate new opportunities for private profit further down the road. Downside of this is that it increases the government's long term interest expense burden.
Government repeats the World War II solution: Use deficit spending to buy a lot of stuff, then blow it up and in the process also destroy a large part of the world's infrastructure, thereby creating demand to replace all the blown-up stuff.
Variation on the above: Instead of blowing up infrastructure to create demand to replace it, make existing infrastructure obsolete via regulation, creating demand to replace it. To kill two birds with one stone, target infrastructure that is bound to become obsolete anyways in the medium term (i.e. infrastructure that assume cheap oil, for one example).
Governments take from the rich (who are saving too much) and give to the poor (who will spend every penny) to eliminate the high private savings rate. Presumably through higher taxes on the upper income brackets.
Variation on the above: Governments figure out some way to shift income from developed countries to developing countries and get them to spend it.
Governments can simply print money and spend it (i.e. no borrowing to finance new deficits) to eliminate the gap between demand and income without increasing the long term interest expense burden on governments. I know people think this will lead to inflation, but as long as aggregate demand more or less matches aggregate productive capacity I don't see why it should. When and if the private sector stops saving and starts living paycheck to paycheck again the government can simply stop printing money and/or increase taxes or interest rates to keep demand balanced with productive capacity.

Conservatives don't really care about the deficit or big government

2010-02-23T04:44:00.000-07:00

In his column on 22 Feb 2010 "The Bankruptcy Boys" Paul Krugman talks about the conservative strategy of "starving the beast" of big government by cutting taxes, and asks what spending programs conservatives will want to cut now that the beast is successfully starved.

I think the whole "starve the beast" and "big government is bad" rhetoric from the conservative movement was just a smokescreen. I think that conservatives don't really care how big government is or care about the deficit at all (in the words of Dick Cheney "deficits don't matter"). What conservatives really care about is preserving and enhancing the status and power of the successful as compared to the less successful. They want nothing more than to grow the stratification of society; to enhance the privileges of success. That means favoring programs that reduce taxes, opposing programs that transfer wealth to the lower end of the income distribution, opposing programs to help the lower end of the economic spectrum improve their standing, and opposing regulation that interferes with making profits at the expense of people lower down the economic scale.

Notice that this model of conservative thought is neutral as to deficits or the size of government. Just as the conservatives took up "states rights" back in the era of federally mandated desegregation and then lost interest in it once desegregation was a fait accompli, conservative opposition to big government and deficit spending only surfaces when there is a threat of new or expanded programs to help the lower end of the economic spectrum. Exhibit A: during the Bush era there was no conservative hand wringing about deficits or big government when the military and homeland security portions of the government were vastly expanded.

When desired savings exceeds desired investment

2009-06-14T05:54:00.000-07:00

In his recent lecture series, The Return of Depression Economics, Paul Krugman described the current global economic situation as one where desired savings exceeds desired investment. In other words, a savings glut where people are saving more money than what other people want to borrow to invest in new enterprises.

That got me thinking. What should we expect to see in a recession with a savings glut? What happens when there is more money looking for a place to be invested than there are worthwhile productive enterprises to invest in? One thing that occurred to me is that in the absence of a sufficient quantity of worthwhile investments in productive capacity the excess savings would tend to flow into commodities and assets that are perceived as having the potential to appreciate in value. You don't want to just leave the money in cash or T-bills earning nothing, and commodities at least have the potential to rise.

If the excess savings (defined as the excess in savings over the demand for investment in new productive capacity) flows into commodities (at least in part) its going to drive up the price of the commodities. The rising prices of commodities will push the prices of finished products higher. In non-recessionary times this would lead to inflation. However, since the economy is in recession, with high unemployment, lots of excess productive capacity, and increasing savings rates, the rising prices will reduce real demand. Consumers won't spend more, so rising prices will just result in a reduction in the quantity of goods sold. Falling consumer demand will reduce profits and increase unemployment and at some point the bubble in commodity prices will pop as investors realize that the bubble commodities are sure to fall and stream for the exits.

So, I am seeing the potential in the near to medium term for a pattern of serial asset bubbles in the context of a fundamentally stagnant economy. Excess savings will flow into some asset or commodity, creating a bubble. The bubble will fuel a perception that things are looking up ('green shoots'), drawing more money into the bubble. Prices will rise. Consumers will fail to increase spending to match the rise in prices. The softening consumer demand will put the money invested in the bubble at risk. Speculators will exit the bubble, triggering another slide.

Paul Krugman's Robbins Lectures: The Return of Depression Economics

2009-06-14T04:55:00.000-07:00

I just finished listening to podcasts of Paul Krugman's recent lecture series at the London School of Economics "The Return of Depression Economics." What he was saying made a lot of sense to me, and it didn't leave me feeling optimistic.

You can download MP3s of the 3 lecture series here at the London School of Economics website. You have to scroll down and find them.

You can get the slides that go with the lectures here:

Lecture 1: The Sum of all Fears
Lecture 2: Eschatology of Lost Decades
Lecture 3: The Night They Reread Minksy

The New York Times is already taking 'the recovery' for granted

2009-06-09T09:59:00.000-07:00

I was struck by this headline in today's New York Times:

High Gas Prices Could Slow Recovery

All this green shoots talk has apparently convinced the New York Times that its a foregone conclusion that the recovery will start in the next few months. Here is how I would have written the headline:

High Gas Prices Could Deepen Recession

My view is that high gas prices won't slow recovery, they will kill the "green shoots" outright before they have a chance to grow. If oil and gas prices continue to grow for the rest of 2009 it will cause consumer spending on all other sectors to continue to fall. I don't see how we can have any meaningful recovery if consumer spending falls.

My personal intuition, which I haven't taken the time to try and support with evidence, is that the recession was triggered by the spike in oil and gas prices last summer. I suspect that rising gas prices were the straw that broke the camel's back for a lot of people who went into default on their mortgages.

Did this recession happen because we just ran out of stuff worth doing?

2009-05-30T05:18:00.003-07:00

I posted this comment to a Paul Krugman blog posting noting that this recession was different than most recessions in that with this one interest rates low going into it.

One that that struck me over and over again during the Greenspan years was that GDP was growing at a lackluster rate (around 3%) despite big deficit spending and very low interest rates. It was like seeing a person get a huge doses of amphetamines but still have barely enough energy to drag themselves through the day. It made me think our economy must be on the brink of collapse if the economic equivalent of crystal meth was required to just make it seem normal.

Keynes once said that the long term interest rate is determined by what kind of future profit borrowers expect from capital investment. If borrowers see lots of opportunities to make a lot of money, they will be willing to pay more to borrow, and vice versa. In other words, look at interest rates for what they say about demand for borrowed funds instead of what they say about the supply of money.

Putting this together, maybe the story of this recession is that all through the Greenspan years people saw the prospects for profit from real capital investment (investing in new businesses that generate profits from selling new goods and services) getting dimmer and dimmer so interest rates had to be pushed lower and lower to get them to continue to borrow and invest, until the point was reached where there were no worthwhile real capital investments left to invest in and the recession began.

This model isn't inconsistent with the bubbles we saw. It makes sense to me that when one runs out of worthwhile real capital investments then one would start to put easy money into speculating on assets and commodities. If there were ways to make a solid 10% profit from buying new capital assets and opening new businesses would there have been any market for subprime mortgage backed securities?

Housing Bubble 2: Rental Properties

2009-05-24T05:15:00.000-07:00

Investors are swarming to buy up foreclosed houses in Phoenix to rent out to tenants (Amid Housing Bust, Phoenix Begins a New Frenzy)

I wonder what will happen to monthly rental rates in Phoenix when all those surplus houses are converted to rentals.

I wonder what will happen to housing prices when rental rates start to fall and all the would-be landlords run for the exit?

I wonder what will happen to all the lenders to the would-be landlords?

The NY Times fixes their faux pas in another article

2009-05-20T07:45:00.000-07:00

Yesterday I mentioned that the NY Times ran a silly front page story saying that the new credit card legislation would cause the credit card companies to get rid of reward programs and other perks for customers who pay their balance every month. Today, Ron Lieber mocks that notion in a Your Money piece, but doesn't mention that it was his own paper that bought this industry propaganda hook line and sinker the day before.

Your Money: Consumers Are Dealt a New Hand in Credit Cards

Why is the NY Times running credit card industry propaganda on the front page?

2009-05-19T06:55:00.005-07:00

This front page story in the New York Times today struck me as really weird:

Credit Card Industry Aims to Profit From Sterling Payers

The thrust of the story seems to be that if Congress passes legislation to more tightly regulate credit cards then all the people who pay their balance in full each month are going to get charged higher rates, have to pay annual fees, and lose all perks like cash back plans, etc. To me it seemed like the piece was slanted to generate opposition to the pending legislation by people who would otherwise be neutral about it (the people who pay their balances each month promptly). While I know that seems paranoid, the article completely failed to mention an obvious flaw in the thesis that credit card companies would raise rates and fees on good customers: People who pay their balances every month don't need credit cards at all, and the only reason they have them is because they can get cash back and pay no annual fee. If the credit card industry tries to raise rates on people who don't really need consumer credit they are going to lose those customers in droves. Not to mention that each credit card company is going to have a strong incentive to poach "sterling payers" from its competitors by continuing to offer perks like no annual fees and cash back.

There is a reason that all these perks evolved in the first place: it was the only way to attract and retain these "sterling payers," and new legislation that makes it harder to squeeze the less-than-sterling payers is not going to change that reality. It reminds me of the delusion currently popular with the media that just because they are losing advertising revenue their readers are going to have to pay more for content. There are reasons that free content evolved in the marketplace, and the loss of advertising revenue doesn't change any of the market forces that created free content.

Restricting credit card rates and fees is not a good idea during a financial crisis

2009-04-24T08:28:00.003-07:00

In today's New York Times it was reported that the Obama administration is supporting legislation to limit the fees and rates credit card companies can charge people (Obama Pressures Credit Card Issuers on Rates, NY Times 2009-04-24). This seems to me to be a really dumb move.

What are banks going to do if they can't raise rates and fees on their higher risk credit customers enough to cover their default risk? That's right: The banks are going to get out of the business of offering credit cards to higher risk borrowers. Which is probably for the best for the people who get cut off (borrowing on credit cards to finance consumption is always and everywhere a poor financial strategy). And it would be a great idea if we weren't in a recession. But isn't reducing the availability of consumer credit during a recession attributed to a credit crunch kind of a dumb move?

On a related front, what is going to happen if banks are not allowed to raise rates and fees on existing credit card balances as the risk of default on those existing loan balances increases? That's right: The banks are going to lose even more money and they are going to need an even bigger bailout from the government to survive. In effect, the costs will be shifted from the higher risk borrowers to the taxpayer. Which makes me feel like a chump for being a taxpayer but not a borrower.

The price of oil and the recession

2009-04-23T10:36:00.000-07:00

An article today in the New York times talks about the fact that the price of oil has been holding up remarkably well despite weakening demand and swelling inventories. Oil Prices Resist the World’s Recession Trend (NY Times 2009-04-22). The author credits the resiliance of the price of oil to OPEC supply cuts and people investing in oil futures as a hedge against the USD and inflation.

To me this dynamic risks worsening the global recession. As one economist once said, a recession is a deflation trying to happen, i.e. when demand drops, but prices don't drop enough to keep pace, then a recession happens as people buy less. As long as the price of oil is artificially propped up by hot money and OPEC the world will continue to consume less and less energy. That doesn't sound so bad on it face. Isn't saving energy good? But the energy will be saved because people are consuming fewer goods and services and because whole businesses will go under because high energy prices cause them to lose money.

The way I see this playing out is that either:

The price of oil will collapse in the near term, which will provide a stimulus to the economy which will help shorten the recession, or
The price of oil will continue to be propped up by speculators and OPEC, which will prolong and deepen the recession, which will in turn cause an even deeper collapse in the price of oil later.

Maybe genes don't determine many diseases after all

2009-04-16T08:45:00.000-07:00

This article in today's New York Times:

Genes show limited value in predicting diseases

Supports my longstanding suspicion of claims that certain diseases (depression, autism, schizophrenia, etc) were caused by genetic defects. It always seemed to me that if a disease truly was caused by a genetic variation then the expression of the disease would follow simple Mendelian rules, like is the case with Huntington's Disease or Tay Sachs disease. And my skepticism increased when the years and decades went by without indentifying the specific culprit genes for various diseases that were attributed to genetics.

How many excess houses are there?

2009-03-03T04:54:00.000-07:00

"Sometimes, indeed, the reduction of stocks [of capital goods] may have to be virtually completed before any measurable degree of recovery can be detected. "

- John Maynard Keynes, The General Theory of Employment, Interest, and Money, Chapter 22.

One of John Maynard Keynes theories was that recessions occur when producers cut back on the production of durable goods because there is a real or perceived oversupply of durable goods. See Chapter 22 "Notes on the Trade Cycle" of the General Theory of Employment, Interest, and Money. I see this effect at work in the current downturn in the US housing market. Housing starts have plummeted as the inventory of houses for sale swelled and prices declined (a sure sign of oversupply), and the resulting decline in construction spending has contributed to the recession. Not to mention that declining home values related to the oversupply of housing have helped trigger a financial and credit crises.

What I think is fascinating about Keynes's theory is that he postulates that before a recovery can begin the excess stocks of durable goods must be eliminated one way or the other. That got me wondering: just how many excess houses are there in the US right now and how long will it take for population growth to soak up this oversupply?

To explore this I put together some rough calculations on this Google Documents spreadsheet. All these numbers were pulled from Census bureau data at the links cited below.

The calculations on the spreadsheet seem to indicate that there were more housing units built in the period 2004 to 2008 than could be absorbed by population growth. From 2000 to 2004 the ratio between population growth and housing stock growth was 4.19 (4.19 new people for every new house). In the period 2004 to 2008 that ratio was 1.29. Given the average people per house over the years (see spreadsheet) it looks like more housing got build in 2004-2008 than could be justified by population growth.

But how to measure how much excess supply there is in the housing stock? The absolute number of vacant houses is not very useful because it doesn't take into account changes in population. So the first thing I did was calculate what population increase it would take to return to the year 2000 ratio of people per housing units, and that number turned out to be 4.5 million more people to get us back down to the people per housing unit ratio of the year 2000. Since our average annual population growth rate is 2.7 million it would take about a year and a half for population growth to consume the excess housing stock assuming that all new housing construction stops immediately.

I also calculated the number of excess housing units assuming the year 2000 ratio for people per housing unit and got 1.9 million extra housing units.

Of course these are really rough calculations. I haven't gone back to look at how stable the ratio of people per housing unit is over time, and presumably preferences change over time for how many people live together in one house. However, even if there was a trend towards smaller households on average earlier this decade, it seems unlikely that that trend would continue during the recession. There are a lot of reasons for people to move in together when the economy is shrinking. About the only thing that would make smaller households attractive at this point would be truly spectacularly low prices on housing.

To me these calculations indicate that:

Housing prices will probably continue to fall until either:

(1) population growth has absorbed the excess housing stock (another 1.5 years at least?) or,
(2) housing gets so cheap that people prefer even less crowded living arrangements than they preferred in the year 2000. Intuitively, it would seem that that price point would have to be significantly lower than the housing prices in 2000, especially since the future was looking bright in 2000 and its looking dark right now. The Case-Shiller home price index was at 107 in June 2000, and it was at 154 in Dec 2008. 107/154 = 1.47, i.e. maybe another 50%+ drop in prices to absorb the excess supply without waiting for population growth?

Any new home building this year and next year will prolong the period of falling house prices.
To instantly stop the housing market decline we need to either bulldoze about 2,000,000 housing units, or get an extra 4,500,000 people to immigrate to the US.

One final comment. I find it really strange that I have not come across any discussion of this issue in the media. Prices are all about supply and demand, yet when people talk about the prospects for the housing market they never seem to talk about the real supply of housing as it relates to population. To me that is the crucial issue. It seems to me that as long as there is more housing than our current population needs to be sheltered there are going to be strong downward pressures on housing prices.

Sources:

Census Bureau: Rental and Homeowner Vacancy Rates for the United States: 1960 and 1965 to 2008

Estimates of the Total Housing Inventory for the United States: Fourth Quarter 2007 and 2008

Housing Vacancies and Homeownership historical tables.

No one home: 1 in 9 housing units vacant - USA Today 2009-02-12

Housing bubble peaked in early 2005.

Thoughts on doctors not spending much time per patient

2009-02-28T05:55:00.002-07:00

"Even as an expert, it takes me over 5 hours to review a typical middle age person’s medical history (plotting test results, comparing to distributions of patients, etc.). To select and optimize the best set of sequential diagnostic tests and treatments takes many hours per patient. No physician spends the time needed. In my review of thousands of cases with chronic conditions, more than 95% provide suboptimal care (excluding minor accidents, simple infections, simple cases).
Conclusion. Today we can spend over $1M per person to improve morbidity and mortality. And tens of hours of professional time. Clearly impossible. Therefore, health care implies rationing and restricting physician’s time, diagnosis and treatment.
Thus, the first priority is to admit that it is impossible to provide the state of the art care to every person. Not even a small proportion of the population. Physicians today allocate less than 10’ per patient, on average. In this time it is impossible to review test results, select optimal sequential testing from a menu of 10K +, order them, review results, and so on.
Once we admit that we can only provide a tiny fraction of what modern medicine provides, then we can optimize the allocation assumming that we can agree on outcomes."
— Eduardo Siguel, MD, PhD
Comment six on The Mounting Price of Health Care’s Status Quo

Here is what I posted in the comments in response:

Thank you Dr. Siguel (Comment 6) for sharing some important insights and providing some validation for something I have been wondering about for years.

For most of my adult life I have been puzzled by how doctors routinely make major decisions with little or no research or analysis. Time after time I saw a doctor make a decision on a complex situation without cracking a book (or a database in this modern age) or reviewing records in detail. I suspected that these decisions were of sub-optimal quality, but hoped (since the health of me and my loved ones was on the line) that somehow these doctors had discovered a way to make complex decisions without doing any work. Dr. Siguel's insider view seems to confirm that that quick medical decisions do tend to be sub-optimal.

However, I have to disagree with Dr. Siguel about the implications of limited time leading to sub-optimal medical decisions. He feels that the solution has to be rationing of doctor's time because providing the time needed for optimal medical decisions would be prohibitively expensive. But what about lowering the cost of doctor's time?

The elephant in the room is that physicians make a lot of money because the supply of physicians is constrained by very high educational and training requirements. Sure we want all our doctors to be genius superstars. But here is the conundrum: what is the use of requiring our physicians to have such high qualifications if the resulting high cost of physician's time means that they mostly shoot from the hip and frequently make sub-optimal decisions? If we are willing to accept sub-optimal decisions, why not at least get them for cheap from less qualified, and therefore less expensive, doctors? If we lower the training requirements for becoming a physician, and open dozens of new medical schools, we could get physician's pay down to say the high 5 figures (as versus the current mid to high 6 figures for specialists), and then it would be affordable to have a physician spend more than 10 minutes per patient.

I personally would jump at the chance to be treated by someone with half, or less, of the qualifications of my current physicians if that person would spend some real time carefully examining my records and doing some research on the options. I don't want a genius, I want a workhorse.

Also, with the advent of computers and data technology, the need for spectacularly trained physicians is declining. In the olden days a physician pretty much had to have a whole library in his head because researching stuff involved, well, going to the library. These days the latest medical research is only a few clicks away, and there is not so much need for a physician to know everything.

Comment not accepted on Krugman blog

2009-02-20T03:56:00.000-07:00

Here is a comment I posted in response to this post on Paul Krugman's blog that apparently didn't make it past the moderator:

http://krugman.blogs.nytimes.com/2009/02/18/the-eschatology-of-lost-decades/

I think its fascinating that so far nobody has really made any predictions for how it will end. So, I will give it a go.

To me the key word for understanding where we are headed is “unsustainable.” I think everyone agrees that the levels of borrowing and spending in the US (both public and private) during the past few years were unsustainable. One way or another the US is going to eventually end up back at sustainable levels of borrowing and spending, and that sustainable level is going to necessarily mean a lower GDP per capita than we had in 2007. Once the economy falls back to a sustainable level of GDP it will start to grow again slowly. So that is my prediction: the economy is never going to “recover” to where it was before, because where it was before was unsustainable.

What is a sustainable level of GDP? I have no idea beyond that its going to be lower than the peak of the bubble.

I see a couple paths back to a sustainable level of consumption:
1. Do it the old-fashioned way and let the contraction run for a few years until consumption bottoms out on its own and all the excess durable goods are used up.

2. Use hyperinflation to wipe out all debts and all financial assets, effectively rebooting the whole economy. Even with hyperinflation we would still have a huge surplus of durable goods (ever noticed how many storage units there are out there?) that we would have to work through, but at least people wouldn’t be investing massive amounts of energy into maintaining an increasingly tangled web of wacky financial arrangements.

3. Have another World War II to blow up all the excess durable goods.

4. Lift all immigration restrictions for people with a positive net worth and a college degree and let all the new immigrants soak up the excess durable goods and boost consumption spending (nothing would stimulate like 10-20 million people with money in the bank setting up house in a new country.) We could kill two birds with one stone by lifting all immigration restrictions for nations facing civil unrest or ethnic conflicts and providing them a subsidy to relocate to the US. That way all the people in Somalia, Gaza, the West Bank, Iraq, Afganistan, the Sudan, etc. who just want to live a peaceful life have a chance to leave conflict behind. When the warring factions see everyone leaving they will realize that if they keep fighting they will soon have nothing left to fight over.

5. Use export sales to replace lower levels of domestic consumption (not looking likely as noted by Prof. Krugman).

I am no expert in economic history, but I cannot think of a single major recession or depression whose recovery didn’t involve one or more of these. So my prediction is that it will end with some combo of the above, just like every other major recession has.

The one thing I am pretty sure of is that bailouts and stimulus packages are not going to magically make unsustainable sustainable.

A modest proposal to save the economy, regain American dominance, and bring peace to the world

2009-02-19T08:16:00.001-07:00

Right now the two things dragging down the US economy are plunging housing prices (and its knock-on effects on the financial system) and softening consumer spending. There is an easy fix that would have the additional benefits of positioning America for continued dominance of the world economy and solving the major conflicts in the world.

The fix is to change immigration policies so that:

Anyone from anywhere in the world who has a college degree and a net worth of at least $20,000 can get a greencard (permanent resident status) provided they emigrate to the US and buy a house in the next 6 months.
Anyone living in a conflict zone can get a greencard on the same conditions regardless of education or net worth, and the US will subsidize moving costs and a downpayment on a house for families below a certain net worth.
Special government subsidized mortgages would be available to these immigrants, as well as special loan programs for financing purchases of everything a family needs to set up a new home in the US: cars, microwaves, TVs, etc.

The surge of home buying by immigrants will stall the downward slide of the housing market, saving us hundreds of billions in bailouts and programs to save people from foreclosure.

The surge in purchases basic durable goods by the immigrants (cars, stoves, clothes, etc) will boost consumer spending right when we need it.

The immigration program for people with college degrees will provide the US with the most highly skilled workforce in the world, giving us a competitive advantage in the future (thanks to Thomas Friedman for this idea).

The immigration program for people in conflict zones will allow the people who want to escape war to escape to somewhere where they can lead a peaceful life. As the best and the brightest start to flee conflict zones, the adversaries will realize that every day of continued fighting is draining away what they are fighting over, and if they don't stop soon there will be nothing left to fight over. The conflicts that have any possible resolution will be settled quickly. The truly intractable conflicts will be concluded when the last non-combatent leaves and the combatents finish killing each other.

Will the surge of immigration increase unemployment? Sure it will in the near term. But in the long term employment will benefit because America will be the go-to country for skilled workers.

What about the personal saving rate?

2009-02-15T08:01:00.000-07:00

One thing that worries me about the current economic unpleasantness is how the personal saving rate plays into the downturn and the possibilities of recovery in the near term.

The personal savings rate is calculated by the Bureau of Economic Analysis (http://bea.gov) as personal income, less taxes, less personal outlays, divided by disposable personal income. To me, its not so much a measure of how much households save for the future. It's more a measure of how much of each paycheck gets spent (i.e. the "average propensity to consume"). If households are, on average, living completely paycheck to paycheck, then the personal saving rate will be zero. If they spend less than they earn, then the personal saving rate will be some positive percentage.

The reason the personal saving rate is important is that it, along with personal income levels, determines the size of consumer spending (called personal consumption expenditures or PCE by the BEA), and consumer spending makes up approximately 70% of Gross Domestic Product.

Now for the scary part.

If you look at the personal saving rate for the last twenty years you will see that in 1988-1992 it was pretty solidly in the 7% range, which is pretty close to its long term average, but then starting in the mid nineties its started to drop until finally in 2005 it hit a low of 0.4%. That means that over that period US households shifted, on average, from spending only 92.7% of each paycheck to 99.6% of each paycheck. While on a percentage basis its just 7 percentage points, in dollars its huge: 7% of the 2008 personal disposable income equals 744.6 billion dollars, or about 5.2% of GDP.

So, what happens if US households revert to the historical average personal saving rate of around 7%? By my amateur calculations there will be a minimum contraction in GDP of 5.2% (just subtracting the reduced consumer spending from today's GDP), before counting multiplier effects and without counting any knock-on reduction in personal disposable income from lost jobs, which means in reality the GDP drop would probably be substantially higher.

This indicates to me that if people stop living paycheck-to-paycheck we are going to have a deep contraction of GDP, and we will not return to previous GDP levels for a few years at least. And once again, that before counting feedback and multiplier effects (declining GDP and declining personal income).

Once I started worrying about the personal saving rate the questions in my mind became:

Why did households start living paycheck-to-paycheck in the first place?
Are households pulling back from living paycheck-to-paycheck, and if so, why?
What are the odds of households going back to living paycheck-to-paycheck soon enough to avoid a long recession?

Why did households start living paycheck-to-paycheck in the first place?

My thesis is that the personal saving rate collapsed in the period 1988 to 2005 in part because US households bought in (literally) to the story of a stock market that reliably returns 10% and housing prices that reliably rise year after year. According to this source equity ownership among US households rose from 29.6% in 1989 to 56.9% in 2005. This was primarily fueled by the explosion in participation in 401k plans. Households saw their 401k statements, and their home equity, growing briskly over time, and were constantly being told by multiple sources that a long term 10% annual return on stock market investments was a sure thing. In this environment of swelling 401ks and home equity values saving $7 out of every $100 seemed kind of dopey and old fashioned. The smart thing to do was to stop saving so much of each paycheck and instead "put your home equity to work for you" by borrowing against it to finance consumption, and trust that a combination of reliable stock appreciation and home value appreciation would take care of retirement savings. I distinctly remember reading articles a few years back about how the declining personal saving rate was nothing to worry about in terms of Americans saving for the future because the appreciation in the stock market and housing meant that Amercan's wealth was growing faster than ever despite the reduction in personal saving.

The other factor that I theorize helped the personal saving rate collapse in the period 1988 to 2005 was the explosion of ways for consumers to borrow. One reason to not live paycheck-to-paycheck is that if your life can get ruined if you get caught out by some large unexpected expense like a car dieing, or a major repair. However, as credit cards and home equity loans became much easier to get, the smart thing to do became to stop saving for a rainy day, and instead just draw on a home equity loan or credit card to get you through any rough patches. There were certainly many experts advising consumers to do just that in the last few years. I theorize that essentially what happened was that many consumers because to view their home equity and the availability of easy unsecured credit as defacto cash in the bank (i.e. very liquid money available for spending on little or no notice). Once these consumers started seeing easy credit and home equity as the equivalent of cash the need for actual cash savings vanished. If you poke around you can find financial advice from circa 2005 essentially advocating this view, and certainly there were a raft of ads around then from home equity lenders promoting the view that home equity should be "put to work" by borrowing against it for consumption.

There is some support for this theory in a May 2006 paper from the St. Louis Fed "Cross Cultural Personal Saving Rates" where they found "The personal saving rate usually declined more in countries where access to domestic credit grew faster."

The decline of the personal saving rate is discussed in detail in "The Decline in the US Personal Saving Rate: Is it Real and is it a Puzzle" from the November/December 2007 edition of the Federal Reserve Bank of St. Louis Review. They run through all the theories for the decline. The first theory (stock and housing appreciation) is mentioned but discounted on the basis that it is not adequately supported by empirical evidence. Oddly, my second theory is not mentioned. The paper discusses the increase of availability of credit, but only through the mechanism of actual borrowing being used to increase consumption. There doesn't seem to be any mention of my theory that just the availability of easy credit can inspire people to spend more of their paychecks even if they don't actually borrow anything. In the end, the authors conclude that no existing theory can explain the decline in the personal saving rate and so its a puzzle. Maybe my second theory of easy credit as a substitute for an emergency fund is one of the missing pieces of the puzzle?

Are households pulling back from living paycheck-to-paycheck, and if so, why?

The personal savings rate has shot up to 3.6% in December 2008. And the reasons seem pretty simple: Credit is harder to get, 401k balances have been decimated, people have much less home equity, jobs are evaporating at near-record levels, and, perhaps most significantly, some of the foundational myths that supported the lifestyle of living paycheck-to-paycheck have been busted:

The stock market has a long term average return of 10% in the long term. Busted.
There has never been a national decline in housing prices so home equity will always grow. Busted.
Its always easy to just borrow to get through emergencies. Busted.

For all these reasons living paycheck-to-paycheck just doesn't look so smart any more. In addition to the busted myths, there are some new factors the promote increased personal saving:

High rates of job losses increase the need for an emergency fund, especially in light of tightening consumer credit.
People who are upside down in their houses must have a substantial emergency fund to avoid complete ruin by unexpected expenses or job losses. There are a number of reasons for this:

Before the real estate bubble burst a middle class person who lost their job could go on a nationwide job search, which minimized the probability of extended unemployment. People who are upside down in their homes don't have this option (actually given the slowness of the real estate market relocation for a job is hard for everyone now).
If you are upside down in your house, the chances of getting credit to tide you through a rough patch are pretty slim.

What are the odds of households going back to living paycheck-to-paycheck soon enough to avoid a depression?

In my mind this is the big big big question that everything turns on. If the personal saving rate peaks at 3.6% and then reverts back to near zero in the next few months, then it seems possible for the economy to recover in the next year or two because consumer spending will recover. If the personal saving rate keeps climbing for the next year or two, then no amount of bailouts and/or stimulus will bring GDP back to its previous level because (1) healthy credit markets don't matter if people just don't feel like borrowing to live paycheck-to-paycheck anymore, and (2) there are no plans in the works for a stimulus package big enough to replace the lost spending from a 7+% increase in the personal saving rate. Increased personal saving will cause GDP to fall, which will reduce personal income, which will, combined with the personal saving rate, reduce consumer expenditures, which will reduce GDP, in a cycle that will continue until the personal saving rate is forced back to zero (like it was in the Great Depression) because personal income has fallen so far that on average households have to live paycheck-to-paycheck just to procure the basics. To avoid an very long depression, the personal saving rate has to fall back to near zero before GDP has contracted substantially. Once GDP (and personal income with it) has contracted substantially it will be too late for a reduction in the personal saving rate to save the economy because the damage will already be done.

If getting the personal saving rate back to near zero in the near term is key, what are the chances of getting American consumers to go back to living paycheck-to-paycheck in the next 12-18 months? I mentioned above about how some of the myths that support living paycheck-to-paycheck have been busted: The myth of the perpetually growing stock and housing values and the myth of perpetually available easy credit. As long as the average household no longer believes in these myths its going to be really hard to get them to spend every penny of every paycheck, especially the baby boomers. There are a lot of baby boomers out there in their mid to late fifties who had been living paycheck-to-paycheck who have just seen their 401k plans lose 30-40% of their value, and much, if not all, of their home equity evaporate. And they are all reading about record unemployment levels. If you were in their shoes would you continue to live paycheck-to-paycheck, with retirement maybe 8 years away? Some will, undoubtedly, but its the average that is important, and its hard to imagine that on average the baby boomers will continue living paycheck-to-paycheck in the coming months.

To me the important question is just how busted are these myths? At the moment I suspect the reputation of these myths has only been damaged, but not completely destroyed, for many people. There are probably many people who expect that we will soon return to "normal." However, with each passing month without a recovery the reputation of these myths will continue to dim. Although the media doesn't yet mention it often, the stock and real estate markets in Japan never did recover after their real estate bubble popped in 1990 (The Japanese stock market was still well below its peak 17 years later in 2007, and Japanese real estate prices declined for 15 consecutive years). As time passes without a recovery, the Japanese lost decade experience may tend to be seen as more and more relevant and telling, and the cultural consensus may shift more and more against the myths required to support living paycheck to paycheck. Some support for this theory that the personal saving rate tends to rise after a real estate bubble bursts can be found in the Japanese "Lost Decade." According to a May 2006 paper from the St. Louis Fed "Cross Cultural Personal Saving Rates" the Japanese personal saving rate jumped after their 1990 crash, and then slowly climbed for almost 9 years.