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Virginia Postrel points out that consumer spending is more stable than income.

There are really two different components of income inequality: permanent differences and temporary fluctuations. People tend to base their spending on what they expect their long-term prospects to be.

She points to a paper by Fabrizio Perri and Dirk Krueger.

It is our hypothesis that an increase in the volatility of idiosyncratic labor income has been an important cause of the increase in income inequality, but that it has also caused a change in the development of financial markets, allowing individual households to better insure against idiosyncratic income fluctuations.

In other words, for any individual, the gap between low-income years (think of a law school student) and high-income years (think of a successful lawyer) has widened. The economy has developed more sophisticated financial institutions for enabling people to borrow in their low-income years and to save in their high-income years.

Discussion Question. Other data show that the ratio of personal debt to GDP is near an all-time high. Do these new financial institutions make the economy less fragile with respect to a short recession, but more fragile if the recession deepens and persists?

When the monthly data on employment and unemployment are released, journalists will say something like "These data show that 100,000 people lost their jobs last month." In fact, the number of people who separate from their jobs in any given month is several million. This is made clear by a new set of reports from the Bureau of Labor Statistics, called Job Openings and Labor Transitions.

The report shows that in August U.S. businesses hired 4.8 million new workers. On the other hand, 5.4 million workers separated from their jobs, of which 1.8 million were discharged or laid off (the remainder quit, retired, or separated for other reasons).

The net change in unemployment is the residual between the flows out of jobs and into jobs. Note, however, that people who leave jobs but do not search for new jobs are not counted as unemployed.

In recent years, economists have become increasingly interested in the fact that the "gross flows" are so much larger than the residual. The new reports from the BLS may help to raise the awareness of this phenomenon.

Discussion Question. Do the data on gross flows affect the interpretation of unemployment from the standpoint of macroeconomic theory and policy?

I explain the differences between the Sweetwater and Saltwater schools of economics.

The Sweetwater school views the economist as a prediction-making machine. As long as the economist's predictions are nontrivial and accurate, the underlying assumptions themselves do not need to be examined. By the same token, Sweetwater economists would argue that in order to show that irrational behavior and imperfect markets matter, you must use your theories to make nontrivial and accurate predictions.

It turns out that this philosophy leads to differences in policy positions between Sweetwater economists and Saltwater economists. Saltwater economists see flaws in economic assumptions as a rationale for government intervention, but Sweetwater economists are more skeptical.

Discussion Question. A Sweetwater economist would not look at Microsoft's market share as an indicator of monopoly. What sorts of predictions would a Sweetwater economist make about the software market, and how well are those predictions satisfied by actual behavior?

There is no simple treatment that works in education or for economic growth. On education research, E.D. Hirsch, Jr. says,

If just one factor such as class size is being analyzed, then its relative contribution to student outcomes (which might be co-dependent on many other real-world factors) may not be revealed by even the most careful analysis...And if a whole host of factors are simultaneously evaluated as in “whole-school reform,” it is not just difficult but, despite the claims made for regression analysis, impossible to determine relative causality with confidence.

On economic growth, Jeff Madrick finds that there is no reliable relationship between tax rates and growth.

it seems that quite a few Americans, including economics writers and media hosts, think that low-tax countries unquestionably grow faster than high-tax economies. Right and left, they seem to attribute more rapid growth in America to lower taxes.

What may surprise them is that there is no evidence for that.

In my view, the causal factors in education and economic growth are too complex and interdependent to be studied easily. Here is a parable for a discussion question:

Imagine that you did not know how a lighting system for a room was designed. However, you are confronted with a control panel with 100 up-down switches in random positions. In fact, for the lights to go on, you need to have 8 switches in the "up" position and 7 switches in the "down" position. The other 85 switches do not matter. Moreover, unless all of the 15 critical switches are in the right position, no individual switch has any noticeable effect on the amount of light in the room. How would you go about figuring out how to turn on the lights?

The Treasury Department is mulling tax reform proposals, and this worries Bruce Bartlett

Adopting a VAT [national sales tax], however it is termed, would put the U.S. on a slippery slope toward European levels of taxation and government. The Bush administration will be making a terrible mistake if it starts down that road.

A sales tax can be made to be both efficient (less distortionary and less costly to comply with) and progressive (by exempting some basic necessities). It might be good to use such a tax to replace both the corporate income tax (which creates huge distortions and large compliance costs) and the Social Security tax (which hits the poor the hardest) with a sales tax. But Bartlett thinks that if our tax system were better, that would make it easier for government to raise taxes. So he would prefer a worse tax structure.

Discussion Question. Is the difference between the size of government ain Europe and the United States really due to the VAT?

Here is an extended reply to Paul Krugman's claim that the wealthy are threatening to crush the middle class in the United States.

most economists who examine the income distribution do so because they worry about how to eliminate poverty, not how to eliminate wealth. In making the argument that disparities between the highest earners and median matter in a society with a prosperous middle class, Krugman is breaking new ground.

The idea of focusing on the disparities between high-income and middle-income earners could be a new breakthrough in political economy. Now that Krugman has presented it in the New York Times, it will be interesting to see it discussed by the economics profession at large.

Discussion Question. Are the families in the top 1 percent of the income distribution today the same families that were in the top 1 percent thirty years ago?

Brad DeLong, who usually is more careful than I am, muffs it in his analysis of the data on income distribution.

between 1970 and 1995 we got much slower growth in average incomes than in any other quarter-century, and a huge increase in inequality--so that in a quarter century the middle fifth got the kinds of income gains that we used to expect in a decade. That's not a well-performing economy.

He is treating the incomes in 1995 and in 1970 as if they were earned by the same people. But the data represent the income distributions of two different groups of people.

Suppose instead that you track a given group of people from 1970 to 1995. What you will find is that regardless of which quintile people belonged to in 1970, the majority wind up in the top 40 percent of the income distribution by 1995!

Our economy is a powerful escalator, pulling people up. By 1995, the bottom of the escalator is dominated by new immigrants and young families. If economic growth continues, they will climb the escalator to affluence. I suspect that part of the reason that the period of 1970 to 1995 does not look good from the standpoint of average incomes is that we introduced an unusually large percentage of immigrants to the bottom of the escalator. Bully for us!

Discussion Question. While the majority of the population rode the escalator, some individuals went up in rockets (Michael Dell, Andrew Grove, as well as many others less deserving). Have the rockets gotten out of hand?

One of the fundamental tenets of microeconomics is that markets operate to eliminate shortages. Roger Bate believes that this would alleviate the scarcity of fresh water.

increasing water scarcity has only attracted greater government involvement in water allocation, when the opposite needs to occur. Government has failed. It's time to try the market. A market in water could lead to increased food production as well as reduced water use. And for many parts of the world it would reduce conflict, too.

Discussion Question. Would it be possible to design a market for water in which ownership of water does not become highly concentrated or monopolized?

Steve Roach argues for an old-fashioned model of investment spending.

Back in the Jurassic Era when I was the Fed’s capital spending analyst, we used to monitor a wide variety of capital spending models -- those driven by profits, cash flow, cost-of-capital considerations, and the stock market (Tobin’s "Q"). But the model that always worked the best was derived from the so-called "accelerator theory" -- that business fixed investment was most sensitive to improving demand expectations and the concomitant impact a rising output trajectory would have on capacity utilization. If pressures on existing capacity were likely to get more intense, then you probably needed more of it -- it was that simple. For all of the reasons noted above, in today’s subdued demand climate, the accelerator effect is likely to remain muted, thereby continuing to inhibit business capital spending.

On a personal note, I was Roach's research assistant at the Fed in the Jurassic Era.

Overall, Roach is arguing for another old-fashioned idea, which is that monetary policy is "pushing on a string" in trying to stimulate the economy. The notion is that when the economy is slumping and expectations are pessimistic, lower interest rates will not be sufficient to boost spending.

Discussion Question. Lower interest rates have the potential to boost consumer spending, housing investment, business investment, and net exports. What are the factors inhibiting each of these channels in today's economy?

After reading a story predicting continued increases in computer power, I tried to come up with a simple way of conveying how this might have an impact on economic growth.

Suppose that in 1987, fifteen years ago, the noncomputer sector was 99.5 percent of the economy, and the computer sector was only 0.5 percent of the economy. Then the average growth rate would be (.995 times 1) plus (.005 times 20), or about 1.1 percent...

But in another ten years, computers will be 27 percent of the economy. If computers are still improving at a rate of 20 percent per year at that point, overall growth will be (.73 times 1) plus (.27 times 20), or 6.4 percent!

Brad DeLong then accused me of using a Laspeyres price index to arrive at my 20 percent growth assumption for the computer sector. In fact, I was just taking a wild guess. He makes the point that an increased share of computers in the economy depends on our ability to come up with uses for enhanced computer power.

Discussion Question. New Growth Theory, as I understand it, says that technological change is endogenous. Would New Growth Theory say that if computers are getting faster, that is because the demand is there for faster computers?