Wednesday, March 12, 2014

Mitchell strikes out again

If Cato’s Daniel J. Mitchell is “particularly impressed” by Sweden’s “genuine fiscal restraint” from 1992-2001, he must love President Obama.

Mitchell shows a graph of total government expenditures in Sweden over the period, noting that “spending grew by an average of 1.9 percent per year” over those nine years. Let’s leave aside the fact that this is in nominal currency– a frequent oversight in Cato’s budget reporting. What I find particularly interesting is that equivalent spending in the United States grew only 0.9 percent per year from 2009-2013. Does that impress Mitchell? I’m guessing not, because spending was especially high in 2009 on account of the bursting of the housing bubble, and resulting unemployment, bailouts, and stimulus. But the story was hardly different in 1992 Sweden– suffering the fallout of a housing bust and banking crisis.

Of course, Sweden went as far as nationalizing banks to deal with the banking crisis and was fully recovered by 1995. So maybe the U.S. should take a lesson from Sweden: nationalize a few banks, get to full employment, and then consider some “fiscal restraint” of its own.

Monday, March 10, 2014

German fiscal policy is not so obviously “onerous”

In Germany last year, households and nonprofits directly consumed 57.4 percent of domestic production. Foreigners (on net) bought another 6.3 percent. Germany invested another 16.7 percent. That comes to 80.5 percent of production. So how can Cato’s Daniel J. Mitchell reasonably claim that “government spending consumes about 44 percent of economic output” as he does in today’s blog post?

The answer is, he cannot. The German government claimed only 19.5 percent of economic output, and even then consumed only 7 percent. The remaining 12.5 percent of economic output– though counted as government expenditure– was in fact consumed by the private sector.

Thus, the domestic private sector eventually claimed almost 93 percent of all economic output.1 So what did Mitchell really mean? The German government received taxes sufficient to purchase 44 percent of GDP, and spent money sufficient to purchase 44 percent of economic output. That’s fine as far as it goes, but it does not tell us how burdensome the government spending. After all, traders spent $108 trillion on stocks in 2008. Does Mitchell believe that they therefore consumed 175 percent of the economic output of the entire world?

Suppose that government directly confiscated every bit of income produced by the economy, but then returned it dollar-for-dollar to each person. Though the government did nothing, Mitchell claims that government consumed 100 percent of economic output. He may not like that governments take money from some and give to others to spend, and he may not like that governments purchase goods and services and give to others to consume, but he inexcusably exaggerates the amount of output actually consumed by the German government.

1 claims include the amount saved through net sales to foreigners

Friday, March 7, 2014

Is It Really Time for the Fed to Worry About Inflation?

Ylan Mui at The Washington Post’s Wonkblog had a piece Thursday titled “This is why the Fed should start worrying about inflation again.” The main bit of evidence is a graph attributed to Kevin Logan showing a negative relationship between the unemployment rate and increasing rates of inflation. But this graph actually says far less than Mui says.

Indeed there is a relationship between unemployment and inflation. The Federal Reserve is tasked with balancing inflation and unemployment, and when the Fed fears inflation, it raises interest rates with the intent of slowing the economy and creating unemployment. To some extent, then, the relationship is the Fed’s doing.

Let us put that aside, however, and take the observed relationship at face value. First, it is far from obvious that 6.5 percent unemployment represents a threshold below which inflation is as likely to rise as fall– particularly given the small sample size. In Figure 1, I was unable to reproduce exactly Logan’s figure, but according to data available at the Fed, four of the five years with the highest unemployment rates under 6.5 percent are associated with decreasing inflation.

Figure 1: Unemployment and Changes in Inflation
Source: FRED, series JCXFE and UNRATE and author’s calculations

Rather than cherry picking, we may regress changes in inflation against the unemployment rate. As it turns out, the relationship is statistically weak. The expected change in inflation switches between positive and negative somewhere between 2.5 and 7 percent. Likewise, this suggests that the 50/50 point lies closer to 5 percent than 6.5.

Table 1: Regression results
(1) (2) (3)
$\beta_0$ constant 0.52 (0.37) 0.52 (0.43) 0.52 (0.39)
$\beta_1$ unemployment rate -0.11 (0.06)# -0.11 (0.07) -0.11 (0.06)#
variance/covariance estimator OLS jackknife bootstrap
$-\beta_0/\beta_1$ 2.6-7.1 2.9-6.8 3.0-6.7
Standard errors in parenthesis
# Significant at 10% level
Source: FRED, series JCXFE and UNRATE and author’s calculations

In Figure 2, we see the probability that inflation will be higher in 2014 than it was in 2013– assuming various year-round average unemployment rates for 2014. At 6.5 percent unemployment, the probability is closer to one in three than one in two.

Figure 2: Probability of Increased Inflation in 2014
Note: The widest (lightest) confidence band covers 95 percent of outcomes and the most narrow (darkest) band covers 50 percent.
Source: FRED, series JCXFE and UNRATE and author’s calculations

More importantly, increasing inflation is the wrong consideration. The Fed has tolerated inflation below 2.0 percent ever since 2007, and in 2013 core inflation ran only 1.2 percent. If the Fed must target some rate of inflation, it should target a higher rate of inflation. Yet, even if the relationship is meaningful then there is less than a 5 percent chance that 2014 inflation will run even as high as 2.0 percent.

Figure 3: Probability of At Least 2% Inflation in 2014
Note: The widest (lightest) confidence band covers 95 percent of outcomes and the most narrow (darkest) band covers 50 percent.
Source: FRED, series JCXFE and UNRATE and author’s calculations

To the extent that the relationship is both meaningful and a result of Fed activity, then, this suggests that meeting a 2% inflation target would require the Fed to be less hawkish than would be normal for the rate of unemployment. It may yet be some time before the Fed raises interest rates.

(This post originally appeared on the CEPR blog.)