Semi-Daily Journal Archive

The Blogspot archive of the weblog of J. Bradford DeLong, Professor of Economics and Chair of the PEIS major at U.C. Berkeley, a Research Associate of the National Bureau of Economic Research, and former Deputy Assistant Secretary of the U.S. Treasury.

Thursday, November 02, 2006

Paul Krugman's Correct Views on Everything

Mark Thoma publishes notes James Crabtree took of the current version of Paul Krugman's "economic situation" talk:

Economist's View: NDN: Krugman's Remarks at the New America Foundation Economic Conference: In general economic terms we are off the map - in two ways on (1) housing and (2) the trade deficit. Because we are off the map, we are struggling to use our fundamental understanding of economics, and some dubious number crunching, to make sense of a situation that doesn't look like anything we've seen before.

  1. Housing. Adjusted for inflation house prices are up 50% by 2000. If this was the end of the story you could just about justify this in terms of lower interest rates and other things. But that isn't the right comparison. It depends on where you look. 1/3rd of the US lives in areas of land scarcity and restrictive zoning. 2/3rds live elsewhere, where land is plentiful.... In... that 1/3rd. you find that house prices are up 80 - 100%. Here it really does look like a bubble. People have extrapolated from rising prices that things will keep rising. The result is a surge in housing demand, with huge impact on the economy. Residential constructions was up to 6.3% of GDP, up from 4%... a bigger GDP stimulus than all of the bush tax cuts.

  2. Trade Deficit. We finance our deficit by borrowing. This cannot go on indefinitely... any kind of scenario will have to involve a substantial fall in the dollar. And the markets are not taking this into account. Inflation adjusted bond rates seem incorrectly priced, compared to the EU or Japan. Some bonds are being bought by foreign based banks for non-market reasons. But many are not. So the market, if it took the dollar decline into account, would price this in. There will be a Wile E. Coyote moment. When? I would have said the answer was two years ago, so I've been wrong before. But it will happen at some point.

So here is the economic problem. We have a big trade deficit and a highly inflated housing sector. One result has been that we've lost a lot of manufacturing jobs.... Eventually this will slide back, and we'll see more jobs in manufacturing if exports pick up. The thing is that the transition will be unlikely to be smooth.

What will happen? If you asked me a year ago I thought... a rise in interest rates, and then a collapse in the housing boom. Then the question would be could exports rise to take up the slack? But this hasn't happened... housing is falling first, without any fall in the dollar.... I've never seen economists disagreeing so much. Not about what will happen in 1 year, but what will happen in the 4th quarter, which we are half way through. Some people say rebounding. Some say worse is to come. The reason for this is conflicting trends. Housing is falling like a stone. Maybe it has hit bottom. But probably not. The fundamentals still look like housing has a long way down to go. The norm for housing construction is 4%, its now down to 5.7% down from above 6%. So I think housing will be much worse.

But as Larry Summers likes to say "you don't have to fill a flat tire through a hole." There are reasons for optimism. Business investment is still good.... Consumer spending is still going up.... I'm with the pessimists. But I'm not sure how solid my ground is.... Merrill Lynch projects a sharp rise in unemployment... it would feel like a recession.

The thing to be worried about is the difficulty of a policy response. We normally count on the Fed to respond. (Bernanke, on the whole, has had his judgment on rates vindicated.) But if this turns nasty, what will the Fed do? They will cut rates. And will this help? Where is the traction on the real economy? The problem is that rate cuts stimulate the economy mostly through the housing and construction market. In truth, business investment is not sensitive to the Fed.... Housing is where the rubber meets the road. So that is a worry...

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