Burn the math

I love it when Paul Krugman channels Alfred Marshall.

Here's Krugman:

I once talked to a theorist (not RBC, micro) who said that his criterion for serious economics was stuff that you can't explain to your mother. I would say that if you can't explain it to your mother, or at least to your non-economist friends, there's a good chance that you yourself don't really know what you're doing.

Math is good. Sometimes jargon is good, too. But plain language and simple intuition are important to keep you grounded.

And here's Alfred Marshall, in a letter to Bowley (or see here), explaining how his approach to mathematics evolved:

I went more and more on the rules—(1) Use mathematics as a shorthand language, rather than as an engine of inquiry. (2) Keep to them till you have done. (3) Translate into English. (4) Then illustrate by examples that are important in real life. (5) Burn the mathematics. (6) If you canʼt succeed in 4, burn 3. This last I did often.

Krugman is really good at the maths, and at illustrating by examples; in that, he's firmly Marshallean. I expect that Krugman, and most of modern econ, is happy using maths as an engine of inquiry as well. But if you can't translate it into English that can readily be illustrated, there's reasonable risk you've produced nonsense.

Maybe we needed a bigger earthquake

Paul Krugman credits the Japanese earthquake/tsunami with high current Japanese growth rates:

Wait, what? Japan as star performer? What’s that about?

Actually, no mystery. From Bloomberg:

Japan’s economy expanded faster than estimated in the first quarter, boosted by reconstruction spending that’s poised to fade just as a worsening in Europe’s crisis threatens to curtail export demand.

So Japan, which is spending heavily for post-tsunami reconstruction, is growing quite fast, while Italy, which is imposing austerity measures, is shrinking almost equally fast.

There seems to be some kind of lesson here about macroeconomics, but I can’t quite put my finger on it …

I'm not a macroeconomist, so there are reasonable odds I've got things wrong. But I would have thought we'd have needed to think a bit more about how a fiscal push gets funded and about any likely reaction from the reserve bank.

Oughtn't there be a reasonable difference between a tax or debt-funded fiscal expansion and one paid by reinsurance inflows? I'm not sure that we can jump from "the Japanese government is spending a lot" to "Japan's growing" without looking at where the money's come from. A tax-funded spending programme will take money out of other parts of the economy; a debt-funded one might induce people to offset government spending with greater savings in anticipation of future taxes. Even if you think it's worthwhile, the effect of spending will be smaller than it would be where the money came as windfall in exchange for wealth reduction. A fiscal push paid for by domestic insurers selling off assets and by inflows from international reinsurers ought to look a little different from one funded by tax or debt; the GDP effects of tsunami-scale spending programmes in Italy or Greece might be comparable to Japan's if they were paid for by selling off little used assets, like some of Greece's uninhabited Adriatic islands.

New Zealand has its own earthquake rebuilding project: Christchurch. While 2012Q1 figures aren't out yet, fourth quarter 2011 had a year-on-year growth rate of 1.1%. And iPredict's picking quarter-on-quarter growth rates between 0 and 0.5% for most quarters all the way through to December 2013, with reasonable risk of bad outcomes for 2013Q4 - one chance in three of growth rates lower than -0.5%. New Zealand's perhaps making it look hard because of the morass of bureaucracy and insurance that's holding things up, combined with lingering worries that a one-in-four chance of another really big aftershock might mean we're best advised to wait on any big building projects anyway. I doubt that the problem was that the quake just wasn't big enough.

Further, any earthquake-related fiscal push also needs an accommodative central bank for expansionary aggregate effects. Here, a fast rebuild push would very likely push up wages and prices in related sectors, at least until we started being able to bid workers back from Oz. We'd also be pushing rents up for temporary workers, which would feed through into national rental markets as displaced Christchurch folks facing a short term vertical housing supply curve moved elsewhere. And then the RBNZ might start having to put the thumb down.

Bottom lines from a non-macroeconomist:*

• Earthquakes are hardly sufficient for macroeconomic stimulus. There's evidence that Canterbury's seeing decent growth relative to the rest of the country, but aggregate national figures are hardly rosy and construction hasn't been particularly helping things. December quarter 2011 had a 2.5% increase over the prior quarter, but only after substantially negative results for the prior three quarters (ie from the quake onwards). See Table 2 of the Excel sheet. Table 3 tells us construction's contribution to GDP is up in 2011 on 2010, but is still lower in real terms than in any year from 2006 through 2009. I suppose earthquake construction booms also operate with long and variable lags.
• Running a big fiscal push doesn't help anything if the Reserve Bank is then just induced to offset. And if you have to get the monetary authority onside, why not just run it as a monetary expansion in the first place? Cowen says the potential for monetary fixes is weakening, but I'd expect the same case to hold against broad fiscal AD pushes as well. And recall that what Krugman means by "austerity" is perhaps not what is commonly understood.
• It makes a lot of sense for New Zealand to borrow heavily to fund the earthquake rebuild and to divert some money from other useful projects, with longer term tax increases and spending shifts to make up the difference. That the coming budget is almost certain to do nothing about longer term structural issues like the retirement age isn't going to help make room for earthquake-rebuilding debt. 
• The quickest way to make room for the RBNZ on interest rates is getting legislation giving effect to the Productivity Commission's recommendations around housing and land use regulation. We're seeing housing prices ramping up again; Auckland median values are now well above the 2007 peak and aggregate values aren't far below it. Price inflation in non-tradeables like housing and fear of setting off another housing bubble could be constraining RBNZ against interest rate cuts. In the last housing run-up, from 2003 through 2007, year on year CPI measures in the "CPI less housing non-tradeable items" series is about twenty percent lower than the full CPI. RBNZ will have more room to accommodate where housing costs are less of an issue. This obviously matters for any monetary push but matters too for any fiscal stimulus because RBNZ moves last and has to offset fiscal moves that look set to push medium-term CPI above 3 percent.**

* Full disclosure: I was very seriously wrong about macro policy in early 2008 when I thought RBNZ was cavalier about a persistently high CPI when instead they had better foresight about the coming maelstrom; I'd calibrated around RBNZ responses to inflation rates circa 2005-6. So discount as you reckon appropriate.

** They've also been looking to other potential tools for damping housing price run-ups.

Easton vs Krugman on Earthquake Finance

Brian Easton argues for a 3% earthquake levy in The Listener.

Prudence suggests the Government should be developing a backup strategy. One possibility is a Canterbury earthquake levy, a surcharge of, say, 3% on each person’s income tax bill. The levy would be used to pay off the government’s earthquake expenses that couldn’t be recovered from insurance and the like. There would be a special account to which these expenses were charged (including those already incurred); proceeds from the levy would be credited to it as long as the account was in deficit – probably for at least 12 years.

This only makes sense if the government faces serious constraints on debt issuance. Again, here's Paul Krugman on how to handle natural disasters:

Now suppose a disaster strikes. What this does is raise the marginal benefit of spending on disaster relief. The appropriate response is to move all the marginals to get them in line: spend less on everything else, and also raise more in taxes. So even there it shouldn’t be all offsetting spending cuts.

But wait: even more important, the government can borrow (or, in principle, lend, if it pays off all its debt). So it should balance its budget in present discounted value terms, not year by year. This means that the tradeoffs should include future spending and taxes as well as this year’s spending and taxes. And a natural disaster, like a war, is a temporary event; it should be met largely through higher taxes and lower spending 
in the future rather than right away, which is another way of saying that it should be paid for in large part by a temporary increase in the deficit.

This isn’t some novel idea, by the way — it’s the standard theory of public finance during war, going all the way back to Ricardo. And the logic of wartime finance applies equally to natural disasters. [emphasis added]

Recall that the standard theory says that, if everything were optimal ex ante, you'd want to cut spending on non-earthquake stuff, issue debt, and raise future taxes. The equilibrium size of government is a bit higher in total but spending on non-earthquake things has dropped. If you think government was too small ex ante, you should push for smaller non-quake cuts, larger debt, and higher post-quake taxes; if you think it was too large ex ante, bigger cuts to non-quake services, less debt, and smaller post-quake tax hikes.

Easton ruled out those options at the outset: spending cuts "could be politically and economically disastrous"; increased debt isn't on the table as he reckons it would make credit downgrades too likely.

But Easton also worries that the "loose fiscal stance" we'd have if we used debt to fund earthquake recovery would give RBNZ cause to tighten monetary policy. Maybe we're in some kind of knife-edge case where earthquake damage is sufficiently large that government cuts to other programmes sufficient to fund the earthquake reconstruction would be seriously damaging while debt issuance sufficient to fund the recovery would be a really large injection in need of partial offsetting; it's otherwise hard to reconcile his fear of big bad things happening with spending cuts and other big bad things happening with debt-funded spending. But standard theory says to fund things by both cutting current spending and increasing debt and future taxes rather than either alone.

And, it's hard to find much evidence of strong constraints on demand for our debt in the auction data; the last offering of government bonds found a weighted average successful yield of 3.8% on bonds maturing 2019. You can make a case for substantial tax increases if you think government is just way too small, but it's perhaps a bit mischievous to hang it on earthquakes.

But as Brian Easton was NZIER's Economist of the Year a couple of years ago, it's likely that I and Krugman and the standard theory of public finance going back to Ricardo are wrong on this one.

Borrow!

It's nice to see both Paul Krugman and Stephen Landsburg agreeing with me, though they surely didn't see my post.

Back in April, I'd argued against the Green Party's push for a tax hike to pay for the earthquake. The New Zealand Greens wanted, and still want, a current earthquake levy on higher incomes to cover some of the rebuilding; they argued vehemently against cuts elsewhere. I made the usual standard argument from standard theory that equating marginal returns from government spending across different areas meant we had to cut spending on some non-earthquake areas. And, we'd want to take on debt.

So even if you reckoned the ex ante mix of spending and taxation was optimal, the best response to the quake seems likely to involve cuts to non-quake programmes, increased debt, and future tax increases. If you figure, like the Greens, that the ex ante mix had way too little government spending, you'd push for smaller cuts to non-quake spending and larger future tax increases; it's beyond me why they're averse to debt to fund a massive capital reconstruction project. If you figure, like National, that the ex ante mix had too much government spending, you'll bring forward some of the cuts that you'd already had in mind while raising debt and pushing back future plans for tax reduction. If you reckoned, like me, that a reasonable proportion of government spending was of negative value, the case for cutting that spending has gotten stronger.

It's hard to avoid that the optimal arrangement involves some cuts to relatively low value government programs, even if you think those programs are of positive value.

And here's Krugman on Hurricane Irene:

Now suppose a disaster strikes. What this does is raise the marginal benefit of spending on disaster relief. The appropriate response is to move all the marginals to get them in line: spend less on everything else, and also raise more in taxes. So even there it shouldn’t be all offsetting spending cuts.

But wait: even more important, the government can borrow (or, in principle, lend, if it pays off all its debt). So it should balance its budget in present discounted value terms, not year by year. This means that the tradeoffs should include future spending and taxes as well as this year’s spending and taxes. And a natural disaster, like a war, is a temporary event; it should be met largely through higher taxes and lower spending in the future rather than right away, which is another way of saying that it should be paid for in large part by a temporary increase in the deficit.

This isn’t some novel idea, by the way — it’s the standard theory of public finance during war, going all the way back to Ricardo. And the logic of wartime finance applies equally to natural disasters.

Steven Landsburg takes issue, pointing out that Krugman's results hinge on the ex ante efficiency of the spending and tax mix:

To get a little wonkier, there are actually two separate points here. First there’s the point that comes from public finance: Unless you believe that everything is perfect to begin with, the Ricardian argument fails, leaving you with no reason to believe that the cost of new spending should be spread widely. Instead, you should start by cutting back on your least wise activities. Cantor and Krugman probably have some legitimate disagreement about what those least wise activities are, but neither of them has any reason that I know of to believe that all activities are currently equally wise at the margin.

And so Krugman puts out the case that the Greens here should be making, and Landsburg adds in that if we were spending too much on dumb things to start with, it makes even more sense to stop doing that when we have to pay for a natural disaster.

So the consensus across me, Krugman and Landsburg seems to be that it's absolutely bonkers to try and pay for something like a massive earthquake out of a current big tax increase. Some mix of debt and reallocation of current spending ought to be used, with tax increases in future.

Economics as Psychohistory

From the New Yorker's truly excellent piece on Paul Krugman:

Krugman explained that he’d become an economist because of science fiction. When he was a boy, he’d read Isaac Asimov’s “Foundation” trilogy and become obsessed with the central character, Hari Seldon. Seldon was a “psychohistorian”—a scientist with such a precise understanding of the mechanics of society that he could predict the course of events thousands of years into the future and save mankind from centuries of barbarism. He couldn’t predict individual behavior—that was too hard—but it didn’t matter, because history was determined not by individuals but by laws and hidden forces. “If you read other genres of fiction, you can learn about the way people are and the way society is,” Krugman said to the audience, “but you don’t get very much thinking about why are things the way they are, or what might make them different. What would happen if ?”

With Hari Seldon in mind, Krugman went to Yale, in 1970, intending to study history, but he felt that history was too much about what and not enough about why, so he ended up in economics.

I wonder what would happen if you split economists by whether they prefer the Foundation Series or the Lazarus Long books.... The would-be planners versus those wary of the fatal conceit?