Inventories

The ratio of real inventory investment to real GDP averages 0.4 percent over the postwar period. The inventory ratio now is -1 percent, on the way up from a record low. When inventories recover, they shoot up very strongly, very quickly: following the 2001 recession it took two quarters from the trough of the recession for the inventory-GDP ratio to go from -0.8 percent to +0.12 percent.

Moving from an inventory-GDP ratio of -1 percent to zero adds one percent to annual GDP growth. If it happens over four quarters it adds one percent to the annualized growth rate in each quarter; if in two quarters, two percent each quarter. So inventory investment should be a powerful driving force for growth in the next few quarters.

I like the Financial Times too, but..

Brad DeLong's going all gaga about the Financial Times' economics coverage versus that of, say, the Washington Post. But the article he cites has an atrocious piece of nonsense in it:

With motor vehicles excluded, output grew by only 1.9 per cent. Up to half of that in turn consisted of businesses rebuilding depleted inventories – a sign of optimism, but also, like cash-for-clunkers, a one-off boost to output that will not persist.

Explain to me how inventory investment can continue to be -$130 billion quarter after quarter after quarter. Mathematically speaking, inventory investment has to be on average over the long haul a small positive number if inventories-sales or inventories-GDP is going to be constant. So inventory investment simply has to rise from its current levels. And as I noted in my previous post, the string of negative inventory investment we've seen is unprecedented. When inventory investment starts to rise, it's going to have a major impact on GDP. It already has!

There's room for improvement in economics coverage all around I'd say.

GDP is up at last!

The Bureau of Economic Analysis reports GDP growth was 3.5% in 2009Q3, considerably higher than the consensus forecasts. Lots of commentary here.

My take, which is largely informed by conversations with Bob Barbera, is that people are being far too pessimistic about the strength of the recovery. For example, here's Bruce Kasman and Jan Hatzius debating whether growth in 2010 is going to be slow at 2%, falling to 1.5% by year's end (Hatzius), or fast at 3.5% (Kasman). If growth is even as slow as 3.5%, that would be very surprising given how fast the economy recovered from the last two deep recessions: in the first five quarters of the recovery from the 1974-75 recession GDP growth averaged 5.4%; in the first five quarters of the recovery from the 1981-82 recession it averaged 6.0%. Forecasters are thinking we're going to have a recovery more like those of 1990-91 and 2000-01 (2.9% and 1.8% respectively), but I don't know why that would be the case. Yes, there are impediments to strong growth in the current recession that didn't exist in the 1974-75 and 1981-82 recession - notably, households have to work through a big debt overhang and the financial sector is still very weak. But there are also forces that should accelerate growth, among them extraordinarily stimulative monetary and fiscal policy. Once growth begins, I would anticipate that all of the accelerator effects that made the downturn so scary - low growth --> problems in housing sector --> problems in financial sector --> credit crunch --> low growth - will begin to work in the opposite direction. The financial sector that looks so weak today won't be looking weak at all a year from now. The threat of massive foreclosures and a crumbling commercial real estate market will recede as growth solidifies. I think it would be prudent to have another round of fiscal stimulus focusing on aid to states, but I don't see grounds for pessimism overall.

As for 2009Q3 GDP, Bob has an interesting take. He says (I'm paraphrasing here) that the inventory numbers the BEA computed are almost certainly too low. They have inventory investment at -$130 billion in Q3 versus -$160 billion in Q2. Bob says - and he's right, I've looked at the numbers - that the US economy has never had such a string of large inventory reductions as the BEA is reporting. And these numbers are essentially a guess anyway - at this point, BEA has the inventory numbers for July, partial numbers for August, and nothing for September.

A more realistic estimate of inventory investment is that rather than improving from -160 to -130 (a +$30 billion addition to GDP in Q3), the improvement was 2 to 3 times that (so inventory investment should be between -100 and -70). Eventually inventory investment has to be positive; this will take a few quarters, but the process has to move faster than the BEA is proposing.

The implications for our estimate of Q3 growth: the $30 billion improvement added 0.94 percent to growth in Q3. Doubling or tripling that gives us an additional 0.94-1.88 boost to growth. Now about a third of the higher inventories, if it occurred, would be due to higher imports, so you have to reduce it proportionately. This would give us a net impact of 0.63-1.25%. That is, Q3 GDP growth should have been between 4.1% and 4.75%.

If Bob's right about the inventory numbers, then when Q3 GDP is revised next month it will be revised substantially upward. If he's wrong about the inventory numbers for Q3, that just means that we're headed for a stronger inventory adjustment in the next quarter or two - we could see 4%+ growth in 2009Q4 and 2010Q1.

After that, it's kind of a race between the momentum of the recovery versus the headwinds in the form of state and local spending, financial stress, etc. I'm betting on the momentum of the recovery.

A difference of opinion

Garry Howard:

This is pretty simple, Green Bay fans:

When Brett Favre, aka No. 4, enters Lambeau Field late Sunday afternoon in his white Minnesota Vikings uniform - intent on working his magic for the purple-helmeted enemy - this is what you should do, please.

Stand up in front of your seat, put your hands together and clap. And whistle. And then clap some more. Forcefully. And cheer. Loud. Louder. The loudest you have ever screamed in your life.

That's right. . . . 

Show him the love and affection he has certainly earned by leading this franchise back to respectability and its rightful place as "Titletown."

Empower yourselves by showing off your obvious class with this rousing ovation.
Make him cry huge teardrops (he may just do that, mind you) all over his graying beard.
And then, after four strong minutes of this lovefest, hope that your boys, the Packers, kick his Hall of Fame (expletive deleted).

Leroy Butler:

The reaction should be 100% about Aaron Rodgers. When Aaron Rodgers comes out there you should give Aaron Rodgers a standing ovation because he’s our guy for the next 10 years. When Brett comes out you do like any other opposing quarterback, you boo him. If you don’t want to boo him, don’t say anything. But if you’re going to stand up wearing Packer clothing or a Packer uniform and cheer when Brett Favre comes out, you should bring a bag and put it over your head. You don’t cheer for somebody to beat your team, I don’t care who it is. You don’t cheer for another quarterback. If you want to cheer Brett, just bring a bag, put it over your head and you can cheer, and no one will hear you and that’s fine. This is Aaron Rodgers’ show. Don’t let somebody come into your back yard and cheer against you. You don’t cheer for another guy to beat your team. I hope I’m crystal clear with these fans who say they love to see Brett Favre. Well, Brett Favre is gone. It’s Aaron Rodgers’ show. He’s the No. 1-rated quarterback in the NFC, including Brett Favre. I’m happy we’ll be good for the next 10 years. I hope they’ll cheer Aaron and boo Brett. If they don’t want to boo him, that’s their right. But any other quarterback they’d boo, what makes him so special? I mean, wait until he has his number retired, you can cheer him then. You can applaud him all you want. You can’t do that the day of the game, and want your team to win. That’s standing on the fence. You’re either a Packer fan or a Brett fan. If you’re a Brett fan, go buy some purple and wear purple. I have a strong feeling on this, this is my team. I played 12 years for this team. Anybody who comes into that stadium, I want them to lose. If it were me coming back, I wouldn’t expect anyone to cheer for me when I’m going to destroy your team. Of course not.

One more on geoengineering, then I'm done

Economists, especially those of Steven Levitt's ilk, are very much aware of the limits of government's ability to intervene in markets. Economies are complex systems whose workings we barely understand. Beware the law of unintended consequences. The subtle ways in which government interventions can backfire by changing incentives in a way that undermines the government's objectives are a staple of economic analysis. Tread lightly, son, respect the market!

So it's odd to see someone like Levitt argue that because of the unintended consequences of trying to reduce carbon emissions through cap'n trade or carbon taxes, what we really ought to do is massively alter the earth's carbon cycle to produce the climate we desire. Launch a giant parasol in earth's orbit to absorb and refract the sun's rays! Dump iron oxide into the oceans to stimulate plankton growth! Create vast algae blooms in lakes and oceans! Have thousands of ships sail the oceans burning sulphur to increase cloud cover!

Yeah, that's the ticket, what could possibly go wrong?

Geoengineering

Jeff Goodall quotes Ken Caldeira (via Brad DeLong):

“Thinking of geoengineering as a substitute for emissions reduction is analogous to saying, ‘Now that I’ve got the seatbelts on, I can just take my hands off the wheel and turn around and talk to people in the back seat.’ It’s crazy.”

Here's another analogy: geoengineering is like Nixon's price controls of the early 1970s. A sensible approach to galloping inflation is a monetary contraction in conjunction with temporary price controls. But imposing price controls without the monetary contraction gives you an explosion of inflation when the price controls are ultimately lifted.

Down with Freakonomics

I thought Freakonomics was a clever little book when it first came out. I've since been convinced that the Freakonomics approach to economics is destroying my profession. The argument against Freakonomics, in a nutshell, is: how about we think about important economic issues for awhile rather than spending so much time and energy showing each other how clever we are?

Sady Doyle has an excellent definition of Freakonomics:

Freakonomics, of course, is the science of choosing an appropriately wacky or controversial subject (sumo wrestlers, abortion), applying a little economic analysis to it and coming up with a shocking conclusion that will make people blog about you.

The takedowns in blogotopia of Levitt and Dubner's new book, Superfreakonomics, have become very tiresome. But the lesson we should learn from all this is simple: don't buy Superfreakonomics. Buy The Cost of Capitalism instead.

A simpler health care reform

Maynard and I exchanged a couple words last week about a very clever idea he had to increase competition in health care markets. Turns out there me be a much simpler way. I did not know until reading today's Washington Post that health insurance has an anti-trust exemption !That could certainly retard competion...

I should note we both confessed that we were not health economists.

The car czars

I suspect that one day the Obama Administration's handling of the GM and Chrysler bankruptcies will be recognized as an economic policy triumph - a model of good practical policymaking and stunning efficiency. Here's the Car Czar himself, Steven Rattner, giving his perspective. Some highlights (my headers):

What a mess:

And so I closed my eyes and jumped. Among the surprises along the way: We were shocked, even beyond our low expectations, by the poor state of both GM and Chrysler. Looking just at the condition of GM's finances and Chrysler's new-car pipeline, the case for a bailout was weak.

But on the other hand, as we surveyed the interconnected web of finance companies, suppliers, and related businesses, the potential impact of the likely alternative -- liquidation -- stunned us. We imagined that the collapse of the automakers could devastate the Midwest beyond imagination. We were determined not to fail. But as we started down the road, we saw mainly obstacles...

Of course, the Bush Administration was no help:

When the Obama administration took office on Jan. 20, it inherited nothing in the auto area: no staff, no stacks of analyses, no plans of any kind. The Bush administration had decided in late December that GM and Chrysler were not going to go bankrupt on its watch and had shoveled $17.4 billion of TARP money into the companies to keep them afloat, but without any meaningful stab at restructuring them...

Everyone wants a handout:

Moving simultaneously down multiple paths, we began meeting with all the interested parties: labor, lenders, legislators, and suppliers. We naively assumed that stakeholders eager to see a rescue of the two companies would come with a set of "gives"; I was startled that each stakeholder meeting invariably included a set of "asks" from the government.

Case in point: parts supplier Delphi, which hoped for government assistance even though nearly 90% of its workforce was outside the U.S. An important part of our job was going to be to convince the stakeholders that the government wasn't going to be everyone's piggy bank...

GM's "stunningly poor management":

Everyone knew Detroit's reputation for insular, slow-moving cultures. Even by that low standard, I was shocked by the stunningly poor management that we found, particularly at GM, where we encountered, among other things, perhaps the weakest finance operation any of us had ever seen in a major company.

For example, under the previous administration's loan agreements, Treasury was to approve every GM transaction of more than $100 million that was outside of the normal course. From my first day at Treasury, PowerPoint decks would arrive from GM (we quickly concluded that no decision seemed to be made at GM without one) requesting approvals. We were appalled by the absence of sound analysis provided to justify these expenditures.

The cultural deficiencies were equally stunning. At GM's Renaissance Center headquarters, the top brass were sequestered on the uppermost floor, behind locked and guarded glass doors. Executives housed on that floor had elevator cards that allowed them to descend to their private garage without stopping at any of the intervening floors (no mixing with the drones).

In my relatively few interactions with chairman and CEO Rick Wagoner, I found him to be likable, dedicated, and generally knowledgeable. But Rick set a tone of "friendly arrogance" that seemed to permeate the organization.

Certainly Rick and his team seemed to believe that virtually all of their problems could be laid at the feet of some combination of the financial crisis, oil prices, the yen-dollar exchange rate, and the UAW.

It seemed completely obvious to us that any management team that had burned through $21 billion of cash in a year and another $13 billion in the first quarter of 2009 could not be allowed to continue. Equally important, GM's February viability plan was more "business as usual" and not the aggressive new approach that we felt was essential...

Meanwhile, if ever a board of directors needed shuffling, it was GM's, which had been utterly docile in the face of mounting evidence of looming disaster. We decided to recommend to Tim, Larry, and ultimately the President a package that would include replacing Rick with Fritz as interim CEO, changing at least half of the board, and making an outside director chairman (which should be universal)...

Obama's style:

The question for us -- and ultimately, the President -- was whether any restructuring could save Chrysler.

Back and forth the debate went in Larry's small office in the West Wing. Our working team was joined by Diana and other administration economists. Gene Sperling, a Michigan native, argued eloquently and passionately for standing by America's heartland.

Austan Goolsbee, a fearless former University of Chicago economist who had been with Obama since the beginning of his campaign, led the charge against Chrysler, marshaling strong factual arguments. One was that letting Chrysler go would give a needed boost to GM (and also to Ford), since most buyers of Chrysler's strongest products -- trucks, minivans, and Jeeps -- probably would turn instead to the other Detroit automakers.

Harry maintained that a Chrysler liquidation could potentially add billions of dollars a year to GM's operating income in a normal sales environment, vastly increasing the value of the company.

The group was torn (at one point the vote was four to four) and so were Tim, Larry, and I. We intuited that from a theoretical point of view, the correct decision could well be to let Chrysler go. But this was not an academic exercise.

Repeatedly, Larry asked us for probabilities -- what did we think the chances would be of Chrysler making it for two years? For five years? Indefinitely? Pressed by Larry, I came down 51-49 in favor of helping. Comfortable that Chrysler could survive, Larry asked us to recast Austan's analysis into an assessment of the employment effects of a Chrysler liquidation.

We were all shocked to realize that when the collateral damage of a Chrysler shutdown was factored in (like lost jobs at dealers and suppliers), the short-term effect of a Chrysler shutdown could be 300,000 more unemployed, similar to what was lost across the entire economy in the month of July. And with the memory of Lehman's collapse still fresh, we imagined the potential for other systemic risk. That cemented matters for Larry and me...

In our meeting in the Oval Office on March 26, Larry began to lay out the issues, only to be interrupted after a few minutes by the President, who said "Larry, I've read the memo," signaling that he wanted to dive into the decision items. Quickly, the question of whether to save Chrysler dominated the discussion.

As we went back and forth over Chrysler, the President himself seemed as torn as Larry and I had been. Suddenly, he realized that Austan Goolsbee, unofficial spokesman for the opposition, was not in the room. "Where's Goolsbee?" the President asked. A few minutes later, Austan joined the conversation. But the President had only about 20 minutes available before his assistant, Katie Johnson, came in with a note urging him to move on to his next appointment. "This is too important to try to decide in a rush," the President told us. "We need to get together again later."

For that early-evening session, we convened in the windowless Roosevelt Room, the only real conference room in the West Wing. Larry asked me to begin by summarizing the consequences of refusing aid to Chrysler, and from there the conversation took off. The group was sobered by my assessment that given the early stage of the Fiat discussions, there was only a fifty-fifty chance of reaching an acceptable agreement.

The President's political advisers were as torn as his task force: Polls universally showed the public strongly opposed to the auto bailouts. At the same time, the advisers recognized the severe economic and political consequences of a Chrysler shutdown across broad swaths of the industrial Midwest. We were dazzled that chief of staff Rahm Emanuel -- a former congressional leader -- could identify from memory the representatives in whose districts the large Chrysler facilities lay.

After about an hour, the President asked for any final comments and then said, "I've decided. I'm prepared to support Chrysler if we can get the Fiat alliance done on terms that make sense to us." And we were thrilled when the President said, "I want you to be tough, and I want you to be commercial."

With that, the meeting dispersed. The recommendation to ask GM's Rick Wagoner to step aside had received barely a mention. New to business meetings with Presidents, I found Obama's style consistent with his "No drama Obama" image and on a par with the best CEOs I had spent time with. He was cordial without being effusive and decisive when his advisers were divided...

Obama plays hardball:

The President's announcement that he was prepared for bankruptcy dramatically changed the nature of the discussions we were having with the stakeholders, none so much as those with Chrysler's 45 senior lenders.

Led by Jimmy Lee, J.P. Morgan's top banker and a long-standing business friend of mine, the banks had been insisting that, as secured lenders, they were entitled to repayment of their entire $6.9 billion. "And not a penny less," Jimmy said to me on more than one occasion.

From the outset that had struck us as ridiculous. The debt was trading at about 15¢ on the dollar, and according to Chrysler's analysis, the liquidation value of the company was around $1 billion. Clearly the banks didn't believe that the government would push back and let the lenders take over the company, if necessary. Until they heard the President speak on Monday morning. Almost immediately afterward, Jimmy called with a new message: "We need to talk."...

Hmm, I'd thought this was intentional:

We had not anticipated one benefit of putting Chrysler on a faster track than GM. The successful completion of Chrysler's restructuring established a clear precedent and signaled to GM's stakeholders that we had leverage. That was helpful because, with hindsight, some form of GM bankruptcy was inevitable from the start. Unlike Chrysler, with its 45 lenders, GM had thousands and thousands of bondholders, many of them individuals. There was no way that we were ever going to corral enough of them to avoid at least a quick-rinse bankruptcy...

Damn Congressmen:

Because we were operating under TARP, we encountered relatively little congressional intrusion -- until the two automakers virtually simultaneously announced their dealer-reduction plans. Our dentistry had finally struck a nationwide nerve.

Every congressional district had dealers, many of whom were leading figures in their communities. We were inundated with an avalanche of calls, letters, and demands. We patiently worked through each grievance and explained hundreds of times that the companies -- not the government -- made the decisions about which dealers to close.

But the episode left an indelible impression on me: If we hadn't had TARP money available and had had to seek congressional approval, I am convinced that one or both of our two automakers would have been forced to liquidate...

The prognosis:

Like any patient that undergoes major surgery, a successful recovery is far from assured. For Chrysler, the biggest challenges are its need to regenerate its product line and manage a significantly leveraged balance sheet. In the case of GM, the overarching question is whether, without an infusion of new blood, its management team can implement the massive cultural change that is essential. But by dramatically lowering the break-even point for both companies, we believed we were creating a healthy margin for error.

Help wanted

Four field goals and a fumble in five trips to the red zone against the lowly Detroit Lions have the Packers sifting through old team programs. A week ago they signed Mark Tauscher, the right tackle they released at the end of last season. Today they signed Ahman Green, the running back they released a few years ago. I wonder if they could land a certain quarterback they let go last year...

A simple application of well-known theory could have saved us a lot of grief

Surely it occurred to everyone that holding an election in Afghanistan was fraught with difficulties. You've got a largely illiterate voting population scattered in small villages across thousands of miles of inhospitable terrain, threatened by the Taliban with having fingers chopped off for voting. Yet the powers that be, in their infinite wisdom, arranged things so that it was probable that there would have to be a runoff election following the initial ballot - and the timing was such that the runoff would have to occur as winter approached, and in Afghanistan, nothing can be done in winter. Knowing all this, couldn't the original round of voting have been an instant runoff vote in which voters specified their first, second, third, etc. choices? The benefits of this would have been, oh I don't know, the avoidance of a crisis of legitimacy, the prompt resolution of the US military strategy in Afghanistan, preventing a big morale boost for the Taliban,...

That's a lot of turmoil!

The Federal Reserve Bank of New York gives us everything in one nice little package. Very handy.

Obama's peace prize

What has Barack Obama done to earn the Nobel Peace Prize? Maybe not much from our perspective. But some friends who are living in a small village in Tanzania write:

Ann came out of the internet café on Friday telling us about our president. Yeah Obama! We are so proud of him as are all the people we meet whether they be Tanzanian, South African or European. One of the first things people will ask us when they find out we are Americans is about our president. He is a hero to so many; and the one consistent remark is, now there is more hope in the world.

How to create jobs

Greg Mankiw recommends we read the American Enterprise Institute's Steven Davis' proposal for for job creation in Forbes Magazine. Hmm, AEI + Forbes + Mankiw; whatever is it going to be? Will he call for more public investment in infrastructure and green energy? Will he call for income support for the poor and jobless? Will he call for investment incentives for businesses? Aid to state and local governments? Let's take a look:

1. Roll back costly benefit mandates for health insurance.
2. Suspend federal minimum wage mandates.
3. Renounce the grossly misnamed Employee Free Choice Act.

Doh! The answer to unemployment, it turns out, is to beat the unemployed over the head with a nightstick. That'll teach 'em to lie around the house collecting government benefits!

At least conservatives have made some progress over the past year - he didn't call for eliminating the capital gains tax or suspending Davis-Bacon.

Actual email exchange

Professor:

"(student name), I do not have a midterm for you from Econ 101. What gives?"

Student:

" I apologize but I think I'm dropping your class. I've been overwhelmed with golf/fraternity responsibilities. I'm sorry for any inconvenience I may have caused."

Competition in the health insurance industry

Suppose we require people to buy private health insurance, subsidizing those who can't otherwise afford it. This gets us close to universal coverage and makes it possible to forbid insurance companies from discriminating against people with pre-existing conditions or capping benefits. But it is very costly, particularly because the health insurance industry is so concentrated. As this AMA study shows, 96 percent of metropolitan areas in the U.S. have "highly concentrated" health insurance markets. For example, at least one insurer controls 30 percent or more of the HMO/PPO market in 96 percent of the MSAs and 50 percent or more in 64 percent of MSAs. Concentration allows insurers to charge excessive rates for health insurance, increasing the cost of reform. In addition, legislation that would force millions of Americans to buy insurance from local monopolies might prove unpopular. So it's imperative that Congress find some way to increase competition in local health insurance markets.

I'm no health economist, but let me take a crack at this anyway. Insurance companies are an intermediary between health care customers (you and me) and health care providers (doctors and hospitals). To enter a local health insurance market, an insurance company has to recruit customers and providers into its network. If the company has a large number of customers providers will want to join the network and the company will be able to negotiate low reimbursement rates for services. If the company has low reimbursement rates, it can charge lower premiums than the competition and get more customers. This basic feature of the industry gives existing firms an advantage in local markets. Say Highmark Blue Shield is the dominant firm in south central Pennsylvania. Now Aetna wants to crack the market. Aetna goes to the hospitals in the area to negotiate reimbursement rates. Since Aetna has few customers it has little bargaining power over the hospitals and therefore has to agree to high reimbursement rates. HBS, meanwhile, is able to use its market power to force lower reimbursement rates. But Aetna signs the deal. Now it tries to recruit customers from companies like Gettysburg College. The Human Resources people at Gettysburg look at the competing plans and rates and see that Aetna, because it pays higher rates for hospital services, charges higher premiums. Gettysburg therefore chooses HBS, and Aetna is out in the cold. Aetna is in a catch-22: it can't recruit customers unless it can negotiate low reimbursement rates, but it can't negotiate low reimbursement rates unless it has a lot of customers. Aetna can't crack the market, and HBS retains its monopoly position.

The problem is, health insurance companies have natural monopolies because of "network effects" or the "first-mover advantage." How do the reform packages currently on the table confront this problem? The health insurance exchanges make it easier for outside companies to recruit large numbers of customers: instead of recruiting people one-by-one, the company can form a pool that attracts a large number of customers at once. Conceivably this could help break the Catch-22, but I don't see the chance for much effect. Insurance companies already have the ability to attract people in big groups by pitching their services to large employers, but this has not been enough to solve the problem.

The public option would take a sledgehammer to insurance companies' monopoly power. It would be fairly easy for a public program modeled on Medicare to get hospitals to sign on at Medicare rates (or something close to it), which would allow it to pull customers away from the insurance companies. This might be a very effective way to force competition on the insurance companies. Unfortunately, the actual public program we are likely to get out of this round of reform is likely to be too modest to change the nature of the game entirely. And there might be some legitimate reasons to worry about a large Medicare-type program with the power to set rates below what hospitals can afford.

Suppose we wanted to increase competition in the health insurance industry without a public option. How could we do this? Well, let's rule out one approach off the bat: eliminating state regulatory requirements on insurance policies, as Republicans propose, is not going to do much if anything. The problem is not that Aetna doesn't have the resources to devise a policy that satisfies Pennsylvania's regulatory requirements; the problem is network effects that give HBS a natural monopoly.

One way we have dealt with natural monopolies in the past is regulation. The problem with a monopoly is it can charge prices above its long run average cost, thereby earning excess profits at the expense of its customers. If a state or federal commission set insurance rates the way many states set utility rates, it could force the companies to charge prices equal to average costs. This could work for health insurance, but again there may be benefits to having a truly competitive market rather than a regulated monopolistic one.

Here's something we could do to open markets to competition. We could require hospitals and doctors to accept any and all private insurance plans that were certified by the state or federal government. To prevent providers from being swamped with paperwork from hundreds of different insurers, we could require uniform reimbursement forms. In other words, hospitals and doctors would be required to operate as "common carriers" in the manner of transportation or telecom companies. In addition, hospitals and doctors could be subject to the equivalent of "most favored nation" requirements. A hospital would be prohibited from charging one insurance company higher reimbursement rates than the lowest reimbursement rates it accepts from other companies. Under this proposal every health insurance company pays hospitals the same rates; every hospital accepts every health insurance policy offered; and health insurance companies compete for customers by offering different types of policies, better service, or lower premiums.

Since insurers are the source of the problem, it might seem odd for a plan to restrict the activities of health care providers rather than insurers. But restrictions on the ability of providers to bargain actually strengthens their position relative to insurers because dominant insurers would no longer be able to force hospitals to accept lower reimbursement rates.

This plan seems to me to offer the best chance of promoting competition in the health insurance industry, thereby lowering the costs of reform in the long run. I would think it would be acceptable to Republicans who are hostile to the idea of a public plan. Though liberals probably would prefer a robust public plan, this plan might be preferable to a weak and ineffective public option. I wonder if anyone has thought of this before.

Daniel Davies on Freakonomics

An excellent critique of the (hopefully ersatz) Freakonomics movement. Via Brad DeLong.

We stopped doing economics and started doing awful amateur-hour sociology, basically, because we believed that all the major problems had been solved, that some form of dynamic general equilibrium was all that there was to be said about the economy considered as a system, and that the only interesting things to do were growth theory and finance. It is no coincidence that Freakonomics began in Chicago; for a guy like Levitt who doesn't possess the engineering-maths to be a finance theorist or the empirical skills to do endogenous growth, there was literally nothing to do...

But however things have turned out, my intuition is that Freakonomics has had its moment in the sun. The central selling point was always, basically, academic machismo; the presumption on the part of economists that because they were "smart" in the Larry Summers sense, they could turn their hand to anything and the rest of the world was bound to listen to them. Those days, to put it mildly, are gone.

Foggy Bottom Borscht Belt

From Talking Points Memo:

A spokesman for the State Department had this take on President Obama's Nobel Peace Prize, reports CNN: "Certainly from our standpoint, this gives us a sense of momentum -- when the United States has accolades tossed its way, rather than shoes."

Congratulations President Obama

Upon receiving word that President Barack Obama won this year's Nobel Peace Prize, Michael Steele, Chairman of the Republican Party, issued this statement:

"While I disagree with President Obama on many issues, I congratulate him on winning the Nobel Peace Prize. All Americans should be proud of the honor awarded to our president."

Oops, that's not what he said. What he actually said was

“The real question Americans are asking is, ‘What has President Obama actually accomplished?’ It is unfortunate that the president’s star power has outshined tireless advocates who have made real achievements working towards peace and human rights...One thing is certain – President Obama won’t be receiving any awards from Americans for job creation, fiscal responsibility, or backing up rhetoric with concrete action.”

That's a small, small man. John McCain and Tim Pawlenty, thankfully, remembered their manners. McCain:

told CNN he could not divine the Nobel committee's intentions, "but I think part of their decision-making was expectations. And I'm sure the president understands that he now has even more to live up to. But as Americans, we're proud when our president receives an award of that prestigious category."

Pawlenty:

"under any circumstances I thought an appropriate response is congratulations."

Maybe the Republicans are learning to be civil. This just in: John Boehner admits that Barack Obama is not a socialist.

More on the problems with macroeconomics

Since Paul Krugman's NY Times piece dissecting what went wrong with the macroeconomics profession, some misinformation has bounced around the blogosphere about the role of rational expectations in all this. Justin Fox, for example, argues:

3) Macroeconomists actually have been making progress over the past couple of decades:

But the standard policy prescription of economists in the rational expectations tradition is that government shouldn't try to do anything about macroeconomic fluctuations. While I think that may be the right course (albeit one that is never really followed) in reaction to a garden-variety recession, I'm not so sure in the case of a potential global depression caused by a huge financial shock. And here's the thing: As best I can tell, modern macro models of almost all stripes don't really take the financial sector and its influence into account. Which is why Krugman and many others find themselves grasping back to Keynes.

Fox's first point is wrong, his second point is right. Back in the 1970s proponents of rational expectations were arguing that policymakers should do nothing about the business cycle. There are still those who peddle that line. But the mainstream of macroeconomic theory, New Keynesian economics, has incorporated rational expecations into models with sticky prices, with the implication that activist monetary policy can help stabilize the economy. This type of model, epitomized by the work of Michael Woodford, has been tremendously influential. It has informed the Fed's policy of "flexible inflation targeting," it justifies the use of various versions of the Taylor rule.

The problem is not in the use of rational expectations, it is in the modeling of the financial system. While there are plenty of models out there that incorporate "financial frictions" into New Keynesian models, the linearity of the models seems to be a fatal flaw. Linearity means that if a financial collapse can cause a recession and deflation, then a boom can cause an equivalent expansion and inflation. Then the proper response to an asset bubble is to lean against the wind only when the effects are visible on GDP and inflation. This reasoning underlies the Fed's policy of not trying to prick asset bubbles (Bernanke and Gertler established this as the conventional wisdom in a couple of papers a decade ago). Unfortunately, it appears that the real world is nonlinear. Asset bubbles may have modest macroeconomic effects on the upside but devastating effects on the downside.

Don't blame rational expectations for this particular shortcoming of macroeconomics - blame the propensity of macroeconomists to favor linear over nonlinear models (I'm looking at you, Blanchard and Khan!).

Who are you calling obscure?

Gregg Easterbrook comments on the Ursinus-Gettysburg football game:

Bonus Obscure College Score: Ursinus 55, Gettysburg 50. There were 15 touchdowns and a field goal, 64 first downs, 1,317 yards of offense and one punt in this scoreboard-spinning contest. (Four turnovers and two missed tries were the undoing of the Gettysburg Bullets.) Located in Collegeville, Pa., Ursinus requires freshmen to spend their year in this pursuit: "read, discuss, write and reflect on the great questions of human existence, like love, friendship, happiness, life, death, God and nature." OK, that should say "such as." The point is, many colleges do not require students to reflect on these matters!

Happy (belated) non-borrowed reserves targeting day

How come none of the economics blogs I follow regularly noted that yesterday was the 30th anniversary of Paul Volcker's announcement that the Fed would begin targeting non-borrowed reserves rather than the federal funds rate? This decision was the beginning of the end of the Great Inflation that wracked the economy in the 1970s. It was such a historical milestone that today no respectable macroeconomist will run a regression on post-war US data without acknowledging the likelihood of a structural break in 1979:Q4.

Bentham v. Hume

David Brooks writes an entertaining piece on our choices for health care reform and climate change policy. He contrasts "Bentham," who thinks he knows how to find cost savings in the health insurance industry and which technologies can reduce global warming, with "Hume," who confesses he's not smart enough to reorganize major sectors of the economy and therefore proposes market-based solutions.

On the economics, Brooks is absolutely right. On the politics, ludicrously wrong. His punch line:

I’ve introduced you to my friends Mr. Bentham and Mr. Hume because they represent the choices we face on issue after issue. This country is about to have a big debate on the role of government. The polarizers on cable TV think it’s going to be a debate between socialism and free-market purism. But it’s really going to be a debate about how to promote innovation.

The people on Mr. Bentham’s side believe that government can get actively involved in organizing innovation. (I’ve taken his proposals from the Waxman-Markey energy bill and the Baucus health care bill.)

The people on Mr. Hume’s side believe government should actively tilt the playing field to promote social goods and set off decentralized networks of reform, but they don’t think government knows enough to intimately organize dynamic innovation.

So let’s have the debate. But before we do, let’s understand that Mr. Bentham is going to win. The lobbyists love Bentham’s intricacies and his stacks of spending proposals, which they need in order to advance their agendas. If you want to pass anything through Congress, Bentham’s your man.

Notice that Brooks can point to real people with real policy proposals pushing the Benthamite view. By contrast, he can't point to any person or proposal pushing Hume's view. So the practical choice before us is not between Bentham and Hume, it's between Bentham and a character that I'll call Org. Bentham believes that government can step in and fix our problems through sheer intelligence. Org thinks that if he sticks his fingers in his ears and shouts Na-na-na-na loud enough, the problems will miraculously go away.

Krugman on restoring the status quo ante

Paul Krugman draws up this schemata of the US financial system.


Traditionally banks lent to borrowers (diagonal line). Since the 1980s, much of the business of banking has been taken up by shadow banking (bottom line). The collapse of the shadow banking system has caused the Fed to create huge amounts of reserves and, since the banks won't lend them out, make loans directly to the public (right-most line).

Krugman asks:

Call me naive, but why does Fed policy seem to assume that the only way to repair credit markets is to return to the status quo ante, circa January 2007?... Are we still convinced that securitization is a far superior system to conventional banking, and if so why?

The answer, I think, is that banking is a particularly costly way of intermediating between savers and investors. It exists because of the problem of asymmetric information in credit markets. Securitization is a way of giving borrowers (almost) direct access to capital markets rather than going through the banking system, resulting in lower borrowing costs. The problem is that as practiced, securitization was not an alternative solution to the problems of asymmetric information but an end-around the banking system. The asymmetric information problem ended up biting us all in the butt. The optimal post-crisis arrangement, it would seem to me, is not to go back to traditional banking but to resolve the asymmetric information problems that exist in the shadow banking system through more regulation, higher capital requirements, etc.

An inefficient way to finance health care

My son plays on a soccer team. The other parents are good, well-meaning Republicans (from what I gather). Today I got the following email from someone on the team, referring to a kid who plays on a different team:

___ is currently being treated at Hershey Medical Center. He has been in the hospital off and on for over a week. ___ has had two surgeries. His most recent surgery was to repair a hole in his stomach caused by an infection and swelling to the point of tearing. The cause of his serious illness was unknown. Now doctors think they know the cause, but can not address it until his condition improves. ____ will likely have a feeding tube for a few weeks...

To help ____ and his family we have set up a fundraiser event at Hoss's in Gettysburg. If you are free on Wednesday, October 7th please print out the attached flyer and join us at Hoss's for dinner. 20% of your purchase will go toward helping the family with travel and medical costs...

Generous people, salt of the earth. But maybe if we had a decent health care system in this country the boy's family wouldn't be facing such financial difficulties. So I sent this as a response:

Please also contact your Senator and Congressmen and tell them to vote for health care reform so that families like ___’s aren’t forced into financial hardship because of health problems.

We'll see how that flies.

Ick

The Employment Situation for September was worse than expected. Unemployment rate up to 9.8%, 263,000 jobs lost in September. The consensus forecast was more like 167,000 jobs lost.

No one thought the economy would start adding jobs until the end of 2009 anyway, so one shouldn't conclude from this data that the recovery is sputtering. Nevertheless, it would be prudent to start thinking seriously about a second stimulus, as Paul Krugman suggests today. This one should be focused on supporting state and local spending. Likelihood of Congress actually taking this on: zero.