*This will be the last ERR for 2004. Our next one will be on Jan. 3rd, 2005.

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Outstanding Stories of the Week

In the Timing of Option, Many, Um, Coincidences
Gretchen Morgenson
New York Times, December 5, 2004, Section 3, Page 1

This article reports on a new study showing that the issuing of stock options to top executives seems to precede the announcement of good news for corporate earnings. This indicates that companies are effectively giving unrecognized compensation by allowing top executives to buy stock (through purchasing options) in advance of market rises.

New Medicare Drug Plan Is Raising Difficult Issues For Nursing Home Patients
Robert Pear
New York Times, December 5, 2004, Page A24
Published online as "Medicare Law Said to Trouble Nursing Homes"

This article reports on the problems that many nursing homes will face in dealing with the new Medicare prescription drug benefit. While most nursing home patients would benefit from the insurance offered under the plan, nursing homes cannot decide on a plan for their residents. However, many nursing home residents are suffering from Alzheimer's, or other forms of dementia, and cannot select a plan for themselves.

Farmers Being Moved Aside By China's Real Estate Boom
Jim Yardley
New York Times, December 8, 2004, Page A1

This article reports on how farmers are frequently displaced in China to accommodate development. They often receive no compensation because of ambiguous laws on land tenure.

Seeking Quick Loans, Soldiers Race Into High-Interest Traps
Diana B. Henriques
New York Times, December 7, 2004, Page A1

This article reports on payday loan operations that prey on military personnel. These loans often carry interest rates of several hundred percent on an annual basis.

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Social Security

Bush Says He Won't Raise Taxes For Social Security Overhaul
Edmund L. Andrews
New York Times, December 10, 2004, Page A24

This article reports on a statement from President Bush's press secretary that Bush has ruled out any tax increases as part of his Social Security program. At one point it refers to Social Security's $10.4 trillion shortfall. It is helpful to note that this amount is calculated over the infinite future. By the same measure, the defense department would have more than a $30 trillion shortfall. Expressed as a share of GDP, the Social Security shortfall is less than 1.5 percent over an infinite future.

Furthermore, most of this shortfall falls far beyond Social Security's seventy-five year planning period. It results from the assumption that taxes are never increased and benefits are never cut even as life expectancy grows ever longer. The deficit over the next fifty years is virtually zero, according to the Congressional Budget Office. The Social Security trustees estimate that the Social Security deficit is equal to 0.7 percent of GDP over the seventy-five year planning period.

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The Housing Market

In Housing Sales, Frenzy Is Giving Way to Balance
Robert D. Hershey Jr.
New York Times, December 6, 2004, Page C14

This article discusses the slowing in the housing market. In the last nine years, home sale prices have outpaced the overall rate of inflation by more than 40 percentage points. Throughout the post-war period home prices have almost exactly tracked the overall rate of inflation. Home prices have also increased hugely relative to rent, which has largely kept even with inflation, even as home prices soared. Home sale prices and rents have also moved at almost the exact same pace in the past. In the last two years, record rental vacancy rates have actually been driving down rental prices, when adjusted for inflation.

This evidence suggests that housing prices are experiencing an unsustainable bubble. This view is never discussed in this article. The absence of any discussion of a housing bubble is comparable to having an assessment of the stock market at end of 1999 that didn't discuss the possibility of a stock bubble. In fact, almost none of the stock market analysis at the time mentioned the possibility of a bubble.

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The Dollar

Dollar's Fall Tests Nerve of Asia's Central Bankers
James Brooke and Keith Bradsher
New York Times, December 4, 2004, Page A1

This article reports on the problem that the falling dollar poses to East Asian central banks that have accumulated large dollar holdings. The banks may want to reduce their dollar holdings in order to avoid losses, but the decision of one of the major banks to dump their dollars could set off an even sharper decline, which could force them to take even larger losses as they unload their dollars.

At one point the article reports that Japanese and Chinese officials have urged the United States to raise its savings rate as an answer to this problem. An increase in the U.S. savings rate would not help Japan and China with their reserves problem, according to standard economic theory. The predicted effect of a higher savings rate would be lower interest rates, which should reduce international demand for the dollar, causing its value to decline further.

A rise in the savings rate could lead an economic downturn in the United States, if it is not accompanied by an offsetting increase in investment. If the United States experiences a prolonged slump, then it would reduce its demand for imported goods, which should then strengthen the dollar. While this may be what Japanese and Chinese officials have in mind, it unlikely that U.S. political leaders will agree to deliberately inflict a prolonged downturn on the economy, simply to prevent Japan and China from experiencing losses on their dollar holdings.

A Field Guide to the Falling Dollar
Daniel Altman
New York Times, December 5, 2004, Section 3 page 5

This article discusses some of the implications of a decline in the dollar. At one point it contrasts a relatively benign scenario in which the dollar falls gradually over a long period of time with a more troubling scenario in which the dollar drops precipitously. It asserts that the latter scenario is likely to be associated with a jump in interest rates.

In fact, the opposite is likely to be the case. If the dollar is widely perceived to be dropping relative to other currencies, then investors will typically demand an interest rate premium in order to hold dollar denominated assets, rather than assets denominated in euros, yen or other major currencies. On the other hand, if the dollar has just plummeted to a level that is consistent with a sustainable trade deficit, then investors will have little reason to fear a further decline, and should not demand an interest rate premium.

A rapid decline in the dollar would also be desirable from the standpoint of the long-term indebtedness of the country. The United States is presently incurring foreign debt at the rate of $650 billion a year. If the dollar fell quickly, the rate of debt accrual would fall rapidly, leaving future generations better off.

The article also asserts that a weaker dollar, by itself, is not sufficient to bring the current account into balance. Actually, a sharp enough fall in the dollar is enough to bring the current account into balance. As the dollar falls, imports decrease and exports increase. At a sufficiently low value, the decline in the dollar will be large enough to bring exports and imports into balance.

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European Labor Markets

Germany's New Reality 
Peter S. Goodman and Petra Krischok
Washington Post, December 10, 2004, Page E1

This article reports on planned employment cuts in the European automobile industry, which it sees as part of a larger trend of declining employment in European manufacturing. At one point it asserts that "rigid labor rules are blamed for European unemployment rates stuck around 9 percent."

While business oriented economists routinely blame labor market protections for high unemployment, the evidence for this claim is actually rather ambiguous. Some of the European countries with the strongest labor market protections, like Austria, Ireland, and Sweden, typically enjoy lower unemployment rates than the United States. While this is an extensively researched topic, statistical tests have generally found little relationship between labor market protections and unemployment. (See "Unemployment and Labor Market Institutions: The Failure of the Empirical Case for Deregulation,"  .)

The article also asserts that Germany and other European countries can expect a period of declining living standards and high unemployment due to the inclusion of low wage countries in Eastern Europe in the European Union. It is important to note that this was almost never mentioned in news reporting preceding the expansion of the European Union. If the claim is true, then this should have been the major theme of such reporting. It is also worth noting that the prospect of high unemployment rates in west Europe directly contradicts the often- repeated accounts of a labor shortage due to an aging population. A country cannot both have a labor shortage and excessive unemployment, which implies too much labor.

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Productivity Growth

Growth in Productivity Slows; Consumer Borrowing Rises 4.4%
 Associated Press
New York Times, December 8, 2004, Page C2

This article reports on the release of new data on productivity growth in the third quarter, showing that growth was slightly lower than previously reported. The article presents this as positive news, because it may mean that firms have to hire more workers.

In fact, the causation usually goes the other way. When firms begin to hire more workers, reported productivity growth generally slows, since output per worker hour falls.

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China

The Two Faces of China
Keith Bradsher
New York Times, December 6, 2004, Page C1

This article discusses China's prospects for the near future. It raises the prospect of an economic collapse repeatedly, with no clear basis for this assessment. China's economy has been growing at a rate of more than 7 percent annually for almost a quarter century. While there could be a slowdown from this pace, there is no obvious reason to expect a collapse, nor does this article present such a reason.

At one point the article notes that China has a closed financial system and that the government plays a large role in directing investment. It then adds, "Japan's stagnation since the early 1990's suggests that such policies may have limitations." Japan is one of many countries (e.g. South Korea and Taiwan are two other obvious examples) that pursued such policies. Its stagnation over the last fifteen years seems primarily to provide evidence that bad macroeconomic economic policy in the wake of a financial crash can lead to stagnation.

Japan's stagnation provides evidence that China's path is destined to fail in the same way that the Great Depression in the United States provides evidence that more market oriented policies are destined to fail. A sample of one is not very convincing evidence. (The stagnation of Latin America over the last quarter century, during which it was pursuing neo-liberal policies, provides another set of examples.)

The article also includes a paragraph expressing concerns that China may become more internationally competitive if its domestic demand floundered - thereby creating a push for even more exports. Actually, virtually all economists expect that China's currency will be rising in the near future, which will reduce its international competitiveness.

The article also raises the prospect that China will need to be bailed out by the west after a crash of its economy. This does not seem likely, since it holds more than $600 billion in reserves.

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Eastern Europe and the Euro

In Eastern Europe, Skepticism Over the Euro
Mark Landler
New York Times, December 6, 2004, Page C3

This article reports on Eastern European attitudes towards adopting the euro. At one point it reports the claim of the finance minister of Slovakia that "joining the euro zone would add half a percentage point to a full point to his country's annual economic growth." The article then adds "that is modest."

While this estimate is almost certainly a huge overstatement of the benefits to Slovakia of joining the euro, adding 0.5 to 1.0 percentage points to the annual growth rate cannot be called modest. In fact, this impact is more than 10 times as large as the projected impact of many policies, such as trade liberalization, that dominate public debate. It is difficult to think of any policy that could have a comparable economic effect.

At one point the article refers to "bad old habits" and includes on this list the decision by Hungary's Parliament to allow the president to appoint the majority of the governing body of its central bank. It is worth noting that the United States has the same bad old habit - the President appoints seven of the twelve members of the Federal Reserve Board's open market committee, which determines monetary policy in the United States

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Great Lakes Cleanup

Officials Lay Groundwork for Cleanup of Great Lakes
 Michael Janofsky
New York Times, December 4, 2004, Page A12

This article reports on joint plans between the United States and Canada for reducing the amount of pollution in the Great Lakes. The article reports that the plan will require the United States to spend $4 billion over the next five years. It would be helpful to relate this figure to projected federal spending over this period. It is equal to approximately 0.03 percent of projected federal spending over the next five years.

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Superfund

Changes May Be Needed In Superfund, Chief Says
Michael Janofsky
New York Times, December 5, 2004, Page A29

This article reports on a new study issued by the agency that oversees the Superfund saying that as much as $250 billion in additional funding may be needed over the next three decades for cleaning up hazardous waste sites. The article does not indicate whether this projected spending is measured in nominal dollars, or is adjusted for inflation. This is extremely important over such a long time frame, since prices are projected to more than double over the next thirty years. It would be most helpful if this figure were simply expressed as share of projected federal spending over this period, so that readers could get a clear sense of its significance in the budget.