China's Income Disparity

China's Gini coefficient reached 0.47, according to a survey in 2001. This is higher than the US's 0.408, Britain's 0.36, and Japan's 0.249. The comparison suggests that China's level of income inequality has surpassed these countries.

Source: Wall Street Journal Dec 18, 2006.

Edward Prescott: Five Macroeconomic Myths

The sky is not falling. No need to panic and start playing around with all sorts of policy responses. Despite the impression created by some economic pundits, the U.S. economy is not a delicate little machine that needs to be fine-tuned with exact precision by benevolent policymakers to keep from breaking down. Rather, it is large and complex, with millions of people making billions of decisions every day to improve their lives...

On the one hand, it's difficult to screw up all these well-intentioned people by crafting bad policy, but, on the other hand, it is of course entirely possible to do so. And once things are broken, they are much harder to fix. For example, all those doomsayers predicting a recession will get their wish if taxes are suddenly raised, new productivity-strangling regulations are enacted, the U.S. turns against free trade, or some combination thereof. Otherwise, we should expect 3% real growth, based on 2% increases in productivity and 1% population growth. This economy is fundamentally sound.

So we have to be careful that we don't believe everything we read in the papers. ...[P]olicy should not be revised at every turn, nor rules changed by political whim. ... One of the great disciplines of economics is that it challenges us to question status quo thinking. So let's take a look at five pillars of contemporary conventional wisdom that have current standing, and see how well they hold up.

Myth No. 1: Monetary policy causes booms and busts. ...

One of the mysteries of the 1990s is how to explain the economic boom when the increase in capital investments -- as measured by the national accounts -- grew at a subdued pace. The numbers simply don't add up. However, it turns out that something special happened in the 1990s, and it wasn't monetary policy. In a recent paper, ... Ellen McGrattan and I show that intangible capital investment -- including R&D, developing new markets, building new business organizations and clientele -- was above normal by 4% of GDP in the late 1990s. ... Output, correctly measured, increased 8% relative to trend between 1991 and 1999, which is much bigger than the U.S. national accounts number of 4%. ...

What about busts? Let's begin with the assumption that tight monetary policy caused the recession of 1978-1982. ... To accept the myth, you have to accept a consistent relationship between monetary policy and economic activity -- and ... this relationship is simply not evident in the data. ... Our obsession with monetary policy in the conduct of the real economy is misplaced.

One caveat: I am not saying that there are no real costs to inflation -- there certainly are. And if we get too much inflation we can exact high costs on an economy (witness Argentina as an example). However, I am talking here of the vast majority of industrialized countries who live in a low-inflation regime... It is simply impossible to make a grave mistake when we're talking about movements of 25 basis points.

Myth No. 2: GDP growth was extraordinary in the 1990s. Even though I referred to the expansion of the '90s as a boom, inasmuch as it was a period of above-trend growth, and I noted the strong gains due to unmeasured investment, we have to put things into historical context. So let's return to the data. GDP growth relative to trend in the early 1960s was 12%, and in the famous 1980s boom (from the end of 1982 to mid-1989) it was a very impressive 9.7%. ...

So we have to be careful about mythologizing the 1990s and drawing misguided policy lessons; yes, it was a boom, and it was better than we think, but let's keep that boom in perspective.

Myth No. 3: Americans don't save. This is a persistent misconception owing to a misunderstanding of what it means to save. ... Our traditional measures of savings and investment, the national accounts, do not include savings associated with tangible investments made by businesses and funded by retained earning, government investments (like roads and schools) and business intangible investments.

If we want to know how much people are saving, we need to look at how much wealth they have. ... Viewing the full picture -- economic wealth -- Americans save as much as they always have... We're saving the right amount.

Myth No. 4: The U.S. government debt is big. ... Let's turn to the historical data once again.

Privately held interest-bearing debt relative to income peaked during World War II, fell through the early 1970s, rose again through the early 1990s, and then fell again until 2003. Even though that number has been rising in recent years (except for the most recent one), it is still at levels similar to the early 1960s, and lower than levels in most of the 1980s and 1990s. ... From a historical perspective, the current U.S. government debt is not large.

Myth No. 5: Government debt is a burden on our grandchildren. There's no better way to get people worked up about something than to call on their sympathies for their beloved grandkids. ... But we should stop feeling guilty -- at least about government debt -- because we are in better shape than conventional wisdom suggests.

Theory and practice tell us that the optimal amount of public debt that maximizes the welfare of new generations of entrants into the workforce is two times gross national income, or GDP. ... Currently, privately held public debt is about 0.3 times GDP, and if we include our Social Security obligations, it is 1.6 times GDP. In either case, we could argue that we have too little debt.

What's going on here? There are not enough productive assets -- tangible and intangible assets alike -- to meet the investment needs of our forthcoming retirees. ... The fix comes from getting the proper amount of government debt. When people did not enjoy long retirements and population growth was rapid, the optimal amount of government debt was zero. However, the world has changed, and we in fact require some government debt if we care about our grandchildren and their grandchildren.

If we should worry about our grandchildren, we shouldn't about the amount of debt we are leaving them. We may even have to increase that debt a bit to ensure that we are adequately prepared for our own retirements.

There are at least three lessons here. First: Context matters. Take what you read in the paper with a many grains of historical salt. Second: Current data often provide poor guidance for effective policy making. To make forward-looking policies you have to understand the past. Finally: Establish good rules, change them infrequently and judiciously, and turn the people loose upon the economy. Booms will follow.

China's economy shifted in 10 years

Between 1995 and 2005, China's total trade has increased from 37.1% of GDP to 62.4% of GDP (Exports increased from 19.4% to 33.4%, and imports increased from 17.4% to 29%). Gross investment has increased from 33% to 41.5%. Total FDI has increased from 3.2% to 5% of GDP. Consumption, on the other hand, has dropped from 44.9% of GDP to 38%.

It is no doubt that China's economic growth now hinges more and more on two pillars: foreign trade and domestic physical investment. What is worrisome is the latter: one wonders how much of the investment is driven by the fervor of local officials, and if those projects will ever turn up any real profits. If bad projects are financed by state banks as before, more trouble is ahead.

The Fed's Confession

When it comes to admitting error, central bankers tend to emulate Benjamin Disraeli, who famously said "never complain, never explain." So it was nothing short of astonishing last week for Richard Fisher, President of the Federal Reserve Bank of Dallas, to confess in public that the Fed had blundered by keeping monetary policy too easy for too long in 2003 and 2004.

Speaking to bankers in New York, Mr. Fisher issued a mea maxima culpa that deserves wide attention: "In retrospect, the real fed funds rate turned out to be lower than what was deemed appropriate at the time and was held lower longer than it should have been." As the nearby chart shows, a Fed worried about possible "deflation" moved the overnight interest rate it charges banks in June 2003 to an extraordinarily low 1% and kept it there for another year.

Mr. Fisher blamed this mistake on "poor data" that underestimated inflation, leading "to a policy action that amplified speculative activity in the housing and other markets. Today, as anybody not from the former planet of Pluto knows, the housing market is undergoing a substantial correction and inflicting real costs to millions of homeowners across the country." In other words, the Fed itself is responsible for the current housing bust because its over-easy policy created a real estate frenzy that was bound to end once the Fed tried to regain control over inflation expectations.

From: Wall Street Journal

Why Money Matters, by Milton Friedman

The third of three episodes in a major natural experiment in monetary policy that started more than 80 years ago is just now coming to an end. The experiment consists in observing the effect on the economy and the stock market of the monetary policies followed during, and after, three very similar periods of rapid economic growth in response to rapid technological change: to wit, the booms of the 1920s in the U.S., the '80s in Japan, and the '90s in the U.S.

The prosperous '20s in the U.S. were followed by the most severe economic contraction in its history. In our "Monetary History" (1963), Anna Schwartz and I attributed the severity of the contraction to a monetary policy that permitted the quantity of money to decline by one-third from 1929 to 1933. Since 1963, two episodes have occurred that are almost mirror images of the U.S. economy in the '20s: the '80s in Japan, and the '90s in the U.S. All three episodes were marked by a long period of rapid economic growth, sparked by rapid technological change and the emergence of new industries, and accompanied by a stock market boom that terminated in a crash. Monetary policy played a role in these booms, but only a supporting role. Technological change appears to have been the major player.

These three episodes provide the equivalent of a controlled experiment to test our hypothesis about what we termed the Great Contraction. In this experiment, the quantity of money is the counterpart of the experimenter's input. The performance of the economy and the level of the stock market are the counterpart of the experimenter's output... The three boom episodes all occurred in developed private enterprise market economies, involved in international finance and trade, and with similar monetary systems, including a central bank with power to control the quantity of money. This is the counterpart of the controlled conditions of the experimenter's laboratory.

The Money Supply: In addition, history has provided a close counterpart to the kind of variation in input that our hypothetical experimenter might have deliberately chosen. As Fig. 1 shows, monetary policy ... was very similar in the three boom periods, and very different in the three post boom periods, with settings that might be described as low, medium, high.

To measure the quantity of money, I use M2 in the U.S. and the conceptually equivalent M2 plus certificates of deposit in Japan. To express the data for the two countries and the widely separated periods in comparable units, I use as an index of the money stock the ratio of the quantity of money to its average value for the six years prior to the cycle peak... Finally, the data are plotted to align the dates at the cycle peak.

Fig. 1 shows a striking contrast between the period before the cycle peak and the period after the cycle peak. There are some differences before the peak -- money growth is slowest on the average for the earlier U.S. episode, fastest for Japan -- but the differences are small and there is reasonably steady money growth in all three episodes. The contrast with the period after the cycle peak could hardly be greater. Money supply declines sharply after the cycle peak in the first episode, goes from stable to rising mildly in the second, and rises steadily and sharply in the third. Our hypothetical experimenter planned his experiment well.

The GDP: The results of the third episode of this natural experiment are now all in. Fig. 2 shows how GDP in nominal terms (dollars or yen in current prices) behaved during the boom and post boom periods. I use nominal GDP rather than real GDP because M2 is also a nominal magnitude. How changes in nominal GDP are divided between prices and output is an important question but one that is not directly relevant to this experiment...

As in Fig. 1, there is a striking contrast between the boom and the post-boom periods: roughly similar growth during the booms, widely variable growth during the post-boom. Both before and after the cycle peak, nominal GDP growth paralleled monetary growth. During the boom, money and nominal GDP grew most rapidly in Japan, most slowly in the first U.S. episode, and at an intermediate rate in the second U.S. episode...

After the cycle peak, money fell sharply in the first episode and so did nominal GDP; money growth stagnated in the second episode and so did GDP; money grew at a rapid rate in the third episode and, after a brief lag (corresponding to the mild 2001 recession) so did GDP. ...

The Stock Market: The peak of the stock market, as measured by S&P's index, coincided with the cycle peak in the first episode, both occurring in the third quarter of 1929... However, that was not the case in the later episodes. ... Accordingly, Fig. 3 plots the data to align the series at the stock market peak.

The near identity of the three stock market series during the boom is truly remarkable. ... Of more interest for our purpose is what happened after the peak. For a year after, the three stock-price series fell in tandem, responding to the inner dynamics of a collapsing bubble. Then, the differences in monetary policy began to have an effect. Beginning in late 1930, the S&P index started falling away from the others under the influence of a collapsing money stock. For another year and a half, the other two indexes move in tandem. Then the much more expansive policy of the Fed in the '90s than of the Bank of Japan in the '80s takes effect and pulls the S&P 500 away from the Nikkei, which stabilizes in response to the passive monetary policy of the Bank of Japan...

The results of this natural experiment are clear, at least for major ups and downs: What happens to the quantity of money has a determinative effect on what happens to national income and to stock prices. The results strongly support Anna Schwartz's and my 1963 conjecture about the role of monetary policy in the Great Contraction. They also support the view that monetary policy deserves much credit for the mildness of the recession that followed the collapse of the U.S. boom in late 2000.