US GDP Growth for Q2 2010 Hit By Large Downward Revision

The growth rate of US real GDP was hit by an unusually large downward revision for the second quarter of 2010. The second estimate of Q2 GDP, released at the end of August by the Bureau of Economic Analysis, showed growth of just 1.6 percent from the previous quarter, compared with an advance estimate of 2.4 percent released at the end of July.

GDP data, which provide critical information to policy makers, are subject to a trade-off between accuracy and timeliness. The so-called advance estimate, released about three weeks after the end of each quarter, is based only about 45% on actual data for the quarter. The rest comes from models and projections. The average revision between the advance estimate and the third estimate, released about three months after the end of the quarter, is plus or minus 0.6 percentage points.

The 0.8 percentage point downward revision for the second Q2 2010 estimate was unusually large. The biggest single cause of the revision was faster than expected growth of imports, which outpaced steady, but slower, growth of exports. International trade is a frequent source of revisions to GDP data, since the advance GDP estimate contains little if any actual trade data for the reported quarter.

Follow this link to download a free set of classroom-ready slides covering the Q2 2010 GDP data revisions, and explaining the trade-off between timeliness and accuracy of data

The Economics of High-Speed Rail: Lessons for Policy Analysis

High-speed rail (HSR) is back in the news. Proponents see it as a cool but practical cure for economic and environmental ills. Opponents see it as a costly boondoggle. Why the huge range of opinion? What can we learn about policy analysis in general from the case of HSR?

Reduced energy use and pollution are among the most widely cited benefits of HSR. Advantages over road or air transport of up to six-to-one are widely cited. However, such data cannot be accepted uncritically.

First, the most favorable comparisons often look at emissions and energy use only in operation. A valid comparison should use life-cycle analysis that also includes energy use and emissions in infrastructure construction, vehicle manufacturing, and fuel production. HSR appears to retain an edge over air travel on a life-cycle basis, but the advantage is not as great, mainly because air travel requires less infrastructure investment per passenger mile.

Similarly, analysis of HSR should employ sensitivity analysis. The viability of HSR on any given route is highly sensitive to variables like passenger load factors per trip and total traffic density. Policy advocates often use inappropriate comparisons, citing data only from best or worst cases without looking at the specifics of proposed projects. City pairs that look superficially similar, like Chicago-St. Louis vs. Paris-Lyon, can turn out to have very different HSR potential.

Finally, one must beware of counting costs as benefits. Proponents of HSR often cite its job-creation potential, but labor and other inputs used in provision of HSR are costs, not benefits. Even when conditions warrant government stimulus spending of some kind, HSR should still compete on its merits with other potentially beneficial projects like renewing sewer and water systems, constructing schools, or expanding the power grid. Drawbacks of HSR as a candidate for stimulus spending include a long start-up time and spending commitments that extend over a period longer than a typical business cycle.

On balance, high-speed rail appears to lie somewhere between a transportation panacea and a hopeless boondoggle. Well-planned projects implemented under favorable conditions can potentially save energy, cut pollution, and improve service quality, but initial costs are high. HSR must compete on its merits with other public and private investment projects.

Follow this link for a free set of classroom-ready slides discussing the economics of high-speed rail and related lessons for policy analysis.

A Natural Experiment in Demand Elasticity: Metered vs. Unmetered Electricity

Economists can't always conduct controlled experiments to test hypotheses about public policy, but sometimes experiments occur naturally. New York City electric rates provide an example. About 1.75 million New York apartments have metered electricity, paying an average of 21 cents per kilowatt hour, among the highest rates in the nation. At the same time, about 250,000 older apartments have unlimited, unmetered electric power included in the rent. A recent article by Sam Dolnick in The New York Times compares electricity use in the two types of apartments. The NYC experiment can be used to test three a priori hypotheses about the elasticity of demand for electricity.

First, demand might be completely inelastic. Although this hypothesis would not appeal to most economists, it reflects a line of argument often found in popular discussions. How many times have you heard someone say something like this: "Raising electric rates wouldn't help conservation. Rich people can afford to use as much as they want regardless of the price. And poor people would still need electricity to live, so raising the price would just make them poorer."

Second,  demand might have constant elasticity. Because of their convenient mathematical form, constant elasticity curves are often used in empirical studies. Because they never intersect the axes, they imply that the quantity demanded would be unlimited if the price fell to zero.

Third, the demand curve might be linear. Textbooks are full of linear demand curves. Some people joke that is because lazy authors find them easier to draw. A linear demand curve implies that demand is finite even when the good is free.

Observations from the New York experiment shed light on these hypotheses. Demand is greater unmetered apartments. Some people do use electricity very wastefully, for example, running their air conditioners full blast while they are at work so that their cats will be comfortable. Still, demand does not increase without limit. Electric use is only about 30 percent higher in unmetered apartments than metered ones.

Taken together, these observations allow us to reject the hypotheses of perfect inelasticity and constant elasticity. Looks like the lazy old linear demand curve provides the best fit after all. And yes, skeptic, charging for electricity does provide an effective incentive for conservation.


Follow this link to download a free set of classroom-ready slides about metered vs. unmetered electricity in New York.

Using Productivity Data to Understand Employment Trends

A slowdown in productivity growth is not usually good news, but the dip in U.S. productivity in the second quarter of 2010 may have a silver lining. The 0.9 percent decline in productivity, and the data that underlie it, appear to indicate that the stage is now set for employment growth in the second half of the year.

Any improvement in the employment picture would be welcome. Although output has grown steadily since the apparent end of the recession in mid-2009, the unemployment rate, which remained stuck at 9.5 percent in July 2010, is only slightly below its peak. Some observers are describing this as a "jobless recovery."

Very strong growth of labor productivity is what has made the "jobless recovery" possible. Output per labor hour usually grows at about 2.5 percent per year, but in the early stages of the recovery, the annualized quarterly rate of productivity growth has surged to as high as 8 percent. Its decline in Q2 2010 was the first since 2008, indicating that employers are running out of ways to squeeze more output from the existing workforce.

Further evidence is found in the fact that hours per worker, which have climbed steadily during the early stages of recovery, are now above their pre-recession average level. If output continues to grow, employers are likely to need to hire additional workers, not just expand hours further.

In making any hiring decisions, employers will keep an eye on unit labor costs--labor costs adjusted both for changes in compensation and in productivity. Productivity fell by 0.9 percent in Q2, but compensation fell almost as much, 0.7 percent, so unit labor costs were essentially flat.

On balance, then, labor market data show an abundant supply of reasonably priced, productive labor, and an exhaustion of reserves produced by recession-driven labor hoarding. The groundwork is laid for employment growth to improve later this year if--and it is still a big if--there is sufficient demand for the output that newly hired workers can produce.

Follow this link to download a free set of classroom-ready slides including charts of the latest labor market data and a discussion of their interpretation.

Recommended Viewing: Two Treasury Secretaries on Taxes and the Economy

At a time when the two parties in Washington are barely speaking to each other, it is refreshing to hear two former Treasury Secretaries, one Democrat and one Republican, having a civilized conversation about taxes and the economy, and agreeing on a great deal. I recommend viewing the conversation between Robert Rubin and Paul O'Neil that took place on Fareed Zacharia's program GPS, broadcast on CNN, August 8, 2010. Here are some excerpts:

Participants:

Host: Fareed Zacharia (FZ)
Guest: Robert Rubin (RR), Treasury Secretary for President Bill Clinton, 1995-1999 and former Co-Chairman of Goldman Sachs
Guest: Paul O'Neil (PO), Treasury Secretary for George W. Bush, 2001-2001 and former Chairman and CEO of Alcoa

On fixing the economy:

FZ: If you could wave a magic wand,  how would you create more demand in the economy?

PO: [I wish that the president and Congress would start] with things like fundamental tax reform. When I was Secretary of the Treasury, I was on this cause to create fundamental tax reform. Unfortunately my client [George W. Bush] didn’t agree with me. . . I kept saying that the tax code we have is proof that we are not an intelligent people, and it’s worse now than it was ten years ago when I was singing this song. . . When you think about how you get capital formation, fairness, the distribution of pain for public goods, if we have something simple instead of the current income tax and corporate tax, something simple like a VAT or a consumption based tax, I think that would create a basis for creating capital formation, and saving, as opposed to consuming everything in sight. . . No intelligent people would create a tax system like this if they were given the chance to create a system worthy of a people who need to free up resources that are being wasted.

RR: [If I had a magic wand] I would stay on roughly the current fiscal track . . . I wouldn’t do a major second stimulus, because I think it would run a risk of being counterproductive by creating a lot of uncertainty and undermining confidence. But at the same time, I would put in place a very serious beginning at deficit reduction that would take place at some specified time in the future, something like two years. It wouldn’t take place right now when the economy is still fragile, but if you could do it, and it was credible, and it was real, I think that would do a lot for confidence. But that is very easy to say and very hard to do.

On extending the Bush tax cuts

FZ: What would you do about the Bush tax cuts?

PO: I was strongly opposed to the Bush tax cuts that took place in 2003. That was one of the reasons I got fired, between that and saying there was no evidence of weapons of mass destruction in Iraq. First of all, I thought we needed the money to smooth the way for fundamental tax reform, reform of Social Security and Medicare. . . and getting ready to go to war in Iraq. I didn’t think we could afford another tax cut.

FZ: What do I think of the tax cuts now?

PO: I don’t think it’s the right issue. The issue is fundamental tax reform. If we let the tax cuts expire, are people going to say, hallelujah, everything is all right now with our tax system? Not me!

FZ: Should we just let [the Bush cuts] all expire?

RR “I’ll tell you what I would do. Number one, I would put on an estate tax right now, because there is no estate tax and I would fill that void. . .  Number two, I would increase taxes on the top two brackets and put them back up to the Clinton rate. I think there is no supply side effect there. I would leave the middle class tax cuts in effect for a limited period because I think the probability is high that we will have slow and bumpy growth.

On political gridlock

RR: I think our country is at a crossroads, I think we have tremendous long-term strength [but] the political system has deteriorated substantially in its ability to work across party lines and make tough decisions.

PO: That may be a blessing in disguise because if they could agree on something, it would probably be negative to the people. . . It is really tragic what has happened to our political system and its inability to have even a civil conversation. . . It is insane that otherwise intelligent people could participate in this folly when the country is at risk.

Follow this link to view the conversation in full. The extracts given here are transcribed by Ed Dolan, not by CNN, and may contain minor transcription errors.

MV=PQ: A Resource for Economic Educators

I have recently added MV=PQ to my list of useful resources. Some good discussions, and a good place to look for links to academic research on topics relevant to your classes.

Financial Reform: What is Basel III and Why Should We Regulate Bank Capital?

The 2010 Dodd-Frank Act reformed bank regulation in several ways. It established a systemic risk council, set out a new resolution mechanism for failure of complex financial firms, improved consumer protection, limited risks from derivatives and private trading, and more. However, there were some big things that it did not do. The biggest of those was not to set rules for bank capital.

Establishing a minimum level of capital lies at the very heart of bank regulation. Banks with too little capital (excessive leverage) are at risk of insolvency if they suffer even small losses on loans or other assets. However, higher leverage also increases the rate of return on shareholder capital for banks that manage to remain solvent. Capital standards are thus is a key element of the trade-off between risk and rate of return for banks and other financial institutions.

Bank regulators, who are concerned about the spillover effects of bank failures on the rest of the economy, generally prefer lower risk and higher capital than do banks. (See this earlier post for a more detailed discussion of the risk-return preferences of banks and regulators.) The regulators of individual countries do not act alone in regulating bank capital. Instead, they coordinate their capital standards through the Basel Committee on Bank Supervision. The BCBS has issued a series of regulatory guidelines, beginning with Basel I (1988), later followed by Basel II (2004).

Unfortunately, the Basel II standards were a spectacular failure. They did not prevent the global financial crisis that began in 2007, and may even have facilitated it. The crisis devastated the nonfinancial economy and required costly rescue of dozens of the world's largest banks, including many that, on paper, fully met Basel II capital adequacy standards. The failures of Basel II can be traced, above all, to the fact that they allowed banks to overstate their true amount of capital and understate the risks to which they were exposed.

Many observers think that the simplest measure of capital, tangible common equity (TCE), is the best for gauging a bank's ability to withstand losses. Tangible common equity counts only assets, like loans, securities, or real property, that could be sold by a failing bank to help cover losses in an emergency. It counts as capital only the equity claims of common shareholders that are the first in line to absorb losses. Basel II instead used a more lenient measure of regulatory capital that differed from TCE in two ways. First, it allowed inclusion of certain intangible assets like goodwill and tax loss assets--accounting entries that could indicate future profits for a healthy firm but that offer no protection to one on the brink of insolvency. Second, they allowed inclusion of certain forms of hybrid capital, like preferred stock, that have properties midway between pure equity and debt. Hybrid capital has proved to be a less secure cushion against insolvency under conditions of stress.

In addition, Basel II allowed banks to hold less capital per dollar of safe assets than per dollar of risky assets. At the same time, it allowed understatement of risks, which in turn, allowed banks to get by with inadequate capital. Excessive reliance on ratings agencies, which exaggerated the safety of complex securities, was one problem. Inadequate attention to off-balance-sheet risks was another.

Now negotiations are underway for a new set of international capital standards that will be known as Basel III. Preliminary proposals show a clear recognition of the shortcomings of Basel II. They recommend tightening the definition of capital, relying less on ratings, and paying more attention to off-balance-sheet risks, among other things. Unfortunately, with finalization of Basel III still months away, the goal posts are already beginning to move. At a July 26 meeting, the BCBS announced an intention to water down some of its initial proposals. Some observers are beginning to worry that furious lobbying by banks is paying off, and that the final Basel III standards will again be inadequate. If so, another global crisis will be only a matter of time.

Follow this link to download a free set of classroom-ready slides discussing the meaning of bank capital, the need to regulate it, and the Basel Accords. You may find it helpful to use these new slides together with this earlier set, which discusses bank regulation and the risk-return trade-off in additional detail.